Thesis Proposal

Thesis Proposal

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The relationship between oil price shocks, stock markets, and the real economy

Abstract

The goal of this study is to try to use the cross-national correlation and relationship between different economic factors in order to explain how the global economy is affected by changes in oil prices. The core macroeconomic variables of each economy, including the real GDP, inflation, real exchange rates, and long-term rates will be compared with changes in the oil prices over the years.

This research could be used in the government and the business community to realize the effects of oil prices on the stock markets and the real economy. Understanding this relationship can help in making investment decisions under the certainty of global oil price shocks. This research also can provide insights into what economies should take into account in order to be protected by surges in oil prices. Another insightful outcome of this research can furthermore explain how oil prices should be regulated worldwide, in order to achieve the protection with high certainty of the effects on both the oil importing and exporting countries.

Background of the Research Topic

Over the years, statisticians have tried to relate oil price shocks and stock markets. Using the Dow Jones Industrial Average (DJIA) and the price of crude oil, there has been a close correlation between the changes in the prices of fuel with the stability in the stock market (Patton, 2016). However, most of the analysis is based on the relationship between the prices of oil and the oil stock markets. When the quantity of oil increases, the value of bonds in the oil stock markets increases. The majority of the researchers who investigated this topic have focused on the demand and supply of oil to changes in the real economy. Researches in countries that depend on fuel such as Saudi Arabia have always found a positive relationship between oil price increases with an increase in their GDP.

On the contrary, countries, which abundantly import oil, are negatively affected by oil price surges. However, most of the research has only focused on the overall economic growth as measured by the gross domestic product without considering other factors such as the stock market. When considering the supply and demand of oil, an increase in the prices of oil is likely to reduce levels of its consumption and consequently, investments in the stock market. Reduction in the consumption and investment is therefore expected to negatively affect the real economy, regardless of whether the country is a fuel importer or exporter. Little research has been done to determine the exact relationship between all three factors: oil price shocks, stock markets, and the real economy. This study presupposes that there is a positive correlation between oil price shocks, stock markets, and the real economy.

Background of the Study                                     

Oil prices have constantly been changing over the years. These changes have been blamed on political, economic, and legal environments associated with the oil industry. From 1948 close to the 1950s, the prices of crude oil ranged from $2.50 and $ 3.00 per barrel and about $17 to $20 when adjusted for inflation. At this time, the United States of America dominated the oil industry. It was able to regulate oil prices, and the oil prices were majorly affected by the laws of supply and demand, such as increased demand during the summer driving season. Between the 1960s and 1970s, Saudi Arabia and other countries majorly from the Middle East and North Africa formed OPEC to control oil prices. The oil prices started to be highly volatile in 1974 due to forces other than those of supply and demand (Soundarapandiyan, 2017). In 1971, volatility in the oil prices made the US dollar to fall off the gold standard. As the value of the dollar plummeted, it also took the oil revenues down with it. In July 2008, the cost of crude oil rose to more than $140 a barrel.

The 2008 global economic recession that happened due to inappropriate investment in the real estate sector has also been related to the oil price shocks that affected the global stock markets resulting in an economic slowdown. In 2015, the actual oil prices fluctuated to the highs of $145 to lows of $15 per barrel. This abrupt increase led to the fluctuation in the global stock markets resulting in domestic oil price increases that, in turn, increased the prices of related products such as coal and electricity. Since 1986, International Monetary Fund (IMF) has recorded six significant episodes of the decline in oil prices where each episode had at least 30% or more price shocks relatively to a brief period of about seven months each(Baffes, Kose, Ohnsorge, & Stocker, 2015). These changes were found to have a significant effect on the global economy. Most researchers all over the world have expressed different opinions on whether price shocks have a deteriorating or a beneficial impact on the worldwide economy. Other researchers have identified,on the contrary, that price shocks, especially price increases, have a positive correlation to the real GDP of oil-exporting countries. Some have rejected the assertion, claiming that oil price surges are equally harmful to both importing and exporting countries. These differences have made it difficult for policymakers to come up with effective ways of controlling global oil prices and ensuring that the costs of oil are advantageous to all economies.

Objectives of the Study

1. Finding out the cross-national impacts of oil price shocks on stock markets and the real economy
2. Identifying the linkages between the differential change in the global price of oil to the stock market’s volatility and the real economy
3. To understand and the impact of oil on both importers and exporters

Hypothesis of the Research

*Increase in the oil prices has a positive correlation with the stock markets and real economy.

Approval from IRB

The approval from IRB for this research is not needed, as it doesn’t take into account human subject involvement in conducting the study. The sources of information are mainly secondary sources and studies not raising ethical issues in the study.

Use of University Equipment

To this moment, the usage of university equipment is to be decided by the advisor, since the models and data resources can be found on the internet in data libraries.

Literature Review

The United States of America is one of the countries, which acts as both an importer and an exporter of oil. The research on the impact of price shocks on the country has attracted a lot of attention due to the complexity of the oil industry in the country. According to the research by Hamilton (2009), oil importers benefit from the fall in oil prices while exporters lose. Hamilton’s research established that oil shocks are the major contributors to the global economic recessions. Research by Obstfeld on the effect of recent oil shocks illustrates that reduction in the oil prices is good for countries such as the United States of America as it reduces the prices in the real economy, which encourages consumption and investment (IMF, 2016).

Some scholars have, however, found a reverse relationship between the prices of oil and the real economic extension as measured by the gross domestic product. Further research has indicated that a positive correlation between oil prices and equity markets. In this case, a decrease in the oil prices results in the overall slowdown in the global economic activity since the softening of the global aggregate demand reduces profits from organizations as well as the demand for oil and oil products. This indicates that the decline in the prices of oil is not good for the industrialized global economy. However, few researchers have been able to find the linear relationship between the two factors. In a research done by Cardiac and Mignon on the effects of oil prices in the economy of China(Lardiac& Mignon, 2016), it was found that while most researchers have rejected the standard co-integration between the two factors, there is evidence of asymmetric co-integration between the GDP in major European countries and the global oil prices. Other scholars have attempted to measure the elasticity of the changes in the Gross National Product to the oil prices. In these measurements, the major assumption is that the macro economy influences oil prices at the demand and supply levels(Sun & Sui, 2019). In this case, the increase in the price of oil can lead to inflation, which can then reduce the consumption of oil-related products and other products as well as an investment due to reduced income. Oil touches on every sector of an economy and consumption and therefore increase in the oil prices.

The impact of price shocks on the global economy is complex. As opposed to country-specific studies, domestic political economy considerations and effects on the oil price changes impact this relationship(Andrea, Francesca & Matteo, 2016). Some factors, which highly affect the oil price changes, are the global energy demand interest rate, financial market, and world trade. Given that there are multiple channels through which the oil sector affects different macro and microeconomics factors, it has become difficult to measure its impacts on the real economy effectively. Most studies focus on the relationship between oil price shocks and the stock markets in developed countries. The major reason behind this research is that stock returns depend majorly on cash flows and earnings. A comparative study done on the US, Japan, and China showed that the effect of price shocks is much lower in the US and Japan than China. According to the orthodox financial theory, stock returns depend on the discounted value of expected cash flows since a unit change in the price of the oil can result in a major impact on the firms’ cash flows(Nasir, Naidoo, Shahbaz&Amoo, 2018). This investigation raises the question of the volatility of spillovers between oil markets and stock markets.

Most of the literature reviews have failed to effectively create a connection between the oil price shocks, the stock market, and the real economy. Most of the researches done usually focus on individual countries like the United States of America and China or countries with similar characteristics and macroeconomic position. For instance, the majority of the researchers have found out that oil price increase negatively affects the stock markets and the real economy of importing countries like China but positively affect oil-exporting countries like Saudi Arabia. However, little research has been geared towards investigating the impacts that oil price shocks affect the entire global stock markets and the real economy.

Methodology of the Study

This research will use the Global Vector Auto-regressive modeling to measure the relationship between oil price shocks, stock markets, and the real economy. This model takes into consideration both real and financial factors affecting oil prices in the global market (Mohaddes&Pesaran, 2016). This model is well suited for this research as it gives room for the identification of country-specific shocks and identifies how such shocks and relates them to their impacts in the stock markets and the real economy. This investigation is different from the majority of the studies that majorly focus on global supply shocks rather than those which affect the specific country. Moreover, the model allows the researcher to deal with inherent heterogeneity existing across nation-states. Furthermore, the model allows the researcher to create inter-linkages and spillovers between different countries and regions that then helps in effectively studying the global economy (Mohaddes&Pesaran, 2016).

In using this model, four countries from different regions will be used for the study. These countries include Saudi Arabia, the United States of America, Japan and South Africa. The countries are a mixture of net oil exporters, importers, and a combination of the two. The countries also consist of both developed and developing countries. The core macroeconomic variables of each economy, including the real GDP, inflation, real exchange rates, and long-term rates will be compared with changes in the oil prices from 2016 to 2019. These variables will then be related to different variables specifically constructed to match the general foreign pattern of the country under consideration.

Model Specification

GVAR model comprises of country vector error-correcting models where the core domestic variables are correlated with country-specific foreign variables. The model consists of four significant variables including the real Gross Domestic Product, rate of inflation, deflated exchange rate and the short-term interest rate.

Data Sources

The data for this research will be obtained from country-specific statistical websites, and government reports on stock market performance and the real economic outlook between 2016 and 2019. Other forms of data will be collected from global forums like the world economic forums, World Trade Organization, and the International Monetary Fund. Furthermore, books, journals, ministerial reports, statistical abstracts, and the World Wide Web will be used to reinforce the research output.

Timeline

Expected duration of this research shouldn’t be a concern since there are sources available and it relies on my ability to compile the data into a methodological framework and test the hypothesis against the data collected. Since there isn’t any expected collection of primary sources for the study, the risks of poor time management and potential issues are minimized. The time needed in total, will depend on my ability to consult with the advisor and provide key findings during the writing process.