Department of Economics and Finance – Chair of Money and Banking ORIGINS AND CONSEQUENCES OF OIL PRICE SHOCKS SUPERVISOR Prof. Paolo Paesani CANDIDATE Riccardo Ambrogi Matr. 184651 ACADEMIC YEAR 2015 / 2016 Index Introduction ........................................................................................................................................ 4 Chapter 1: The Macroeconomic Reactions to Oil Price Shocks ................................................ 5 1. Oil prices over time .................................................................................................................... 5 2. Oil Shocks Propagation Channels ............................................................................................ 8 2.1 Oil Price Shocks and Recession ............................................................................................. 9 2.1.1 Effects of an Oil Price Decrease on Output Growth .................................................... 12 2.2 Oil Price Shock and Inflation ............................................................................................... 13 2.3 Modelling the Macroeconomic Impact of Oil Price Shocks ............................................ 14 2.3.1 First Round Effects........................................................................................................ 15 2.3.2 Second Round Effects .................................................................................................... 16 3. Different Effects of Oil Price Shocks Over time .................................................................... 17 3.1 Structural Changes in the Propagation Mechanism ............................................................. 18 3.1.1 Decrease in Oil Consumption ....................................................................................... 19 3.1.2 Weaker Nominal Wage Indexation ............................................................................... 20 3.1.3 Higher Central Bank Credibility................................................................................... 21 3.2 Different Source of Oil Price Shocks ................................................................................... 22 3.2.1 Oil Supply Shocks.......................................................................................................... 24 3.2.2 Oil Demand Shock ........................................................................................................ 25 3.2.3 Speculative Oil Demand Shocks ................................................................................... 28 3.3 Petrodollar Recycling ........................................................................................................... 29 Chapter 2: Correlation of Oil and Stock price changes ............................................................... 31 1. Effects of Oil Price on Stock Market ...................................................................................... 31 2. Oil price and Stock Market Return Movements ................................................................... 32 2.1 Statistical Analysis of Oil and Stock Prices ......................................................................... 34 2 2.1.1 Stocks and Oil Estimated Price Demand Effect ............................................................ 38 2.1.2 Stocks and Volatility Related Change in the Price of Oil ............................................. 44 3. Conclusion................................................................................................................................. 50 3 Introduction The oil price is considered to be one of the most important variables in the global economy. The attentions economists pay on forecasting and interpreting the changes in the price of this commodity triggered my interest to further investigate on this topic. In this paper, and mainly in chapter one, are discussed the macroeconomic and financial effects of shocks to oil prices over time and the different transmission channels through which oil price shocks propagate. Indeed, while the first episodes of sharply rise in the price of oil, occurred in 1973 and in 1979, have been followed by dramatic economic performances with high level of inflation and negative output growth rate, more recent oil price shocks, occurred in 1999 and 2002, have led to effects so small to be considered negligible. Two different hypotheses are reported to explain this difference. The first one is linked to structural changes in the economy that have helped the economy to better respond to unexpected rise in the price of oil. The structural changes refer to the increase in central banks’ credibility, the fall in oil consumption as a share of GDP and the high reduction in the level of nominal wage indexation. The second hypothesis of the different impacts each shock has brought over time, is rooted in the nature from whom it stems. While the first two shocks, the ones occurred in 1973 and 1979, are driven by oil supply disruption, the latest ones, happened in 1999 and 2002, are mainly driven by an increase in global demand. Therefore, whether oil price shocks are the cause or simply the mirror of global economic conditions mainly depends on the nature of the shock. In chapter two the relationship between oil price changes and U.S stock return is analysed. When the price of oil rises, the price of many inputs go up together with the cost of energy and this leads to a decline in the corporates’ profits. Consequently, the shares price of corporation should fall. Nevertheless, the expected negative correlation between the two variables seems to have vanished in the last five years and, in order to find an explanation for this phenomenon, I have applied a decomposition of oil proposed by Hamilton (2014) to test whether the reason that explain why stock returns and oil price move in the same direction can be attributed to a softening in the global demand. The results obtained confirms the hypothesis that the two variable taken into consideration moves together not because one affects the other, but because they both respond to the same external factor, a decrease in the global demand. Furthermore, the equation proposed by Hamilton has been augmented by the introduction of an additional variable, the volatility index, namely the VIX index. The introduction of the volatility further explains the positive correlation between the stock market returns and the oil price change. Nevertheless, the decomposition described above only partially explains the trend of oil and stocks to move together, since subtracting the demand and the volatility component of the oil price, the correlation approaches zero, but is still not negative as it should be expected. 4 Chapter 1 The Macroeconomic Reactions to Oil Price Shocks 1. Oil prices over time From the late 1940’s to the 1970’s the oil price was very stable and exceptionally low compared to modern price. The stability of oil price, during this period, was granted in the U.S. by the Texas Railroad Commission (TRC). Along with some other state regulatory agencies, TRC made previsions and predictions about the quantity of oil demanded for the upcoming month, and set production quotas in order to satisfy the forecasted demand. As a result, the quantity produced was enough to meet the quantity demanded, and consequently, the price of oil remained essentially stable. The calm experienced by oil price was interrupted on October 1973, when the Yom Kippur War started. In this occasion, the Organization of Petroleum Exporting Countries (OPEC1) experienced for the first time the great power it had over the level of oil price. Due to the support the U.S. and many European countries offered to Israel in the conflict, OPEC imposed an oil embargo on western countries. The result was dramatic, and the first oil shock occurred. Oil production felt by 5 million barrels a day and the price of oil rose by more than 200 percent, reaching 11,16 USD per barrel2 in 1974 . Afterwards, the price of oil remained stable for a period of two years, until the second oil price shock occurred. Two events triggered the second shock: The Iranian Revolution (1979) and the following Iran-Iraq war (1980). The oil production decreased by around 10 percent, due to the fact that Iran nearly stopped supplying oil, and Iraq production had been really harmed by the war. Consequently, oil price experienced an upward change from 14,85 USD to 39,5 USD by April 1980. During the following years, in the first half of the 80’s, OPEC tried to stabilize the oil price by setting production quotas for its members. This attempt, due the internal conflict in the organization, and to OPEC members cheating on production quotas, finished up to be a failure, and new producers entered in the 1 : OPEC was formed in 1960 by 5 founding members: Iraq, Iran, Kuwait, Saudi Arabia, and Venezuela. Now it counts 13 country members. Qatar, Indonesia, Libya, the United Arab Emirates, Algeria and Nigeria joined the organization by the end of 1971 and, more recently, in 2007, Angola and Ecuador decided to be part of it 2 Crude Oil Prices: West Texas Intermediate (WTI) - Cushing, Oklahoma. Prices are reported, on quarterly base, according to U.S. Energy Information Administration data. 5 market. Consequently, given the increase in the supply of oil brought by new entrants, on July 1986, oil price fell sharply reaching 13,81 USD. Figure 1 Oil Price ($ per Barrel) Spot Oil Price: West Texas Interm ediate (DISCONTINUED)© 40