Oil Sector Spillover Effects to the Kuwait Stock Market in the Context of Uncertainty.

• Date: 01 March 2019
• Author: Abdulrazzaq, Yousef M.

Introduction

Oil is considered as the most important energy resource worldwide due to its role in economic development and the lack of alternatives that share similar properties, uses and costs. The relationship between oil prices and stock markets performance has enjoyed a significant level of attention among the research community (Arezki et al., 2017; Al-Qudsi and Ali, 2016). To name a few studies, Driesprong et al. (2008) studied stock market data from 48 countries, a world market index, and oil spot prices for three main indices--Oil-Brent, Dubai and West Texas Intermediate--concluding that stock returns seem to underreact to oil price fluctuations. Narayan and Gupta (2015) implemented a least square estimator using over 150 years of monthly data and found evidence of nonlinear predictability, suggesting that negative oil prices have predictive power on US stock returns. Hamilton and Herrera (2002) found that oil price shocks in the 1970s had a negative impact on stock returns. Malik and Ewing's (2009) findings suggest that oil price shocks and stock returns are negatively correlated, indicating that higher oil prices raise production costs and eventually stock returns decline. According to Jones et al. (2004), oil prices could influence stock markets through numerous channels, as increasing oil prices can indirectly impact on interest rates that seek to control inflationary pressures, increase business costs and as such reduce potential gains that impact negatively on the performance of stock returns (Jiang et al., 2017; Grima and Caruana, 2017; Ansani and Daniele, 2012; Filis et al., 2011; Adrangi et al., 2014; Gil-Alana and Yaya, 2014). Schubert (2014) and Kisswani (2014) argue that oil prices directly and indirectly impact core macroeconomic indicators like inflation, aggregate demand, imports, exchange rates, exports, real economic development, and employment. Guesmi et al. (2018) argue that oil prices fluctuations are a risk factor on their own leading to potential effects of market contagion towards equity markets with origins in oil price fluctuations. Researchers have highlighted the significance of oil prices to the business and economic cycle, offering significant evidence on the importance of oil prices to the global economy. However, there is a general lack of research studying oil prices and stock markets interlinkages in the context of small oil exporting economies, a research gap that is addressed on this paper.

This study seeks to understand oil prices and the stock market dynamics during times of sustained levels of political and economic uncertainty in Kuwait. Kuwait is a small open economy highly dependent on oil exports that has been affected by regional and global uncertainty over the past few years. Due to data limitations, this paper examines Kuwait's stock market reaction to severe market uncertainty associated with two political events--the case during the Iraq invasion and the Arab Spring revolution. The study also incorporates the 2008/09 Global Economic and Financial Crisis (GEFC) to bring further insights with regard to Kuwait's exposure to global economic and financial uncertainty.

Effects of Regional and Global Uncertainty on the Kuwait Stock Exchange

Kuwait is a leading producer of oil (see table 1 below), and as such it was included in the top eight countries in the crude oil production ranking in 2017 (OPEC, 2017). The country's government budget revenues, earnings, and aggregate demand are positively influenced by higher oil prices, and they are severely impacted when oil prices decline. Kuwait is considered one of the major oil suppliers in the world energy markets with crude oil reserves of around 102 billion barrels representing more than 6% of the world's reserves. The economy of Kuwait largely relies on petroleum exports that account for 60% of its GDP (IMF, 2017), as petroleum accounts approximately 95% of export revenues, and 95% of the government income (CIA World Factbook, 2016).

The increase in oil prices between 2003 and 2007 brought inflows of money to Kuwait's economy and its stock market signaling the positive influence of oil prices on Kuwait's stock market over the period. On the other hand, the dramatic drop of oil prices that took place in 2014 had ramifications that have been reflected by a noticeable drop in trading indicators, and primary price levels in the Kuwait stock market (Central Bank of Kuwait Annual Report, 2014). The impact of oil price changes on oil-exporting economies varies greatly when compared to those of oil-importing countries, as increases in oil prices are strongly correlated to increases in national income (Hammoudeh and Alesia, 2008). Previous studies have been mainly concerned about the analysis of oil-importing countries, with only a few studies analyzing the interactions between oil prices and equity prices and their dynamics in oil-exporting countries. As a result, there is a significant lack of attention regarding the specific case of Kuwait; as most of the existing research focuses its attention on the Gulf Cooperation Council (GCC) countries as whole (Arouri et al., 2010; Mohanty et al., 2011; Azar and Basmajian, 2013; Mohanty et al., 2011; Cunado and Perez de Gracia, 2014; Demirer et al., 2015). Table 2 below shows the degree of dependence of Kuwait on oil revenues, with the value of oil revenue reaching its peak in 2012 of nearly $112,933 million and dropping to $41,461 million in 2016, quite a worryingly outcome that clearly signals the lack of diversification in this economy and its significant exposure to the oil sector. The level of decline experienced by oil revenue is explained by Gause (2015) who identified how the decline in world oil prices in 2014 was explained by geopolitical issues, mainly due to the ongoing struggle for regional influence between Saudi Arabia and Iran.

The country's stock market has been quite sensitive to regional political unrest and to global market uncertainty. The removal of the political regime in Iraq back in 2003 had a myriad of effects on Kuwait's economic performance. One of the most prominent outcomes was the reduction of the market risk premium. This change affected corporate profitability greatly, as it reflected how markets movement improved by more than 100% during the first nine months of 2003 (Global Investment House Market Outlook January, 2004; Milyo, 2012). Another event that created significant disruption was the GEFC that originated in the US subprime market with negative spillover effects with global implications, and where Kuwait's stock exchange and its overall economy were negatively affected. At the time, the stock exchange index plummeted by 50%, with the largest fall experienced by the investment and real estate sectors. $1.4 billion was lost by the country's third largest bank due to its involvement in derivative transactions. Moreover, in December 2008, $3 billion of debts were defaulted by the largest investment company in Kuwait, and a large Islamic investment company was seeking to refinance up to $1 billion in debt (IMF, 2009). The 2008 crisis is widely regarded as one of the most detrimental shocks to ever hit the Kuwait stock exchange. Before the first quarter of 2008, the KSE price index had increased by 13.7% and the value traded averaged was 200 mn KD. In April 2008, the price index increased by only 403.10 points (2.82%), while the average value traded decreased 160 mn KD, marking the beginning of the downfall of the exchange (Global Investment House Market report February 2009).

After the critical situation faced during the GEFC, another event spooked the country's stock market. The 2011 Arab Spring revolution led to significant falls in the Kuwait stock index resulting in the KSE's worst first half market performance since 1988. This was the result of selling pressures that arose from political unrest within the region. The analysis of the KSE revealed that during the first half of 2011 all sectoral indices were negative, with the global services index experiencing the worst effects with loses up to 23.72% of its value. Within this sector Kuwait National Airways was the biggest loser, with a loss of 76.25% of its share value. The "Arab Spring" offers some potential insights into the negative relationship that exists between political unrest within the region and stock market performance. It has been shown, for example, by market reactions in Kuwait, where the KSE has exhibited high sensitivity to political uncertainty (Global Investment House, 2011). Kuwait's economy is heavily exposed to the oil sector, to regional and global dynamics, and as such a study examining its stock market reaction to oil prices shocks due to political and economic uncertainty is more than justified.

Methodology and Model Selection

A variety of econometric techniques were...