Oil price shocks and Nigeria's stock market: what have we learned from crude oil market shocks?

• Published date: 01 March 2014
• Author: Ekpeno L. Effiong
• DOI: http://doi.org/10.1111/opec.12027
• Date: 01 March 2014

Oil price shocks and Nigeria’s stock market:

what have we learned from crude oil

market shocks?

Ekpeno L. Effiong

Lecturer, Department of Economics, University of Uyo, P.M.B.1017, Uyo, Nigeria. Email:

ekpenoeffiong@uniuyo.edu.ng; ekpenol@gmail.com

Abstract

Oil price shocks do not only originate from the supply-side of the crude oil market but may also be

demand driven.The impact of oil price shocks on stock market activities may be different depending

on its origin (i.e. demand and supply shocks).This paper provides the first examination of the impact

of the origin of oil price shocks on Nigeria’s stock market for the period 1995:1–2011:12. Oil price

shocks is decomposed into oil supply shocks, aggregate demand shocks and oil-specific demand

shocks using a structural vector auto-regression model, and their impacts on stock market prices

were analysed using impulse response and variance decomposition analysis.The impulse response

results show that stock market’s response to oil supplyshocks is insignificantly negative but signifi-

cantly positive to aggregate demand and oil-specific demand shocks.The cumulative effects of the

oil price shocks account for about 47 per cent of the variation in stock prices in the long term. These

results suggest that the origin of oil price shocks is crucial for understanding the volatility in

Nigeria’s stock market. Future policy direction should focus on diversifying the economyto reduce

its vulnerability to oil price fluctuations while addressing the inefficiencies in the stock market.

1. Introduction

Since the seminal work of Hamilton (1983), a large literature has investigatedthe impact

of oil price shocks on the macroeconomy for both oil-importing and oil-exporting coun-

tries.1Oil price shocks may have significant effect on economic activities of both oil-

importing and oil-exporting countries. Based on the classic supply-side model, oil price

shocks may slow downeconomic g rowth and stimulates inflation for oil-importing coun-

tries while increasing the oil revenues of oil-exporting countries through the wealthtrans-

fer effects. Despite the fact that the oil price–macroeconomy relationship has been

extensivelystudied, another strand of the literature that is gradually growing identifies the

impact of oil price shocks on the financial markets, particularly the stock market.

JEL Classification: C32, G12, Q43

36

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Oil price shocks can be transmitted to the stock markets through its impact on stock

prices. Stock markets are known to possess informational efficiency and, in turn, stock

prices are reasonably expectedto reflect all cur rent and availableinformation including oil

price shocks. Theoretically, oil price shocks affect stock market prices through their effect

on expected earnings (Huang et al., 1996). An increasing literature has investigated the

impact of oil price shocks on stock market prices (or returns) with mixed results.2The con-

ventional wisdom in the literature is that oil price shocks should lead to stock market

decline. However, such impact may differ between oil-importing countries and oil-

exporting countries depending on the relative importance of oil to their macroeconomy

(see Park and Ratti, 2008; Bjørnland, 2009).

Recent development in the crude oil market such as wide volatilityof oil prices and the

increased demand for oil from emerging economies (such as China and India) has led to

the recognition that the impact of oil price shocks may depend on its origin (or source).

Contrary to the implicit assumption in standard macroeconomic models that unexpected

oil price hikes were exclusively due to exogenous supply shocks in the crude oil market,

researchers such as Hamilton (2009a, b) and Kilian (2009) have shownthat oil prices may

also be demand driven.Thus, oil price shocks has been decomposed by Kilian (2009) into

shocks driven by demand (aggregate demand and oil-specific demand shocks) and supply

(oil supply shocks) and are likely to have different impact on macroeconomic variables.

The impact of oil price shocks based on its origin has been extended to the analysis on

stock markets for only developed oil-importing and oil-exporting countries and emerging

economies (see Aspergis and Miller, 2009; Kilian and Park, 2009; Basher et al., 2012;

Wanget al., 2013). However, a considerable gap exists in the literature for developingoil-

exporting countries like Nigeria, which is yet to be explored.

This paper provides the first examination of the impact of oil price shocks on stock

market activities in Nigeria, an oil-exporting country, with particular reference to the

origin of oil price shocks using monthly data from 1995 to 2011. As an emerging stock

market and in the light of the 2008 global financial crisis that bolstered a cyclical downturn

in oil prices and stock market activities, understanding the dynamic interaction between

crude oil market shocks and stock market activities is of relevanceto policymakers, finan-

cial experts and investors in the Nigerian economy. Following Kilian and Park (2009), a

structural vector auto-regression (VAR)model is employed to decompose oil price shocks

into oil supply shocks, aggregate demand shocks and oil-specific (or precautionary)

demand shocks, and their impacts are examined on Nigeria’s stock market prices. The

direction, timing and duration of stock market prices response to each oil price shocks is

analysed using impulse response functions, and their relative importance is analysed by

means of variance decomposition.

The remainder of the paper is organised as follows. Section 2 providesa review of the

empirical and theoretical literature on the relationship between oil price shocks and stock

Oil price shocks and Nigeria’s stock market 37

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