Altering strategic investments
Crude oil or black gold is considered to be one of the most important commodities because it caters to about 30% of the world’s energy needs. The reliance on crude oil may moderate in the long run but crude oil will continue to be used for energy requirements in the near future. It is because of the dependence on crude oil, increase in the international crude oil price can have a severe impact on a crude oil-importing country like India. It may, however, be good news for a crude oil-exporting country.
A country like India which imports most of its crude oil needs from other countries ends up paying more money if crude oil prices increase in the international market. The dollar is the currency for international payments, therefore, India needs to first buy dollars. India needs to pay in rupees to buy the dollar and which may exert a negative impact on the rupee and India’s Balance of Payments (BOP) account. Nevertheless, higher crude oil prices result in high prices of diesel or petrol and that increases the transportation cost. It results in higher price of goods and services (inflation) and citizens have to spend more money to meet daily needs, therefore, are left with less money for savings.
Companies that are reliant on crude oil may also face the impact of high crude oil prices due to increased production costs and, therefore, end up with lower than expected profits. It may also get reflected in the share prices of the companies. Therefore, to get a sense of association between crude oil price changes and stock market movements, we investigated the relationship between crude oil and stock markets of G7 (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States) and the BRICS nations (Brazil, Russia, India, China and South Africa). However, we considered the relationship in variance (shock or fluctuation) while investigating the association between crude oil and stock markets.
Relationship between crude oil and stock markets
To investigate the relationship we took crude oil (Brent) and stock index returns of G7 and BRICS nations. Due to certain statistical reasons, we did the analysis by calculating returns and not prices. We found that the relationship between crude oil and stock markets is dynamic. In other words, the relationship changes with time. Crude oil and a stock market can move in the opposite direction (negative correlation) during some periods and can move in the same direction (positive correlation) in others. It suggests that the underlying reasons for the relationship between crude oil and stock markets keep on changing with time.
Moreover, this association between crude oil and stock markets has increased after the 2000s due to the financialisation of commodity markets. Where speculators (who buy or sell stocks to make money) started to enter the market to earn profits rather than buying the crude oil for trading or to use in further production processes etc. For example, the correlation between crude oil and stock markets was on the higher side during the Global Financial Crisis (2008-2009). An important insight we get with this result is that when stock market volatility (variance or fluctuation) went up, volatility of crude oil also went up and vice-versa. It also indicates that such movement in volatility could indicate the onset of a crisis. Furthermore, we also tested for the impact of a sudden movement (shock) in crude oil on stock markets and vice-versa.
All stock markets show increased variance (shock or fluctuations) to sudden fluctuation in crude oil except for France. On the other hand, crude oil also shows increased variance (fluctuation) for extended periods due to sudden movement in the stock market, except for China. Therefore, we found considerable association between crude oil and stock markets over the study period.
Difference between G7 and BRICS
We found that the pattern of the relationship over time is similar in the case of G7 nations but vary considerably among the BRICS nations. It could indicate that G7 is economically integrated in comparison to BRICS. It also suggests that the movement of relationship in one market can indicate the movement in other markets and more so in G7 nations. To investors, BRICS offer some advantage over G7 nations by way of diversification of investment among the BRICS nations.
On average, the strength of the association (correlation) between crude oil and stock markets is stronger in the case of BRICS than in G7. In the case of G7 nations, Canada exhibits the strongest relationship with crude oil followed by Japan, United Kingdom, Italy, Germany, France and United States. During the period of study, the Canadian stock index was constituted mainly of commodity companies and therefore resulted in the highest association between crude oil (a commodity) and the Canadian stock market. Among the BRICS nations, Brazil shows the strongest association followed by Russia, South Africa, China and India. It seems that the Brazilian economy that is highly reliant on biofuels show high sensitivity to fluctuations in crude oil returns.
In conclusion, economies reliant on crude oil need to pay close attention to the movements of stock markets along with crude oil. Shocks to one market (crude oil or stock market) may transfer to another market (stock market or crude oil). Investors investing in crude oil and stock markets may be better off by altering investment strategies when the correlation between crude oil and stock markets are on the rise.
(This study has been authored by Vaneet Bhatia.)