ENERGY SECURITY Coping with Oil Price Volatility Robert Bacon Masami Kojima Energy Sector Management Assistance Program Energy Sector Management Assistance Program (ESMAP) Purpose The Energy Sector Management Assistance Program is a global technical assistance partnership administered by the World Bank and sponsored by bilateral offi cial donors since 1983. ESMAP’s mission is to promote the role of energy in poverty reduction and economic growth in an environmentally responsible manner. Its work applies to low-income, emerging, and transition economies and contributes to the achievement of internationally agreed development goals. 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Washington, DC 20433, USA Tel.: 202-458-2321; Fax: 202-522-3018 ENERGY SECURITY Special Report 005/08 Coping with Oil Price Volatility Robert Bacon Masami Kojima Energy Sector Management Assistance Program Contents Acknowledgments ix Abbreviations and Acronyms xi Executive Summary xiii 1 Context 1 Oil Price Trends 1 Effects of Oil Price Volatility 2 Report Structure 3 2 Measurement of Oil Price Volatility 5 Trends, Cycles, and Volatility: Measurement and Statistical Analysis 5 Statistical Analysis of Oil Prices 8 3 Statistical Analysis of U.S. Gulf Coast Prices 9 Are Crude Oil Prices Stationary? 9 Are Oil Product Prices Stationary? 10 Construction of Filtered Series 10 Volatility of Returns 11 4 Application to Prices in Developing Countries 19 Chile 19 Ghana 21 India 23 The Philippines 24 Thailand 25 Observations 27 5 Hedging 29 Role of Hedging 29 Hedging with Futures Contracts 31 Costs of Running a Hedging Program 33 Estimation of Hedge Ratios, the Effi ciency of Hedging, and Returns from Hedging 35 Use of Options 39 Issues in Operating an Oil Hedging Program 41 6 Security Stocks and Price Hikes 47 Supply Disruptions 47 The Operation of a Two-Period Price-Smoothing Security Stock Scheme 50 Simulation of a Security Stock Scheme between 1986 and 2007 52 International Experience with Strategic Petroleum Reserves 56 iii iv Special Report Coping with Oil Price Volatility 7 Price-Smoothing Schemes 59 Setting a Target Price 59 Case Studies in Price Smoothing 65 Assessment 67 8 Tackling Oil Intensity and Diversifi cation 69 Oil Share of GDP and Intensity 69 Relative Price Levels and Price Volatility 72 Energy Diversifi cation Index and Oil Share of Primary Energy 76 Policies for Reducing Dependence on Oil 78 9 Conclusions 81 Statistical Analysis of Price Volatility 81 Hedging 83 Strategic Stocks 84 Price-Smoothing Schemes 84 Reducing the Importance of Oil Consumption 84 Annexes 1 Impact of Fiscal Parameters on Government Oil Revenue 87 2 Statistical Methods 93 3 Statistical Analysis of U.S. Gulf Coast Prices 97 4 Statistical Analysis of Developing Country Prices 115 5 Hedging Parameters 141 6 Price-Smoothing Formulae 145 Glossary 147 References 149 Boxes 5.1 Sasol’s Hedging Experience 29 6.1 Experiences with Other Commodities 47 Figures 1.1 Monthly Average Spot Price of WTI Crude 1 3.1 Weekly Nominal Prices of WTI Crude and HP Filter 11 3.2 Weekly Real Prices of WTI Crude and HP Filter 11 3.3 Weekly Real Prices of Gasoline in the U.S. Gulf Coast and HP Filter 11 3.4 Returns on Weekly Real WTI Crude Prices 12 3.5 Returns on Weekly Real Gasoline Prices in theU.S. Gulf Coast 12 5.1 Spot and Futures Prices of WTI Crude 43 7.1 WTI Crude Monthly and Six-Month Moving Average Prices 61 7.2 Cumulative Cost of Regulating the Price of Crude Oil with Lagged Three- and Six-Month Moving Averages 62 7.3 Thai Oil Fund Financial Status 66 7.4 Actual and Hypothetical Diesel Prices in Thailand, January 2002–September 2007 66 8.1 Historical Oil Share of GDP for Select Countries 70 8.2 Historical Oil Intensity for Select Countries 71 8.3 Historical Oil, Gas, and Coal Prices 72 8.4 Volatility of Historical Oil and Coal Prices 74 8.5 Volatility of Historical Gas and Coal Prices 74 8.6 Historical HHDI for Select Countries 77 8.7 Historical Oil Share of Primary Energy for Select Countries 78 A1.1 Production Profi le of Each Field 87 Contents v A1.2 Aggregate Production Profi le of All Fields 87 A1.3 Oil Prices Used in the Calculations 88 A1.4 Production-Sharing Revenue Flow 88 A1.5 Government Revenue from First Field to Come on Stream 90 A1.6 Government Revenue from Sixth Field to Come on Stream 90 A1.7 Government Revenue from All Fields 90 A3.1 Forecast of Returns of Logarithms of WTI Crude Daily Spot Prices and Variance of Returns, April 4–November 14, 2007 104 Tables 1 Ratio of Price Increase in U.S. Dollars to Increase in Local Currency Units, January 2004–January 2008 xiv 2 Statistics on Monthly Spot Oil and Oil Product Prices xiv 3.1 ADF Test Results for WTI Crude Oil 9 3.2 ADF Test Statistics for Monthly U.S. Gulf Coast Oil Product Prices 10 3.3 Standard Deviation of Returns for Logarithms of Nominal WTI Crude and U.S. Gulf Coast Oil Product Prices 12 3.4 Variance Equality Tests for Returns for Nominal WTI Crude and U.S. Gulf Coast Oil Product Prices 14 3.5 GARCH Analysis of Returns of Logarithms of Nominal Daily Prices 15 3.6 GARCH Analysis of Returns of Logarithms of Nominal Weekly Prices 16 3.7 GARCH of Returns of Logarithms of Nominal Monthly Prices 17 3.8 Runs on Cumulative Cycles of Nominal Prices, September 1995–March 2007 17 4.1 Difference between Percentage Price Increase in U.S. Dollars to That in Chilean Pesos 20 4.2 GARCH Analysis of Returns of Logarithms of Nominal Monthly Prices in Chilean Pesos 21 4.3 Cumulative Cycles of Nominal Monthly Chilean Prices, July 1999–March 2007 21 4.4 Difference between Percentage Price Increase in U.S. Dollars to That in Ghanaian Cedis 22 4.5 GARCH Analysis of Returns of Logarithms of Nominal Monthly Prices in Ghanaian Cedis 22 4.6 Cumulative Cycles of Nominal Monthly Ghanaian Prices, July 1999–March 2007 22 4.7 Difference between Percentage Price Increase in U.S. Dollars to That in Indian Rupees 23 4.8 GARCH Analysis of Returns of Logarithms of Nominal Monthly Prices in Indian Rupees 23 4.9 Cumulative Cycles of Nominal Monthly Indian Prices, July 1999–March 2007 24 4.10 Difference between Percentage Price Increase in U.S. Dollars to That in Philippine Pesos 24 4.11 GARCH Analysis of Returns of Logarithms of Nominal Monthly Prices in Philippine Pesos 25 4.12 Cumulative Cycles of Nominal Monthly Philippine Prices, July 1999–March 2007 25 4.13 Difference between Percentage Price Increase in U.S.