Shocks and Stocks: A Bottom-up Assessment of the Relationship Between Oil Prices, Gasoline Prices and the Returns of Chinese Firms.
Author | Broadstock, David C. |
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INTRODUCTION
China is one of the largest net importers of oil in the world. Consumption levels are growing at a tremendous pace, with a year-on-year average growth in oil consumption of 6.3% between 2000-2013. At the same time the import dependency of the nation is also increasing: domestic production accounted for 68.3% of consumption in 2000, but by 2013 this had fallen dramatically to just 38.9%. Accordingly, shocks (1) in the international price of oil cannot be avoided by the Chinese economy. Many existing studies have sought to document what consequences such price shocks have upon the various parts of an economy, with a growing body of literature specifically considering the Chinese context. Results are inevitably mixed, for example: Broadstock and Filis (2014) and Fang and You (2014) show that the source of oil shock can lead to different signs of effect; Broadstock and Filis (2014) further argue effects are positive in some periods and negative in others; and Wen et al. (2014) suggest effects may be negative in the short run and positive in the long run. Together, these facts, along with a simple understanding of the scale of China, comprising a population well in excess of a billion people with rapidly growing wealth, create an imperative to study this economy. Further, China is in a unique stage of transformation and economic development, global oil prices continue to boom and bust, as do the Chinese financial markets: factors all of which create an urgency to develop an up-to-date, innovative and detailed understanding of how international oil prices pass through to the domestic economy.
There are several routes by which energy price shocks can exert an influence on the economy. Brown and Yucel (2002), review the various transmission mechanisms that have been presented in the literature. The identified channels include impacts on the costs of production (supply side effects) and downstream inflationary pressures (both wages and general prices) that these may instill. Reactions to sudden energy price shocks have been shown by some to alter the demand for money, and create incentives for monetary authorities to revise monetary policy (real balance effects). Other effects to manifest include rebalancing of the industrial structure mix that can result from changing costs of production, and other 'unexpected' effects attributed to energy price uncertainty. All of these channels have ramifications that manifest in fluctuations of financial markets, and for decades economies have paid close attention to energy price changes, oil prices in particular.
Narayan and Sharma (2011) and more recently Phan et al. (2015a) discuss in reasonable detail how energy price shocks can plausibly result in either positive or negative effects on firm returns. (2) These effects can arise due to trade-offs between risk and return, the potential to hedge spot and future contracts, inflationary effects and wider general equilibrium effects. The unique reaction to price changes by specific firms will vary for a number of reasons, including internal managerial processes, the regulations and governance structures that may exist for the industry as well as (and perhaps most importantly) the choices and behaviors of investors. Narayan and Sharma (2011) made an initial effort to characterize the nature of firm specific reactions, by considering the impact of oil price changes upon stock value changes (i.e. market returns) separately for 560 US firms. Their results intuitively reveal substantial differences in the types of firms which are affected, how quickly they react to oil price changes, and how their resilience may vary in line with factors such as firm size.
The body of literature which Narayan and Sharma (2011) is a part of is heavily grounded within the financial economic literature, where questions regarding the reaction of stock markets to commodity prices are commonplace, (see for example Ciner (2012), Nguyen and Bhatti (2012), Driespong et al. (2008) and Jones and Kaul (1996) among many others). In this context oil prices are used as a general measure of energy price risk exposure--a measure which is freely available and obtainable in high-frequency (e.g. observed daily) making it convenient for comparing against stock market data. Oil prices have proved a valuable indicator in this area of research, however as for example Smith (2009) remarks, "... [the] demand for crude oil is a derived demand that stems from the demand for gasoline...", a point which is generally taken for granted as common knowledge among energy economists but admittedly one which is easily overlooked--even by energy economists. Gasoline is of relevance to all firms as a consequence of the unavoidable requirement for transportation services--either directly for delivery of goods and services, or indirectly to support the travel of workers to and from the workplace--hence gasoline price shocks are more directly relevant than oil prices to the cost performance (and hence financial value of) firms. Moreover very few firms require oil as an intermediate input into their production supply chain in any scale (notwithstanding for instance lubrication liquids for machines etc.), which implies reactions to gasoline shocks would likely be more prevalent than reactions to oil shocks.
This issue has not however been considered within previous related literature e.g. the literature connecting energy prices to company stock returns, and so the extent to which this might be considered a limitation, concern or deficiency of the existing literature must be given due and fair consideration. Reviewing some of the facts as we know them, beyond transformation for gasoline, oil has a rather limited range of uses, which results in a naturally high degree of correlation between oil and gasoline markets. In markets/countries where gasoline prices are absent of strong regulations, such as in the US, it can be seen that the degree of association between oil and gasoline prices is very high (see Figure 1, Panel A), with a correlation of 0.87 between 2005-2012. Conversely in an economy like China, which is still in the process of marketization, and where there remains a high degree of price regulation for gasoline--discussed in further detail below--which serves to mediate the speed and extent to which international oil price changes pass through to gasoline prices (see Figure 1, Panel A) there may exist a much weaker correlation between oil and gasoline, 0.46 between 2005-2012 in the case of China. Accordingly for studies concentrating on markets like the US, including Narayan and Sharma (2011) among many others, the high degree of correlation between oil and gasoline, including gasoline prices would be unlikely to result in largely different insights, but probably generate some statistical problems increasing the estimation complexity. For China on the other hand, since oil and gasoline follow clearly different trends, additional insights may well emerge. It is reasonable to imagine that (i) the reactions to oil price shocks and gasoline price shocks should not be the same; and further posit that (ii) under the assumption that gasoline prices are regulated for the purpose of reducing the extent of risk exposure to oil price movements, then when regulation exists, oil shocks should be much less likely to impact stock returns; and lastly that (iii) given the specific nature of the Chinese gasoline price regulation mechanism, that price changes should be predictable and their effects more easily managed than if the regulation was absent. To paraphrase the above, this line of questioning is of special relevance in countries where gasoline price regulation mechanisms are being adopted.
This study closely follows the line of research presented by Narayan and Sharma (2011) (3) inasmuch as it makes a comprehensive bottom-up assessment of the relationship between energy price shocks and the financial returns of 963 Chinese listed firms. The aims of the work are to discern, from the highly computational exercise, a more concrete understanding of where, when and how oil prices pass through to Chinese firms. The first, and more general of the two empirical contributions is to explicitly test the hypothesis that, in addition to oil price shocks, gasoline price shocks impact firm financial performance, modelled in the context of a general asset pricing model of the capital asset pricing model (CAPM) type. From this stems two natural sub-questions including (i) whether the firms/industries impacted by oil shocks are the same as those affected by gasoline price shocks and/or (ii) whether the size of reaction to a gasoline price shock is the same as the size of reaction to an oil price shock--intuitively there should be some important differences. The second contribution stems from the application of the bottom-up approach of Narayan and Sharma (2011) to a different market context, with our empirical sample being from the still developing Chinese economy, as opposed to the developed market economy context of the US, and also covering a larger sample of firms, increasing the confidence in the conclusions drawn. Also, the presence of gasoline price regulation in China allows for potentially different insights to be revealed compared with for example the US.
Our results offer a comprehensive understanding of the relationship between energy price shocks and stocks of different types in China, with lessons that are very clearly generalizable to other international contexts. The primary result is that, in the long-run, oil price shocks have some impact, either positive or negative, on the asset returns of 89.2% of firms. Gasoline price shocks are even more widespread, affecting the financial outcomes of 95.7% of firms. There is no clear evidence that the firms most severely impacted by oil shocks are the same ones that are most severely affected by gasoline price shocks. This...
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