The Influence of Change in Crude Oil Prices on Equity Market Returns
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Department of Business Studies MSc Finance and International Business The Influence of Change in Crude Oil Prices on Equity Market Returns: an empirical study in the transport sector analysed with the use of Hubbert’s curve and the peak oil theory Author: Nataliya Georgieva Pavlova Academic Supervisor: Thomas Berngruber Aarhus School of Business, Aarhus University December 2011
The Influence of Change in Crude Oil Prices on Equity Market Returns Summary We live in a world that is changing with ever accelerating pace. What was science fiction just a few decades ago is now a common everyday reality. And all the new technology, transportation, agriculture, and the economy as a whole is build on the abundance of affordable energy – the black gold – oil. In 1956 the geologist Martin King Hubbert published his peak oil theory and made a very accurate prediction that USA will reach a peak oil point in the 1970s and from them on the production of oil will decline very rapidly. At the time he was discredited for his theory but in 1970 the American oil production began to decline. The country’s economy is now especially dependent on import for its energy needs. But how long can this be sustain? At the present 33 out of 48 oil-extracting countries already peaked. Basic economic law tells us that while oil keep decreasing price will keep increasing. In valuing companies on the stock market the analytics use an assumption that there will be infinitive stream of relatively cheap oil. So if the peak oil theory come to be that means all the companies are overvalued. In this empirical study the relationship between stock rate of return and the oil price is studied for the United States transport industry in the last 11 years. The results of the study are not conclusive since some the coefficients in the regressions are not statistically significant. Despite that there is evidence for relationship between oil prices an equity market. This correlation means that in case of peak oil the transportation sector will be fully affected in negative direction. To transfer the whole sector away from the oil as an energy source will be long an expensive process. Since the Page | ii
The Influence of Change in Crude Oil Prices on Equity Market Returns economy depends so heavily on the transportation to function it can affect all areas of the economy. Despite of being such a big threat for the economy the problem off limited oil supply is not extensively researched. Few papers argue the validity of Hubbert’s model, but not many make the connection between the theoretical model and its application in evaluating companies or predicting market research. This paper reaches as far as analysing the results from an empirical study using the influence of Hubbert’s curve over the economy. It involves some speculations and educated guesses but all models have their assumptions. So does this one. Page | iii
The Influence of Change in Crude Oil Prices on Equity Market Returns Table of content Summary ................................................................................................................................ii Table of content ....................................................................................................................iv 1. Introduction ..................................................................................................................... 1 1.1. Motivation .................................................................................................................1 1.2. Problem statement .................................................................................................... 2 1.3. Applied methodology ................................................................................................3 1.4. Boundary delimitations .............................................................................................3 1.5. Structure of the paper ................................................................................................4 2. Theory .............................................................................................................................6 2.1. Oil price volatility .....................................................................................................6 2.2. Oil price shocks .......................................................................................................10 2.3. Oil prices and the economy......................................................................................11 2.4. Oil prices and the stock market................................................................................13 2.5. Dependency of crude oil .........................................................................................16 2.6. Hubbert’s curve and peak oil theory .......................................................................17 2.6.1. What is peak oil theory ................................................................................17 2.7. Literature review......................................................................................................22 2.7.1. Supporting Hubbert’s theory ........................................................................24 2.7.2. Opposing Hubbert’s theory ..........................................................................24 Page | iv
The Influence of Change in Crude Oil Prices on Equity Market Returns 3. Hypothesis ......................................................................................................................26 4. Statistical methodology...................................................................................................27 4.1. Linear Regression Model with Ordinary Least Squares (OLS) ..............................27 4.2. Principal component analysis .................................................................................28 4.3. Linear and non-linear dimensions of xi ...................................................................31 4.4. Hypothesis tests ......................................................................................................31 4.5. Residual tests ..........................................................................................................32 5. Empirical analysis ..........................................................................................................33 5.1. Data and model .......................................................................................................33 5.2. Descriptive statistic .................................................................................................35 5.3. Linear regression .....................................................................................................41 5.4. Principal Components Regression ..........................................................................43 5.4.1. Linear rate of return of oil prices .................................................................50 5.4.2. Non-linear oil price increases .......................................................................51 5.4.3. Other explanatory variables .........................................................................52 5.5. Hypotheses tests ......................................................................................................52 5.6. Residual tests ..........................................................................................................54 5.7. Discussion ...............................................................................................................55 6. Conclusion ......................................................................................................................59 6.1. Limitations ..............................................................................................................60 Page | v
The Influence of Change in Crude Oil Prices on Equity Market Returns 6.2. Further research........................................................................................................60 References.............................................................................................................................62 Appendixes: Appendix A: List of companies included in the study............................................................a Appendix B: Distribution of included in the study companies’ rate of return over time……b Appendix C: Distribution of the included in the study variables’ rate of return aver time...c Page | vi
The Influence of Change in Crude Oil Prices on Equity Market Returns 1. INTRODUCTION This chapter is dedicated to explaining the purpose the objectives of this paper, as well as the motivation for its writing. It also contains a section with some limitations as well as a description of the structure of the paper. 1.1. Motivation “For the first time since the Industrial Revolution, the geological supply of an essential resource will not meet the demand.” Deffeyes (2005) “Oil is so significant to the international economy that forecasts of economic growth are routinely qualified with the caveat: provided there is no oil shock.” Adelman (1993) The purpose of this paper is to study the effects of change in global crude oil price over the equity market and more specifically over the transport industry which is so dependable on oil. The results are discussed in the light of Hubbert’s curve and peak oil theory. The International Energy Agency is referring to crude oil as the number one energy source in the world and the most actively traded commodity. The present global situation is far from perfect partly because it is built on the available cheep energy of petroleum. The developing countries are causing rapid demand growth, far greater than the growth in production, which slowed even more with the conflict in Libya. This asymmetry between demand and supply is keeping the prices at one of the highest ever. Prices above $100 per barrel on the other hand are weighing down the economic development and already unstable financial market, raising the prices of other commodities, keeping inflation high as Page | 1
The Influence of Change in Crude Oil Prices on Equity Market Returns well as concerns about speculation. The energy market is experiencing one of the most uncertain periods in history. But the beginning of petroleum usage has been far less turbulent. In fact the oil prices have been fairly steady up until the 1970s. In 1973 OPEC (Organization of Petroleum Exporting Countries) placed embargo over the oil price which led to oil prices’ raise four times in a few short months and causing a following recession. For the next 40 years the price of oil has continued to vary in a general upwards direction and has become more and more essential to the world’s economy. Soltes (2010) states that the oil price will keep increasing because of the limitations in supply just like Hubbert’s model predicts. This must have an effect on the economy by reducing the expected return and thus reducing the price of equity. There are a few studies on the effects of oil price fluctuation but none of their results are discussed from Hubbert’s curve point of view. This is the motivation conducting such a study and analysing the results from the perspective of Hubbert’s model. 1.2. Problem statement Petroleum is non-renewable energy source and it will be depleted at one point in the future. Since the whole modern world is build on the availability of oil as cheap energy, if people want to sustain today’s lifestyle, oil have to be replaced by another type of energy. Considering these points come the big question of what will happen to all those industries that depend on oil as their main resource. The transport industry is the key to our modern civilization, because it enables trade. It allows companies to make big cost savings from scale and scoop, by using one big production site and distributing the finished product to the clients. It affects our very survival since nowadays huge part of the food cost is the price of fuel, as well as other chemicals used in the production – almost all of which are on the basis of oil. Besides food Page | 2
The Influence of Change in Crude Oil Prices on Equity Market Returns is not produced close to the people who consume it, but on huge fields and later on it is shipped to supermarkets. This makes the transportation industry vital for today’s economy. This study employs the stock price of listed companies with field of business in land, water and air transportation of people or goods as a benchmark for the overall industry. It allows for the influence of changes in oil price over the industry to be studied. To summarise the objectives of this study: 1) To summarise the results from the discussions regarding the validity of Hubbert’s peak oil theory and prove that it should be a guiding tool for the economical policies. 2) To illustrate the relationship of crude oil prices and equity prices through conducting empirical study. The limitations of supply on economies most important energy source is an important issue. But almost all of the studies discuss the effect of Hubbert’s curve over the macroeconomical variables. This paper aims to connect it with the state of the equity markets as well and prove that low supply of crude oil will affect every aspect of the economy. 1.3. Applied methodology This paper will present an empirical study to answer the problem statement. Theoretical and empirical literature will be used as alternative data and estimating procedures as well as comparative instruments (how close this study come to the finding of other similar studies). Principal component analysis is the analytical tool of choice. The description and specification of the statistical model can be found in chapter four “Statistical methodology”. 1.4. Boundary delimitations Page | 3
The Influence of Change in Crude Oil Prices on Equity Market Returns The empirical study is limit to one industry so that the results can be analyzed more thorough. The reason for choosing the airline industry is that it is very dependent on oil so the relationship between oil price and stock price will be clearer. For many industries that are not so oil dependent this relationship can be lost in the noise of many other factors influencing a stock price. Another limitation is that the data is taken from the US market. This country was chosen for several reasons: 1) it is very dependable on oil, so the whole economy reacts very strongly to any shocks in oil prices; 2) there is a rich database with available and reliable data going far back in time. 1.5. Structure of the paper The structure of the paper is presented graphically in figure 1. The first chapter presents the chosen subject and gives a brief description of the problem statement. Chapter two studies the theoretical background, including a review of several relevant literature sources and empirical studies. This helps forming a valid hypothesis in the next chapter. Chapter four is dedicated to explaining the statistical method used to analyse the data – principal component analysis, and explaining why this particular study is conducted with this particular tool. Chapter five gives a description of the data and the results from the analysis. The last chapter is conclusion and further research. Page | 4
The Influence of Change in Crude Oil Prices on Equity Market Returns I. Introduction • Motivation • Problem statement • Applied methodology • Boundary delimitations II. Theory • Oil price volatility • Oil price shocks • Oil price and the economy • Oil price and the stock market • Hubbert's curve and peak oil theory • Literature review III. Hypothesis IV. Statistical methodology • Linear regression • Principal component analysis • Additional tests V. Empirical analysis • Data and model • Descriptive statistics • Discussion VI. Conclution • Limitations of the paper • Further research Fig. 1: Structure of the paper – graphic representation of the key point in the Master Thesis. Page | 5
The Influence of Change in Crude Oil Prices on Equity Market Returns 2. THEORY The theoretical part of this thesis is divided into several parts. The first five parts are dedicated to the price of crude oil, examining its volatile nature, and the dynamics between oil and the economy and oil and equity market. The next two sections are dedicated to Hubbert’s peak oil theory, explaining the nature of his model and reviewing some relevant literature of debates about the validity of the curve. 2.1. Oil price volatility Figure 2 shows the movement of nominal and real oil prices since 1974 until present days. The graph is constructed based on monthly data so the daily highest and lowest peaks are slightly softened. Despite that it is clear that crude oil is a commodity with highly volatile price – for the last 35 years presented here the price have varied between a minimum value of $9.39 per barrel (December 1998) and a maximum value of $127.77 per barrel (July 2008). Page | 6
The Influence of Change in Crude Oil Prices on Equity Market Returns Nominal and Real Crude Oil Price ($/barrel) 140,00 Oil price bubble and financial 120,00 crises 100,00 80,00 East Asian 60,00 crises Iran – Iraq 40,00 Persian war Gulf War 20,00 OPEC embargo 0,00 Collapse Recession in Юли 1975 Юли 1978 Юли 1981 Юли 1984 Юли 1987 Юли 1990 Юли 1993 Юли 1996 Юли 1999 Юли 2002 Юли 2005 Юли 2008 Юли 2011 Януари 1995 Януари 2004 Януари 1974 Януари 1977 Януари 1980 Януари 1983 Януари 1986 Януари 1989 Януари 1992 Януари 1998 Януари 2001 Януари 2007 Януари 2010 of OPEC US Nominal Price Real Price Fig. 2: The nominal and real price of crude oil from 1974 presented as monthly average. Real oil price is computed by dividing the nominal price for particular month to the Consumer Price Index (CPI) for the same month to account for inflation (data source: US Energy Information Agency). There is clear pattern of rising nominal prices over time. With real prices there is not such an obvious trend. However the real prices keep values under $40 for the period before 2004, with the exception of the war periods in the Middle East – a value that is briefly reached during the drop in 2008 when the price bubble burst. Adjusting energy prices for inflation can be considered unnecessary since energy price increases are the main drivers of inflation (LeBlanc and Chinn, 2004) and thus a vicious cycle is created. For this empirical study nominal prices will be used. Before the 1970s the price of crude oil has been varying very slightly in comparison. During this period USA was still the biggest consumer but also the biggest producer and even exporter. In 1973 short after the US peak in production the Yom Kippur Page | 7
The Influence of Change in Crude Oil Prices on Equity Market Returns war led to the OPEC embargo and cause a surge in oil prices and recession. Next oil price shock can be attributed the Iranian revolution and the Iran – Iraq war from 1980 – political instability in the major oil exporting region. The prices suddenly fall when in 1986 disagreement in OPEC cause the organization to collapse and the market was flooded with oil. During the Persian Gulf War (1990) when Iraq occupied Kuwait the oil price almost double. It was quickly restored because of Saudi Arabia’s quick reaction to increase production. During the 1990s new power emerged and started increasing the demand – the developing countries with leaders China and the Asian Dragons. These countries started to industrialise their economies, causing gradual increase in oil prices, with the exception of the period between 1998 and 1999 when the East Asian crises caused collapse in the financial systems of the regions. The next dip in the market was caused by the recession in the US in 2001. This was also the year of the terrorist attack in New York. After that the global economy had several years of high economic growth which caused increase in oil demand and price until 2008. For these years there were several spikes and dips in the market caused by conflicts in Iraq and Nigeria, strikes in Venezuela, the peak in production of several substantial fields. But the biggest fall of oil price in history came with the financial crises of 2008 when the price dropped from $145 per barrel (all time highest price for crude oil) to $39 per barrel in several short months. Hamilton (2011) argues that the prices may be unusually high because of speculations on the market, which led to oil price bubble bursting and ledding to the significant fall. Since then the oil prices have been steadily claiming back to values over $100 per barrel. From this historical overview can be concluded the before 1990s main drivers for oil price surges were wars, conflicts and OPEC’s control over production (Hamilton, 2011). Since then most spikes and dips are a result of the economical and financial instability and increased demand without the corresponding increase in supply. As showed above crude oil is quite volatile commodity. The factors that influence the movement in price can be separated in to several categories: Page | 8
The Influence of Change in Crude Oil Prices on Equity Market Returns - Global oil supply and demand – just like every item that is subject to trade, crude oil dependents on the supply and demand law of economics. The main factors that drive the price of oil are global changes in supply and demand. This is not however entirely competitive market. The production is controlled by OPEC. The organization’s aim for the past decade has been to keep oil prices stable. With time however this task has proven increasingly difficult and oil prices have been bouncing up and down in response to major global events or speculations. - War and natural disasters – war and devastating disasters are among the main external factors affecting oil prices. The region of Middle East holds the largest amount of oil supply in the world. At the same time it is one of the most politically unstable regions. During the wars in Iraq and Afghanistan the concerns that delivery of oil would stop was among the reasons that led to increase in oil prices up to $136 per barrel in July 2008. The price rise high in 2005 as well when Hurricane Katrina stopped the oil production in the South Gulf Coast area. With less supply and the same demand the price rose in a short period of time and forced President Bush to release 30 million barrels from the Strategic Petroleum Reserve of the United States to bring the prices down. - Changes in the social and political structure – events in the social or political scene influence the petroleum market. For instance general increase in strike activity can disrupt any of the supply or demand sides. Some of the historical spikes in oil prices are caused by strikes in the energy sector (1952 – strike by oil, coal and steel workers, 1969 – strikes by oil workers, 1970 – strike by coal workers). Before the last decade of XX century most of the world’s economies were agricultural in nature. Since then many of them started transitioning to more industrial economy which in turn led to increase in oil consumption. Among these countries are China, India and the Asian Dragons (Hong Kong, Singapore, Taiwan and South Korea). The accelerated development of Asian countries accounts for as much as 70% of the increase in oil consumption for the last two decades. China was the third biggest consumer of crude oil for 2010 (9.189 million barrels/day), behind only USA (19.150 million Page | 9
The Influence of Change in Crude Oil Prices on Equity Market Returns barrels/day) and the European Union (13.730 million barrels/day) (data source: Central Intelligence Agency, publication: the World Factbook) - Recession and the decreased demand for oil – Oil prices have very complex relationship with the state of the economy. Empirical research (Hamilton, 1983) has shown that oil price shocks can cause a recession. At the same time a recession reduces production, which in turn lowers the demand. Decrease in demand is a force that drives the price down. - Speculation on the market – some changes in oil price cannot be linked to actual changes in supply and demand but can be attributed to speculations in the market. Former Algerian energy minister and president of OPEC Boussena said in interview in September 2007: “Non-commercial participants are playing bigger role in the oil markets. Funds are investing more capital in oil markets because of the volatility, diversification, and opportunities to produced outsized returns.” Despite the fact that there are many factors influencing the movement on the petroleum market, they all work by pushing up and down the demand and supply lines. The price is volatile because the demand and supply is constantly changing. The general tendency however is of constant growing need for more energy to fuel the economic growth and limited supplies of oil which is reducing the extraction growth rate and lowering the supply. 2.2. Oil price shocks The rapid change in oil prices are known as oil shocks. These shocks can be classified and measured in three ways: 1) linear oil price shocks; 2) non-linear oil price shocks; 3) asymmetric oil price shocks. Hamilton (1983) estimate oil price shocks by using the log difference of nominal oil prices to estimate a linear model for oil prices. Asymmetric oil price shocks represent both significant increases and significant decreases of oil price treated as separate variables. Mork (1989) discovered stronger Page | 10
The Influence of Change in Crude Oil Prices on Equity Market Returns statistically significant relationship between oil price and economic variables using asymmetric oil price model compared to Hamilton’s (1983) linear oil price model. Non-linear oil price model was researched by Hamilton in later paper (1996). He points out that most of the increases in oil prices are followed by immediate and sometimes even bigger decreases. These decreases are mere corrections to the previous surges rather than a real movement away from stable environment. He suggests an alternative model for estimating change in oil price – Net Oil Price Increases (NOPI). This model suggests that the oil price should be compared to its rate from the previous year. As value for the oil price is assumed the difference between present value and the maximum value measured for the previous year or zero if the number is negative. 2.3. Oil prices and the economy For several decades petroleum has played the part of the main energy source for the industrialized countries. So it is not a surprise that a vast volume of literature is developed to study the effects of oil over various macroeconomic variables such as Gross Domestic Product, economic stability and growth, international debt, inflation, interest rates. Crude oil prices play very important role in the US economy (Hamilton, 1983; Mork, Olsen and Mysen, 1994; Gisser and Goodwin, 1986). There is an obvious link between oil prices and the basic macroeconomic variables. In his research Hamilton (1983) studies the influence that oil price shocks have over the economy. He proves that after World War II all but one of the recessions in the US can be directly correlated with large increases in oil prices. His paper points out some facts about the poor performance of the United States after the 1973 embargo: 1) the real GDP growth has fallen from an average of 4% for the previous decade to 2.4%; 2) for the same period the inflation has more than double; 3) and the unemployment rate of 6.7% was higher than in any year between 1948 and 1972 (with the exception of the recession of 1958). Of course these symptoms of deep economic crisis following a reduction in oil supply can be merely a coincidence. Hamilton however prove at 1% significance level that there is a systematic Page | 11
The Influence of Change in Crude Oil Prices on Equity Market Returns relation between oil prices and output – increases in oil prices are followed by decreases in economic activity three to four quarters later. This is one of the first researches done on the effects of oil prices on the economy. Kato (2005) however argues that current oil price surges has not lead to extreme inflation and reduction in corporate earnings in Japan, as it happened in USA in 1970s, suggesting there is another cause for the recession but oil price shocks. Gisser and Goodwin (1986), Mork, Olsen and Mysen (1994) show similar results – negative correlation between oil prices and economical output. Mork, Olsen and Mysen (1994) find asymmetric correlation pattern when there are price increases and price decreases – the coefficients for price decreases tend to be with the opposite sign to the coefficients of price increases. These results are sharpest for the United States as a developed economy and show that the economic performance goes up when the price of oil goes down. Bjørnland (2009) points out that the reasons behind oil price increase is important to evaluate the effect of this increase over the economy. Recent studies point out increased economic growth simultaneously with increased oil price, suggesting that oil spikes caused by increase in demand have different effect then if caused by limited supply, like in US in the 1970s. Often the change in oil price affects decisions on the highest governmental level. The example that LeBlanc and Chinn (2004) give is from September 2000 when the price of crude oil in United States tripled its levels from December 1998 and remained high and volatile way into 2001. The increase in oil prices raised some legitimate concerns about raising inflation. The Federal Open Market Committee and the Federal Reserve Board raised the federal funds rate on six different occasions and one of the reasons was the increased oil price. The price lowered only when the US economy went into recession and reduced the demand. Page | 12
The Influence of Change in Crude Oil Prices on Equity Market Returns 2.4. Oil prices and the stock market The relationship between oil prices and stock market has not been researched as extensively as the relationship between oil prices and the economy. This is probably due to the short period of time since the oil price has become so volatile. It is logical however, if the oil prices play such crucial role in the economy as showed above, that oil prices and financial markets are correlated. Stock prices are indicators for invertors’ expectations for future profits, and as such give different perspective regarding oil price change. Several key empirical studies will be mentioned in this section with regard to building some expectations about this particular study. Figure 3 presents the changes in S&P 500 index in comparison to Brent crude oil price for the last 11 years. It gives a little insight to the correlation between oil price and financial markets. This period includes the 2001 recession and 2008 financial crises which can be seen as two serious dips in the S&P 500 graph, but also a number of smaller variations of the index. Both graphs on figure 3 seem to have synchronized large variations that may suggest the existence of variables to which both oil and stock market react simultaneously. Page | 13
The Influence of Change in Crude Oil Prices on Equity Market Returns Brent Crude Oil 160 140 120 100 80 60 40 Brent Crude 20 Oil 0 S&P 500 1800 1600 1400 1200 1000 800 600 S&P 500 400 200 0 Fig. 3: Movement of Brent Crude Oil price and S&P 500 index from 2000 until 2011 (data source: Datastream) In an efficient market the expectation is that oil and equity prices are correlated. They are both highly volatile and the prices in both markets are often changing due to the same economic or geopolitical events. Cochrane (2001) suggests inflation shocks hit simultaneously oil price and stock market with the same factor thus affecting both their returns and creating a link. If the fluctuations in oil price are affecting real output as Page | 14
The Influence of Change in Crude Oil Prices on Equity Market Returns discussed in the previous section then it has to be affecting the expected earnings of companies and subsequently their stock prices. Kaul and Jones (1996) and Sadorsky (1999) are one of the first papers that find the relationship between oil and financial market. Later Ciner (2001), Park and Ratti (2008), Lai, Wang and Chen (2011) build on to these earlier researches and find with statistical significance that the change in oil price really affects the equity returns. All these studies use different data and estimation techniques but reach the same conclusions – crude oil prices have a negative relationship with stock prices. Lai, Wang and Chen (2011) give very logical explanation of this negative relationship. A rise in crude oil price is an increase in the price of an important commodity. This will increase the costs for companies and the price for customers (reduced sales), both of which have negative effect on profitability, causing drop in stock prices. This of course does not apply for oil producing companies, which increase profits margins when spikes in oil price occur. Positive correlation between oil price and stock market is found by Bjørnland (2009) in his study on Norway. He explains the results by the fact that this is an oil exporting country, so the economy benefits from higher oil prices. This is consistent with studies on OPEC (Bina and Vo, 2007; Mehrara and Sarem, 2009). Huang, Masulis and Stoll (1996) research the relationship between oil prices and stock market indexes and with selected companies whose stock prices are most likely to be sensitive to oil shocks using oil futures. He found no statistically significant connections, with the exception of oil companies. Ciner (2001) argues that the reason for lack of correlation in their study is that they research only for linear relationship. Ciner’s (2001) empirical study suggests that oil price shocks affect the return on equity in non-linear fashion. He also finds that stock market performance affect oil futures market (feedback relation). Page | 15
The Influence of Change in Crude Oil Prices on Equity Market Returns Special emphases on the transport sector can be seen in Nandha and Brooks (2009) paper. They find significant negative oil risk premium for the developed countries, in particular if the analysis model is asymmetric. 2.5. Dependency of crude oil Data source for this section is US Energy Information Administration unless specified otherwise. United States dependency United States of America is the largest economy in the world and the single biggest consumer of crude oil with 19.150 million barrels/day for 2010 (data source: Central Intelligence Agency). It satisfies 37% of nation’s energy needs – the highest of all energy sources (the rest are coal, natural gas, nuclear energy and renewable sources). The official oil reserves in US are 30.5 billion barrels which is 2.4% of world oil reserves. Before the 1970s US has been oil exporting country. In fact it is still the 3rd largest oil producing country in the world. The consumption however has grown and the reserves lowered. At present US is oil importing country – 63% of the consumed in the country oil for 2009 is imported. Transport industry dependency “Over the next 25 years, demand for petroleum and other liquid fuels is expected to increase more rapidly in the transportation sector that in any other end-use sectors” states IEA report from 2007. Currently US transportation uses are fuelled by 95% petroleum products and only 5% natural gas and renewable energy. During 2010 71% of US oil consumption goes for transport. This is 2/3 of all petroleum. Page | 16
The Influence of Change in Crude Oil Prices on Equity Market Returns 2.6. Hubbert’s curve and peak oil theory In 1956 Marion King Hubbert, geophysicist doing research for the Shell lab in Houston, Texas, predicted that US oil production will peak in the early 1970s. At that point oil was abundant and both scientists and oil industry rejected his work. But in 1970 the US production of crude oil peaked. Since 1985 US production is slightly higher than Hubbert predicted, mainly because of some successful discoveries in Alaska and the off-shore Gulf Coast, but besides that his analysis turned out to be accurate. During 1990s several scientists applied Hubbert’s model to the world supplies of oil trying to calculate the year of a possible global peak. Some of the results predicted a peak as early as 2004. The estimations continue to around 2050. 2.6.1. What is peak oil theory? Peak oil theory developed by Hubbert (1956) is a model that was initially created to predicted a path for depletion of oil resources in the United States, but at present is also used to analyse other fossil fuels like natural gas (Reynolds and Kolodziej, 2009) and coal, non-renewable natural resources like metals and slowly renewable biological resources like whale’s population (Bardi and Lavacchi, 2009). The bell shaped curve was not scientifically proven in his paper. What Hubbert did was to plot past production under a curve of his prediction. The total area of the bell curve was the total amount of petroleum left in the ground according to his estimate. Using this method he made two peak estimates: pessimistic in the middle of the 1960s and optimistic around early 1970s. In his later paper Hubbert (1959) developed his analysis adding other elements. He noticed a pattern of discovery and production – their graphs had similar shapes but shifted in time. By this time the discovery of new oil fields was already slowing down. Based on the existing production fields and the rate at which new petroleum fields were found he estimated remaining oil of 150 billion (pessimistic guess) to 200 billion (optimistic guess) barrels. Another addition was the specification of a functional form for his model. Stating Page | 17
The Influence of Change in Crude Oil Prices on Equity Market Returns that the cumulative production follow a logistic curve he explains why he uses the bell shaped curve in his initial report – it is the first derivative of a logistic curve. Figure 3 shows a rudimentary representation of Hubbert’s curve showed as opposed to a curve of resource stock. The production grows over time as new oil fields are discovered. At the same time the demand grows making necessary even higher production. With the increase of production however the oil reserves decrease at faster rate. The pace at which new oil is discovered slows down and then start to decline and some of the existing fields are exhausted. The production is still increasing for some time after that – it takes minimum of 10 year period of discovered oil fields to become operating production sites. But eventually with the depletion of oil in stock comes the reduction in production which is shown on figure 3 (it is presented how the production decreases simultaneously with the depletion of the resource in stock). The classic Hubbert’s curve is symmetric bell-shaped curve that peak when the resource is 50% depleted. Page | 18
The Influence of Change in Crude Oil Prices on Equity Market Returns a) Production Time b) Resource stock Time Fig. 3: Basic graphic representation of Hubbert’s curve: a)Hubbert’s curve: production before and after the peak; b)the reduction of the natural resource supply. The graph of Hubbert’s curve is consisted of three elements: 1) gradual increase from zero that rises at accelerated rate; 2) a peak representing the maximum level of production; 3) a steep decline from the peak that become more gradual as approaching zero. If the area under the curve is denoted as Qt the peak will occur when the area reaches . is the fraction of the total oil that is already produced and 1 - is the fraction that is yet to be produced. So the production P is: P=α+ Q Page | 19
The Influence of Change in Crude Oil Prices on Equity Market Returns and it is linearly dependent on the fraction of oil left unexploited. After the US peak oil in 1970 exactly as Hubbert had predicted in his early papers, his theory became very popular among researches concerned with the depletion of natural resources. In more recent years the interest toward this model is renewed in the 1990s by Campbell, who was among the first to apply Hubbert’s curve towards the global oil resources (Campbell and Laherrere, 1998). The modern Hubbert’s model is a combination of techniques, most of which developed by Hubbert, but some by other researchers after him. It includes three steps: 1) analysis of past discoveries; 2) estimation of future discoveries; 3) projection of future production. Past and future discoveries of oil fields are plotted on a curve. There are several methods of estimating undiscovered oil. Brandt (2007) classifies them as Campbell’s “creaming curve” method, plotting ultimate recovery by using the so called “Hubbert linearization” method, or using statistical relationship such as extrapolating the future discoveries based on the past (Laherrere, 1996). Using the discovery data a production curve can be plotted so that the area under the curve equals total discovered and not yet discovered oil. The most important part for this methodology to produce accurate prediction is the total number of oil production. This is the area under the production curve and it has extremely strong influence over the distribution of the curve over time. For the model to be practical some assumptions are often made. Most frequently these are: production follows a bell-shaped curve; production is symmetric over time – year with most production, or peak year, happens when the resources are half depleted, discovery and production will have the same distribution with a constant time lag; production increase and decrease in one cycle – there are no multiple peaks. In reality some or all of these assumptions can be untrue. Their use however helps simplify the model and give an approximate estimate for the peak year. Since the accuracy of Hubbert’s curve is so dependent on one estimated number – total production – and is subjected to many simplifications, there is variation in the Page | 20
The Influence of Change in Crude Oil Prices on Equity Market Returns estimations of different researchers. Even Hubbert’s original graph did not come to past as he predicted. The peak did happen in 1970 as he estimated but since 1985 US have produced more oil than the curve shows because of successful discoveries in Alaska and the Gulf Coast. Also new technologies become available that allowed drilling in much deeper waters than in the 1950s, when Hubbert first announce his discoveries, giving the possibility of producing more oil from the ocean bottom. Despite the widespread use of Hubbert’s curve, it is not a perfect model predicting the future. It is often criticized for being arbitrary so other methods are used as well to calculate oil production, for example resource-to-production ratio (both parts of this ratio are constantly changing so in the end the number has little meaning). In Hubbert’s curve there is a big accent of the physical limitations (the fact that oil is a non-renewable energy source) and less consideration of the economic and political reactions to the physical limitations (new legislations for limiting greenhouse gases, different agreements between oil import and oil export countries, reducing the use of crude oil when the price is too high and switching to natural gas instead, etc.). So the crude oil depletion is not a question of physics or economics or politics alone. Only a combination of all can explain the peak. And since geology cannot be change much of the discussion is centred on the political and economical side of the issue. Even with all the imperfections the Hubbert’s model is the most accurate so far. Many scientists seem to forget however that this is only a model and there has to be some assumptions. After all the very definition of a model is a method to simplify the complex reality. The purpose of any economical model in general is not to accurately predict the future but to provide a tool for understanding patterns in the behaviour of the economy, to give a basic idea of what to be expected. By simple macroeconomic rule, the increased demand for oil put together with the physical limitations of supply with the approach of Hubbert’s curve should establish new equilibrium at higher price. Deffeyes (2005) however believes that this is going to cause an increase in volatility, much like the situation at present (in later paper Deffeyes (2009) he stated that peak oil has occurred in 2008). The production and consumption systems are Page | 21
The Influence of Change in Crude Oil Prices on Equity Market Returns dependent of political and economical factors and can be easily disturbed. But essentially most of the oil use is in the transportation which is relatively inelastic in a short term. Deffeyes advices not to dismiss the peak oil theory just because the price of oil sometimes swings downwards. The long war for recognition of the problem of impending energy shortage came one step closer to goal when in 1998 the International Energy Agency for the first time forecasted a possible date of the peak in global oil production between 2010 and 2020, validating Hubbert’s theory. 2.7. Literature review Hubbert’s peak oil theory has been a controversial one from the very beginning. There are still many discussions concerning its credibility. A number of scientists support it because it gives logical explanation for the present global situation concerning oil. Some go as far as stating there is an inevitable collapse of the modern economic and financial system, or even the end of the western society. Others are far less sceptical and dismiss this theory explaining the increase in oil prices with the general inflation, political situation in the Middle East, the monopoly of OPEC as main exporter, etc. In this section a review of relevant literature concerning Hubbert’s theory will be presented. Different research papers divided in supporting and opposing views on his model are summarised in Table 1. Page | 22
The Influence of Change in Crude Oil Prices on Equity Market Returns Article Main point Summary Mohr and Develop a theoretical model of production Showing Evans (2008) that validate Hubbert’s curve theoretical proves Brandt (2006) Find Hubbert’s model as most useful, for the validity of especially if allowance for asymmetry is Hubbert’s curve made and the bell-shaped Supportive Bardi and Show that Hubbert’s model is applicable to distribution of Lavacchi (2009) several historical case even if the underlying production (prove assumptions are minimized with some Soltes (2010) Prove the existence of peak oil and use it as a historical data) basis for trading strategy Laherrere Supports the idea that a multiple peak curve Accepting eventual (2000) best fit the global oil production peak in oil Postill (2008) Describes oil reserves and production as production but asymptotical curve (it will approach zero but questioning the never reach it) credibility of Hubbert’s curve (Reynolds and Discuss the role of natural gas and prove that Proposing plateau Opposing Kolodziej, Hubbert’s curve does not work for all as more appropriate 2009) regions; discuss role of institutions form for oil Harris (2010) Describes the peak oil moment as a drown- production curve out plateau in the production with price spikes and dips; suggest the importance on natural gas N/A Perpetually growing oil production Table 1: Summary of literature review discussing the validity of Hubbert’s curve and peak oil theory. Page | 23
The Influence of Change in Crude Oil Prices on Equity Market Returns 2.7.1. Supporting Hubbert’s theory There is a debate among the supporters of peak oil theory about when and how is the global peak oil happening. The estimates are in range of more than 40 years (from 2004 up until 2047) with estimates for total oil supplies between two and three trillion barrels (Mohr and Evans, 2008). Mohr and Evans (2008) attempt to construct the oil production profile without having a particular production curve in mind. They develop a model based on simple theoretical logic and then compare it with the existing data about production. The model follows almost symmetric bell-shaped curve, similar to Hubbert’s model. Their estimation of peak year is between 2010 and 2025, with ideal case peak in 2013. Brandt (2006) researches all oil producing regions individually and finds Hubbert’s theory most widely fitting the historical data. He however makes some corrections to the original model noticing that in most cases asymmetric bell-shaped curve fits better than symmetric. Some researchers use Hubbert’s theory as basis for trading strategy. Soltes (2010) is presenting astonishing profit of 399% for 7 months trading Brent Oil with long and short Turbo Certificates. His strategy is less risky than initially assumed since he expects the oil price to continue to grow in a long run. Laherrere (1999) makes summary of the official peak oil production forecasts showing that many scenarios are beyond optimistic (US Department of Energy – 2025 – 2030). 2.7.2. Opposing Hubbert’s theory The opposition of Hubbert’s model can be classified in two categories. There are researchers that recognise that oil production will peak and then start to decline at some Page | 24
The Influence of Change in Crude Oil Prices on Equity Market Returns point in the future. They however disagree with Hubbert’s bell shaped distribution of production and look for an alternative model. The other category of researchers considers the influence of more than simply physical factors over the global oil production and predicts a production plateau, not a peak. Although a supporter of Hubbert’s theory Laherrere (2000) argues that the model is applicable only when the production follows natural process of depletion, unaffected by significant political or economical interference. He suggests a model with multiple Hubbert’s peaks that can account for political and economical disturbance, for discovering a major oil field after the production has already peaked, or for countries with too few oil production sites. Postill (2008) argues that although the global oil reserves are finite, they will never be depleted. Reserves and production are both asymptotically approaching zero value, so the symmetric bell-shaped curve does not describe these tendencies. Harris (2010) also does not support the bell-shaped curve. He claims that the oil production may look like a peak at some point and there could have difficulty in supply but it is actually a plateau with varying prices. Even Brandt (2006) who supports the model in his paper claims that in some regions linear or exponential curve fits better the historical results. Research of natural gas from Reynolds and Kolodziej (2009) shows that Hubbert’s curve work only for some regions, but not for all. They attribute this to the role of institutions since the discovery graphs they plot are very Hubbert’s like, but the production is highly regulated which distorts the curve. If managed correctly by institutions many countries can avoid the Hubbert’s curve type peak and have a long plateau way before they reach the full potential of production. Reynolds and Kolodziej (2009) and Harris (2010) put natural gas in the equation of world’s energy needs because oil and gas can be interchangeable to some degree. 12% of the crude oil needs in 2008 are met by natural gas and the percent is expected to grow to 25% until 2030, which should reduce some of the stress from the oil supply side of the market. Page | 25
The Influence of Change in Crude Oil Prices on Equity Market Returns The reasons that some researchers reject Hubbert’s peak oil theory can be summarised as: 1) new technology will be developed allowing companies to drill deeper in search for oil and speed up the exploration process; 2) financial pressure for optimising the production – when the price of oil become too high new technology will be developed that will not require fossil fuels, thus reducing the demand; 3) political and social pressure for reducing CO2 emissions will force some companies to switch to cleaner technologies which will reduce the demand; 4) the volatility of oil prices is due more to market speculations rather than real supply shortage; 5) OPEC is using its monopoly power by keeping the supply low so that they earn abnormal profits. Many papers use one or combination of several of these reasons. In table 3 there is a third category of opposition to the Hubbert’s peak theory – completely rejecting peak oil theory’s main paradigm, that crude oil production will eventually reach a maximum and start declining. This however is equal to suggesting that oil production will keep growing in perpetuity which is physically and logically impossible – since there is a limited amount of oil in the ground limited amount is available for extraction. Not one paper was found that support the view of unlimited oil. Even governmental institutions are forced to admit that fossil fuels have finite nature and correct their development plans according. Still the notion of infinite supply of cheap energy is still used in the evaluation of the price of equity. 3. HYPOTHESIS The majority of the empirical studies researching the relationship between oil price and equity return find a significant negative correlation. Many researchers find negative correlation between oil prices and market returns (Kaul and Jones, 1996; Sadorsky, 1999; Ciner, 2001; Park and Ratti, 2008; Lai, Wang and Chen, 2011). This is especially strong for economic sectors that are strongly dependant of oil (Nandha and Brooks, 2009). Transport industry is very dependent on the prices of gasoline, one of petroleum’s main products and according to IEA report this dependency Page | 26
The Influence of Change in Crude Oil Prices on Equity Market Returns will only grow stronger in the next 25 years. The expectations are that it affects the industry by increasing the costs and decreasing profits, which consequently lowers the market return. Based on that the first two hypotheses suggest: Hypothesis 1: Linear oil price shocks have negative effect on the stock returns. Ciner (2001) argues that the only reason Huang, Masulis and Stoll (1996) didn’t find any correlation between oil price and stock markets is because they tested with linear distribution of the oil price. If Hamilton’s (1996) NOPI model is used the expectations are that negative correlation exists. Hypothesis 2: Non-linear price shocks have negative effect on the stock returns. 4. STATISTICAL METHODOLOGY The data is regressed using Ordinary Least Squares method with the Principal component as variables. 4.1. Linear Regression Model with Ordinary Least Squares (OLS) Ordinary Least Squares in statistics is an approach that estimates the best linear approximation of y from xj (j = 1,..., k) by minimizing the sum of the squared residuals. All fitted values are on a straight regression line. ŷi = xi’β. The difference between the observed and approximated value makes the error term yi = ŷi + εi = xi’β + εi or y = Xβ + ε, Page | 27
The Influence of Change in Crude Oil Prices on Equity Market Returns where y and ε are n-dimensional vectors of dependant variables and error terms; X is n×k matrix of variables x. For the statistical model to have econometric sense there are several conditions (Gauss-Markov conditions): 1) the expected value of the error term is on average zero (E{εi} = 0, i = 1,...,N); 2) X is a deterministic nonstochastic matrix – it is independent from ε; 3) homoscedasticity – all error terms have the same variance (V{εi} = σ2, i = 1,...,N); 4) no autocorrelation – zero correlation between different error terms (cov{εi,εj} = 0, i, j = 1,...N i ≠ j). As a test for statistical significance standard t-test statistic is used to test a single restriction. = , where is estimate for β and it standard error; is a value chosen by the researcher. The hypothesis that βk = is rejected at the 5% level if tk > |0.96|. Using the standard normal approximation the 95% confidence interval for βk is: {bk – 1.96se(bk), bk + 1.96se(bk)}. 4.2. Principal Component Analysis Principal component analysis is a research method used to analyse a large data set of interrelated variables. The purpose is to retain as much as possible of the variation present in the data by transforming it to a new set of variables called principal components. The new variables are linear combinations of the original variables. Principal components are uncorrelated and set in a descending order by the amount of variation present in all of the initial variables – the last few principal components identify near-constant linear relationships among the original variables and have very little variation. The expectations of this study are that the oil price will be placed among the first few variables, thus account for as much of the variability of the data as possible. Page | 28
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