Managing geopolitical risk in petroleum markets

Petroleum market insecurity arising from geopolitical events is a perennial concern. The rise of modern industrial economies and global conflicts has made secure supply paramount. Although instances of actual disruption are rare, there has been a perception, especially since petroleum markets have evolved from bilateral relationships between oil majors and oil-exporting countries to become a traded commodity, that geopolitical risks are a threat to secure supply. By examining historical shocks to petroleum markets, we highlight the use of futures and options derivatives to manage risk during extreme conditions, challenging the view that concerns over supply disruption are warranted. Although the utility of futures and options markets in managing “day-to-day” firm-level exposure is acknowledged, concerns remain that derivatives markets can neither handle the risks associated with historic geopolitical shocks nor yield macro benefits. Using historical data on trader intentions and commercial and non-commercial activity from various exchanges, we find that positioning is statistically related to both volatility and price level. Faced with geopolitical risk, price instability and stochastic volatility, positions can be taken to mitigate exposure while yielding social benefits in stabilizing markets. Further, notwithstanding perceptions of insecurity, we show using option theory that market participants attach a low probability to illiquidity or price extremums during geopolitical events. Finally, we address the extent to which the specifications of option models present a limitation to managing the risks associated with exogenous perturbations. Our results support the argument that the existence of geopolitical risk is manageable and historical concerns over market insecurity are exaggerated.