Stock Markets and Energy Prices

1. Definition and Economic Importance

2. Relationship between Stock Markets, Energy Prices, and the Economy

3. Oil Markets and Oil Prices

4. Futures Markets, Oil Price Volatility, and Stock Markets

5. Oil Prices and Currency Exchange Rate Risk

6. Technology Stock Prices and Energy Prices in the New Economy

7. Modeling Approach and Quantitative Methods

8. Empirical Evidence on the Relationship between Oil Price Movements and Stock Price
Movements

9. Energy Price Risk Management

Glossary
arbitrage pricing theory (APT)
A theoretical development in corporate finance that yields a model for pricing risk. The APT model linearly
relates stock returns to several risk factors.
autoregressive conditional heteroskedasticity (ARCH)
A statistical modeling technique that takes into account volatility clustering.
backwardation
A pricing structure in which futures prices are lower than spot prices or when the near futures price
exceeds the distant futures price.
contango
A pricing structure in which futures prices are higher than spot prices.
forward contract
A contract for the purchase or sale of a commodity for future delivery, given by a specific delivery date,
and not traded on an organized market.
futures contract

Standardized contract for the purchase or sale of a commodity for future delivery, given by a specific
delivery date, and traded on an organized futures markets.
heteroskedasticity
The variances of a set of random variables are not constant.
ordinary least squares (OLS)
A statistical modeling technique that posits a linear relationship between a set of drivers and a dependent
variable.
risk
A source of randomness that can be quantified.
uncertainty
A source of randomness that cannot be quantified.
vector autoregression (VAR)
A statistical modeling technique in which each variable of interest is explained by lagged values of itself
and the lagged values of other variables in the system of equations.
volatility
A tendency for prices to fluctuate widely.
volatility clustering
A tendency for large movements in prices to be followed by large movements in prices in either direction.
The interaction between changes in energy prices and economic performance has been of interest for a
long time. For example, in the 1890s J. D. Rockefeller publicly expressed concern over rapidly fluctuating
oil prices and advocated controlling oil prices in order to stabilize oil company profits and economic
activity. Conversely, the relationship between stock markets and energy prices is a relatively new and
emerging field of energy economics and finance that sprung to life after the two oil price shocks of the
1970s and the development of the oil futures market in the 1980s. Serious study of the relationship
between stock markets and energy prices, and energy and the macroeconomy, has only occurred during
the past 20 years.
1. DEFINITION AND ECONOMIC IMPORTANCE
Higher energy prices, mostly through higher oil prices, act like an inflation tax on consumers and
producers. Higher oil prices raise the cost of production for non-oil-producing companies and, in the
absence of fully passing these costs on to consumers, reduce profits and dividends. Profits and dividends
are included in the income side of a country's national accounts. Consequently, sharp reductions in profits
and dividends reduce gross domestic product (GDP). Reduced profits dampen the future outlook for
corporate earnings, a major driver of stock prices, and decrease stock returns. Steel mills, paper mills,
sawmills, airlines, trucking firms, and other companies lay off workers and close plants when faced with
steadily increasing fuel bills. Higher oil prices impact consumers directly via increases in the price of
gasoline. This reduces the amount of disposable income consumers have left for purchasing other goods

and services. Firms selling nonessential goods and services experience a decrease in business activity,
which in turn results in lower profits, corporate earnings, and dividends and feeds back into the economy
and the stock market.
With the U.S. Federal Reserve moving to an ever more transparent monetary policy, oil price changes
have the potential to have a larger impact on stock prices than interest rate changes. This is because oil
prices fluctuate more than interest rates do, and oil price changes embody more uncertainty regarding oil
demand and supply imbalance, geopolitical, and institutional factors than do interest rates.
2. RELATIONSHIP BETWEEN STOCK MARKETS, ENERGY PRICES, AND THE ECONOMY
Real crude oil prices were highest in two distinct periods: 1861-1869 and 1974-1981. Real oil prices in the
period 1861-1869 were very volatile and this is historically identified as the period with the highest real oil
prices and the most amount of oil price volatility. Russian oil exports began in the 1880s and this helped
to lower oil prices. After the discovery of oil at Spindletop, Texas, at the turn of the 20th century, real oil
prices tended to stay fairly constant for long periods of time, particularly between the 1930s (at
approximately the time that the East Texas oil field was discovered) and the early 1970s. Price changes
did occur, but these changes were few and far between. After the oil price shocks of 1973 and 1979, the
underlying structure of the world oil market changed and oil price volatility increased considerably. In fact,
oil price volatility in the late 1970s was almost as high as that during the 1860s. Increased oil price
volatility created a need for risk management tools and the development of forward and futures markets
for crude oil followed. Futures markets for natural gas and electricity are also important, but most of the
attention regarding stock markets and energy prices is focused on the crude oil futures market. Today, it is
the interaction between oil futures markets and the stock market that financial managers watch closely for
signs of pricing pressure on the economy. In the future, with deregulated natural gas and electricity
markets, the prices of natural gas and electricity will have a much larger impact on financial markets and
the economy.
Since World War II, almost every recession in the United States has been preceded by a large increase in
oil prices. Generally, the negative correlation between oil prices and GDP is taken as an empirical fact.
During the four quarters preceding the onset of the 1948-1949, 1953-1954, 1957-1958, 1960-1961, and
1969-1970 contractions, the real price of energy increased on average 1.5%. The average increase in
real energy prices prior to the onset of the four recessions during the periods 1973-1975 (called the Ushaped recession because real GDP growth during this period resembled the letter U), 1980, 1981-1982
(the W-shaped recession), and 1990-1991 (the V-shaped recession) was 17.5%. This increase in real oil
prices was much greater than in earlier recessions. The economic downturns in the United States during
the 1970s and 1980s were the largest since the Great Depression. The impact of oil price shocks on the
U.S. economy became more pronounced after 1970. This was the time when U.S. demand for imported
oil increased and the Organization of Petroleum Exporting Countries (OPEC) cartel began to exert their
influence on the world oil market. The 1970s and early 1980 were also turbulent times for world equity
markets. Oil price shocks can also occur from large decreases in oil prices. Large decreases in oil prices
in 1986 and 1998 are two such examples.
Until the early 1970s, the price of internationally traded oil was set by a group of major oil companies
(know as the seven sisters). During this time, the major oil companies set the price of oil on a reference

barrel of oil (Arabian Light 34 API) so that the price remained constant in nominal dollars. OPEC basically
inherited this pricing regime with some modifications. It was not until 1987 that OPEC adopted the current
pricing regime whereby the price of internationally traded oil is determined by a pricing formula based on
a reference basket of crude oils.
To understand the relationship between stock markets and energy prices, it is useful to use an equity
pricing model. In such a model, the price of equity at any point in time is equal to the expected present
value of discounted future cash flows. A firm's cash flow can be affected by economy-wide factors as well
as firm-specific factors. Approximately 60-80% of stock price movements result from broad-based market
and industry sector factors and only 20-40% are related to company-specific factors. Cash flows are
affected by business cycle conditions, and business cycle conditions can be represented by several key
macroeconomic variables, such as industrial production, crude oil prices, interest rates, consumer prices,
and possibly currency exchange rates. The ability to manage firm-specific and economy-wide risks
determines the economic evolution of a firm.
Oil prices can affect the expected present value of cash flows in several ways. Oil is a resource and
essential input into the production process. The basic production function requires inputs on capital (K),
labor (L), energy (E), and materials (M): This is the basis for the KLEM model. Increases in energy costs,
with the prices of other inputs held constant, will increase the cost of production and, without any
offsetting effects, will reduce company profits and dividends. More generally, energy price increases can
be mitigated by substitution effects among the other factor inputs. The impact on stock prices depends on
whether the company is a net producer or consumer of energy. Increases in energy prices lower (raise)
the stock prices of energy-consuming (producing) companies.
The net effect of higher energy prices on the stock market depends on how many firms are net users of
oil. Given that there are more firms using oil than producing oil, oil is an input to the global economy. As a
result, increases in oil prices lead to decreases in stock prices.
Future oil price changes can also impact stock prices through the discount rate. The expected discount
rate is composed of a real interest rate component and an expected inflation component. Higher oil prices
put upward pressure on the general price level, thereby raising the aggregate supply curve for a country
that is a net user of oil and oil-related products. Higher oil prices can lead to increases in expected
inflation and higher nominal interest rates. Since interest rates are negatively correlated with stock prices,
increases in interest rates depress stock prices.
Economic growth leads to feedback effects between the economy, energy prices, and the stock market.
Increasing industrial production generates a stronger economy and, as a consequence, higher profits and
dividends. Higher profits and dividends raise stock prices. A stronger economy also raises the demand for
oil and oil-related products. An increased demand for oil and oil-related products puts upward pressure on
aggregate prices and interest rates, and the reaction of the Central Bank becomes critical to the
movement of the stock market. The Central Bank can either accommodate or dampen the increased
economic activity via expansionary or contractionary monetary policy, respectively. Which path the Central
Bank takes directly impacts stock returns.

Interest rates can impact stock prices in three ways. First, changes in interest rates are changes in the
price charged for credit. The price of credit affects both firms and consumers. Firms seeking to expand
existing operations or build new ones need to borrow money. Consequently, the price charged for credit is
an important influence on the level of corporate profits and changes in corporate profits are a major driver
of stock prices. The price of credit, through its impact on corporate profits, affects the price that investors
are willing to pay for equities. Companies prefer to borrow money or issue debt when interest rates are
low. In addition, a higher interest rate makes it less likely for consumers to purchase big ticket items, such
as houses, automobiles, furniture, and appliances. Second, higher interest rates alter the relationship
between competing financial assets. As interest rates rise, fixed-income securities become more
attractive relative to equities and investors rebalance their portfolios to take this into account. Third, some
stocks are purchased on margin and changes in interest rates impact the cost of carrying margin debt.
Higher margin debt limits the ability of investors to participate in the stock market.
Inflation, a sustained rise in the general price level, erodes the real value of investments. This was
particularly evident in the high-inflation period of the 1970s and early 1980s. As an example, consider the
case of person A loaning $100 to person B for 1 year. Person A would like to earn a 3% real rate of return.
Suppose that the current inflation rate is 2% per year and this is expected to be the inflation rate in the
following year. Person A will then loan person B $100 at an interest rate of 5%. At the end of 1 year,
person B agrees to pay person A $105. Now suppose that the inflation rate over the coming year is not
2% but instead 4%. In this case, person A's real return on his or her investment is 1% (5%-4%). Inflation
(unexpected) has lowered the return on person A's investment.
Furthermore, inflationary pressures tend to lead to higher interest rates and a slowing economy, which
lessens the ability of growth companies to meet revenue and earnings targets, causing stock prices to fall.
Oil price increases are one of the most likely sources of inflation and oil is a raw material used in almost
everything that is made. Crude oil and natural gas are required to produce 98% of North American
manufactured products. Oil price increases usually impact the transportation sector first through higher
prices for fuel (gasoline, diesel, and jet fuel), with initial price hikes being absorbed by this sector. Airlines
are particularly susceptible to higher oil prices because jet fuel represents a major cost of doing business
in the airline industry. Persistent oil price increases lead to higher producer prices and eventually, after 69 months, inflation. Inflation, which erodes the real value of investments, leads to higher interest rates as
contractionary monetary policy is used to bring economy-wide price increases down. Crude oil price
increases in 1973, 1979, and 1990 were followed by stock market downturns.
Although oil price increases are not very good for the performance of the economy as a whole, oil price
increases are very beneficial to companies engaged in the oil and gas industry. Consequently, oil price
risk is a major concern for oil and gas companies. Higher oil prices lead to increased profits and spending
on capital budgets, whereas lower oil prices lead to lower cash flows and reduced spending patterns of oil
producers. Annualized oil price volatility is approximately 25% per year and annualized natural gas price
volatility is approximately 40%. Hence, price variability is a major impact on the stock returns of oil and
gas companies. There are three ways in which crude oil prices affect oil company stock prices. First,
investors in oil stocks are usually only concerned about the flow of profits from their stock investment and
future profits are determined by the expected average price of oil over a particular period. If investors

expect the average price of oil to fall (rise), then they will sell (buy) shares in oil companies. Second, oil
company stocks are more leveraged than crude oil. Oil exploration, development, and production is a
capital-intensive business and oil and gas companies often borrow large amounts of money to go into
production. The capital costs of exploration, development, and production depend on several factors,
including whether the deposit is underground, under the ocean, or open pit; the type of plant required for
oil extraction; and the location of the plant. As oil prices rise or fall, marginal oil deposits become
profitable or unprofitable, which in turn changes the value of the company by more than the change in the
actual price of crude oil. Third, the profits of oil companies, as for other companies, are a function of
production costs and production costs are influenced by the economic business cycle, which in turn is
affected by energy prices. In the usual case, rising energy prices contribute more to the revenue side of
an energy company's profits than to the cost side.
3. OIL MARKETS AND OIL PRICES
The global oil and gas industry is a mature industry that has prospects for growth as long as global
demand for oil and gas products continues to grow. Oil and gas product demand is difficult to predict but
is generally highly correlated with worldwide industrial production. In 2000, world oil consumption was
73,905 thousand barrels of oil per day (b/d). The United States accounted for 25.6% of this world total,
whereas Europe accounted for 21.4%. During the period 1990-2000, world oil consumption increased
12.9%. World demand for oil is expected to grow 2% per year during the next decade. United States
energy demand sensitivities indicate that a 1% increase in real U.S. GDP raises U.S. petroleum demand
by approximately 0.6% and U.S. natural gas demand by approximately 1.1%. A 10% increase in crude oil
prices, assuming no price response from nonpetroleum energy sources, reduces U.S. petroleum demand
by 0.3%. These data were obtained from the U.S. Energy Information Administration Short-Term Energy
Outlook (www.eia.doe.gov/emeu/steo/pub/sensitivities.html). The oil and gas industry, however, is very
sensitive to business cycle conditions.
In 2000, world oil production was 74,510 thousand b/d. The five largest producing countries were Saudi
Arabia (12.3% of world production), the United States (9.8%), the Russian Federation (9.0%), Iran (5.2%),
and Mexico (4.8%). In 2000, OPEC accounted for 41% of world production. When OPEC member
countries act in unison, they command monopoly power over approximately one-third of the world's oil
production. During the period 1990-2000, world oil production increased by 13.9%.
Of course, future oil production depends on where the oil reserves are located. This is where it becomes
interesting because most of the world's consumption of oil (62.4% of the world total) occurs in the
Organization of Economic Cooperation and Development (OECD) countries, whereas most of the world's
oil reserves are located outside of OECD countries. In fact, OECD countries only account for 8.1% of the
world's oil reserves. For example, the United States, the world's largest consumer of oil, currently imports
approximately 60% of its crude oil. During 2001, approximately 48% of U.S. crude oil imports came from
the Western Hemisphere (19% from South America, 15% from Mexico, and 14% from Canada), whereas
30% came from the Persian Gulf region (18% from Saudi Arabia, 9% from Iraq, and 3% from Kuwait).
Since 1960, U.S. petroleum imports have increased more than sixfold.
In 2000, total world proven oil reserves were estimated at 1046.4 thousand million barrels of oil. At current
production rates, this implies that there are 39.9 years of oil remaining in the world. Saudi Arabia has the

most proven oil reserves with 261.7 thousand million barrels of oil. This equals 25% of the world total.
OPEC countries own 77.8% of the world's proven oil reserves. In comparison, the United States and
Mexico have proven oil reserves numbering 29.7 (2.8% of the world total) and 28.3 (2.7%) thousand
million barrels of oil, respectively. Plentiful cheap oil is found mostly in OPEC countries. The wild card is
the Russian Federation, which, in the interim, can rival Saudi Arabia in terms of crude oil production.
In a competitive well-functioning market, the price of oil would be determined by the intersection of
demand and supply. An increase in demand (assuming supply does not change) would increase oil prices
and an increase in supply (assuming demand does not change) would decrease oil prices. The actual
mechanics of the world oil market, however, are much more complicated and are heavily influenced by
global politics, institutions, and futures markets.
Political factors are important determinants in oil policy in both the oil-exporting countries (historically
OPEC) and the oil-importing countries. The oil-exporting countries tend to intervene in the oil market
when prices are too low. Low oil prices reduce the revenue of oil-exporting countries, dampening their
economic growth and prosperity. OPEC sells oil in international markets on the basis of price formulae
that use as a reference the spot or futures prices of certain important crude oil prices, such as West Texas
Intermediate, Brent, or Dubai. Oil-importing countries often enact oil-directed energy policies when oil
prices become too high. Higher oil prices tend to be followed by inflation, which erodes the real value of
investments and slows economic growth and well-being. Oil-exporting countries can also use oil as a
strategic weapon in response to U.S. foreign policy. The world oil market is populated by many
consumers and many suppliers, which by itself suggests a competitive market for crude oil. The reality is
that the world oil market is very much influenced by institutional factors such as OPEC, strategic oil
reserves in OECD countries, and the role that the large multinational oil companies play.
Generally, the difference between oil that is produced and oil that is consumed, if positive, goes into oil
inventory stocks. Short-term supply disruptions can be met with a drawdown of oil stocks. Obtaining
reliable estimates on oil stocks, however, is difficult because different countries use different reporting
systems. Moreover, there is the issue of oil tanker traffic, which plays a major role in getting oil out of the
producing countries in the Middle East and into the OECD consuming nations. Supply bottlenecks caused
by oil tanker traffic can have a huge impact on gasoline prices in oil-importing countries.
Trade on the marginal barrel of oil sets the price of crude oil. The 11 members of OPEC (Algeria,
Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela)
are the marginal producers. The near-term outlook for the oil market can be determined be matching data
on future consumption, OPEC oil being transported by tanker, and oil inventories. The problem is that
OPEC members are very secretive about how much oil they are actually exporting at any given timeso
secretive, in fact, that they do not even reveal their oil exports to each other. Tracking the amount of oil in
transit is difficult but essential to understanding the world oil market.
The bulk of OPEC oil moves from Quoin Island in the Persian Gulf to ports in New York, Gibraltar (via the
Suez Canal), New Orleans, Montevideo, Uruguay, Fremantle, Australia, and Yokohama, Japan. It can
take several days to fully load an oil tanker at Quoin Island. Once an oil tanker is loaded, it sails to its
destination. Sailing time depends on the distance traveled. The shortest trips of 12 or 13 sailing days are

from Quoin Island to Gibraltar and Fremantle. The longest trip takes 31 days to New Orleans. Once the
crude oil arrives at its destination, it is unloaded and piped to refineries to be turned into refined products
such as gasoline, heating oil, and jet fuel. The refined products are then moved in pipelines and trucks to
consumer outlets. This process takes approximately 2 months. In total, it can take 3 or 4 months for crude
oil from the Persian Gulf to reach gasoline stations in the United States. Consequently, knowing the
amount of oil in transit is essential to knowing the amount of oil available for supply in the next 3 or 4
months. The oil futures markets react quickly to expectations about differences in oil supply.
4. FUTURES MARKETS, OIL PRICE VOLATILITY, AND STOCK MARKETS
Oil is a commodity that is traded in both the spot and the futures markets. The spot market reflects trading
for oil delivered today. The futures market reflects trading for oil delivered at some specified time in the
future. The futures market provides an essential ingredient to risk management. In the oil market, futures
prices tend to be followed more closely than spot prices because futures prices are not as affected by the
short-term supply disruptions that affect spot prices. Futures markets for petroleum products are located
in New York, London, and Singapore. The three major energy futures exchanges are the New York
Mercantile Exchange (NYMEX), the International Petroleum Exchange (IPE), and the Singapore
International Monetary Exchange (SIMEX). The NYMEX launched the futures contract on heating oil No.
2 in November 1978. In April 1983, NYMEX introduced the popular futures contract on crude oil. A futures
contract on unleaded gasoline followed a few years later. The natural gas contract has only traded since
April 1990. The NYMEX natural gas contract size is 10,000 million British thermal units of natural gas
deliverable to Henry Hub, Louisiana.
The deregulation of the natural gas industry began in 1978 and was completed in November 1993. As
deregulation evolved, the marketplace changed from one dominated by fixed long-term contracts
(provided by the pipeline companies) to a spot market, followed by a forward market, and finally a futures
market. The success of the natural gas futures contract in the 1990s enabled the natural gas industry to
more efficiently manage risk through hedging strategies. In turn, the natural gas futures market has
become the foundation for other types of derivatives and now forms the basis for financial engineering in
the natural gas industry. Since its introduction in April 1990, the NYMEX natural gas contract has
increased in importance as an effective financial instrument for natural gas price discovery.
In 1996, NYMEX launched two futures contracts on electricity. Trading in electricity futures is likely to
increase in importance as North America experiments with energy market deregulation. NYMEX also
trades options on futures for crude oil, New York Harbor unleaded gasoline, heating oil No. 2, natural gas,
and electricity. Options on futures contracts are very useful for risk management.
The IPE trades two popular petroleum futures contracts in Brent crude oil and gasoil. Gasoil can be either
heating oil or diesel fuel. Gasoil is the largest single product market in Western Europe. The IPE also
trades futures in natural gas. The SIMEX trades residual fuel oil and the market is relatively small
compared to NYMEX and IPE.
The West Texas Intermediate (WTI) crude oil futures contract traded on NYMEX is the most closely
watched oil price in the world. One contract of WTI crude oil is for 1000 barrels. The NYMEX crude oil
market is the largest market (in terms of volume traded) outside of the financial futures market. The WTI

crude oil futures market is clearly important to the United States. Moreover, the physical market
underlying WTI crude oil is of particular importance to those interested in the demand and supply
relationships that reflect the flow of oil from the Gulf of Mexico into the Chicago region. In a broader
sense, the WTI crude oil futures contract has become a benchmark for the global oil industry. Reliable
fundamental information on global demand and supply in the oil market is often difficult to obtain.
Production estimates for some countries, for example, tend to be higher than actual production, and
consumption data tend to be made available after some lag time. In contrast, reliable data on oil demand
and supply in the United States are often easily accessible and very reliable. Given that United States oil
consumption is approximately 25% of world consumption and the fact that the United States accounts for
approximately 31% of global GDP, it is natural to use the U.S. data as a proxy for unobservable global
fundamentals.
In some instances, futures prices can be used to provide a reasonably good forecast of future spot prices.
In other cases, futures prices may provide poor forecasts of future spot prices. The key to determining
when futures prices might reasonably be expected to forecast spot prices is to understand the role that
storage plays in commodity markets.
Nonstorable commodities are those that are perishable and cannot be stored. Examples include
agricultural products such as dairy products. For nonstorable commodities, futures prices reflect the
relationship between demand and supply for commodities to be delivered in the future. Small changes in
anticipated supply and demand conditions are immediately reflected in futures prices. In this case, futures
prices can be used to forecast future spot prices.
Some commodities can be stored and have large inventories. For these commodities, futures prices are
equal to the spot price plus the carrying costs associated with storage. In this case, futures prices provide
little guidance to future spot prices. Examples include agricultural products such as corn and wheat and
also metal products.
Some commodities, such as crude oil, can be characterized as storable commodities with modest
inventory levels. In general, consumption is high relative to inventory levels. If futures prices are lower
than spot prices, then the pricing structure is called backwardation. In this case, oil can be characterized
as a nonstorable commodity. If oil supplies are expected to increase in the future, then the futures price
would decrease relative to the spot price. This difference in price creates an apparent arbitrage possibility
but low inventory levels prevent the actual collection of arbitrage profits. When commodity markets are in
backwardation, futures prices are useful in predicting future spot prices.
If futures prices are higher than spot prices, then the pricing structure is called contango. In this case, oil
can be characterized as a storable commodity with large inventory. If the supply of oil is expected to
decrease in the future, then futures prices will be higher than spot prices. The difference between futures
prices and spot prices reflects carrying costs associated with storage. When commodity markets are in
contango, futures prices are of little use in predicting future spot prices.
Futures markets respond to news on four factors: demand and supply fundamentals, geopolitics,
institutional arrangements, and the dynamics of the futures market. Whereas some of the spot markets for

crude oil tend to be thinly traded, the futures markets (or markets for paper barrels) tend to be very liquid.
Futures markets respond not just to facts about the demand and supply balance but also to rumors. In
fact, some of these rumors can impact trader sentiment, which may be unrelated to the actual mechanics
of the physical market for crude oil. Unanticipated changes in these factors, be it fact or rumor, can create
volatility in oil futures prices.
Volatility in the oil futures market leads to uncertainty and this affects the decision making of consumers,
producers, investors, and governments. Economic uncertainty creates situations in which planned
spending on consumption and investment is postponed or canceled. This economic uncertainty affects
the consumption, investment, and government spending categories of the expenditure side of a country's
national accounts. Oil price uncertainty impacts the profits of firms, which in turn creates more uncertainty
in the stock markets. Uncertainty in the stock markets usually translates into stock price declines, which
further affect the economy either through reductions in consumer wealth or postponed investment by
business. Volatility in oil prices makes short-term oil price forecasting very difficult. In the long term, oil
price fundamentals should dominate, making it easier, at least conceptually, to forecast the price of oil.
Forecasting oil prices and oil price volatility, in general, is very difficult, but progress has been made in
recent years by using new statistical techniques in modeling and simulation.
5. OIL PRICES AND CURRENCY EXCHANGE RATE RISK
There is evidence that currency exchange rates impact the movement of commodity prices. Since
commodities are homogeneous and traded internationally, it is very likely that they are subject to the law
of one price. This means that commodities have similar prices in each country's home currency. Thus, as
the U.S. dollar weakens relative to other currencies (ceteris paribus), commodity consumers outside the
United States should be willing to pay more dollars for commodity inputs priced in U.S. dollars. A
strengthening U.S. dollar relative to other currencies (ceteris paribus) increases the price to commodity
consumers outside the United States resulting in lower demand for the commodity. Most internationally
traded commodities, including crude oil, are priced in U.S. dollars. Consequently, currency exchange rate
movements may be an important stimulus for energy price changes. In particular, currency exchange rate
movements impact crude oil prices and crude oil prices affect the prices of derivative products, such as
heating oil and unleaded gasoline. Crude oil price changes also affect the price of natural gas. Thus,
changes in crude oil prices create a ripple effect throughout the pricing structure of petroleum products.
The dominance of the U.S. dollar may be challenged in the future as European countries make more use
of the Euro currency in their business transactions. Already, some European countries prefer to price oil in
Euros and measure oil in metric tonnes. Thus, there are times when the price of crude oil changes not so
much from changes in the demand and supply balance in the global oil market or changes in OPEC
pricing structure but instead from changes in currency exchange rates.
6. TECHNOLOGY STOCK PRICES AND ENERGY PRICES IN THE NEW ECONOMY
There are two views on the relationship between oil price movements and technology stock prices. The
first view is that oil price changes have very little impact on technology stock prices because technology
companies engage in business activities that are not very energy intensive. The second view is that oil
price changes do have an impact on technology stock prices because oil price increases fuel inflation and

inflation leads to economic downturns. High-technology companies are very sensitive to the overall
business cycle. Both views deserve further discussion.
The basis for the first view is the fact that technology companies produce products or services that are
less energy intensive than products produced in other sectors of the economy. For example, it takes less
energy per unit of output to produce telecommunications equipment than it does to produce steel beams.
Manufacturing, in general, has also become less energy intensive. In the United States, it takes 45% less
energy to produce one dollar of GDP today than it did in 1973. Automobiles built today are 50% more fuel
efficient than automobiles built in the 1970s. The combination of less energy-intensive manufacturing and
energy efficiency suggests that technology stock prices are relatively unaffected by oil price movements.
The second view is that oil price movements have a major impact on technology stock prices. Technology
stocks, especially prices of Internet stocks, tend to be valued at very high price earnings multiples and
stock price movements are linked to expected earnings. These stocks are highly vulnerable to market
cycles. In particular, technology stocks, like other growth stocks, are very susceptible to inflation because
inflation reduces corporate earnings. Furthermore, inflationary pressures tend to lead to higher interest
rates and a slowing economy, which lessens the ability of growth companies to meet revenue and
earnings targets, causing stock prices to decline.
Oil price increases are one of the most likely sources of inflation. Oil price increases usually impact the
transportation sector first, with initial price hikes being absorbed by this sector. Persistent oil price
increases lead to higher producer prices and eventually, after 6-9 months, inflation. Inflation, which erodes
the real value of investments, leads to higher interest rates as contractionary monetary policy is used to
bring economy-wide price increases down. In the high-technology sector, oil price increases can directly
impact technology stock returns by raising the costs of the transportation component of e-business. When
a customer places an order for a product online, the product still needs to be shipped from the warehouse
to the customer's doorstep. Higher interest rates also create competition for equity financing, and equity
financing is more important than debt financing in the high-technology sector. In March 2000, for example,
the debt equity ratio for NASDAQ listed stocks was 16.6%, whereas that for the rest of the U.S. stock
market was 85.2%. Moreover, some large technology companies such as Cisco Systems have no debt.
As interest rates rise, private investors may choose to buy fixed-income securities rather than invest in
venture capital pools to finance the startup of new technology companies.
7. MODELING APPROACH AND QUANTITATIVE METHODS
There are three main ways to empirically investigate the interaction between stock prices and energy
prices. The first approach uses arbitrage pricing theory (APT), the second approach uses a discounted
cash flow model, and the third approach uses unrestricted vector autoregressions.
The APT approach uses an arbitrage pricing argument to relate priced risk factors to required rates of
return in assets (securities):

where Rt is the expected excess return on an asset or stock market index, j are the factor loadings or
systematic risks, and Fjt are the risk factors. The variable t is a random error term. The APT assumes that
the total variability of an asset's returns can be attributed to market-wide risk factors that affect all assets
and other risks that are firm specific. Market-wide risk factors are known as systematic or nondiversifiable risks, and firm-specific risk factors are known as unsystematic or diversifiable risks. A widely
diversified portfolio of equities can reduce or eliminate unsystematic risks, but systematic risk cannot be
diversified. Thus, an investor must be compensated for systematic risk. In APT models, assets can have
exposure to a number of different risks, including market risk, inflation risk, default risk, exchange rate
risk, and oil price risk. Equation (1) can be estimated by ordinary least squares (OLS) regression using a
time series data set on a single asset or as a cross section for one particular point in time with many
assets. Model adequacy can be checked using regression diagnostic tests. More sophisticated models
may involve many assets or classes of assets. In this case, a system of equations estimation approach
would be used. There is considerable evidence that asset prices display time-varying risk premiums and
volatility clustering. Time-varying risk premiums can result from time variation in the risk sensitivities
(factor loadings) or time variation in the market premiums (factors). Volatility clustering means that major
stock price changes follow major stock price changes but the direction of the change is not known. As a
result, time-varying autoregressive conditional heteroskedasticity models are often used in the estimation
of Eq. (1).
The second approach uses a discounted cash flow model to test whether stock prices react rationally to
changes in oil prices:

where RSt is the log real return on a stock in period t, E t is the mathematical expectation operator, Ct is the
log of real cash flow in period t, p is a parameter close to but not equal to 1, OIL t, is the percentage
change in oil prices, and t is a random error term. The model can be estimated by OLS. If the stock
market is rational, then the coefficients on the OIL variables should be statistically insignificant from zero.
At the economy-wide level, aggregate future cash flows can be approximated by future industrial
production.
The third approach uses an unrestricted vector autoregression (VAR). This approach is intentionally
unrestricted and useful for determining or confirming patterns between economic variables. Many
interesting dynamic relationships can be captured using multiequation regression models such as VARs.
Moreover, the VAR is very useful for performing policy simulations. The basic form of the VAR treats all
variables symmetrically. No reference is made to distinguish which variables are independent and which
variables are dependent. Consider a congruent statistical system of unrestricted forms represented by Eq.
(3):

where xt is a (nx1) vector of variables, and the error term t is independent and identically distributed with
mean zero and variance . Economic theory guides the choice of variables. Typical variables used in
studying the relationship between stock prices and energy prices include industrial production, interest
rates, stock prices, oil prices, consumer prices, and, possibly, exchange rates. The variables in the vector
xt might also be transformed into growth rates or may be estimates of volatility. In the latter case, the VAR
would be used to investigate the dynamic relationship between oil price volatility and stock market
volatility. Basic research questions include the following: What are the determinants of stock market
volatility? Has stock market volatility increased over time? Has international financial integration led to
faster transmission of volatility across international stock markets?
8. EMPIRICAL EVIDENCE ON THE RELATIONSHIP BETWEEN OIL PRICE MOVEMENTS AND
STOCK PRICE MOVEMENTS
The empirical evidence on the relationship between oil price movements and stock price movements is
mixed. Empirical models can be estimated using daily, monthly, quarterly, or annual data, and the analysis
can be conducted at the firm, industry, or economy-wide level.
Empirical models using the APT model generally use monthly data to investigate the relationship between
oil price movements and stock price movements across industry sectors or at the economy-wide level.
Generally, the empirical results indicate that an oil price factor is an important driver behind stock price
movements. At the economy-wide level, an oil price risk factor is important but it does not have the same
impact on all countries' stock markets. Countries that are net importers (exporters) of oil and gas tend to
have a negative (positive) correlation between oil price changes and stock returns. The Group of Seven
(G7) economies (Canada, the United States, England, France, Germany, Italy, and Japan) is adversely
affected by oil price increases. This effect is muted in Canada since it is a net exporter of energy
products.
Industries are not all the same and different risk factors can have different effects across different
industries. Empirical results suggest that factor sensitivities vary across industries. At the industry level, oil
price risk factors have a positive and significant impact on oil company stock returns. For Canadian and
U.S. oil and gas companies, market betas are typically approximately 0.7 and oil price betas are typically
approximately 0.3. For industries that are net users of oil and gas, such as airlines and trucking
companies, oil betas have a significant negative impact on stock prices.
Empirical results from a discounted cash flow model to test whether stock prices react rationally to
changes in oil prices are mixed. The reaction of Canadian and U.S. stock markets to oil price shocks can
be completely accounted for by the impact of oil price shocks on real cash flows. The results for the
United Kingdom and Japan are not very strong. For these countries, their respective stock markets seem
to overreact to oil price shocks.
The VAR approach has been widely used in studies investigating the relationship between oil price
movements and stock price movements. This approach, which is generally applied at the economy-wide
level using monthly or quarterly data, has provided evidence across a variety of developed and emerging

economies showing that oil price changes do impact stock returns. One of the more interesting
discoveries from these studies is that oil price changes have asymmetric effects on economies and the
stock market. Positive oil price changes exert a much larger impact on economies and stock markets than
do negative oil price shocks. This is because positive oil price shocks are associated with an increase in
uncertainty. In periods of high uncertainty, firms postpone their hiring and investment decisions. This
slows GDP growth. Negative oil prices shocks tend to be viewed as temporary and unlikely to affect the
investment and hiring decisions of firms. Any benefits of lower oil prices are usually seen in increased
profits for energy-consuming companies.
The VAR approach applied at the industry or firm level using daily data to investigate the lead-lag
relationship between oil futures prices and stock prices during the day has provided little evidence of a
relationship between broad-based stock prices and oil prices. This is probably because oil price changes
take several months to impact the non-oil-related sectors of an economy. As expected, there is strong
evidence to support the hypothesis that daily oil company stock prices respond quickly to daily oil price
movements.
The VAR approach is also useful for studying the relationship between stock market volatility and the
volatility of oil prices. Empirical results indicate that the conditional volatilities of oil prices, interest rates,
and U.S. inflation rates each have a significant impact on the conditional volatility of equity markets.
9. ENERGY PRICE RISK MANAGEMENT
Fluctuating energy prices create uncertainty for both consumers and producers of energy products.
Energy consumers prefer low and stable energy prices, whereas energy producers prefer higher energy
prices. This situation creates a demand for risk management practices. There are a number of risk
management tools, including forward contracts, futures contracts, options on futures contracts, and other
derivative products (some traded and others not traded).
A typical example is an electricity power generator that needs to buy a known amount of natural gas 6
months in the future. The power generator is a heavy user of energy products and is concerned that
natural gas prices will increase in the future. Rising natural gas prices will increase costs and lower
profits, possibly resulting in declining earnings, a cut in dividends, and declining share prices. A useful risk
management strategy is to employ a hedging strategy. The power generator could buy a forward contract
for delivery of the natural gas in 6 months. In this case, the power generator buys the required amount of
natural gas from a seller at a price negotiated today. This locks in the price at today's forward prices. The
power generator could also use the futures markets for natural gas to buy the appropriate number of
natural gas futures contracts on the NYMEX for delivery of natural gas 6 months in the future. Provided
that the price of natural gas increases enough in the 6-month period, the forward or futures contracts will
have provided the power generator with an effective hedge against rising natural gas prices. Hedging
strategies that use forward or futures contracts eliminate the upside risk by locking in the price for natural
gas. This eliminates the company's exposure to rising natural gas prices but, unfortunately, also gives
away all or part of the company's exposure to declining natural gas prices.
Buying options on natural gas futures contracts is another form of risk management available to the
power generator. In this case, the power generator pays the premium to purchase the options. The

options premium is a form of insurance against rising natural gas prices. The power generator has the
right but not the obligation to purchase the underlying futures contracts. The options will be exercised if
natural gas spot prices rise high enough relative to the futures prices specified in the options contract. If
spot natural gas prices decline, then the options expire worthless. The company loses the premium paid
on the options but can still buy natural gas in the spot market at a lower price than would have been
available under the forward or futures contract.
SEE ALSO THE FOLLOWING ARTICLES
Business Cycles and Energy Prices Derivatives, Energy Economics of Energy Demand Economics of
Energy Supply Energy Futures and Options Inflation and Energy Prices Innovation and Energy Prices
Markets for Petroleum Oil Price Volatility Prices of Energy, History of Trade in Energy and Energy
Services
Further Reading
BP (2001). Statistical review of world energy, www.bp.com.
Engle, R. F. (1982). Autorcgrcssivc conditional heteroskedasticity with estimates of the variance of UK
inflation. Econometrica 50, 987-1008.
Ferson, W.; Harvey, C. R. (1994). Sources of risk and expected returns in global equity markets. J.
Banking Finance 18, 775-803.
Fusaro, P. C. (1998). Energy Risk Management: Hedging Strategies and Instruments for the
International Energy Markets. McGraw-Hill New York.
Hamilton, J. D. (1983). Oil and the macroeconomy since World War II. J. Political Econ. 91 (2), 228248.
Huang, R. D.; Masulis, R. W.; Stoll, H. R. (1996). Energy shocks and financial markets. J. Futures
Markets 16 (1), 1-27.
Jones, C. M.; Kaul, G. (1996). Oil and the stock markets. J. Finance 51 (2), 463-491.
Sadorsky, P. (1999). Oil price shocks and stock market activity. Energy Econ. 21 (5), 449-469.
Yergin, D. H. (1991). The Prize: The Epic Quest for Oil, Money and Power. Simon & Schuster New
York.
PERRY SADORSKY
YORK UNIVERSITYTORONTO, ONTARIO, CANADA