THE ELEPHANT IN THE GROUND: MANAGING OIL AND SOVEREIGN WEALTH

Dec 2013 | 129

Authors: Rick Van der Ploeg Ton van den Bremer


One of the most important developments in international finance and resource economics in the past twenty years is the rapid and widespread emergence of the $6 trillion sovereign wealth fund industry. Oil exporters typically ignore below-ground assets when allocating these funds, and ignore above-ground assets when extracting oil. We present a unified stylized 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 unhedgeable 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. Finally, we discuss how our analysis could improve the management of Norway’s fund in practice.

JEL Codes: E21, F65, G11, G15, O13, Q32, Q33

Keywords: oil revenue, portfolio allocation, sovereign wealth fund, leverage, hedging, optimal extraction, prudence, risk aversion


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