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07030248044CHAPTER ONE
INTRIODUCTION
BACKGROUND OF THE STUDY
The importance of energy is obvious but our understanding of its supply-demand and trading links is definitely not good enough. In macroeconomic or business cycle theories energy is either neglected or treated as an exogenous source of shocks. Therefore there is neither general explanatory theory about the role of energy in economic system nor much theory about its price formation, even though historical examples (oil shocks in the 1970s-1980s) show the reasonable necessity of such theories and much available data allow for the research to be done. Among the energy sources oil is proved to be the most efficient concerning concentration of pure energy and convenience of usage and transportation. More than 40% of the world energy consumption is satisfied with oil, and in the transportation sector it, in fact, does not have other competitors: 93% of transport fuels are based on oil. In addition to that, plastics and fibers used by practically each individual are products of petrochemical industry. It is not difficult to deduct that crude oil prices have a huge influence on the world economy and, being highly uncertain and volatile, are a source of economic and political risks and instability. The main purpose of this thesis is trying to investigate what drives crude oil prices and which modeling method is able to give a good price forecast. Broad literature concerning modeling of oil prices can be divided into two streams by treatment of oil: either it is an industrial product with respective supply-demand links or an underlying financial asset broadly used to price various traded derivatives. Clearly the two approaches use completely different methods to assess oil price behavior. But no matter which approach is chosen it is important to understand that oil possesses unique properties emerging from specifics of petroleum industry and oil consumption. Oil is a physical resource limited in volumes. World oil reserves are highly concentrated in not numerous geographical locations. Half of the world oil is located on Middle East. Naturally, as in any other industry, competition level and producers‟ market power matter for the price formation. In addition to that, most oil producers are nationalized companies and thus supply side of the petroleum industry is often driven by political motives. This high market power feature of the industry is also greatly fueled by strategic significance of oil. Even though world dependence on oil is not that critical now as some decades ago especially with alternative energy generating methods development, but it still remains high. It is probably too early to talk about existence of economically efficient substitutes for oil. And finally, oil industry is very capital intense and thus requires huge inventories input on all levels. Basically these specifics can be projected onto dependence of oil prices on macroeconomic foundations through expectations and precautionary demand channels. Precautionary demand concept, introduced by Kilian (2009), concerns a unique feature of oil market. Based on the common knowledge about global significance of oil, high market power of the producers and possible political instability market participants form their expectations concerning future need for oil. If the macroeconomic background is (believed to be) sound, market is in optimistic mood – thus, expectations of future oil necessity are high resulting into high precautionary demand. At this state market is very vulnerable to any announcements and price responses immediately and strongly. So for modeling oil prices it can be beneficial to include some macroeconomic indicators in order to capture the expectations impact. However expectations formation mechanism and macroeconomic conditions soundness are hardly defined concepts. This is a big obstacle for their correct measurement and implications for modeling. Obvious macroeconomic indicators may not be relevant due to reverse causality and leading-lagged relationships with oil prices. Oil is mostly traded on the financial markets and only a very small fraction of contracts is set for actual physical delivery. That is why it would be more efficient to model price of oil as a price of financial asset. In this thesis two simple models proposed by the financial literature are estimated. The Geometric Brownian Motion (GBM) and The Mean-Reversion models developed by Brennan, Schwartz (1985) and Schwartz (1997) are based on the assumption that oil price follows a stochastic process with known mathematical properties.
STATEMENT OF THE GENERAL PROBLEM
The impact of oil price shocks on oil sector stock prices in developing countries has not been sufficiently covered in the literature especially in the area of tracing out oil blocks and the financial bonds hence, the present study further attempts to determine the dynamic impact of effects of oil price shocks on oil sector stock prices in Nigeria. The oil price shock of 1973 and the subsequent recession gave rise to a plethora of studies analyzing the effects of oil price increases on the economy. The issue of oil price shocks and oil sector stock prices, it effects on economy has posed serious concern to many policy makers and financial experts. This is due to the fact that in recent years, some studies have tended to focus majorly on developed economies such as the European, Asian and Latin American emerging markets and shown significant relationships between oil price changes and emerging stock markets. For instance, Papapetrou (2001) showed a significant relationship between oil price changes and stock markets in Greece. Basher and Sadorsky (2006) reach the same conclusion for other emerging stock markets using an international multifactor model. However, less attention has been given to smaller emerging markets, like the Nigerian capital market hence, the need to explore the major causes of the stock market dynamics in Nigeria. Indeed, previously, the world has witnessed an extraordinary collapse of financial institutions, loss in asset value/share price particularly of mortgage related securities, stock market declines, speculative bubbles and currency crisis, among others. For example, Nigeria has witnessed a sudden decline in oil prices from the peak of US$147 per barrel in July 2008 to US$40 per barrel in February 2009. Also, the economy has experienced decline of the value of stocks prices in its capital markets in the same period. The oil prices witnessed significant bearish trends in the previous periods coupled with the fluctuations of the international oil prices. The trend of demand and supply in the global economy coupled with activities of OPEC consistently affects the price of oil. The recent changes in oil prices in the global economy are so rapid and unprecedented. However, the current global economic meltdown suddenly counteracted the skyrocketing oil price.
AIMS OF THE STUDY
The major aim of the study is to examine the framework for predicting crude oil price in Nigeria. Other general objectives of the study include;
RESEARCH QUESTIONS
RESEARCH HYPOTHESIS
H0: There is no framework for predicting crude oil price.
H1: There is a framework for predicting crude oil price.
SIGNIFICANCE OF THE STUDY
The study would be of immense importance to policy makers and government at all levels as it would serve as a source of enlightenment in improving the economy of the country. the study would also benefit students, researchers and scholars who are interested in developing a further study on the subject matter.
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