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The Elephant in the Ground: Managing Oil and Sovereign Wealth

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  • Rick Van der Ploeg
  • Samuel Wills
  • Ton van den Bremer

Abstract

Many oil exporters accumulate large sovereign wealth funds, though their portfolio allocation does not take into account below-ground assets, like oil. Similarly, the above-ground portfolio does not affect the decision to extract oil. This paper shows that subsoil oil wealth should change a country's above-ground asset allocation in two ways. First, the holding of all risky assets is leveraged because there is additional wealth outside the fund. Second, more (less) is invested in financial assets that are negatively (positively) correlated with oil to hedge against the riskiness of subsoil exposure. Furthermore, if marginal oil rents move pro-cyclically with the value of the financial assets in the fund, then oil will be extracted slower than predicted by the standard Hotelling rule. This leaves a buffer of oil to be extracted when both oil prices and asset returns are high. Finally, any unhedged residual volatility must be managed through additional precautionary saving.

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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number OxCarre Research Paper 129.

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Date of creation: 31 Dec 2013
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Handle: RePEc:oxf:wpaper:oxcarre-research-paper-129

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Keywords: oil; portfolio allocation; sovereign wealth fund; optimal extraction;

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