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Crude oil and sectoral stock market indices

Vaneet Bhatia, assistant professor and assistant dean (research) Jindal School of Banking & Finance, O P Jindal Global University
Results in mean indicate that crude oil has a strong impact on all sectoral stock market returns.(REUTERS)
Updated on Oct 14, 2021 10:51 AM IST
ByOP Jindal Global University

Crude oil is considered to be one of the important commodities. Some investors or investment houses buy crude oil or its derivative contracts for purely speculation purposes, i.e., to earn profits. Many companies buy crude oil or its byproducts to use as input in different kinds of production processes. Countless others, including retail users, buy refined crude oil products to power different modes of transportation. It is due to our reliance on crude oil, any change in crude oil prices can result in system-wide shocks and more specifically inflation. The companies or industries (e.g., energy sector) reliant on crude oil are likely to be severely impacted due to the rise in crude oil prices and at the same time, the impact of crude oil is likely to be limited on companies or industries having limited dependence on crude oil. To estimate the impact of variables like crude oil on different types of companies or industries, changes in share prices or changes in stock market indices are generally considered to be a good indicator. Therefore, to examine the impact of crude oil on similar types of companies and specifically on different industries, we investigated the relationship between crude oil and sectoral stock market indices.

To carry out the analysis, we focused on the origin of crude oil prices changes i.e., whether the change in crude oil was due to demand-driven or supply-driven factors. Demand-driven price changes in crude oil are due to the rise or fall in the demand for crude oil and supply-driven price fluctuations in crude oil are due to rise or fall in the supply of crude oil and we named them demand shock and supply shock respectively. We considered the crude oil prices changes due to demand shock and supply shock to conduct rest of the analysis. We also investigated the relationship in mean (returns or first moment) and volatility (variance or second moment) as well as different market states (bullish, bearish, and normal market conditions). The bullish market state is a condition when returns are on the high side and the bearish market state is a condition when returns are negative or on the lower side. Bullish and bearish market states are extreme market conditions in comparison to normal or median or average market state. To select the sectoral stock indices, we employed the Emerging Market Sectoral Index (EMSI) of Morgan Stanley Capital International (MSCI). The index is available for 11 different sectors, namely communication services, consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, real estate, and utilities. The emerging market countries in MSCI-EMSI include Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates.

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The results were very different from our expectations. Results in mean indicate that crude oil has a strong impact on all sectoral stock market returns. Moreover, both demand shock and supply shock to crude oil have a comparable influence on sectoral stock market indices. We found that the impact of crude oil demand and supply shock on sectoral stock indices does not change to bullish, bearish, or normal market states. However, for extremely bearish states, i.e., when returns are very low, supply shocks do not influence returns of consumer staples, energy, and real estate sectors. The energy sector seems to be an exception in these results and suggests that extremely low changes in crude oil due to supply shocks do not influence energy sector stock market returns. In an extremely bullish market state, crude oil supply shocks seem to have a limited impact on the real estate sector. Overall, both crude oil demand and supply shocks have a statistically significant impact on sectoral stock market indices in mean, but demand shocks appear to have more influence in comparison to supply shocks.

We found some interesting results while investigating the relationship between crude oil and sectoral stock market indices in the second moment (variance or volatility). The impact of crude oil on sectoral stock market indices breaks down in bearish and bullish market states. However, demand shocks appear to outperform supply shocks with a considerable margin. In comparison to the variance of crude oil supply shocks, the variance of crude oil demand shocks seems to impact the variance of sectoral stock indices over a greater range and such an influence is prominent in the bearish market state. However, there are a couple of exceptions to the above-mentioned pattern. First, the health care sector seems to be screened from the effects of crude oil demand and supply shocks in variance. Second, both demand and supply shock impact the real estate sector in all bullish, bearish, and normal market states.

In conclusion, our results suggest that changes in crude oil prices not only impact the energy sector stock market returns and volatility but stock market return and volatility of all other sectors. Moreover, investors should consider the source of crude oil price changes/shocks while making investment decisions and should be more cautious if crude oil price changes are demand driven. Finally, the health sector seems to be a good investment option against high volatility in the crude oil market.

The study has been accessed by clicking here.

(Vaneet Bhatia, assistant professor and assistant dean (research) Jindal School of Banking & Finance, O P Jindal Global University)

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