DP10188 The Elephant in the Ground: Managing Oil and Sovereign Wealth

Author(s):	Ton van den Bremer, Frederick van der Ploeg, Samuel Wills
Publication Date:	October 2014
Keyword(s):	hedging, leverage, oil, optimal extraction, portfolio allocation, sovereign wealth fund
JEL(s):	E21, F65, G11, G15, O13, Q32, Q33
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=10188

Oil exporters typically do not consider below-ground assets when allocating their sovereign wealth fund portfolios, and ignore above-ground assets when extracting oil. We present a unified framework for considering both. Subsoil oil should alter a fund?s portfolio through additional leverage and hedging. First-best spending should be a share of total wealth, and any unhedged volatility must be managed by precautionary savings. If oil prices are pro-cyclical, oil should be extracted faster than the Hotelling rule to generate a risk premium on oil wealth. We then discuss how the management of Norway?s fund can practically be improved with our analysis.