OPEC’s Impact on Oil Price Volatility: The Role of Spare Capacity

OPEC claims to hold and use spare production capacity to stabilize the crude oil market. We study the impact of that buffer on the volatility of oil prices. After estimating the stochastic process that generates shocks to demand and supply, and assessing OPEC’s limited ability to accurately measure and offset those shocks, we find that OPEC’s use of spare capacity has reduced price volatility, perhaps by as much as half. We also apply the principle of revealed preference to infer the implicit loss function that rationalizes OPEC’s investment in spare capacity and compare it to other estimates of the cost of crude oil supply shortfalls. That comparison suggests that OPEC’s buffer capacity was in line with global macroeconomic needs.