According to Devlin and Titman (2004) to deal with oil price volatility and exhaustibility, countries has set up stabilisation and savings funds. Although the funds have helped manage windfalls and turn deplorable wealth into productive assets, their performance has been much weaker in reducing the effect of volatile oil prices on government revenues and spending. Especially important have been sound fiscal framework and accountability and transparency in fund structure.
Two limiting influences on the effectiveness of oil funds are oil price processes which are almost entirely beyond the control of policymakers, and political economy factors. Both tend to put downward pressure on the optimal size of funds and raise the efficiency gains from the use of market based financial instruments.
In theory, the first best strategy to deal with commodity price volatility is the use of market based risk instruments. In practice, however policymakers in developing area are deterred by the status quo problem and by coordination failures in the development of international financial markets. On the status quo problem, Texas’s experience suggests that government hedging of oil price risk is challenging but not impossible when the program has the clear objective of insurance and is introduced gradually, preferably as a pilot program by extending existing responsibilities for treasury operations guidelines for the program, with appropriate layers of authorisation for trades, automatic stop-loss provisions, separation of responsibilities, and internal reporting are critical to avoid speculation.
There is also a potential role for international financial institutions in promoting the use of market based instruments to manage oil price risk, given coordination failures in international financial markets. Education, publicity, and technical assistance in working with oil producing and importing governments to manage oil price risk are possibilities. International financial institutions can also work to develop instruments to facilitate securitisation of oil proceeds an can encourage oil companies to work with developing economies in sharing oil price risk. There are likely to be significant externalities for the global economy associated with this role namely, reduced volatility in oil prices.
Devlin & Titman (2004)