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Modelling the Impact of Oil Price Volatility on Investment Decision THE UNIVERSITY OF HULL Modelling the Impact of Oil Price Volatility on Investment Decision-Making Being a Thesis Submitted for the Degree of Doctor of Philosophy at University of Hull by Rayan Salem Hammad MBA, University of Arkansas at Little Rock BBA (Finance), University of Arkansas at Little Rock December, 2011 I Acknowledgement First and foremost, I offer my sincerest gratitude to my supervisor, Dr Raymond Swaray, who has supported me throughout my thesis with his knowledge whilst allowing me to work in my own way. Without his help and support, this thesis would not have been completed and written in this shape or form. I am grateful to Dr Liang Han, my second supervisor, and to Prof Mike Tayles, the former Director of the Centre for International accounting and Finance, for their helpful comments and suggestions. I extend my sincere thanks to the staff in Hull business school as well as in the graduate school. Finally, and most importantly, I offer my all my love and my deepest thanks to my family for their unconditional love and support. They are the number one reason for me to keep going. I will always have the greatest and most sincere love for them. II Abstract The energy industry is transforming from the old, vertically integrated model into a more competitive model in which most companies are exposed to different types of risk. One of the major challenges facing energy companies is making investment decision- making associated with the prices of crude oils. Since 1973, crude oil price behaviour has become more volatile, which suggested that different forces were driving crude oil prices. One of the main factors in generating the behaviour of crude oil prices is the role performed by OPEC and non-OPEC crude oil producers. Several theoretical and empirical analyses suggested that the economics behind OPEC’s supply of crude oil is different than those of non-OPEC supply. This study investigates whether prices of OPEC crude oils and prices of non-OPEC crude oils share a common data-generating process. The study empirically tests oil price volatility of OPEC and non-OPEC crude oil prices using GARCH models. It also applies the Johansen Cointegration Model and the Engle-Granger Error Correlation Model (ECM) model to test the long – and short-term relationship between crude prices (OPEC and non-OPEC) and stock prices of different oil companies. Finally, a panel data approach using fixed and random effects is used to estimate the reaction of OPEC and non-OPEC crude oil prices to events and news items that could possibly affect oil supply and prices. The results obtained suggest that the behaviour of crude oil prices is not affected by OPEC or non-OPEC affiliation. This finding suggests that the international oil market is globally integrated market that is able to factor in any possible changes to supply behaviour of OPEC or non-OPEC producers. III Table of contents Chapter 1: Introduction 1.1 Motivation and background ............................................................... 1 1.2 Research Objectives............................................................................7 1.3 The importance of the study ............................................................12 1.4 The Global Energy System..............................................................17 1.4.1 Natural Gas Market.......................................................................18 1.4.2 Power Market................................................................................21 1.5 Study data and descriptive statistics.................................................23 1.6 Thesis structure ...............................................................................31 Chapter 2: Price volatility of OPEC and non-OPEC crude oils 2.1 Introduction.....................................................................................34 2.2 Demand...........................................................................................39 IV 2.3 Supply...........................................................................................42 2.4 Need for new investment ........................................................... 43 2.5 Why does volatility matter? ........................................................48 2.6 Crude oil price behaviour and ARCH-type models ....................51 2.7 Empirical model and data set......................................................65 2.8 Descriptive statistics...................................................................68 2.9 Unit root testing.........................................................................70 2.10 Testing for ARCH effects........................................................77 2.11 Results and discussion.............................................................78 2.12 Concluding remarks................................................................81 Chapter 3: Modelling long-term relationship between stock prices of oil companies and crude oil prices: an application of co-integration and Error Correction Models 3.1 Introduction ............................................................................82 3.2 Contracts and cash cycle in the petroleum industry ................90 V 3.3 Asymmetry of information and project decision-making……92 3.4 The role OPEC and non-OPEC oil producers as sources of information 94 3.5 Literature and Methodology....................................................96 3.6 Data and model specification .................................................99 3.6.1 Johansen’s co-integration technique ..................................105 3.6.2 Engle-Granger error correction model................................107 3.7 Empirical results....................................................................109 3.8 Conclusion.............................................................................131 Chapter 4: Determinants of OPEC and non-OPEC crude oil prices: a panel data analysis of endogenous and exogenous factors 4.1 Introduction...........................................................................133 4.2 Crude oil supply disrupting events........................................137 4.3 Impacts of Oil disruptions ....................................................139 4.4 Crude oil price discovery .....................................................141 4.5 Data and Methodology..........................................................144 VI 4.6 Model specification...............................................................154 4.7 Empirical results and discussion ..........................................159 4.8 Conclusion ...........................................................................166 Chapter 5: Conclusions 5.1 Summary of findings..........................................................168 5.2 Implications for the decision-making process .................. 174 5.3 Limitations of the thesis.....................................................176 5.4 Recommendations for future research ..............................177 References...............................................................................179 VII Appendices Appendix 1.................................................................................................194 Appendix 2.................................................................................................195 Appendix 3.................................................................................................196 Appendix 4.................................................................................................197 Appendix 5.................................................................................................207 Appendix 6.................................................................................................216 Appendix 7.................................................................................................220 Appendix 8.................................................................................................224 Appendix 9.................................................................................................228 Appendix 10...............................................................................................232 Appendix 11a.............................................................................................262 Appendix 11b.............................................................................................295 Appendix 12...............................................................................................310 VIII List of Tables Table 2.1.......................................................................................................67 Table 2.2.......................................................................................................69 Table 2.3.......................................................................................................70 Table 2.4.......................................................................................................75 Table 2.5.......................................................................................................76 Table 2.6.......................................................................................................78 Table 2.7.......................................................................................................79 Table 3.1......................................................................................................101 Table 3.2......................................................................................................102
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