Int. J. Global Energy Issues, Vol. 38, Nos.

1/2/3, 2015 5

Volatility analysis and forecasting models of crude oil

prices: a review

Liwei Fan*
School of Business,
Hohai University,
Nanjing 211100, China
Email: hhufanlw@163.com
*Corresponding author

Huiping Li
College of Economics and Management,
Nanjing University of Aeronautics and Astronautics,
Nanjing 211106, China
Email: nuaalihui@163.com
Abstract: Accurate forecasting of crude oil prices plays a significant role for
supporting policy and decision making at economy and firm levels. The
successive developments in econometric and artificial intelligence models
provide opportunities to analyse crude oil market in depth and improve the
accuracy of oil price forecasting. Past years have seen an increasing number of
studies on the volatility analysis and forecasting of crude oil prices by different
techniques such as econometric and artificial intelligence models. This paper
aims to present a systematic review of existing tools used to model the
volatility of crude oil prices. It is found that the integration of time series
models with artificial intelligence models has received increasing attention in
oil price forecasting owing to its satisfactory prediction performance. Also,
feature extraction of oil price series with appropriate multivariate statistical
analysis techniques plays an important role in improving the prediction
performance.

Keywords: crude oil price; volatility analysis; forecasting; energy market.

Reference to this paper should be made as follows: Fan, L. and Li, H. (2015)
‘Volatility analysis and forecasting models of crude oil prices: a review’,
Int. J. Global Energy Issues, Vol. 38, Nos. 1/2/3, pp.5–17.

Biographical notes: Liwei Fan is an Assistant Professor at the School of

Business in Hohai University. She has published articles in international
journals such as Energy Policy, Journal of Air Transport Management and
Expert Systems with Applications. Her research interest is systems modelling
and forecasting, with particular interest in the use of statistical and data mining
techniques to model energy issues.

Huiping Li is a Graduate Student at the College of Economics and

Management in Nanjing University of Aeronautics and Astronautics, China.
Her main research interest is crude oil price analysis.

Copyright © 2015 Inderscience Enterprises Ltd.

6 L. Fan and H. Li

1 Introduction

Crude oil is not only a crucial natural resource but also the largest and most actively
traded commodity at global level. As a special kind of commodity, crude oil is traded
internationally among many different players – oil producing nations, oil companies,
individual refineries, oil importing nations and speculators. Large fluctuation in the world
oil prices in the 1970s/1980s produced tremendous impact on the world economy. Many
earlier studies have examined the relationship between crude oil prices and economic
activity. For instance, Hamilton (1983) showed that all but one of the USA recessions
since the World War II has been Granger-preceded by dramatic price increments. Mork
(1989) found that higher oil prices reduced economic output and price asymmetry had an
important effect on the directionality of the economy.
Volatility analysis and forecasting of crude oil prices is extremely difficult due to its
intrinsic complex features and the uncertainty of external environment. A large number
of studies have been devoted to examine the mechanism governing the dynamics of crude
oil prices and improve the forecasting performance. While Behmiri and Manso (2013)
have conducted a review of crude oil price forecasting techniques, their review mainly
focused on the use of econometric models. In view of the popularity of other models in
oil price forecasting, it is meaningful to provide a review of diverse models for volatility
analysis and forecasting of crude oil prices, which may provide a useful schematic
summary of the developments in this field and shed insights for the possible future
research directions.
Our review suggests that the models for volatility analysis and forecasting of crude
oil prices tend to vary in accordance with different perspectives, which may be classified
into four categories as given in Figure 1. In the followings, we shall review the existing
studies with particular emphasis on the models shown in Figure 1. Section 2 gives a
summary of the three theoretical analysis models. The structure models and time series
models are, respectively, summarised in Sections 3 and 4. Artificial intelligence models
have been elaborated in Section 5. Section 6 concludes this study.

Figure 1 Classification of oil prices-analysing-forecasting methods

Volatility analysis and

forecasting models

Theoretical Structure Time series Artificial intelligence

analysis models models models models

 Exhaustible resource theory  Supply-demand imbalance  Single models

 Cost theory  Unexpected events  Hybrid models
 Market structure theory  Financial factors
 Volatility analysis and forecasting models of crude oil prices 7

2 Theoretical analysis models

The development of different theoretical analysis models depends on specific

assumptions, such as setting up hypothetical oil market structure and bringing in various
relevant parameters. The main theoretical analysis models, including exhaustible
resource theory, cost theory and market structure theory, tend to analyse crude oil price
volatility with certain theory.

2.1 Exhaustible resources theory

Exhaustible resources theory determines the optimal oil price by taking into account the
exhaustibility of crude oil. The well-known ‘Hotelling rule’ lays a solid theoretical
foundation for the development of exhaustible resources theory, which suggests that
crude oil price increases exponentially with respect to the product of time and interest
rate of capital.
The Hotelling rule was built upon the assumption of reserve certainty and perfect
competition. More studies investigated the exhaustible resources theory by considering
reserve uncertainty and specific world crude oil market participants. For example, Arrow
and Chang (1978, 1982) formulated the corresponding problem for a finite area of
unexplored land and pointed out that crude oil is a randomly distributed natural resource.
They further modified the model to guarantee that each discovery reveals a random
amount of the resource and improved the accuracy of analytical results. Despite of its
theoretical elegance, it may not be appropriate to use the Hotelling rule to analyse the
complex global crude oil market accurately.

2.2 Cost theory

As a long-term determinant, cost can influence crude oil prices in an indirect way
through influencing oil supply decisions, thus causing the fluctuations of world oil prices.
Cost theory explains crude oil price by assuming that producers select optimal
exploration rate to maximise the net present value of profits.
Exhaustible asset pricing ought to take consumer cost into account. That is to say,
optimal crude oil price should be equal to the sum of marginal costs for production and
consumption. A rising cost of marginal consumption or an expected future decline in the
marginal production cost may lead to a decline of the amount of the current produced
quantity in a perfectly competitive market. Solow and Wan (1976) surveyed the output
and shadow-price implications of optimal extraction under some broad assumptions and
gave a striking result that relatively large resource availability changes trigger small
changes in the sustainable level of final consumption.
Taking cost as one main explanatory variable to forecast crude oil prices may be
effective if oil prices tend to decline. However, it is difficult to use cost theory to explain
global oil market when encountering a high oil price.

2.3 Market structure theory

With the increasingly crucial role of OPEC in crude oil market since the fist oil crisis,
researchers started to explain oil price volatility by market structure. A representative
work is to use the Nash-Cournot approach to set up a dynamic game equation among
8 L. Fan and H. Li

principal participants consisting of OPEC, Non-OPEC and the dominant consumers

(Salant, 1976). Market structure theory may be divided into two categories depending on
whether OPEC is a price taker or a price maker. The former treats global oil market as a
perfectly competitive one and OPEC is only a price taker, while the latter treats OPEC as
a price maker.
Monopolistic competition theory may be divided into two subsets: wealth
maximisation and capacity objective. Wealth maximisation emphasises the monopoly
part in exhaustible resource theory. It attempts to calculate optimal monopolistic price
trajectories for oil cartels and thereby determines the potential gains to producers from
cartelisation. Optimal pricing model for OPEC was proposed by Cremer and Weitzman
(1976) without taking into account the response lag to world oil demand and the oil
supply of non-OPEC countries.
Target zone model aims to search for the hidden optimal pricing strategy for OPEC in
the direction of capacity utilisation goals, regardless of the true parameter values
underlying the market. Gately et al. (1977) and Gately (1983) proposed a robustly
optimal pricing strategy that can benefit OPEC more in contrast to alternative strategies.
In their study, the capacity utilisation target was also used as scarcity indicator of oil
market to adjust the direction and magnitude of output.
Compared with the Hotelling rule, market structure theory has practical significance
for the long-term oil price volatility analysis, whereas it may not be an appropriate tool
for forecasting crude oil prices.

3 Structure models

Many studies have attempted to investigate the relationship between crude oil prices and
some explanatory factors. The possible explanatory factors may be classified into the
following categories: (a) supply–demand imbalance; (b) unexpected events and (c)
financial factors.

3.1 Supply–demand imbalance

Supply–demand imbalance originates from global crude oil demand and production,
OPEC’s production policy, production costs, oil inventory levels as well as alternative
energy.
Pindyck (1978) proposed the well-known oil supply equation and the demand
equilibrium schedule to analyse the world oil price. Villar and Joutz (2006) studied the
impact of the availability of alternative energy and the relationship between natural gas
and crude oil prices. Kilian (2008) examined how crude oil demand was responsive to its
price fluctuations and estimated the energy-price elasticities of energy demand in 2008.
As for the oil inventory-price relationship, many researchers took petroleum
inventory as a measure of imbalance between oil production and oil demand.
Accordingly, inventory behaviour may be regarded as an influential factor of global oil
market and will result in the frequent changes of oil prices. Ye et al. (2002) developed a
dynamic short-term forecasting model for West Texas Intermediate crude oil spot price
using OECD normal petroleum inventory levels, which verified the anticipated negative
price-inventory relationship. The study by Ye et al. (2005) showed that relative inventory
levels of petroleum was a better market indicator of crude oil price change rather than
 Volatility analysis and forecasting models of crude oil prices 9

normal inventory levels (Ye et al., 2005). Ye et al. (2006) further integrated the low-
inventory and high-inventory variables into a single equation model to forecast short-run
WTI crude oil prices from post 1991 Gulf War to October 2003.

3.2 Unexpected events

An increasing number of studies have focused on the role of unexpected events in crude
oil price changes. As discussed by Zhang et al. (2009), unexpected events refers to the
events which have serious and medium-term impacts on world crude oil market, e.g.,
wars and global economic recessions. On the other hand, irregular events denote the
events which have important but short-term effects on crude oil prices, e.g., hurricanes,
OPEC production policy changes and strikes of oil workers.
Zhang et al. (2008a) showed that extreme events were the major driving forces of
crude oil price fluctuations in medium term (three–ten years), whereas irregular events
triggered large variability in short term (less than three years). They found that the shocks
of unexpected events became more and more frequent and serious over time. More
recently, Zhang et al. (2009) employed the Empirical Mode Decomposition (EMD)
approach to testing the role of unexpected events in global petroleum market, which was
found to be particularly useful in this application.

3.3 Financial factors

The growing financialisation of global petroleum market triggered a controversial
discussion on whether oil price volatility can be captured. Oil spot price fluctuation was
exacerbated by financial factors consisting of petroleum futures market, stock market and
exchange rate behaviour.
A number of studies have investigated the relationship between crude oil futures and
spot price and tested market efficiency hypothesis. Liu et al. (2011) used nonlinear model
to validate the long-run equilibrium relationship between futures and spot prices of crude
oil. Wang et al. (2011) verified the long-term cross-correlation between WTI crude oil
futures and spot prices and fluctuations in 2011. There are also different viewpoints
about the causality of petroleum futures and spot prices. Bekiros and Diks (2008)
explored the WTI petroleum market in two given sample periods and found the existence
of bi-directional linear causality in the first period. Huang et al. (2009a) showed that
there exists at least one causal linkage between petroleum futures and its spot prices
under two specific situations. On the other hand, existing studies on market efficiency
offered mixed discussions and conclusions. Gülen (1998) analysed the market efficiency
of NYMEX crude oil futures market and justified the price discovery function of crude
oil futures price. Quan (1992) verified the inefficiency of petroleum futures market.
Zhang and Wang (2010) tested the forecasting accuracy of one month, three month, six
month, nine month and 12 month ahead crude oil futures prices and the efficiency of oil
futures market in the long-term. More recently, Zhang and Wang (2013) concentrated on
the market efficiency of global petroleum market and concluded that crude oil futures
market performed well in price discovery.
The role of speculation in influencing crude oil prices is also a hot research topic.
Considerable studies have examined whether financial speculation exacerbated the real
oil price. Cifarelli and Paladino (2010) pointed out that increasing financial operators in
10 L. Fan and H. Li

the petroleum market resulted in immense deviations of crude oil prices from their base
value and tested the hypothesis by using the modified ICAPM model and GARCH-M
model. Their findings justified the presence of positive feedback in crude oil market and
verified the significant role of speculation in petroleum market. Similarly, Kaufmann and
Ullman (2009) utilised the asymmetric Granger causality test to investigate the
mechanism of oil price fluctuations and found that the combination of changes in both
market fundamentals and speculation had impacts on the changes of oil prices. More
recently, Zhang (2013) investigated how speculators’ positions influenced the returns of
WTI crude oil futures, which demonstrated the significant linear feedback relationship
and the nonlinear relationship between speculative trading and oil price. Conversely,
some scholars concluded that speculative behaviour played a limited role or even no role
in petroleum market. The important role of speculation was disputed by Weiner (2005),
who examined the global oil market during the Gulf Crisis of 1990–1991 and pointed out
that it was the combination of political events and market fundamentals, rather than the
speculation, that resulted in oil price fluctuations. Moreover, the empirical study by
Sanders et al. (2004) showed that traders’ positions may not bring petroleum market
returns.
Many studies have also investigated the relationship between crude oil prices and
exchange rates. In spite of their mixed conclusions, most relevant studies indicated an
asymmetric correlation between oil prices and exchange rates. Bénassy-Quéré et al.
(2007) showed that increasing oil prices resulted in the causality running from oil price to
the exchange rate. Selmi et al. (2012) evaluated the effect of oil prices fluctuations on the
exchange rate volatilities in Morocco using specific GARCH.
Since crude oil is traded in US dollars, it is believed that the US dollar exchange rate
volatility also drove the crude oil price fluctuation. Chaudhuri and Daniel (1998) used the
cointegration and causality tests to find the non-stationary behaviour of US dollar real
exchange rate and concluded that it stemmed from the non-stationary behaviour of real
oil price. By using econometric techniques including cointegration, VAR and ARCH
models, Zhang et al. (2008b) examined the mean spillover, volatility spillover and risk
spillover efforts, which provided empirical evidence in support of the exchange-rate-to-
oil price causality relationship. More recently, the conditional dependence structure
between crude oil prices and US dollar exchange rates was examined by Aloui et al.
(2013), which provided an evidence of significant and symmetric dependence on almost
all the pairs of oil-exchange rate.
Only few studies have examined the interaction between oil price fluctuations and
exchange rates in accordance with oil prices. Vo and Ding (2011) utilised the
multivariate stochastic volatility and the multivariate GARCH models to examine the
fluctuation correlations between the petroleum market and the foreign exchange market.
Chen et al. (2008) investigated whether oil prices were useful in predicting exchange
rates and found that crude oil price had limited exchange rate predictability.
The existing studies on the relationship between crude oil prices and stock returns
mainly focused on how oil price volatilities affected stock returns. Apergis and Miller
(2009) showed that crude oil price changes affected the non-oil stock returns in a
negative and weak way. Consistently, Sukcharoen et al. (2014) examined the relationship
between the oil price and stock market index of various countries between 1982 and 2007
and suggested a weak dependence in most cases. Park and Ratti (2008) explored the
nonlinear or asymmetric relationship between the oil prices and stock markets and
 Volatility analysis and forecasting models of crude oil prices 11

verified the existence of nonlinear relationship. Moreover, asymmetric influence of oil

price shocks on stock market returns in Gulf Cooperation Council (GCC) was also
verified (Mohanty et al., 2011).
In application, structure models are able to quantify the impacts of influential factors
on oil prices, which may be suitable for providing insights relevant to the causes of short
or intermediate oil price fluctuations. However, the difficulty in selecting proper input
variables for specific models makes it hard to us structure models to explain international
oil market and provide superior prediction performance.

4 Time series models

A rich body of literature on oil market employed time series models, e.g., the Auto
Regressive Integrated Moving (ARIMA) model, to investigate how the crude oil future
price vary with time in related to its previous values. Huntington (1994) presented a
sophisticated econometric model to forecast crude oil price in the 1980s. Lanza et al.
(2005) investigated the price of crude oil and its derivatives using Error Correction
Models (ECM). More recently, Murat and Toket (2009) employed random walk model to
forecast oil price movements. As for crude oil price risk, Askari and Krichene (2008)
used a Merton jump-diffusion process to model oil price returns and the result indicate
that discontinuous Poisson jump component dominated oil price dynamics between
2002–2006. Conditional Autoregressive Value at risk method was also employed to
forecast multi-period oil price risk (Huang et al., 2009b).
Both parametric and non-parametric GARCH models have been used to analyse
crude oil price volatility. Morana (2001) introduced a semi-parametric approach and
examined how the GARCH properties of oil price changes were employed to forecast the
oil price distribution in short term. Sadorsky (2006) used several different univariate and
multivariate statistical models such as GARCH to examine daily volatility of petroleum
futures returns. Hou and Suardi (2012) verified the out-of-sample oil volatility
forecasting performance of the nonparametric GARCH model in contrast to extensive
parametric GARCH models. Considering structural break in global oil market, Arouri
et al. (2012) employed the ARCH-type models to analyse the conditional volatility of oil
spot and futures prices before and after a structural break. Kang and Yoon (2013)
adopted intraday data to forecast crude oil price volatility along with relevant time-series
models. Their empirical result showed the superior short-term volatility prediction
performance of power autoregressive models and the preponderant longer-horizon
prediction accuracy of GARCH-type models.
Time series model are able to capture the trend and seasonal components of oil
prices. However, extreme events and policy factors have also important effects on the
changes in oil prices, which are difficult to be modelled by time series models.

5 Artificial intelligence models

More recently, Artificial Intelligence (AI) models have received increasing attention in
crude oil price forecasting. AI models have the ability to learn complex and nonlinear
relationships, which may be considered as nonparametric models that map the input–
output relationship without exploring the underlying process. Existing AI models such as
12 L. Fan and H. Li

Artificial Neural Networks (ANN) and Support Vector Machines (SVM) provide
powerful solutions to nonlinear petroleum price prediction. AI models may be further
divided into two categories, namely single model and hybrid model.

5.1 Single model

As one of the most popular prediction methods, ANNs has captured much attention for
crude oil price trend forecasting recently. Abramson and Finizza (1991) used belief
networks, a class of knowledge-based models, to forecast crude oil prices. Kaboudan
(2001) compared genetic programming with ANNs and suggested that the neural network
forecast performed worse than random walk predictions whereas genetic programming
proved superior. Shambora and Rossiter (2007) used the ANN model to predict crude oil
price. Support vector regression (SVR), a neural network model developed from
statistical learning theory, has also been widely applied in forecasting crude oil prices.
For instance, Xie et al. (2006) employed SVM to monthly crude oil price forecasting and
got relatively high prediction accuracy. Fan et al. (2008) applied a pattern-matching
technique to multi-step prediction of crude oil prices.
Decomposition methods such as wavelet analysis and EMD can capture complex
multiscale data characteristics in the global petroleum market and have become popular
in forecasting crude oil price. The idea of using wavelet decomposition to forecast crude
oil futures price was proposed by Yousefi et al. (2005). By decomposing time series into
a small number of independent and concretely implicational intrinsic modes based on
scale separation, EMD is an appropriate spectrum tool in studying global oil market.
EMD was extended to EEMD which provides a feasible solution to estimate the impact
of extreme events on crude oil prices (Yu et al., 2008).

5.2 Hybrid model

Despite their usefulness, single AI models also suffered from a number of shortcomings,
such as the risk of model over-fitting (Tay and Cao, 2001). To remedy this shortcoming,
some hybrid methods have been proposed to improve the prediction performance of
crude oil price. It is well known that a combination of different forecasting methods can
improve forecast accuracy (Krogh and Vedelsby, 1995).The existing hybrid models can
be classified into three categories in term of different corporation ways: (a) ANN-based
models; (b) integration of SVM and other models and (c) DAC – divided and conquer
models.
ANN models own the ability to capture the autocorrelation structure in a time series
and have been widely used by integrating with some nonlinear time series models for oil
price forecasting. Mirmirani and Li (2005) integrated ANN and Vector Auto-Regression
(VAR) to predict crude oil price and verified its superiority in prediction accuracy over
single VAR model. Afterwards, Amin-Naseri and Gharacheh (2007) proposed a hybrid
AI approach integrating feed-forward neural networks, genetic algorithm and k-means
clustering, to predict the monthly crude oil price and obtained satisfactory results.
Azadeh et al. (2012) proposed a flexible forecast algorithm based on ANN and fuzzy
regression. To extract various features of oil price data, He et al. (2009) used a hybrid
model consisting of SVM and ARMA to forecast crude oil price. Saini et al. (2010)
proposed an improved oil price forecast model namely SVM-GA which showed a better
prediction performance than the traditional SVM.
 Volatility analysis and forecasting models of crude oil prices 13

The hybrid DAC methodology, which was proposed by Professor Shouyang Wang
and his collaborators, employs the “decomposition-and-ensemble” principle to construct
a novel crude oil price forecasting technique. DAC methodology captures the complex
petroleum market effectively and provides very high prediction accuracy. An important
progress in DAC is the development of TEI@I methodology (Lai, 2005; Wang et al.,
2005). Existing literature in DAC framework mainly included two categories:
(a) wavelet-based models and (b) EMD-based ensemble learning models. As a pre-
processing tool for feature extraction of non-linear and non-stationary time series, either
wavelet analysis or EMD can capture complex multiscale data characteristics in the
global petroleum market. Bao et al. (2007) and Shambora and Rossitier (2007) pointed
out that the interaction of multi-scale wavelet decomposition and ANN in crude oil
forecasting provided better prediction performance. de Souza et al. (2010) developed a
three step forecasting model based on wavelet analysis and Hidden Markov Model
(HMM). Wavelet analysis removes high frequency price movements and HMM presents
the probability distribution of the price return, so their integration gives a scientific
inference of future trend of crude oil price. Jammazi and Aloui (2012) employed wavelet
decomposition to smooth the original oil price data and adopted back propagation neural
network to do oil price prediction.
One precondition of wavelet analysis application is to determine a proper filter
function, which might be hard to catch under many unknown cases. This shortcoming
may be overcome by EMD. Yu et al. (2007) applied EMD to time series before training
with ANN and their empirical results demonstrated its effectiveness in forecasting crude
oil spot price. More recently, the EMD–SBM–FNN model was proposed to capture the
complex dynamic of crude oil prices and improve prediction performance (Xiong et al.,
2013).
The strength of AI models lies in its ability in data learning and mining. However,
constructing a reliable AI model for oil price forecasting is challenging since it often
involves the choice of different parameters. In view of the impacts of various factors on
oil prices, the DAC methodology is likely to play a more significant role in capturing the
intrinsic features of oil price series.

6 Conclusion

This paper presents a review of the methodological developments in volatility analysis

and forecasting of crude oil prices. Whereas structure models, time series models and AI
models have been extensively employed, an increasing trend in using various AI models
to forecast crude oil prices has been identified. On the other hand, with the appearance of
more financial investors in crude oil market, financial factors tend to affect the dynamics
of oil prices more frequently. Therefore, the impacts of financial factors are also required
to be taken into account. Clearly, capturing the underlying mechanism of oil futures
market becomes more significant in order to improve the accuracy of crude oil price
forecasting.
Through observing the trend in modelling crude oil prices, we may find that there
was a continuous improvement in the prediction ability whereas the forecasting model
becomes more and more complex. Every type of models has its strength and weakness
and none of them can be treated as a superior model. Therefore, it is meaningful to make
use of the strengths of different models and develop integrated models for better
14 L. Fan and H. Li

prediction of oil prices. In particular, the integration of time series models and AI
models, namely, AI-based hybrid models seem to be promising for future research. It
should be noted that the influential factors of oil prices are diverse. It might be
worthwhile extracting the multi-dimensional features of oil price series with appropriate
multivariate statistical analysis techniques to improve the forecasting performance.
Along this line of thought, the DAC framework, which is basically a kind of philosophy
for complex systems analysis and modelling, should be paid more attention in this field.

Acknowledgements

The authors are grateful to the financial support provided by the National Natural Science
Foundation of China (No. 71203055) and the Humanities and Social Science Foundation
of the Ministry of Education (No. 12YJCZH039).

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