The impact of geopolitical uncertainty on energy volatility

Abstract Energy and geopolitics have always been closely intertwined. In this paper, we empirically investigate the impact of geopolitical uncertainty (GPR) as measured by Caldara and Iacoviello (2018) on the volatility of major energy commodities: crude oil, heating oil and natural gas. Through the framework of GARCH-MIDAS, we find strong evidence that geopolitical uncertainty exerts a significantly positive impact on energy volatilities in the long run. The results emphasize that, first, after controlling the realized volatility, fundamental variables, financial market stress and economic policy uncertainty, geopolitical uncertainty still provides marginal explanatory power. Second, regarding to the transmission mechanism, the impact of geopolitical uncertainty on energy market is more likely to be transmitted through threats to adverse geopolitical events relative to their realizations. Third, by combining high frequency information, the GARCH-MIDAS model has a unique ability to capture long memory characters of geopolitical uncertainty and provides significant out-of-sample forecast of energy volatility. The robustness is solid with alternative proxies for geopolitical uncertainty, with GPR index constructed by search terms in French, Chinese and Arabic, with prices of energy futures, as well as with energy prices denominated in SDR.