Journal of Energy Finance and Development 4 1999 69–87
Oil price risk and the Australian stock market
Robert W. Faff
a,
, Timothy J. Brailsford
b
a
RMIT University, School of Economics and Finance, GPO Box 2476 V, Melbourne, Victoria 3001, Australia
b
Australian National University, Department of Commerce, Canberra, ACT 0200, Australia Received August 1998; accepted February 1999
Abstract
The primary aim of this paper is to investigate the sensitivity of Australian industry equity returns to an oil price factor over the period 1983–1996. The paper employs an augmented
market model to establish the sensitivity. The key findings are as follows. First, a degree of pervasiveness of an oil price factor, beyond the influence of the market, is detected across
some Australian industries. Second, we propose and find significant positive oil price sensitivity in the Oil and Gas and Diversified Resources industries. Similarly, we propose and find
significant negative oil price sensitivity in the Paper and Packaging, and Transport industries. Generally, we find that long-term effects persist, although we hypothesize that some firms
have been able to pass on oil price changes to customers or hedge the risk. The results have implications for management in these industries and policy makers and enhance our
understanding of the “Dutch disease.”
1999 Elsevier Science Inc. All rights reserved.
Keywords: Asset pricing; Oil price risk; Australian industries
1. Introduction
Energy expenditures account for a relatively large proportion of GDP in most industrial nations. For instance, Jones and Kaul 1996 document that energy
expenditure was as high as 14 of GDP in the U.S. during the 1980s. Similar figures have been documented for other countries in Helliwell et al. 1986. The importance
of oil to individual economies and the world economy is well known and is demonstrated by the events surrounding the Iraqi invasion of Kuwait in 1990. Evidence
is provided by Malliaris and Urrutia 1995, who document a strong negative share price reaction to the Persian Gulf crisis. Notably, the strongest effects were observed
in markets in the Asian and Australian region.
Corresponding author. Tel.: 161-399-255-906. fax: 161-399-255-986. E-mail address
: robertfbf.rmit.edu.au R.W. Faff 1085-744399 – see front matter
1999 Elsevier Science Inc. All rights reserved.
PII: S1085-74439900005-8
70 R.W. Faff, T.J. Brailsford Journal of Energy Finance and Development 4 1999 69–87
There has been a continuing interest by researchers over recent years in the role and impact that oil and other energy sources have on financial markets and stock
prices of modern corporations. Some researchers e.g., Strong, 1991 have examined how well investors are able to hedge oil price risk using oil equity portfolios. Others,
such as Miller and Upton 1985a, 1985b and Crain and Jamal 1991, have investigated how well Hotelling’s valuation principle applies to oil and gas companies. Other
research has analyzed forward and futures prices on oil-related contracts see Bopp Lady, 1991; Farmer, 1993; Moosa Al-Loughani, 1994; Foster, 1996.
However, of greatest relevance are papers such as Chen et al. 1986, Hamao 1989, Al-Mudhaf and Goodwin 1993, Kaneko and Lee 1995 and Jones and Kaul 1996,
which tested whether an oil price factor constitutes a systematic influence in the determination of prices in the equity markets of the U.S., Canada, Japan, and the
U.K. Energy prices in general, and oil prices in particular, are likely to have an important potential impact on the costs of factor inputs for many companies. Specifi-
cally, we expect the potential for a negative oil price sensitivity to be greatest in industries with a relatively high proportion of their costs devoted to oil-based inputs,
such as Transport. However, the detection of any impact either direct or indirect is complicated by the ability of firms to pass on their sensitivity to oil price changes
to customers through changing goods prices or by the extent to which firms hedge against oil price risk.
In their trail-blazing paper, Chen et al. 1986 provided a test of a multi-factor asset pricing model using innovations in a set of macroeconomic variables. This analysis
included the possibility that a return series derived from oil prices could constitute an economic pricing factor. Generally, Chen et al. found no evidence to suggest that
such a factor exists in their sample of U.S. equities. Hamao 1989 re-applied the Chen et al. approach to a set of Japanese equity data and confirmed the result for
the oil price change factor. In contrast, Kaneko and Lee 1995 found that the oil price change factor was important in a more recent sample of Japanese equity data.
Kaneko and Lee attribute this divergence in results to method and data differences between studies. In a study concerning predictability and time-varying risk across
world equity markets, Ferson and Harvey 1995 reject the hypothesis that a risk variable based on oil price changes is equal across their sample of 18 countries. On
the basis of rejecting this inequality hypothesis, they include the oil price risk variable as a separate factor in their asset pricing analysis. Finally, Jones and Kaul 1996, in
perhaps the most comprehensive study, analyze the impact of oil price changes in Canada, Japan, the U.K., and the U.S. Their findings indicate that oil price changes
have a detrimental effect on output and real stock returns in all four countries. Moreover, the magnitude of the impact is substantially different across the four
markets.
The issue of asset pricing in general in relation to equities is controversial. The development of alternative multi-factor models, such as the arbitrage pricing theory
APT, is a response to the failure of traditional models, such as the capital asset pricing model CAPM, to adequately explain cross-sectional variation in equity returns. More
recently, research has again cast doubt on the CAPM e.g. Fama French 1992,
R.W. Faff, T.J. Brailsford Journal of Energy Finance and Development 4 1999 69–87 71
1996a, 1996b. Within this context, researchers have sought to examine the sensitivity of equity returns to economic factors.
For example, Al-Mudhaf and Goodwin 1993 investigated a two-factor version of the APT, using a market and an oil price change factor. Based on a sample of 29
NYSE-listed oil companies covering the period 1970–1978, they found that the oil price risk premium was highly unstable. Specifically, in the period immediately following the
OPEC oil price shock of 1973, equity returns of domestic oil producers and large multinationals were associated with a significant ex ante oil risk premia. While their
investigation of the asset pricing issue in the context of a small sample of oil companies served the narrow purpose of their study, it leaves open the question of how pervasive
the oil price factor is across all sectors. Similarly, Jones and Kaul 1996 use an APT- type model in which fundamental variables are augmented by an oil price change
variable.
This article follows in the spirit of this previous work. We do not propose to conduct a full-scale asset pricing test. Rather, we focus on the well-known market model and
augment it through the addition of an oil price change factor. Our purpose is to establish whether an oil price change factor exhibits a systematic influence on equity
returns over and above the influence of market returns. The focus on Australian equities is important given the limited international evidence in this area and the
unique characteristics of the Australian environment. The large geographical size of Australia combined with a diverse and small population base and relative isolation
from the rest of the world means that oil price changes are likely to have important consequences for many industries.
The analysis by industry is important for two reasons. First, it extends on previous work and follows in the spirit of Fama and French 1997, who find substantial
differences in factor sensitivities across U.S. industries. Industries are not homoge- neous, and different factors can have different industry influences. An understanding
of how certain economic factors impact on equity returns is important for management in those industries.
Second, the importance of recognizing differential industry effects is recognized in economic theory through the work of Gregory 1976, Corden 1984, and others on
the so-called “Dutch disease.” In this analysis, the emergence of a new export sector may result from a boom in mineral or energy prices shifting the foreign exchange
supply curve to the right. The resultant excess foreign exchange supply induces a contraction in the outputs of other competing industry sectors. Foreign exchange
intervention in such circumstances through devaluation leads to either higher inflation or an accumulation of foreign exchange reserves. The model highlights the sectoral
dependence in an economy and how the price of output of each sector relative to that of other sectors determines the allocation of resources. The Dutch disease is
often cited in the context of mineral and energy booms, such as the natural gas discoveries by the Dutch in the 1960s, the North Sea oil discovery in Britain in the
1970s, and the various mineral booms in Australia as in the late 1960s. The focus on Australia is particularly relevant in this context given its large natural resources sector.
This article initially conducts a study to investigate the sensitivity of Australian
72 R.W. Faff, T.J. Brailsford Journal of Energy Finance and Development 4 1999 69–87
industry equity returns to an oil price factor. The paper is organized as follows. Section 2 discusses the importance of oil across the different Australian economic sectors. Section 3
outlines the data and research design, and the results are presented in section 4. Section 5 briefly discusses results from some sensitivity and further analysis. The final
section presents the summary and concluding remarks.
2. Oil and the Australian economy
