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Oil Volatility and the Option Value of Waiting: An Analysis of the G-7

There has recently been considerable interest in the potential adverse effects associated with excessive uncertainty in energy futures markets. Theoretical models of investment under uncertainty predict that increased uncertainty will tend to induce firms to delay production and investment. These models are widely utilized in capital budgeting and production decisions, particularly in the energy sector. There is relatively little empirical evidence, however, on whether such channels have industry-wide effects. Using a sample of G7 countries we examine whether uncertainty about a prominent commodity – oil – affects the time series variation in production in energy intensive industries. Our primary result is consistent with the predictions of real options theory – uncertainty about oil prices has had a negative and significant effect on manufacturing activity in Canada, France, UK and US.