AN EMPIRICAL ASSESSMENT OF THE IMPACT OF OIL SHOCK ON STOCK MARKET

CHAPTER ONE

INTRODUCTION

2.1 Background of the study

Following the discovery of crude oil by Shell D, Arcy Petroleum, pioneer production began in 1958 from the company’s oil field in Oloibiri in the Eastern Niger Delta. By the late sixties and early seventies, Nigeria had attained a production level of over 2 million barrels of crude oil a day. Although production figures dropped in the eighties due to economic slump, 2004 saw a total rejuvenation of oil production to a record level of 2.5 million barrels per day. Petroleum production and export play a dominant role in Nigeria’s economy and account for about 90% of her gross earnings. This dominant role pushed agriculture, the traditional mainstay of the economy, from early fifties and sixties, to the background. (NNPC, 2009). As of January 1, 2009, the estimated crude oil and natural gas reserve are, respectively, 36.2 billion and 182.4 trillion cubic feet (tcf), and ranks as the 12th biggest oil producing country of the world with a 2.4m bpd or 3.1% of the estimated world total in 2008 (Liveoilprices, 2008). An unresolved research issue in stock market is the role played by oil prices. If you ask a layman about the relationship between the price of oil and the stock market, the expected answer would be: “the relationship is negative”. This kind of view is also shared by the financial press. But in reality, the relationship is much more complicated than this simple answer. It depends on the circumstances and the prevailing state of the macro economy (Hammoudeh, 2009). While most prior research on the relationship between oil prices and stock market could not find strong and convincing evidence to support the proposition that oil prices drive the stock market returns (Pescatori and Mowry, 2008., Fisher,2005., Agusman and Deriantino, 2008., Weiner,2005 and Apergis and Miller, 2009), yet a number of studies have found evidence to the contrary. Some of the studies that shows that a relationship exists between oil prices and the stock market include those of Sadorsky (2008), Aloui and Jamazi (2009), El-Sharif et al (2005), Hammoudeh (2009), Gogineni (2007) and Rault and Aruori (2009). It is against this backdrop that this study was carried out to find out whether oil price volatility affects stock market performance in Nigeria. The term volatility has been given different definitions by different scholars across disciplines. In relation to crude oil price, volatility is the measure of the tendency of oil price to rise or fall sharply within a period of time, such as a day, a month or a year. Most oil price movements, especially up to the mid- 1980s' and earlier, consisted in price increases. However, the pattern has changed. There are large price increases and decreases reflecting a substantial rise in the volatility of the real oil price which creates market uncertainties that induce companies to postpone their investments (Sauter andAwerbuch, 2003). A number of factors have been identified as triggers of oil price volatility. These factors range from demand and supply of crude oil, OPEC decisions, crises, wars to economic downturn. Using a traditional approach to assessing the tightness of the oil market, Merino and Ortiz (2005) contended that the evolution of oil inventories should reflect the interaction between supply and demand forces, and therefore, should contribute to explaining oil price changes. Oil is the life blood of modern economics and when countries urbanized and modernized, demand for oil increases (Eryigit, 2009). Unanticipated economic developments could, in principle, roil crude oil markets and increases volatility. Examples include the unexpected surge in energy demand from China and India, which helped to draw down worldwide buffer stocks, and the decline in the trade weighted value of the U.S dollar increase in the volatility of oil prices and the average price of crude oil (Guo and Kliesen, 2005). A long term explanatory factor for increasing oil price could be the decline of the world reserve base. Factors such as political unrest like that experienced by oil producing Venezuela and Nigeria, OPEC quota system decisions as well as speculative buying and selling all affect prices as financial traders adjust their investment portfolios to reflect market conditions (Pirog, 2004). The fear of global shortage of crude oil may also account for changes in oil price. As noted by Appenzeller (2004), there have been diverse arguments about how much more of crude oil reserve the world has before the wells dry up. Whereas historical oil price shocks were primarily caused by physical disruptions of supply, the price run-up of 2007- 2008 was caused by strong demand confronting world production (Hamilton, 2009; Cale, 2004). Mabro (2001) cited the market's perceptions of the state of OPEC's solidarity as well as the dynamics of futures markets as the causes behind violent oil price movements. Since Hamilton’s (1983) seminar paper there is a growing interest in the effects of oil prices on stock market returns, as well as, on the economy. The aim of this paper is to examine the relationship between the oil prices and the stock market from a different angle. In particular, we define a regime switching model specification and investigate whether oil price shocks and oil price volatility can predict states of the stock market. A large body of the academic literature has provided mounting empirical evidence regarding the relationship between oil prices and macroeconomic variables. In the main, the results suggest that oil prices exert a very significant impact on the economy either due to their effects on pricing and production costs or due to their effects on aggregate demand (i.e. via inflation and monetary policy channels) and aggregate supply (i.e. via output). Important studies include those by Segal (2011), Rahman and Serletis (2011), Tang et al. (2010), Nakov and Pescatori (2010), Jbir and Zouari-Ghorbel (2009), Blanchard and Gali (2007), Hamilton (2008, 1996), Hamilton and Herrera (2004), Barsky and Kilian (2004), Jones et al. (2004), Leduc and Sill (2004), Brown and Yucel (2002), Bernanke et al., (1997), Rotemberg and Woodford (1996), Huang et al. (1996), Mork et al. (1994), Mork (1989) and Burbidge and Harrison (1984). Notwithstanding this general conclusion that oil prices influence the economy, a strand in the literature over the last decade or so has been shaping around the concept that the relationship between oil prices and the economy changed after the 80s (see, inter alia, Lescaroux and Mignon, 2008; Blanchard and Gali, 2007; Hooker, 2002, 1996; Bernanke et al., 1997; Darrat et al., 1996). Specifically, they maintain that oil price changes are no longer inflationary, and do not significantly impact output levels and, thus, do not constitute a source of recessionary periods. Even though there is an extended literature on the relationship between oil prices and the macro-economy, research in the area of oil prices and stock markets is still growing. The bulk of the literature finds a negative relationship between changes in oil prices and stock market returns (see, inter alia, Filis, 2010; Chen, 2010; Miller and Ratti, 2009; Driesprong et al., 2008; Nandha and Faff, 2008; O'Neill et al., 2008; Park and Ratti, 2008; Bachmeier, 2008; Henriques and Sadorsky, 2008; Sadorsky, 6 2001; Papapetrou, 2001; Ciner, 2001; Gjerde and Sættem, 1999; Huang et al., 1996; Jones and Kaul, 1996)

1.2 STATEMENT OF THE PROBLEM

Since Hamilton’s (1983) seminar paper there is a growing interest in the effects of oil prices on stock market returns, as well as, on the economy. The In particular, we define a regime switching model specification and investigate whether oil price shocks and oil price volatility can predict states of the stock market. A large body of the academic literature has provided mounting empirical evidence regarding the relationship between oil prices and macroeconomic variables.  It is in view of this that this that the researcher intend to investigate the impact of oil shock on stock market.

1.3 OBJECTIVE OF THE STUDY

The main objective of the study is to assess the impact of oil shock on stock market. But for the successful completion of the study the researcher intends to achieve the following sub-objective;

i)             To ascertain the impact of oil shock on the economic growth of Nigeria

ii)           To ascertain the effect of stock market on the growth of Nigerian economy

iii)          To ascertain the relationship between oil shock and economic growth

iv)         To investigate the role of Nigerian security and exchange commission in the regulation of stock market

1.4 RESEARCH HYPOTHESES

For the successful completion of the study, the researcher formulate the following hypotheses;

H0:oil shock does not have any significant impact on the economic growth of Nigeria

H1: oil shock does have a significant impact on the economic growth of Nigeria.

H02:stock market does not play any significant role in the growth of Nigerian economy

H2: stock market does play a significant role in the growth of Nigerian economy.

1.5 SIGNIFICANCE OF THE STUDY

It is believed that at the completion of the study the findings will be of great importance to the Nigerian security and exchange commission as the study seek to elaborate on the role of stock market on the economic growth of Nigeria.

The findings will also be useful to federal government in their quest to diversify the economy from being oil  so as to avoid the effect of oil shock on the economy.

The study will also be of great importance to student who intend to embark on a study in similar topic as the findings of the study will serve as a pathfinder to them. Finally the study will be of great importance to students, teachers and the general public as the finding will add to the pool of existing literature

1.6 SCOPE AND LIMITATION OF THE STUDY  

The scope of the study covers an assessment of the impact of oil shock on stock market. In the cause of the study, the researcher encounters some constraint which limited the scope of the study;

a)     AVAILABILITY OF RESEARCH MATERIAL: The research material      available to the researcher is insufficient, thereby limiting the study.

b)     TIME: The time frame allocated to the study does not enhance wider         coverage as the researcher has to combine other academic activities        and examinations with the study.

c)     FINANCE: The finance available for the research work does not     allow for wider coverage as resources are very limited as the        researcher has other academic bills to cover

1.7 DEFINITION OF TERMS

Oil shock

A sudden dramatic increase in the price of oil; a period of economic difficulty caused by such an increase; specifically either of two oil price rises imposed by the Organization of Petroleum Exporting Countries.

Shock

In economics, a shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it refers to an unpredictable change in exogenous factors that is, factors unexplained by economics which may influence endogenous economic variables.

Economic growth

Economic growth is the increase in the inflation-adjusted market value of the goods and services produced by an economy over time. It is conventionally measured as the percent rate of increase in real gross domestic product, or real GDP. Growth is usually calculated in real terms – i.e., inflation-adjusted terms to eliminate the distorting effect of inflation on the price of goods produced. Measurement of economic growth uses national income accounting.

1.8 ORGANIZATION OF THE STUDY

This research work is organized in five chapters, for easy understanding, as follows. Chapter one is concern with the introduction, which consist of the (background of the study), statement of the problem, objectives of the study, research questions, research hypotheses, significance of the study, scope of the study etc. Chapter two being the review of the related literature presents the theoretical framework, conceptual framework and other areas concerning the subject matter.     Chapter three is a research methodology covers deals on the research design and methods adopted in the study. Chapter four concentrate on the data collection and analysis and presentation of finding.  Chapter five gives summary, conclusion, and recommendations made of the study.