Study confirms oil’s impact on equities

(July 7, 2004) Canadians are all too aware of the effect oil prices have on everyday life. Life in a cold climate, an American style love-affair with cars and a massive resource sector can make the price of petroleum a hot topic.

It might come as no surprise then, when academics find a correlation between the price of oil and equity market returns. What may come as more of a shock, is that this research has only recently been completed.

“Striking Oil: Another Puzzle” is a report by Dutch researchers Gerben Driesprong, Ben Jacobsen and Benjamin Maat of the Erasmus Research Institute of Management (ERIM), part of the Rotterdam School of Economics.

“We find statistically significant predictability, especially in developed markets,” the report says. “Stock returns tend to be lower after oil price increases and higher if the oil price falls in the previous month. This predictability is not only statistically significant but also economically significant in many countries.”

Not only is there a correlation, but it appears to be non-sector-specific, meaning it affects the entire market and not just, for example, transportation stocks. Furthermore, the report says “oil effect” is significant enough that investors can capitalize on it.

“A simple trading strategy generates economically significant outperformance around 4% annually (after transaction costs) in comparison to a risk-corrected buy-and-hold benchmark,” the researchers state. “Although — as we have only one sample of oil returns — these results had to be based on in sample predictability results.”

Prior to the 1973 Yom Kippur War, the price of oil had been artificially stable, maintained by the “Seven Sisters,” the group of large U.S. oil firms that dominated the market.

But after 1973, crude oil, arguably the most economically important commodity, began trading as such. The power to control world oil supply slipped from the grasp of the Seven Sisters and into the hands of OPEC.

The study examined equity market data in 48 countries, with 30-year data available for the 18 most advanced markets, including Canada. The less developed markets offered “out of sample” data which appeared to back up the study’s findings, though the oil effect was less pronounced.

“The impact of changes in the oil price on stock returns tends to be large. For instance, a decrease of the oil price of 10% in the U.S., will double the expected return on the stock market in the next month,” the report says. “This oil effect is also significantly present in the world market index.”

But the researchers are still at a loss to explain why this pattern exists.

“It might be that this predictability is related to the lagged reaction of the market to the general impact of oil price changes in the different economies. An alternative explanation could be that this predictability is related by a lagged reaction to the oil price change due to an increase in international political instability,” the report says. “Which of these explanations is most likely needs further research. But even if we are able to determine the source of the predictability, we have no idea why financial markets react slowly to information in oil prices. That remains the real puzzle to be explained.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com