Oil Prices and Long-Run Risk

I add an oil good endowment to the Long-Run Risk model of Bansal and Yaron (2004) to study the asset pricing implications of a constrained oil supply. Lack of responsiveness of the oil endowment changes both the physical and risk-neutral dynamics of oil prices, and explains significant differences in the observed behavior of oil futures prices and returns from 2004 to 2008 relative to the prior 15 years. The model predicts that an unresponsive oil supply increases the risk of exogenous oil shocks, but mitigates risk from other shocks to growth, thereby lowering overall economic risk and the equity premium.