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In this paper we try to measure oil price uncertainty. The measure of uncertainty is based on the conditional standard deviations. The time-varying conditional standard deviations are estimated using univariate (G)ARCH moels.

We focus on volatility of the price of a barrel Brent crude, over the period 5 January, 1982 to 23 April, 2002 representing 5296 daily observations. The preferred model is a symmetric GARCH(1,3) model. Asymmetric leverage effects are not found. We also examine the volatility in monthly time series for the period January, 1970 to April, 2002. For this time span and frequency we prefer the GARCH(1,1) model. .H\ZRUGV Volatility, ARCH, Oil prices -(/ &ODVVLILFDWLRQ C22, Q43 Also downloadable in electronic version: http://som.rug.nl/

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In many economic time series applications there is reason to believe that the variance of the error term varies over time with the volatility of errors in the past. This clustering of large and small errors may be observed for exchange rates, stock rate returns, interest rates, irreversible investments and option pricing. Volatility clustering is apparent in Figure 1. This figure plots the daily price of Brent crude oil (log-differenced). The implication of volatility clustering is that volatility shocks today influence the expectation of volatility many periods in the future.

.2 .1 .0 -.1 -.2 -.3 -.4 -.5 82 84 86 88 90 92 94 96 98 00

Figure 1. Daily the price of Brent crude (US$ per barrel), log-differenced.
2

In this paper we try to understand the nature of dependence of the conditional variance on past volatility in oil prices. The conditional standard deviation is interpreted as a measure of uncertainty. As far as the question of model selection is concerned we follow an unpublished paper by Engle and Patton (2001).

Section 2 briefly explains ARCH models, while Sections 3 to 5 are about modelling GARCH models for different frequencies and time spans. Section 6 defines the measures of uncertainty. Section 7 concludes.

 $5&+ PRGHOV
From an econometric point of view, neglecting the exact nature of the dependence of the variance of the error term conditional on past volatility results in loss of efficiency. ARCH models are developed to model timevarying conditional variances (see Bollerslev et al., 1994). ARCH models consist basically of two equations, one for the mean and one for the conditional variance. The mean equation can be univariate or may contain other variables (multivariate): \ = [ + . The mean equation may also
W W W

include the conditional variance or the conditional standard deviation (ARCHin-Mean models). The specification for the conditional variance may allow for asymmetric effects, LH positive errors have a different effect on future variances than negative errors. Here we start with a symmetric univariate specification.

In applications using daily data the error variance depends on past volatilities going back a number of periods. For these applications GARCH (generalised ARCH) models are developed. The GARCH(ST) model has S ARCH terms and T GARCH terms (the values of S and T are determined by the Schwarz Information Criterion):

2 = 0 + 2 + 2
W L W L M W L

=1

=1

It is commonly assumed that the innovations are Gaussian. If this

W

assumption is violated the usual standard errors are not consistent and the quasi-maximum likelihood covariances and standard errors described by Bollerslev and Wooldridge (1992) have to be used. The tables with the estimation results below report these robust standard errors. The simplest GARCH model is the GARCH(1,1) model that in many applications provides a good description of the data. The error variance depends on all past volatilities with geometrically declining weights as long as 1 < 1 . Welldefined conditional variances require that the parameters 0 , 1 , 1 are non in the GARCH(1,1) 1 + negative. In many applications the estimate for 1

model is close to unity, which means that the model is not covariance stationary. In that case the model can be used only to describe short-term volatility.

Note that in the symmetrical model, the conditional variance is a function of the size and not of the sign of lagged residuals.

 0RGHOOLQJ RLO SULFH YRODWLOLW\

In this paper we focus on volatility of the price of a barrel Brent crude, over the period 5 January, 1982 to 23 April, 2002 representing 5296 daily observations (source: Datastream. Series code: OILBREN). These prices are plotted in Figure 2. Appendix A lists some major political and economical factors that have influenced the oil market and the oil prices.

44 40 36 32 28 24 20 16 12 8 82 84 86 88 90 92 94 96 98 00

Figure 2. Daily prices of Brent crude (US$ per barrel).

We assume that the level of the oil price is not stationary. Formal unit-root tests (including a constant, no trend and 10 lags) reject the hypothesis of a unit root at 5% (the ADF test statistic equals -3.271, 5% critical value equals
5

2.863). However, these tests have only little power if errors are not homogeneous (Kim and Schmidt, 1993). Furthermore, the power of unit root tests depends more on the span of the data, which in our case is only 20 years, than on the number of observations (Perron and Shiller, 1985). Moreover, the presence of structural breaks reduces the power of unit root tests also (Perron, 1989). More details on unit roots, structural breaks and trends can be found in Stock (1994). In this paper we use the log-differenced price of a barrel Brent crude. Table 1 summarises the data.

This table shows that the average is about zero and the standard deviation is 0.023. The log-differenced oil prices are asymmetrically distributed and the lower tail of the distribution is thicker than the upper tail (negative skewness), and the tails of the distribution are thicker than the normal (kurtosis coefficient>3). Correlograms of the log-differenced oil prices and of the squared log-differenced oil prices suggests weak dependence in the mean (only a few significant lags) but substantial dependence in the volatility (see Table 2).

Table 1. Log-differenced price of Brent crude (US$ per barrel), summary statistics Mean Standard Deviation Skewness Kurtosis -5.88E-05 0.022945 -1.245912 34.99789

6\PPHWULF VSHFLILFDWLRQ We use a simply univariate model GARCH (S,T) model in which the mean is assumed to be constant as is suggested by the autocorrelations in Table 2 .

Table 2. Autocorrelations of the level of daily log-differenced price of Brent crude (US$ per barrel) and the squared daily log-differenced price of Brent crude Lags 1 2 3 4 5 6 7 8 9 10 Level  -0.024  -0.025 0.001   -0.019 0.022  Squared      0.025 0.022    Lags 11 12 13 14 15 16 17 18 19 20 Level 0.014 -0.020 0.006 0.022 0.026 0.002 -0.008 0.014 -0.010 0.010 Squared      0.012 0.020  0.016 

Bold: significantly different from zero at (approximately) the 5% significance level. The Schwarz Information Criterion suggests that S=1 and T=3. The results are in Table 3.

Table 3. GARCH(1,3) model results, 5 January, 1982 to 23 April, 2002 Coefficient Mean equation Constant Variance equation 0.000100 0.000213 Robust standard error

0 , Constant

1.64E-06 0.043112 2.278829 -2.046053 0.725680 Statistic 12.92877 11.010

M M

7.10E-08 0.007825 0.054223 0.079137 0.039443 Probability 0.880419 0.946 0.599428

1 , ARCH(1) 1 , GARCH(1)

2 , GARCH(2)
3 , GARCH(3)
Diagnostics ARCH LM (20 lags) Q (20th lag)

=1 1 + Wald:

0.275860

The ARCH LM test indicates that there is no autoregressive conditional heteroskedasticity up to order 20 in the residuals. An alternative test is the Ljung-Box Q-statistic of the standardized squared residuals. At the twentieth lag Q equals 11.010, indicating that the standardized squared residuals are serially uncorrelated. From these tests we conclude that the volatility model is adequate. The Wald test clearly indicates that the volatility process does not return to its mean. This means that the model can be used only to describe short-term volatility. Volatility is plotted in Figure 3 that shows the conditional standard deviation of the GARCH(1,3) model.
8

.20

.16

.12

.08

.04

.00 82 84 86 88 90 92 94 96 98 00

Figure 3. GARCH(1,3) conditional standard deviation

$V\PPHWULF VSHFLILFDWLRQV As mentioned earlier, in the symmetrical model the conditional variance is a function of the size and not of the sign of lagged residuals. One way to allow for asymmetries is the Threshold GARCH (TARCH) model:

2 = 0 + 2 + 2 + 1 2
W L W L M W M W W L

=1

=1

where = 1 if < 0 , and 0 otherwise. The coefficient measures the leverage

W W

effect. In theory there may be many leverage effects, Eviews only allows for one. The results for the TARCH(1,1,3) model are in Table 4.
9

In this model, good news ( < 0 ) and bad news ( > 0 ) have different effects
W W

on the conditional variance. Good news has an impact of 1 , while bad news has an impact of 1 + . The leverage effect term is not significantly positive (even with a one-sided test) so there does not appear to be an asymmetric effect.

An alternative, and popular model, that allows for asymmetric shocks to volatility is the Exponential GARCH (EGARCH) model:

ln 2 = 0 +
W L

( )

=1

+ ln ( 2 ) + =1 =1
T S W L M W M W L M L

W W

The coefficients

measure the leverage effects. The results for the

EGARCH(1,3) are presented in Table 4, and imply that there are no asymmetric effects ( = 0 ).

10

Table 4. Asymmetric ARCH model results, 5 January, 1982 to 23 April, 2002 TARCH(1,1,3) Coefficient Robust standard error Mean equation Constant Variance equation 0 , Constant -0.000128 0.000204 0.001273 0.000387 EGARCH(1,3) Coefficient Robust standard error

3.09E-06 0.084260 0.076147 1.083399 -0.857373 0.661459 Statistic 1.353697 25.259 1.164522

2.11E-06 0.020539 0.060497 0.070263 0.156568 0.099630 Probability 0.133845 0.192 0.280579

-0.766997 0.379711 -0.018730 0.377280 0.427833 0.130200 Statistic 1.459749 21.001 17.82720

0.377393 0.106758 0.050906 0.228842 0.217882 0.200065 Probability 0.084580 0.397 0.000025

1 , ARCH(1)
, Leverage

1 , GARCH(1)

2 , GARCH(2)
3 , GARCH(3)
Diagnostics ARCH LM (20 lags) Q (20th lag) Wald: =1 1 +
M M

 *$5&+ PRGHOV DW D GLIIHUHQW IUHTXHQF\

It is known that the GARCH model depends on the frequency of the data (Engle and Patton, 2001). In this section we specify a GARCH model for oil prices based on monthly data for the same period as before: January, 1982 to April, 2002 representing 243 observations (source: Datastream. Series code:
11

OILBREN). The log-differenced monthly oil prices are slightly negatively skewed and the tails of the distribution are thicker than the normal. Figure 4 again reveals volatility clustering.
.6 .4 .2 .0 -.2 -.4 -.6 82 84 86 88 90 92 94 96 98 00

Figure 4. Monthly log-differenced the price of Brent crude (US$ per barrel)

Table 5. Log-differenced monthly price of Brent crude (US$ per barrel), summary statistics Mean Standard Deviation Skewness Kurtosis -0.001547 0.106620 -0.205274 7.639494
12

Table 6. GARCH(1,2) model results, January, 1982 to April, 2002 Coefficient Mean equation Constant Variance equation -0.005372 0.003748 Robust standard error

0 , Constant

0.000147 0.636781 -0.006866 0.520726 Statistic 11.98145 12.292

M M

0.000145 0.148259 0.022229 0.065329 Probability 0.286300 0.266 0.149570

1 , ARCH(1) 1 , GARCH(1)

2 , GARCH(2)
Diagnostics ARCH LM (10 lags) Q (10th lag)

=1 1 + Wald:

2.076629

The Schwarz Information Criterion suggests that S=1 and T=2. The results of the GARCH(1,2) model are in Table 6. Table 6 shows that there is no autoregressive conditional heteroskedasticity up to order 10 in the residuals. At the tenth lag Q equals 12.292, indicating that the standardized squared residuals are serially uncorrelated. The Wald test again clearly indicates that the volatility process does not return to its mean. Volatility is plotted in Figure 5 that shows the conditional standard deviation of the GARCH(1,2) model.

13

.5

.4

.3

.2

.1

.0 82 84 86 88 90 92 94 96 98 00

Figure 5. GARCH(1,2) conditional standard deviation

We do not report results for the TARCH and EGARCH models since leverage effects are not significant.

14

 *$5&+ PRGHOV XVLQJ D GLIIHUHQW VDPSOH SHULRG

Finally, we examine a longer monthly time series for the period January, 1970 to April, 2002 representing 387 observations.
40

30

20

10

0 1975 1980 1985 1990 1995 2000

Figure 6. Monthly refiner acquisition cost of imported crude oil (US$ per barrel)

These monthly prices of imported crude oil are taken from the Energy Information Administration (http://www.eia.doe.gov/emeu/cabs/chron.html). Figure 6 plots the level of this series and Figure 7 plots the log-differences. Volatility clustering is clearly present.

15

1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 1970

1975

1980

1985

1990

1995

2000

Figure 7. Monthly log-differenced acquisition cost of imported crude oil (US$ per barrel)

For this longer span, unit-root tests (including a constant, no trend and 4 lags) do not reject the hypothesis of a unit root at 5%. The ADF test statistic equals 2.204 which, in absolute value, is smaller than the 5% critical value equals 2.8693. However, as we have noted before these tests have only little power if errors are not homogeneous.

For this longer monthly time series the preferred model, based on the Schwarz Information Criterion, is GARCH(1,1).

16

Table 7. GARCH(1,1) model results, January, 1970 to April, 2002 Coefficient Mean equation Constant Variance equation 0.005682 0.003235 Robust standard error

0 , Constant

0.001276 0.524305 0.394720 Statistic 12.48495 12.503 0.102330

0.000979 0.229117 0.150115 Probability 0.253910 0.253 0.749051

1 , ARCH(1) 1 , GARCH(1)
Diagnostics ARCH LM (10 lags) Q (10 lag)
=1 1 + Wald: 1
th

The results in Table 7 indicate no autoregressive conditional heteroskedasticity up to order 10 in the residuals. This is confirmed by the Q-test: At the tenth lag Q equals 12.503, indicating no serially correlated squared standardised residuals. From the Wald test we conclude that the model is covariance stationary (the sum of the coefficients equals 0.919) and converges to 0.001276/(1-0.919)=0.016. Figure 8 plots the corresponding conditional volatility.

17

.6 .5 .4 .3 .2 .1 .0 1975 1980 1985 1990 1995 2000

Figure 8. GARCH(1,1) conditional standard deviation

 0HDVXUHV RI XQFHUWDLQW\
The ARCH models in the previous sections generate conditional standard deviations. This information will be used to compute measures of uncertainty on an annual basis since these measures will be used, in the next section, in models based on annual data.

The measure of uncertainty we choose is the within-year high-low range of the conditional standard deviations (see also Bollerslev et al., 1994, p. 3012). It is

18

likely that the higher the uncertainty, the higher the high-low range within a year will be.

Depending on the frequency of the data (daily and monthly) and the length of the sample period (1970-2001 and 1982-2001) we construct three measures of uncertainty. Using the daily data, the within-year high-low range is calculated as

9 range 9 max 9 min =

W W W

[1 Jan, W ;31Dec, W ]

max

,
W

[1 Jan, W ;31Dec, W ]

min

where , is the conditional standard deviation for day in year W. This series
W

is labelled DAILY in Figure 9. Similarly, we calculate uncertainty measures based on the monthly time series for two samples: 1970-2001 and 1982-2001, labelled as MONTHLY1 and MONTHLY2, respectively. These three measures are plotted in Figure 9 also.

The differences in the levels result from differences in the number of observations in each of the experiments. The volatility measures based on the same data source, DAILY and MONTHLY2 are highly correlated, as is shown in Table 8. The correlation between measures based on a different data set, DAILY and MONTHLY1, are weakly correlated.

19

.20 MONTHLY2 MONTHLY1 DAILY (RIGHT AXIS) .6 .5 .4 .3 .2 .1 .0 1970 1975 1980 1985 1990 1995 2000 .00 .16 .12 .08 .04

Figure 9. Within-year high-low ranges

Table 8. Correlation matrix MONTHLY2 MONTHLY1 DAILY MONTHLY2 1.000000 0.812107 0.867505 MONTHLY1 0.812107 1.000000 0.536319 DAILY 0.867505 0.536319 1.000000 Alternatively, we also may use both the within-year maximum conditional standard deviation and the within-year minimum conditional standard deviation (for the period 1970-2001, these series are shown in Figure 10).

20

.6 Vmax .5 .4 .3 .2 .1 .0 1970 Vmin

1975

1980

1985

1990

1995

2000

Figure 10. Within-year maximum and minimum conditional standard deviations

 &RQFOXVLRQV
In this paper we try to understand the nature of dependence of the conditional variance on past volatility in oil prices. Time-varying conditional variances are estimated using univariate (G)ARCH models. We focus on volatility of the price of a barrel Brent crude, over the period 5 January, 1982 to 23 April, 2002 representing 5296 observations. The preferred model is a symmetric GARCH(1,3) model. Asymmetric leverage effect are not found.
21

GARCH models depend on the frequency of the data, so we also examine monthly time series for the period January, 1970 to April, 2002 and for a subsample consisting of the same years as our daily time series.

The measure of uncertainty we choose is the within-year high-low range of the conditional standard deviations.

22

5HIHUHQFHV
Bollerslev, T., R.F. Engle and D.B. Nelson (1994), ARCH Models, Handbook of Econometrics, 4, Chapter 49, pp. 2959-3038.

Bollerslev, T. and J. M. Wooldridge (1992), Quasi-Maximum Likelihood Estimation and Inference in Dynamic Models with Time Varying Covariances, Econometric Reviews, 11, pp. 143-172.

Engle, R.F. and A.J. Patton (2001), What Good is a Volatility Model?, unpublished paper.

Kim, K. and P. Schmidt (1993), Unit Root Tests with Conditional Heteroskedasticity, Journal of Econometrics, 59(3), pp. 287-300.

Perron, P. (1989), The Great Crash, the Oil Price Shock and the Unit Root Hypothesis, Econometrica, 57, pp. 1357-1361.

Perron, P. and R.J. Shiller (1985), Testing the Random Walk Hypothesis: Power versus Frequency of Observation, Economics Letters, 18(3), pp. 381386.

Stock, J.H. (1994), Unit Roots, Structural Breaks and Trends, Handbook of Econometrics, 4, Chapter 46, pp. 2739-2841.

23

$SSHQGL[ $ 2LO 3ULFH &KURQRORJLHV  

Below are some major factors that have influenced world oil markets and the oil price. An extensive chronology was originally published by the Department of Energys Office of the Strategic Petroleum Reserve, Analysis Division. Updates for 1995-2001 are from the Energy Information Administration (source: http://www.eia.doe.gov/emeu/cabs/chron.html).

1973-1974 Oil embargo begins (October 19-20, 1973) Oil embargo ends (March 18, 1974)

1979-1982 Iranian revolution; Shah deposed OPEC raises prices 14.5% on April 1, 1979 and OPEC raises prices 15% Iran takes hostages; President Carter halts imports from Iran Saudis raise marker crude price from 19$/bbl to 26$/bbl Kuwait, Iran, and Libya production cuts drop OPEC oil production to 27 million b/d Saudi Light raised to $28/bbl, Saudi Light raised to $34/bbl First major fighting in Iran-Iraq War

1983-1986 Libya initiates discounts OPEC cuts prices by $5/bbl and agrees to 17.5 million b/d output Norway, United Kingdom, and Nigeria cut prices OPEC accord cuts Saudi Light price to $28/bbl
24

1990-1991 Iraq invades Kuwait Operation Desert Storm begins Persian Gulf war ends

1996-2001 U.S. launches cruise missile attacks into southern Iraq following an Iraqisupported invasion of Kurdish safe haven areas in northern Iraq. Prices rise as Iraqs refusal to allow United Nations weapons inspectors into "sensitive" sites raises tensions in the oil-rich Middle East. OPEC raises its production ceiling. This is the first increase in 4 years. World oil supply increases by 2.25 million barrels per day in 1997, the largest annual increase since 1988. Oil prices continue to plummet as increased production from Iraq coincides with no growth in Asian oil demand due to the Asian economic crisis and increases in world oil inventories following two unusually warm winters. Oil prices triple between January 1999 and September 2000 due to strong world oil demand, OPEC oil production cutbacks, and other factors, including weather and low oil stock levels. Oil prices fall due to weak world demand (largely as a result of economic recession in the United States) and OPEC overproduction. Oil prices decline sharply following the September 11, 2001 terrorist attacks on the United States, largely on increased fears of a sharper worldwide economic downturn (and therefore sharply lower oil demand).

25