REVIEWARTICLE

Zoheir EBRAHIM, Oliver R. INDERWILDI, David A. KING

Macroeconomic impacts of oil price volatility: mitigation andresilience

© Higher Education Press and Springer-Verlag Berlin Heidelberg 2014

Abstract Dependency on oil-derived fuels in varioussectors, most notably in mobility, has left the globaleconomy vulnerable to several macroeconomic economicside effects. Numerous studies have addressed the effect ofprice volatility on specific economic parameters. However,the current literature lacks a comprehensive review of theinteractions between global macroeconomic performanceand oil price volatility (OPV). Price volatility is intrinsic incommodity markets, but has been advancing at a faster ratein the crude oil market in comparison to other commoditiesover the past decade, reflecting the status of oil as the mostglobalised commodity. In this paper, the analyticalliterature review and analysis of the behavioral responsesof macroeconomic agents to OPV shows that suchvolatility has several damaging and destabilizing macro-economic impacts that will present a fundamental barrier tofuture sustainable economic growth if left unchecked. Toensure macroeconomic isolation from OPV, a combinationof supply and demand-side policies have been recom-mended that can help to mitigate and build resilience to theeconomic uncertainty advanced by OPV.

Keywords conventional oil, price volatility, macroecon-omy, economic stability, energy security

1 Introduction

Not long ago, anyone who had mentioned that the UnitedStates would likely become energy independent or wouldhave said that they could consider exporting fossil

resources would have received roaring laughter. Theenergy market in North America has, however, undergonea full transformation and neither energy independence northe US as a fuel exporting country is an unrealisticassumption. This is good news for the economy as will belaid out in this study, but bad news for greenhouse gasemission and looming climate change, as one of us hasexplained in a publication co-authored with Friedrichs [1].But is it really the price of energy commodities thatimpacts macroeconomic stability and growth? In thispaper, the effect of the price of energy resources onmacroeconomic issues will be assessed comprehensivelyusing the obvious choice — oil.Fossil fuels have represented the lifeblood of the global

economy ever since the long-term trajectory shift in globaloutput, income, and population growth, led by theIndustrial Revolution. Today, world energy consumptioncontinues to be dominated by fossil fuels, which constitutealmost 90% of the global energy mix [2], and in particularby crude oil, which displaced coal as the dominant worldfuel source in the mid-1950s. However, the burgeoning useof oil has come at both a significant environmental andeconomic cost, the latter in part reflecting the significantmacroeconomic uncertainty associated with oil pricevolatility (hereafter referred to as OPV).OPV is defined as the standard deviation of oil prices in a

given period. The economic uncertainty generated by theextreme volatility of oil prices has important consequencesfor the global economy that differ markedly from theimpacts of oil price shocks.1) While the economy-wideimplications of oil price shocks as well as the upside anddownside potential in oil prices have been extensivelystudied, the literature examining the macroeconomiceffects of OPV remains relatively underdeveloped.Through a comprehensive survey of the OPV literature,this paper highlights the fundamental concerns posed byprice volatility for the global economy and examines the

Received September 27, 2013; accepted November 18, 2013

Zoheir EBRAHIM, Oliver R. INDERWILDI (✉), David A. KINGSmith School of Enterprise and the Environment, University of Oxford,Oxford, OX1 3QY, United KingdomE-mail: Oliver.Inderwildi@weforum.org

1) An oil price shock is a manifestation of extreme volatility. For the purposes of the present study, which focuses on oil price volatility as opposed to shocks, itis reasonable to understand the distinction between both measures in terms of the size of price deviations. Acute deviations in oil prices, such as those seen inearly 2008 are termed shocks, while relatively minor price deviations are referred to as price volatility.

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behavioral responses of macroeconomic agents to OPV,with a view to highlighting the policy trade-offs involvedwith minimising volatility and its associated economicrisks. The results of this paper will inform the supply anddemand-side priorities for policymakers who are facedwith the challenging task of minimising adverse macro-economic impacts associated with OPV.The nature of oil prices changed fundamentally after the

1973 oil embargo by the Organisation of Arab PetroleumExporting Countries (OAPEC). Prior to 1973, for instance,US oil prices displayed low volatility across broad timeperiods and approximated a step function, due to thedistinct regulatory structure of the oil industry from 1948to 1972 in which state regulatory services such as the TexasRailroad Commission assigned permissible productionlevels based on their one-month-ahead forecasts ofpetroleum demand [3]. Post-1973, oil prices began toexhibit nonlinearity and unprecedented levels of volatility,a characteristic that has increased sharply during the majorsupply disruptions over the past four decades, and whichcontinues to typify the oil market today. Oil prices reachedtheir historical high of $147 per barrel midway through2008, only to drop sharply to below $40 per barrel by theend of the year. Such acute oil price deviations haveincreased the vulnerability of the global economy to crisesby generating considerable economic uncertainty. Figure 1depicts the average monthly nominal Brent Crude price(US dollars) and standard deviation from 1988 to 2013.The inception of the International Energy Agency (IEA)

in November 1974 was a direct response to the pricevolatility impacts of the 1973-1974 OAPEC oil embargo.The foundational remit of this institution delineated itscoordinative role in assisting member countries to issue acollective response to major disruptions in oil supply

through the release of emergency oil stocks to markets [4].This core energy security mechanism, which still remainsthe nucleus of the IEA today, requires that IEA membercountries maintain emergency oil reserves equal to thevalue of 90 days of net oil imports so that the economicrepercussions of significant supply-side oil shocks can bemitigated through their release. The US Strategic Petro-leum Reserve, which has the capacity to hold 727 millionbarrels of oil, is the largest such emergency reserve ofcrude oil in the world [5]. However, while the IEA securitymechanisms provide an effective supply-side risk manage-ment solution, they are unable to entirely reduce OPVbecause the supply of oil is characterized by significantinelasticity (vide infra) and because supply-side oildisruptions only partially drive price volatility.

2 Drivers of OPV

Reflecting the status of oil as the most globalisedcommodity, oil prices have historically exhibited greaterlevels of volatility than other commodities and asset prices[6]. There are three main drivers of OPV: characteristics ofoil market fundamentals, speculation in the oil derivativesmarket, and inadequacies in oil market data.

2.1 Characteristics of oil market fundamentals

The physical demand and supply of oil constitute thefundamentals of the oil market. The short-run demand andsupply of oil are both strongly price inelastic [7], meaningthat marginal changes in either oil demand or supplyinduce greater than proportional oil price changes and,often, large price deviations. From a long-term perspective,

Fig. 1 Average monthly nominal Brent Crude price (US dollars) and standard deviation from 1988 to 2013

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growth in OPV has been primarily attributable to thedecrease in the price elasticities of both oil supply anddemand since the mid-1980s [8]. Over the past decade, thetransition of both oil demand and supply toward a moreinelastic state has become particularly apparent. Despitethe unprecedented demand-led growth in oil prices overthe 2003-2008 period, for instance, conventional crude oilproduction stagnated from 2005 to 2008 [9]. In contrast,global oil demand, remained resilient, as increases in thedemand for oil in the BRICs and the Middle East, morethan offset decreases in the demand for oil in WesternEurope and North America.The increasing inelasticity of oil supply has been fuelled

by several factors, most notably decreasing conventionaloil production capacity and rates of new discovery, as wellas blockages to new oil market investment. Infrastructuralinvestment in the oil sector in Iraq, for example, has beenmore-or-less stationary over the past decade, reflecting asignificant investment risk due to political and nationalinstability. And while unconventional oil reserves arepresently seeing increasing rates of exploitation in manycountries around the world, slower production rates incomparison to conventional reserves are significantlyreducing the pace at which producers are now able torespond to price changes [10].Demand-side inelasticity has been primarily driven by

the decades-long structuring of the global economy aroundoil, particularly in the case of the transportation sector, inwhich oil powered transit and associated infrastructureretains market dominance, despite the increasing popular-ity of alternatives such as electrically powered vehicles.This structural dependence on oil has been augmented byextensive and institutionalised fuel consumption subsidiesin non- OECD countries, which have dampened substitu-tion effects and preserved oil demand at an artificially highlevel [11].In addition to the inelastic nature of both oil supply and

demand, there are several specific supply and demand-sidefactors that aggravate OPV. Oil supply, for example, isvulnerable to unquantifiable sources of instability, such asregional conflict in producing areas, theft, and theuncertainties raised by the nationalisation of oil companies,which can lead to significant disruptions in both invest-ment cycles and short-term supply availabilities. Globalratings agencies, for example, have pointed toward thepotential for both growing regulatory and investmentuncertainty for foreign and domestic companies wishing toinvest in the Argentinian oil industry, following thenationalisation of Yacimientos Petrolíferos Fiscales(YPF) in 2012. The demand for oil, on the other hand,exhibits cyclical tendencies and seasonality [12] so that therelationship between the demand for oil and real output isprocyclically contemporaneous [13]. Inherent businesscycle volatility is thus also likely to make itself manifest inoil prices. The relationship between oil prices and businesscycles is augmented by the fact that oil demand is more

responsive to changes in income than changes in prices[14].Disruptions caused by political tension and conflict in oil

producing regions have historically held the greatestweight in explaining the largest fluctuations in oil prices[15,16], and evidence suggests that market participantscontinue to respond strongly to the potential for supplydisruptions in producing nations experiencing politicalturmoil. The 2011 Libyan Civil War and continuinggeopolitical tensions centered around the Iranian nuclearprogram, for example, have both placed significant upwardpressure on oil prices [17].However, the explanatory power of supply-side shocks

has somewhat deteriorated over the past decade, becausethe largest producers are now undertaking significantefforts to stabilize prices by offsetting decreasing regionalsupply with increasing production in other jurisdictions[18]. For instance, Saudi production levels reached their30-year high in the first financial quarter of 2012 and weremaintained at well above their average level throughout theyear in an attempt to offset geopolitical tensions [19]. But itis important to note that the potential for such supplycoordination is becoming significantly limited by thegrowing domestic use of petroleum in producing countries.More than a quarter of the oil produced in Saudi Arabia, forexample, is now consumed domestically, reflecting theimpact of extensive and institutionalised fuel consumptionsubsidies, which have prevented domestic fuel prices fromreflecting their true market value [20]. This means thathigher oil production will not immediately or necessarilytranslate into larger export availabilities.In addition to unprecedented producer efforts to stabilize

prices, the IEA collective response mechanism hasmarkedly mitigated the potential for severe price volatilityon several recent occasions. The 2011 Libyan Civil War,for instance, saw IEA member countries release 60 millionbarrels of oil to mitigate supply disruptions of Libyan lightsweet crude. This markedly reduced tightness — the maindrive of short-term OPV (vide supra) — in the promptsupply of light sweet crudes [21].On the demand-side, growing but steady patterns of oil

consumption in emerging economies (where demandgrowth has been centered over the past decade) are equallyunable to account for intense swings in crude oil prices.Instead, a popular explanation of the fortification of OPVin recent years is that the progressive financialisation of thecrude oil market has led to its transformation from a largelyphysical market into a complex and predominantlyfinancial market [18].

2.2 The oil derivatives market and its price impacts

2.2.1 Origins and purposes of the oil derivatives market

After the damaging economic impacts of the 1973 oilcrisis, a consensus emerged acknowledging the critical

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need for the creation of effective risk managementmechanisms in the oil market, similar in utility and scopeto the contemporary risk management systems in foreignexchange markets. In response, a diverse set of financialinstruments was adapted to allow oil industry actors toeffectively manage capital and diversify risk, becomingcollectively known as the oil derivatives market. Since itsinception, the oil derivatives market has grown exponen-tially in size and is now at least 14 times larger than thephysical oil market [22]. Its precise dimensions are,however, difficult to gauge given the bifurcation of themarket between regulated exchange-traded derivativescontracts and unregulated over-the-counter (OTC) deriva-tives contracts.With technological advancement, the range of financial

tools available to investors has gradually expanded andincreased in complexity, enabling new forms of transactionand behavior to evolve in accordance with the market.However, these new operations have increasingly divergedfrom the raison d'être of the market.Oil derivatives wereoriginally devised and intended to be used to guard andhedge against the uncertainty generated by price volatility.But non-commercial investors have increasingly beenusing oil derivatives for a different purpose all together: toaccept financial risk in exchange for prospective reward.Such speculative activity has been driven by the belief thatexploitable inefficiencies exist in financial markets.

2.2.2 Efficient markets and Hotelling’s rule

Building on earlier research which advanced the idea thatthe path of stock prices follows a random walk, EugeneFama proposed in his efficient markets hypothesis (EMH)that the informational efficiency of financial marketsrenders it impossible to use price trends and informationto achieve consistently above average stock market returns[23]. Arbitrage — a riskless profit obtained through thesimultaneous sale and purchase of an asset to takeadvantage of price disparities [24] is thus unattainable ifthe EMH holds. For finite resources in particular, theeconomic theorist Harold Hotelling argued that arbitrage isimpossible [25]. According to Hotelling’s rule, the netprice of a non-renewable resource such as oil, should rise atthe market interest rate in a purely competitive marketequilibrium, in order to reflect the appreciation in the valueof exhaustible resources as reserves are depleted.

2.2.3 Market inefficiencies

However, all available evidence suggests that both theEMH and Hotelling’s rule, with respect to the crude oilmarket, have not been held in reality, due to the variousinefficiencies that characterize the crude oil market(videinfra). The main prediction of Hotelling’s rule that oilprices should be characterized by an upward trend over

time, and stand in opposition to historical oil pricemovements. Excluding episodic volatility, oil pricesgenerally decreased over the 1980-2000 period. Factorssuch as technological change, political disruption, revisedexpectations relating to the availability of resources, andthe structure of the global oil market, have all historicallyplayed a more significant role in dictating price trends [26],reflecting the fact that the Hotelling model’s assumption ofa perfectly competitive market failed to fit the structuralform of the oil market. The oil production quotas imposedover the 1982-1986 period by Organisation of thePetroleum Exporting Countries (OPEC), for example,represented a significant disruption to natural marketdynamics [27]. Moreover, such market disturbance wasaugmented by the non-formulaic nature of OPEC produc-tion ceilings [28]. In the view of the WTO, the marketstructure of non-renewable resources is thus bettercharacterized as imperfect [29]. But, providing that theoil market becomes more transparent and less ‘imperfect’over time, this dynamic could change. The waning powerof OPEC, for example, has significantly reduced non-competitive market pressures [30], and may provide anexplanation as to why with the exception of oil prices in2009, the price trend over the 2003 – 2012 period followedthe predictions presented by Hotelling’s rule.In opposition to the predictions of the EMH, behavioral

economists emphasizse that herding behavior, which hasprevailed in the crude oil market [31–33], and human dataprocessing errors have created market inefficiencies,leading prices astray. For example, increases in indexfund flows have been found to accurately predict higher oilfutures prices three months later, while the flows ofmanaged money spread positions have been shown topositively affect future oil prices [34]. Oil derivativesmarkets are now also displaying a strengthened relation-ship with seemingly unrelated markets. For example,despite sharing wholly different fundamentals, the cross-market correlations between West Texas Intermediate(WTI) Crude futures and the Euro Stoxx 600 and Standardand Poor’s Goldman Sachs Commodity Indexes (S&PGSCI) have evolved from displaying approximately nocorrelation to a near perfect correlation over the course ofthe past decade [17,34,35]. Such developments suggest anon-fundamentals based explanation of OPV.

2.2.4 Speculation as a driver of price volatility

A large body of evidence suggests that speculative activityhas divorced oil prices from solely reflecting developmentsin market fundamentals on specific occasions. Theincreased volatility and upshot in crude oil prices duringthe 1990-1991 Persian Gulf War, for example, occurredwith no analogous alteration in oil supply. Price develop-ments during this period, instead, solely reflected uncer-tainty [36]. In addition to their price impact during the

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1990-1991 Persian Gulf War, speculative demand shockswere a critical determinant of the volatility in oil prices in1979 (following the Iranian Revolution), in 1986 (follow-ing the collapse of OPEC) and in 1997-2000 (following theAsian financial crisis) [16]. However, current evidence(vide supra) related to new cross-market correlationssuggests a systemic increase in the price volatility impactsof speculation quite apart from the outlier impacts ofspeculation during exceptional oil market episodes overthe past decades. With financial investors providing thekey link between unrelated markets, previously intangiblevolatility spillovers from the stock market to the oil marketand vice versa, appear to have been institutionalised.Furthermore, the dominance of herd behavior in the oil

derivatives market as the market has expanded [18], hascompounded existing volatility associated with marketfundamentals, through the amplification of upswings anddownswings already implied by movements in physicalmarket demand and supply, as high frequency and short-term trading positions have gained in popularity andincreased in financial significance. Such complex interplaybetween speculative activity in response to developmentsin market fundamentals and activity based on recent pricetrends rather than market fundamentals has added to thediverse set of conflicting factors within the oil market andcreated a self-sustaining source of price volatility.While there are still significant academic divisions

regarding the precise impact of speculation on volatility(partly reflecting disparities in the methodology and timeperiods considered in the causal analyses of volatility), theimpact of speculation on volatility appears to be relativelymuted in comparison to other market factors. In hisanalysis of the drivers of the oil price shock of 2007-2008,for example, James D. Hamilton concluded that while theflow of speculative investment influenced the ‘miscalcula-tion’ of oil prices in 2008, the stagnation of productionsince 2005 together with highly inelastic demand hadgreater explanatory power [37].

2.3 Inadequate market data

Herd behavior is, in part, precipitated by inadequacies inthe transparency, accuracy, and availability of critical oilmarket data, including inventories and estimations ofcurrent and future quantities of oil demand, supply,production, stocks, and reserves. Uncertainties regardingsuch variables have impacted OPV by shifting theinformation sources that guide investment decisions fromrelatively inaccessible but pertinent oil market data toaccessible yet comparatively uninformative trends inrecent oil prices [6].The joint organisations data initiative (JODI) was

specifically created to address the link between OPV andthe opacity of oil market information. Its core institutionalaim is to improve the accessibility and accuracy of oilmarket data in order to moderate excessive price volatility.

However, while the initiative has made much progress onimproving data transparency, results are not yet optimalbecause data submission rates by member countries havebeen declining for the past three years. Moreover, thetimeliness of data submissions remains inconsistent,creating additional uncertainty [38]. The JODI databaseis also not subject to external review and does not cover thedata relating to oil reserves [39]. While this data ispublished by several independent sources, non-uniformityin the reporting of both volumes and grades places theaccuracy of such estimates under considerable ambiguityand, moreover, restricts direct comparability [40]. TheIEA, for example, incorporates natural gas liquids, refineryfeedstocks and additives in its definition of crude oil; all ofwhich are excluded in the definition of crude oil employedby the Energy Information Administration (EIA). Non-standardised data collection and reporting methods, are thenorms across a range of physical oil market variables, thecorollary being sizeable variations in market forecastsacross different agencies. A forecast disparity amountingto approximately 30 million barrels per day exists, forexample, between IEA and OPEC forecasts of cumulativeoil demand up to 2035 [41]. Such data deficiencies drivevolatility by hindering the formation of accurate mediumto long-term price expectations. Countering inadequaciespertaining physical market data thus requires greaterinternational and institutional collaboration to ensurehomogeneity in data collection, variable definitions,coverage and statistical representations, and may alsorequire an expansion in coverage to include more diverseand underappreciated market variables. For example,improved coverage of oil tanker traffic could be useful inproviding an alternative measure of production.In addition to the informational deficit in the physical oil

market, opacity and non-uniformity in both regulatorystandards and coverage characterize several variables ofinterest in the oil derivatives market. Publishing of thecategorisation and positions of traders, for example, is nota constitutional requirement on the main European boursetrading in oil derivatives, the Intercontinental Exchange,Inc. (ICE), whereas the disclosure of this information ismandatory for participants on the New York MercantileExchange (NYMEX). But despite differing nationalregulatory structures, identical derivatives contracts aretraded internationally; the WTI Light Sweet Crude Oilcontract, for example, is common to both ICE andNYMEX.

3 Effects of OPV

3.1 Asymmetrical response of macroeconomic activity tooil price changes

“Oil prices have fallen lately. We include this news for thebenefit of gas stations, which otherwise wouldn’t learn of it

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for six months.”1)

One reason that the volatility of oil prices mattersfundamentally more in terms of economic output than thelevel of oil prices is that OPV has been found to amplifythe asymmetrical response of economic activity to oil pricechanges— a phenomenon first documented by the econ-omist Knut Anton Mork [42]. Mork’s findings show thatoil price increases have a proportionally greater (andnegative) impact on economic activity than the corre-sponding positive economic impact of oil price decreases.The intensification of the asymmetrical economic outputresponse to oil price changes under OPV has since beenconfirmed by several national studies of the impact of OPVon macroeconomic variables [43–49].

3.2 Literature survey

Literature examining the link between OPV and economicactivity strongly suggests that OPV negatively affectseconomic output in the short to medium-term [43–57].Adverse short-term economic impacts largely reflect thedeterioration of aggregate demand as OPV intensifies.Aggregate consumption and investment, for example,immediately decrease in response to the economicuncertainty created by OPV [43,48–54,57,58], a dynamicwhich is augmented by volatility driven unemployment[50,54]. While industrial production has also been found todecline in the short-run [43,52,53,57], production declinesare more likely to be a response to downward trends inaggregate demand than to production cost uncertainty. Thisis because industrial producers respond to production/inputcost uncertainty by raising product prices to incorporate anuncertainty premium, rather than by reducing productionlevels [59]. In the medium-term, aggregate supply is moreresponsive than aggregate demand to the effects of OPV.This is foremost the product of decreasing investment inthe short term which results in constrained productioncapacity and increased supply-side inelasticity in themedium-term. Other negative economic effects of OPVin the medium-term such as inflation [48,56,57,59], arealso likely to stem from supply-side responses to OPV; theaforementioned uncertainty premium, for example, pre-cipitates increasing inflation.

4 Responses to OPV

The literature survey has indicated that the occurrence ofcertain events is probable in the precarious economicenvironment created by OPV; inflation and unemploymentare both likely to increase, while investment, stock marketreturns, consumer demand, and industrial production arelikely to decrease. However, under certain circumstances,

counterbalancing influences and moderating responses canoffset some of the economic effects of OPV discussed thusfar. This section explores the viability of such responses toexamine whether OPV will necessarily lead to a decline inthe constituent elements of aggregate demand and supply,in the short, medium, and long-term. This analysis willhelp to clarify the trade-offs involved with minimisingprice volatility and inform section 7 of this paper, whichfocuses on the priorities and areas of focus for policy-makers who are faced with the task of minimizing theadverse macroeconomic impacts of OPV. Figure 2illustrates the direct and indirect responses to OPV.

4.1 Direct responses to OPV

OPV directly impacts three primary macroeconomicchannels: consumption, investment, and industrial produc-tion [43,46–54]. The precise extent to which thesevariables are affected is dependent on two factors: thedegree of uncertainty generated by OPV; and the attitudesof economic agents to uncertainty. Hereafter, the possibleresponses of consumers, investors, and producers to OPVare analyzed in order to understand the optimal policyresponse(s) to OPV.

4.1.1 Consumption

Declining consumer demand under OPV [46,49–51,58]reflects the fact that the uncertainties advanced by OPV,regarding future income and employment prospects,decrease consumer confidence [60] and prompt consumersto adopt precautionary savings behavior at the opportunitycost of current consumption [49,58]. This confirms theprincipal prediction of precautionary savings literature thatby reducing the average propensity to consume (thepercentage of income spent rather than saved) greatereconomic uncertainty should result in declining aggregateconsumption [61–64]. In the medium-term, volatility-driven unemployment [50,54] augments downward pres-sures on aggregate consumption by increasing consumerpessimism regarding future economic prospects andreinforcing existing precautionary savings motives [64].Economic models, such as Hall’s random-walk model ofconsumption, also suggest that by increasing the uncer-tainty about future income, OPV should increase thestochasticity (randomness) of consumption [65].

4.1.2 Investment

Because investment is most responsive in areas whereconsumer demand is either resilient or expected to grow,the effects of OPV on aggregate consumption have a

1) William Tammeus, The Globe and Mail (Toronto), 1991

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significant impact on investment decisions. Real optionsvaluation literature suggests that, due to the uncertaintiesrelating to the profitability of investment in a volatileenergy environment, the benefits of holding a more riskaverse investment portfolio outweigh the future advantagesgained from current commitments to irreversible invest-ment expenditures [66,67]. Evidence of decreasingaggregate investment as a result of OPV [47,50,51,68–71] suggests that firms do indeed optimise their investmentexpenditures in this fashion and that, parallel to theattitudes of consumers under OPV, investors are risk-averse. This commonality is in part driven by the fact thatinvestment is determined by expected trends in consumerdemand. In other words, the deterioration of aggregateconsumption as a result of OPV has a negative bearing oncurrent investment decisions by leading to the downwardsrevision of future demand expectations [49]. Additionally,stochastic consumption [65], in conjunction with theincreased unpredictability of marginal production costsunder OPV, has been found to significantly deterinvestment by amplifying the uncertainties related tofuture demand (and, hence, investment profitability).However, as a result of differences in aggregate risk

preferences between investors in financial and realmarkets, as well as the differences in the quality of riskcompensating mechanisms in financial and real markets,financial investment may be positively correlated withOPV. Stock market returns, for example, may necessarilyappreciate during periods of acute OPV, as investorsdemand higher risk premiums [72] to compensate forincreased investment risk [71]. Furthermore, while fre-quent price deviations increase the chances of financialloss, such deviations also shape perceived opportunities forarbitrage. Thus, one consequence of OPV may be thedeterrence of risk-averse investors and the attraction ofrisk-loving investors to financial markets. The degree towhich volatility is detrimental or beneficial to stock marketinvestment is thus a function of the prevailing riskpreference in financial markets at any given time. In arisk-loving market, stock market investment can realisti-cally increase alongside OPV.The negative relationship between real investment and

OPV is, additionally, only specific to the short andmedium-run and disintegrates in the long-run, reflectingthe fact that further delays to investment are subject to anincreasing opportunity cost over time, as the strategic effort

Fig. 2 direct and indirect responses to OPV

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to establish market share through commitment to newtechnologies acquires greater importance [71]. In the long-run, therefore, aggregate investment will recover to pre-volatility equilibrium levels, regardless of the extent ofprice volatility in the market. Moreover, price volatilitymay actually drive increasing investment in the long-run ifthe volatility-induced switch in household behavior fromconsumption to precautionary savings in the short tomedium-run enlarges the pool of savings available forfunding investment [49,58].

4.1.3 Industrial production

Industrial production generally declines in response toaggregate price volatility [73], but the essentiality of oil asan input into industrial processes means that OPV has anespecially adverse effect on industrial production growth[43,52,53,57]. Although the time horizons considered ininvestment and production level planning differ markedly,the central determinants of investment (expected con-sumption and returns) are also common to industrialproduction. The decrease in industrial production as OPVincreases is a response to the expected decreases andincreased unpredictability of consumption as well asproduction and delivery cost uncertainty, vide supra.However, unlike the predetermined negative relation-

ship between aggregate investment and OPV in the shortterm [71], industrial production levels may be maintainedin the short term despite of the uncertainty created by pricevolatility, reflecting the differing production cost risk-management mechanisms commonly used by industrialproducers and investors: contrary to the investor responseof delaying expenditure as production cost uncertaintyincreases, industrial producers maintain production levelsby increasing product prices to incorporate an uncertaintypremium in order to compensate for increased productioncost uncertainty [59].

4.2 Indirect responses to OPV

The impact of price volatility on consumer, investor, andproducer behavior, strongly influences both the level ofinflation and the level of unemployment within oildependent economies [48,50,53–56,58]. This sectionexplores the extent to which inflation and unemploymentmay indirectly increase in the short, medium, and long-term as a result of OPV, the relationship between inflation,unemployment and OPV, and the extent to which monetarypolicy can effectively regulate both the inflationary anddeflationary pressures of OPV.

4.2.1 Inflation and monetary policy

Inflation is a natural by-product of the premium that

industrial producers attach to the prices of their goodsunder production cost uncertainty. The high inflation ratesthroughout the 1970s can thus arguably be largelyattributed to the sharp increase in OPV which occurredover the decade [48,59]. From this point of view, inflationmay be interpreted as a ‘necessary evil’ in maintainingindustrial production levels under OPV. The source ofinflation, however, remains crucial in determining whetherthe impact of inflation on industrial production is positiveor negative. If high energy prices are the cause of inflation,a negative correlation should characterize the relationshipbetween industrial production and inflation, because higherenergy prices imply an increase in production costs and acorresponding reduction in profitability. Rising energyprices during the first half of 2012, for example, boostedUS Consumer Price Index (CPI) inflation while weighingheavily on US factory output [74]. On the other hand, ifinflation is the product of an expansionary monetary policyresponse to OPV, industrial production is likely to bepositively correlated to inflation.While supply-side responses to OPV create inflationary

pressures, demand-side responses, such as lower con-sumption and investment expenditure (vide supra), createdeflationary pressures. These opposing deflationary andinflationary pressures carry different weights over differenttime periods and give rise to the U-shaped term structure ofinflation under OPV. In the short-run, inflationarypressures created by supply-side responses to productioncost uncertainty are likely to outweigh the deflationarypressures created by demand-side expenditure shifts,because of the lag before which consumers are able toform accurate expectations of how OPV will affect boththe future economic outlook and the future level ofinflation [75]. Consumers, therefore, do not immediatelyadjust expenditures downwards in response to OPV. In themedium-term, however, deflationary pressures created byreduced demand-side expenditure are likely to outweighinflationary supply-side pressures, as fully formed inflationand growth expectations reduce consumption and force aproportional decrease in production levels. In the longterm, inflationary pressures are likely to accumulate as thedecline in investment expenditure in response to OPV inthe short to medium-term70 reduces production capacityand increases supply-side inelasticity.Changes in inflation expectations strongly influence the

orientation of monetary policy. OPV exacerbates thetraditional policy dilemma faced by monetary policyauthorities of lowering interest rates to directly promoteeconomic growth (accommodative policy) or raisinginterest rates to limit inflation (tight policy), by creatinginflationary pressures and simultaneously lowering eco-nomic activity [48]. This conflicting policy choice is likelyto be fluid and responsive to business cycles as well as tothe overall condition of the domestic economy.In low-inflation economies, monetary policy authorities

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have more flexibility to pursue an output target, due to thegreater capacity of low-inflation economies to sustainablyabsorb further inflation. Therefore, in a low-inflationenvironment, monetary policy authorities have a strongerincentive to focus on supporting consumption, investment,and production through expansionary monetary policyrather than limiting inflation through contractionarymonetary policy. In addition to its beneficial impact onreal investment, such a monetary policy response impliesthat financial investment could increase regardless of OPV,because a decrease in the interest rate (which represents theapplied discount rate in the calculation of the current valueof companies), should result in an increase in the value andshare returns of stock market-listed companies [24]. Suchconditions could feasibly precipitate an increase infinancial investment, as investors rush to benefit from amarket in which stock returns are appreciating.However, such a simplistic view of monetary decision-

making does not account for the role of expectations indetermining the effectiveness of policy. A significant riskposed by the use of expansionary monetary policy to boostconsumption, investment, and production under OPV, isthe creation of a liquidity trap. The liquidity trap asformulated by John Maynard Keynes in his GeneralTheory of Employment, Interest and Money [76], refers to asituation in which the approach of the nominal rate ofinterest toward zero fails to reverse the preference forsaving. Since the nominal rate of interest cannot benegative, conventional monetary policy ceases to beeffective in stimulating the economy when the nominalinterest rate reaches zero. The Japanese economy in the late1990s remains the most prominent example of thisscenario [75], however, the low interest rates in Europeaneconomies and the US over the past two years, which havefailed to substantially increasing bank lending or consumerdemand, also imply the existence of a wide-scale modern-day liquidity trap [77]. OPV directly increases the risk of aliquidity trap by adversely affecting consumer confidence[49,58,60]. In an environment in which low consumerconfidence pervades, the cheaper availability of money isunable to overturn the precautionary savings behavior ofconsumers, which OPV encourages [49,58] This bottle-neck has two fundamental implications for the futuredirection of monetary policy: the management of OPVshould lie beyond the remit of monetary policy; andmonetary policy should be more conservative. Thisreflects the fact that the necessarily forward-looking orpre-emptive nature of monetary policy [78], is ill-suited inaddressing short-term price volatility. Moreover, despitethe fact that the term-structure of inflation under pricevolatility is predictable, price volatility itself is difficult topredict. A less conservative expansionary monetarypolicy approach may unintentionally augment theinflationary pressures created by price volatility becauseof the limitations involved in the forecasting ofOPV [79].

4.2.2 Unemployment

The increasing rate of unemployment under OPV[51,54,80] is precipitated by the decline in both industrialproduction and overall economic activity as OPVintensifies [43–57]. In periods of excessive OPV, anincrease in the rate of unemployment occurs because theindustrial workforce in the short to medium-term is morelikely to wait in anticipation production level restoration(and commensurate job opportunities in the industrialsector) than to retrain for jobs that require alternative skillsets [81–85].The extent to which unemployment is affected by price

volatility depends on the contribution of the industrialsector to GDP and the structure of labor market laws. OPVis likely to lead to higher unemployment in economies inwhich the industrial sector holds a fundamental place in thesectoral composition of economic growth, than ineconomies in which the industrial sector plays a compara-tively less important role. This explains why OPV has hadsuch a significant impact on the rate of unemployment inthe US [50,81] (the world’s second largest industrialproducer), but relatively muted unemployment-impacts inservice-based economies [86]. The structure of labormarket laws also play a crucial role in determining theextent to which adverse industrial production andconsumption under OPV are translated into higherunemployment. Over the past decade, government invol-vement in labor markets has decreased substantially inmost OECD countries; however labor market structureswithin the OECD are still characterized by significantheterogeneity. The increase in unemployment under oilOPV in countries characterized by flexible labor marketsincluding Estonia, Poland and the UK, is thus likely to bemore severe than in countries with limited labor marketflexibility such as Belgium, France, Italy and Spain [87].The rigidity of unemployment levels in countries with lessflexible labor markets may also explain the trade-offbetween inflation and unemployment implied by the short-run Phillips curve.

4.2.3 Stagflation

In the 1970s, the negative relationship between the rate ofinflation and the rate of unemployment, graphicallyrepresented by the Phillips curve, ceased to hold.Unemployment and inflation, instead, rose in conjunctionwith one another in several countries, while economicgrowth was either stationary or declining, a conditionknown as stagflation. The finding that OPV both increasesinflation and unemployment and decreases economicgrowth, suggests that OPV also pushes the economy intoa stagflationary mode. The stagflation that pervaded the1970s can arguably thus be largely attributed to thesignificant increase in OPV which occurred over thedecade.

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5 Dependency on crude oil and financialimplications

In the context of the increase in oil prices and pricevolatility which has occurred over the past decade, theglobal dependency on crude oil has serious financialimplications; chiefly, trade deficits are now foremost theresult of expenditure allocated to crude oil imports (Fig. 3).Expenditure devoted to crude oil imports as a percentage

of the trade balance has significantly increased in themajority of OECD countries over the past decade, despitedeclining consumption. Crude oil import expenditurerepresented 86% of the UK trade deficit in 2011, up from

22% in 2003. This reflects a greater reliance on oil importsto fulfil domestic demand since the peak in UK oilproduction in 1999 [88], which ultimately shifted itsposition from being a net exporter to a net importer of oil in2005 [89]. In contrast to the low oil prices faced by Britishoil exporters in the zenith of the UK oil export market inthe 1990s, the position of the UK from 2005 onwards as anet oil importer coincided with the upward trend in oilprices beginning in 2003. The upward trend in oil pricesover the past decade also explains why expenditure onimported crude oil has increased in countries where oilimports have been declining. Despite the decline in UScrude oil imports since 2006, for example, expenditure on

Fig. 3 Expenditure on imported crude oil as a percentage of the trade balance

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imported crude oil represented 65% of the US trade deficitin 2011, up from 36% in 2006.Such adverse pressure on trade balances will worsen in

oil-importing countries over the coming decades as theprice of oil continues to increase. By 2035, the IEAestimates that nominal oil prices will reach $215 per barrel.According to the IEA, the US is also likely to approachenergy self-sufficiency by 2035 [90]. But this does notimply that pressure on the US trade balance, as a result ofincreasing oil prices, is no longer likely to be a problem.Pressure on the disposable incomes and consumptionpatterns of US consumers would still remain high asdomestic US oil prices are, after all, dictated by globalmarket forces [91]. Thus, the possibility of future USenergy self-sufficiency does not eliminate the macroeco-nomic problems created by the increasing trend in oilprices; it merely alters the specific framing of the problem.In contrast to both the UK and the US, Germany has

successfully maintained a trade surplus throughout the pastdecade, due to the vitality of its export sector [92], and itsexpenditure on imported crude oil as a percentage of thetrade surplus has plateaued in recent years. However, thisexpenditure trend masks significant concerns for futureGerman economic sustainability. Since 1995, Germanimport dependency with regard to both petroleum fuels andcrude oil and natural gas liquids (NGL) has remainedabove 93% [93]. And despite the fact that the expendituredevoted to imported crude oil as a percentage of theGerman trade surplus has stagnated over the past decade,Germany is still spending a substantial proportion of itstrade surplus to finance domestic oil consumption. In 2011,for example, 29% of its trade surplus was used to financeoil imports.Such acute import dependency can be hazardous in the

event of a negative economic shock. For example, Greekexpenditure on imported crude oil, which already con-stitutes an enormous proportion of the Greek trade deficit(77% in 2011), would increase unsustainably in the event

that Greece exits the Eurozone. This is because thereversion to its old currency — the Drachma — comes atthe cost of a significant devaluation. According to certainestimates, reversion to the Drachma would see Greecespending almost three times more on crude oil imports[94]. A visualization of the hypothetical increase in oilimport expenditure under the Drachma in the event thatGreece exits the Eurozone compared to the value of theDrachma when Greece first joined the Eurozone, ispresented in Fig. 4.

6 Key messages

Price volatility in the crude oil market is increasing at afaster rate than volatility in other commodity markets,partly due to the status of oil as the most globalisedcommodity.There are three main drivers of OPV: tightness, or the

highly inelastic nature of both supply and demand, in thecrude oil market; speculation in the oil derivatives market;and inadequacies in oil market data.While improvements in the quality and transparency of

oil market data will be important in lessening the extent offuture price volatility, most of the price volatility that hasoccurred over the past decade reflects market tightness andspeculative activity in the oil derivatives market. Realign-ing the use of the oil derivatives market toward its initialpurpose (hedging) will be fundamental in managing futureprice volatility.The uncertainty advanced by OPV has damaging and

destabilizing macroeconomic effects. The high degree ofOPV which has characterized the market for the past fourdecades represents a fundamental barrier to stability andhence growth. The management and reduction of pricevolatility will play a key role in enhancing stability infuture economic growth trajectories, vide infra.Policies to reduce price volatility must be balanced

Fig. 4 Greek expenditure on imported crude oil under the old and new Drachma

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between the prevention and the cure of OPV.Preventative policy should center around the stabiliza-

tion of oil supply. The IEA collective response to the Libyacrisis in June 2011, which saw member countries release60 million barrels of oil to mitigate the ongoing supplydisruption of Libyan light sweet crude, effectively reducedthe potential severity of price volatility. Cooperation andconcerted action of this kind will be fundamental inmitigating future price volatility.The solution or ‘cure’, however, will be intrinsically

linked to demand-side policies focused on reducing theglobal reliance on oil, achieving greater diversification inthe global energy mix and increasing energy efficiency. Incontrast to the antiquate adage, the cure is better than theprevention, because the instability and inelasticity of oilsupply (the primary drivers of volatility) will only worsenover the coming decades as the quantity of conventional oilreserves diminishes.Finally, future research needs to focus on the quantifica-

tion and forecasting of OPV to allow policy makers toeffectively prepare appropriate risk-management responsemechanisms to address price volatility.

7 Policy interventions

Price volatility is primarily driven by supply-side factorsbut mainly has demand-side impacts. Policy to reduceprice volatility and its associated adverse macroeconomiceffects must therefore encompass both supply-side anddemand-side solutions. The primary focus of supply-side(preventative) policy should be the stabilization of oilsupply because the largest increases in price volatility havehistorically arisen from supply-side oil disruptions. To anextent, the market is self-correcting in this regard.Production practices from the largest oil producers inorder to stabilize prices, such as the increased productionlevels in Saudi Arabia during the first half of 2012 to offsetgeopolitical tensions [19], suggest that oil producers areconcerned about the adverse long-term demand-sideimpacts of sustained high oil price intervals and areunwilling to tolerate both high prices and volatility in themarket. Despite this, the IEA projects that, nominal oilprices will reach at least $215 per barrel by 2035 [90].Global cooperation and concerted action will thus befundamental in the management and reduction of futureprice volatility. In this regard, the IEA collective actionframework, which mandates the maintenance of strategicoil reserves, has recently been highly effective on severaloccasions in reducing the extent of price volatility in thecontext of oil-supply disruptions. The IEA collectiveresponse to the 2011 Libya crisis, for example, which sawmember countries release 60 million barrels of oil tomitigate the ongoing supply disruption of Libyan lightsweet crude, effectively reduced the potential severity ofprice volatility[21]. Strengthening and expanding IEA and

analogous systems will thus be important in enhancingfuture market stability. One possibility might be thelegislative requirement that companies and industrieswhich are heavily reliant on oil powered productionprocesses, should maintain individual strategic oil reservesto provide effective insulation from price volatility.Supply-side risk management policies are important but

at best can only minimise OPV and its associatedmacroeconomic effects. Macroeconomic isolation fromOPV can only be achieved through a combination ofsupply and demand-side policies. Demand-side policyshould prioritise strategies that reduce oil dependency,such as disincentivising oil consumption through tax andsubsidy reform, improving sectoral energy efficiency andfacilitating greater diversification in the global energy mix.Institutionalised oil price subsidies in non-OECD countrieshave augmented the global structural dependence on oiland provided little incentive for lowering oil consumption[11]. An important initial policy step would be the reviewof national energy subsidy policies to assess the areas inwhich there is greatest scope for both subsidy and taxreform in relation to oil consumption. Due to thefundamental dependence of mobility on crude oil-derivedfuels, energy subsidy and tax reforms and improvements inenergy efficiency must be all centered around innovationsin the transportation sector. Fuel taxes have raisedconsumer awareness about the fuel economy of vehiclesand have been particularly effective in improving fueleconomy and reducing vehicle emissions in the EuropeanUnion [95]. However, several strategies to improve energyefficiency in the transportation sector including theadoption of fuel-economy standards and the constructionof codes and requirements for greater efficiency in powerplants, have been restricted by poor government organiza-tion [96]. Significant political will is thus required toachieve effective policy reform related to energy efficiencystandards. Governments must also play a role in creating afacilitating environment in which a diversified set ofalternative and renewable sources of energy can thrive.Part of this role includes the re-alignment of financialindustry in order to increase its contribution toward thefunding of alternative energy sources [97]. Alternativefuels that have the potential to be used in the transportationsector, including algae derived fuels [98], natural gas [99],hydrogen [100], and decarbonised electricity [101], allrequire significant financial backing before they canbecome economically viable.Finally, the significant growth and impact of speculation

on price volatility over the past decade has highlighted thenecessity of policies that constrain the misuse of the oilderivatives market. The European Commission’s proposedFinancial Transactions Tax, which has the backing of tencountries and is expected to come into force in 2014, isunlikely to be adequate in tackling speculation on the oilderivatives market for two reasons: the proposed tax,which is estimated to be levied at 0.01% for derivatives

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transactions, is too small [102]; and the tax will notdifferentiate between speculators and hedgers and is thusonly likely to increase the cost of hedging withoutspecifically tackling speculation [103]. To effectivelygauge and address speculative activity, policies to improvethe systems of identification of traders and their respectivepositions are necessary so that regulators are better able tomanage speculative activity. This may necessitate theadoption of an American style model in European tradingexchanges. The mandatory classification of traders andtheir respective positions — an already institutionalisedfeature on NYMEX — could, for example, be exported tothe ICE. Additionally, improvements in the general qualityand transparency of both physical and financial oil marketinformation would lessen market uncertainty and pricevolatility by improving the accuracy and homogeneity ofprice expectations. Strengthening and expanding the scopeof oil market information and assessment systems such asLatest Energy, Metals & Steel News, Market Data andAnalysis (PLATTS) and JODI by instituting policies toimprove consistency and reliability in data submissions isthus essential in lessening future price volatility.

8 Conclusions

The high degree of OPV that has characterized the marketfor the past four decades represents a fundamental barrierto economic growth, due to its damaging and destabilizingeffects on the macroeconomy. Through the generation ofeconomic uncertainty, OPV adversely impacts aggregateconsumption, investment, and industrial production,resulting in an indirect ripple-through impact on aggregateunemployment and inflation. Uncertainties pertaining tofuture income streams under OPV decrease consumerdemand while increase the randomness of consumption.This prompts the decrease of physical investment expen-diture in both the short and medium-term. However, as thepool of savings available for investment expands, greateraggregate investment is facilitated in the long term. Short-term financial investment, in contrast, may increase inresponse to OPV (depending on the degree of riskpreference which characterizes the financial market atany given time) reflecting risk premium revision andperceived opportunities for financial gain as price devia-tions increase. Industrial production is also adverselyaffected under OPV, due to the impact of price volatility onconsumer demand and production costs. However, becauseproduction cost uncertainty can be offset through priceincreases, OPV only guarantees declining industrialproduction in the short-run if its effect on consumption isgreater than its impact on production costs.The effects of OPVon consumer, investor, and producer

behavior, strongly influence both the level of inflation andthe level of unemployment within economies affected byOPV. Under OPV, the term-structure of inflation is likely to

correspond to a U-shape, in reflection of the relativeweights of the inflationary and deflationary pressurescreated by OPV over time. In response to the decline inindustrial production, investment and consumption, unem-ployment also significantly increases under OPV. But theprecise extent to which unemployment is affected by pricevolatility will depend on the contribution of the industrialsector to GDP and the structure of labor market laws. Thefinding that OPV both increases unemployment andinflation and decreases economic growth suggests thatOPV pushes the economy into a stagflationary mode. Thestagflation that pervaded the 1970s can arguably thus belargely attributed to the significant increase in OPV thatoccurred over the decade.A combination of supply-side and demand-side policies

aimed at preventing and providing a solution to OPV isvital if stability in future economic growth trajectories is tobe achieved. An expansion of systems that mandate globalcooperation and concerted action in oil supply chainmanagement, such as the IEA collective action framework,is necessary in order to minimise short-term price volatilityand promote market stability. In addition to supply-sidedisruptions, high frequency trading (speculation) is also asignificant driver of short-term OPV. Policy must focus onrealigning the use of the oil derivatives market away fromspeculation and toward its initial purpose: hedging.Improving derivatives market regulatory systems andworking toward international derivatives regulatory stan-dards will be vital in achieving this goal but efforts to curbspeculation so far have been lacklustre. While a step in theright direction, the European Commission’s proposedFinancial Transactions Tax, which is expected to comeinto force in 2014, is unlikely to be adequate in curbingspeculation and its effects on oil prices because of therelative size of the tax (0.01% for derivatives transactions)and the lack of differentiation between speculators andhedgers in the tax structure. Instead, the tax may simplydisincentivise hedging behavior at a time when hedging isvital. In the medium and long-term, the main task ofgovernments should be to create a facilitating environmentwhich incentivises infrastructural investments and theproduction of a diversified set of alternative renewablefuels that can be used as a substitute for oil, particularly inthe transportation sector. Complementary to this aredemand-side management policies to reduce the globalstructural dependence on oil. Part of this role will requirethe politically challenging task of energy subsidy and taxreform to incentivise the consumption of alternative fuelsand disincentivise oil consumption, particularly in non-OECD countries where oil price subsidies have beeninstitutionalised. But a significant opportunity in reducingthe demand for oil is also to be found in policies that areaimed at improving energy efficiency such as the adoptionof fuel-economy standards and the construction of codesand requirements for greater energy efficiency in varioussectors of the economy.

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It has not escaped out attention that the researchpresented herein strongly suggest that the significantproduction capacities of unconventional fossil fuelreserves coming online over the next decade are highlylikely to mitigate price volatility and keep prices — atleast relatively — low. While this is terrible news for theenvironment, it is excellent news for the economy:unconventional reserves could provide the dearly neededeconomic boost and they will “buy us time” fordecarbonisation endeavors. On the long-run, these dec-arbonisation endeavors will be essential in order toincrease sustainability, mitigate climate change anddecrease dependence on fossil feedstock.

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