1.1 BACKGROUND OF STUDY

“There are various evidences, particularly over the post-Breton woods era, pointing to the vital role of oil price fluctuations in the determination of the path of the exchange rate” (Adeniyi et al, 2004). According to Krugman (1983), exchange rate appreciates in response to rising oil prices and depreciates with response to falling oil prices in oil exporting countries, while the opposite is expected to be the case in oil importing countries.

Volatility is the fluctuation in the value of a variable, especially price (Routledge, 2002). According to Englama et al (2010), a volatile exchange rate makes international trade and investments more difficult because it increases exchange rate risk. Exchange rate volatility tends to increase the risk and the uncertainty of external transactions and predisposes a country to exchange rate related risks (Jin, 2008).

According to Adedipe (2004), when Nigeria gained politically independence in October 1960, agricultural production was the main stay of the economy, contributing about 70% of the Gross domestic product (GDP), also employing about seventy percent of the working population and responsible for about ninety percent of foreign government revenue. The initial period of post-independence till mid – 1970s witness a fast advancement of industrialized capacity and output, as the contributions made by the manufacturing sector to GDP rose from 4.8% to 8.2%. This pattern changed when crude oil became very important to the world economy.

According to Englama et al (2010), crude oil became an export commodity in Nigeria in 1958, following the discovery of the first producible well in 1956. The contribution of oil to the federal government revenue in 1970 rose to 82.1% in 1974 from 26.3% and in 2008 constituted 83% of the federal government revenue, largely on account of increase in oil prices in the international market. The gigantic rise in oil revenue was caused by the Middle East war of 1973. It created extraordinary, surprising and unforeseen wealth for Nigeria and the naira appreciated as foreign exchange influxes offset outflows and Nigeria foreign reserves assets increased (Adedipe, 2004). The economy of Nigeria gradually became dependent on crude oil as productivity declined in other sectors (Englama et al, 2010).

Nigeria is a mono – product economy, according to OPEC statistical bulletin (2010/2011) the value of Nigeria’s total export revenue in 2010 was US$70,579 million and the revenue of petroleum exports from the total export revenue was US$61,804 million which is 87.6% of total export revenue this means that Nigeria’s economy will be vulnerable to the movements of oil prices.

During periods of favorable oil price shocks triggered by conflict in oil – producing areas of the world, the rise in the demand for the commodity by the consuming nations, seasonality factors, trading positions etc. Nigeria experiences favorable terms of trade evidenced by a large current account surplus and exchange rate appreciation. On the converse, when crude oil prices are low, occasioned by factors such as low demand, seasonality factors, excess supply, the Nigeria experiences unfavorable terms of trade evidenced by budget deficit and slow economic growth (Englama, 2010). An example was a drop in the revenue from oil exports during the global financial crisis in 2009. According to, OPEC statistical bulletin (2010/2011), oil export revenue dropped from US$74,033 million in 2008 to US$43,623 million in 2009 and the naira depreciated to N148.902 in 2009 from N118.546 in 2008.