Oil Prices and Long-Run Risk

I show that relative levels of aggregate consumption and personal oil consumption provide anexcellent proxy for oil prices, and that high oil prices predict low future aggregate consumptiongrowth. Motivated by these facts, I add an oil consumption good to the long-run risk model of Bansal and Yaron [2004] to study the asset pricing implications of observed changes in the dynamicinteraction of consumption and oil prices. Empirically I observe that, compared to the rst half of my1987 - 2010 sample, oil consumption growth in the last 10 years is unresponsive to levels of oil prices,creating an decrease in the mean-reversion of oil prices, and an increase in the persistence of oil priceshocks. The model implies that the change in the dynamics of oil consumption generates increasedsystematic risk from oil price shocks due to their increased persistence. However, persistent oil pricesalso act as a counterweight for shocks to expected consumption growth, with high expected growthcreating high expectations of future oil prices which in turn slow down growth. The combined eectis to reduce overall consumption risk and lower the equity premium. The model also predicts thatthese changes aect the riskiness of of oil futures contracts, and combine to create a hump shapedterm structure of oil futures, consistent with recent data.