an empirical study of stock price reactions to opec output announcements

159 Pages·2009·4.51 MB·English

Department of Business Studies Author:
MSc in Finance and International Business Morten Christensen (Exam ID: 274305)

Academic advisor:
Stig Vinther Møller

A E S S P
N  MPIRICAL  TUDY OF  TOCK  RICE 
R OPEC O
EACTIONS TO    UTPUT 
A
NNOUNCEMENTS 

‐ focus on Scandinavia

May 2009
Aarhus School of Business, University of Aarhus
Abstract 
This thesis evaluates the effects of OPEC production announcements on Scandinavian
stocks. The initial expectation is that, due to stock prices being calculated as the present
value of a company’s discounted future cash-flows, at least large scale consumers
should react on the announcements. An event study methodology is conducted in order
to detect abnormal returns in the days surrounding the announcements, thus the study is
based on daily prices of different sector indices as well as on the Brent spot price. With
respect to increasing the reliability of the analysis parametric tests are conducted in
conjunction with non-parametric tests.
The main empirical finding is that since OPEC is not able to manipulate the oil price,
the reaction within the focal sectors is rather limited and blurred. The reasons for the
‘missing’ findings may be found in different circumstances. The organization notice
their meetings in substantial advance which means that market expectations may grow
slightly and stable up to the meeting, which violates the assumption about an
unanticipated single event, and which may not be captured by the CAR tests.
Furthermore, it is discussed whether the power of OPEC, today, is too low to
manipulate the oil price, as well as companies’ use of risk management activities is
evaluated. On the empirical technical side, the choice of FTSE indices may be too
crude, thus subsectors may react conflictingly which oppose the observation of
abnormal returns.
Table of Contents 
1  Introduction and Motivation ..................................................................................... 4 
1.1  Research Question .............................................................................................. 5 
1.2  Delimitation ........................................................................................................ 5 
1.3  The Approach ..................................................................................................... 6 
2  Literature Review and Hypotheses ........................................................................... 7 
3  OPEC ...................................................................................................................... 11 
4  The Methodology Applied ...................................................................................... 14 
4.1  The Efficient Market Hypothesis ..................................................................... 15 
4.2  Unanticipated Single Event .............................................................................. 16 
4.3  Measuring ‘Performance’ Based on Daily Quotes ........................................... 16 
4.4  Event Window .................................................................................................. 17 
4.5  The Estimation Period ...................................................................................... 18 
4.6  Measuring the Expected Return ....................................................................... 18 
4.7  Challenges Regarding OPEC Announcements ................................................ 20 
4.8  Measuring the Abnormal Return ...................................................................... 21 
4.8.1  Parametric Tests ........................................................................................ 21 
4.8.1.1  Test one (T1) – t-test with Adjusted Cross-sectional Independence . 22 
4.8.1.2  Test two (T2) – t-test with Standardized Abnormal Return .............. 23 
4.8.1.3  Test three (T3) – t-test with Crude Dependence Adjustment ............ 24 
4.8.1.4  Test four (T4) – t-test with Patell’s Standardized Residual ............... 25 
4.8.2  Non-Parametric Tests ................................................................................ 26 
4.8.2.1  Test five (T5) – Rank Test ................................................................. 26 
4.8.2.2  Test six (T6) – Sign Test ................................................................... 27 
4.8.3  Criterions for ‘Reliable’ Tests ................................................................... 27 
5  Data ......................................................................................................................... 28 
6  Discussion of the Selected Approach ...................................................................... 32
6.1  Overview of the Research Approach ................................................................ 32 
7  Empirical Results .................................................................................................... 34 
7.1  Brent Oil Reactions on OPEC Output Decisions ............................................. 35 
7.1.1  Discussion ................................................................................................. 36 
7.2  The Influence of OPEC Output Decisions on Cross-sectional National Stock
Market Indices ............................................................................................................. 37 
7.2.1  Cuts ........................................................................................................... 37 
7.2.2  Raise .......................................................................................................... 40 
7.2.3  Status Quo ................................................................................................. 42 
7.2.4  Discussion ................................................................................................. 43 
7.3  The Influence of OPEC Output Decisions on Inter-Scandinavian Stock Market
Indices ......................................................................................................................... 44 
7.3.1  Basic Materials .......................................................................................... 45 
7.3.2  Industrials .................................................................................................. 46 
7.3.3  Oil & Gas .................................................................................................. 48 
7.3.4  Transportation ........................................................................................... 49 
7.3.5  Health Care ............................................................................................... 51 
7.3.6  Telecom ..................................................................................................... 52 
7.3.7  Financials .................................................................................................. 53 
7.3.8  Technology ................................................................................................ 54 
7.3.9  Consumer Goods ....................................................................................... 55 
7.3.10  Discussion ................................................................................................. 56 
7.3.10.1  Hedging .............................................................................................. 58 
8  Conclusion .............................................................................................................. 59 
9  Bibliography ............................................................................................................ 63
‘Stocks slip over OPEC decision’
– Herald Sun (Melbourne, Australia), September 26 2003.

‘Stocks cheer OPEC plan to raise output’
– USA Today, June 3 2004.

‘U.S. stocks down after OPEC speculation’
– UPI, November 12 2007.

‘OPEC Output Cuts Roil Stock Markets’
– Voice of America News, October 24 2008.

‘Airline stocks trade lower ahead of OPEC cut’
– MarketWatch, December 17 2008.
1 Introduction and Motivation 
The motivation for choosing this topic is my interest in energy sources as well as in the
financial markets. Oil (and its by-products) still, by far, is the most important
commodity regarding energy consumption. Even though focus on renewable energy
sources is increasing, the demand for oil within the Nordic countries, and Western
industrialized countries in general, has been steadily rising throughout the last two
decades. Although Forecasts by EIA1 show a little decline in the market share for liquid
fuels, which is oil and oil by-products, and which is expected only to fall from 37% in
2005 to 33% in 2030, the demand for liquids continues to rise steadily, thus it is still of
great importance for world wide economies.
The different financial medias, the oil market watchers, and stock market analytics
regularly post that stock markets are roiled by oil prices. As the Organization of the
Petroleum Exporting Countries (OPEC) has, or at least used to have, power to
manipulate oil prices by either cutting or increasing production, this should have
influence on the earnings and thus the cash-flow of many businesses, in particular large
scale consumers of oil and its by-products. Consequently, as the stock price of a
company reflects the present value of the future discounted cash flows, oil price
movements are expected to be reflected in the stock price. However, as a response to
OPECs oil price manipulations and oil price fluctuations in general, large scale
consumers in many situations hedge the price of oil, that is, they lock the price or
speculate in lower prices or making profits. Accordingly, OPEC production
announcements may not have as big an influence on stock markets as it sounds like in
the medias.
The object with this thesis, therefore, is to add to the number of previous and similar
studies on the field, which show some significant but unambiguous reactions to OPEC
output announcements. Depending on the state of the economy in focus, be it an
industrialized or emerging country, the studies show reactions in one way or another.
Most studies, however, are conducted on North American stocks and, initially, there

1 The Energy Information Administration (2008).
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have not been conducted similar studies on Scandinavian stocks, which is why this
thesis considers that particular angle.
1.1 Research Question 
On the basis of previous studies on oil vs. stock markets, the ambition with this thesis is
to apply a popular and appropriate research method on the topic, namely the Event
Study methodology. This method is ideal when one wants to test stock market reactions
to exogenous events like OPEC announcements e.g. Hence, in order to conduct the
analysis on whether OPEC output announcements have any effect on Scandinavian
stock prices, the following research question is posed.
Is it possible to detect abnormal returns on and around the official days of
OPEC output announcements?
In order to ensure the depth of the thesis, the research question is analyzed in
conjunction with the following sub-questions.
Do OPEC announcements influence the oil price?
Do OPEC announcements influence national sectors on average?
Do OPEC announcements influence the individual sector?
Knowing that OPEC meetings are announced in substantial advance, the market
naturally has some expectations to what OPEC may come up with. Thus, in order to
capture these expectations, the analysis will be conducted on daily Brent spot prices as
well as daily prices for Scandinavian stock indices with event windows of three, seven,
thirty, and sixty days respectively.
1.2 Delimitation 
As all companies are likely to be affected by OPEC production changes focusing on
single companies would be irrational. Hence, in consultation with the academic advisor,
it was decided to focus on sector level. Furthermore, the object is to analyze
Scandinavian markets, thus portfolios are constructed on the basis of sectors in
Denmark, Norway, Sweden and Finland. Within the world of event studies different test
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methods have been used to test for abnormal returns. Within the frames of this thesis,
the tests being conducted are ‘traditional’ t-test’s as well as a pair of nonparametric
tests. According to the ‘fathers of event studies’, these tests are just as appropriate as
modern GLS tests etc. Hence, the underlying basis is well documented tests by Brown
and Warner, Patell and Corrado and Zivney.
Oil prices are seen in different forms, spot and futures. WTI, the OPEC basket and
Brent oil are highly correlated, nearly 1:1. Moreover prices on electricity, natural gas
and coal correlate highly with oil prices, so, in general, companies are directly or
indirectly exposed to fluctuating oil prices. That is, to a great extent, no matter which
energy source is being focused on basically the same result is expected. In this
framework the oil price in focus is Brent spot. As the spot price is the price of the
commodity to immediate delivery, this is expected to be relatively more exposed to
OPEC announcements, the argument being that futures are very much based on
expectations.
1.3 The Approach 
The next section deals with the previous studies conducted on the topic. Different
methodologies have been used, but the main body of literature is based on vector auto
regression (VAR) models and event studies like in this thesis. In the third section OPEC
is described and evaluated in order to understand the way it works as well as why it
might influence the market for oil. It can only be expected to observe abnormal returns
induced by OPEC decisions on financial markets if the oil itself reacts. In section four
the methodology applied in this thesis is described and the challenges regarding OPEC
announcements in relation to an Event Study approach are evaluated. Also the ‘battery
of tests’ is presented, followed by the way data was collected and prepared in section
five. In section six the appropriateness of the methodology is evaluated in the light of
previous studies and the data that has been collected. The empirical results are
presented, discussed, and compared to previous findings in section seven, as well as it is
discussed why any insignificant returns are likely to be seen. Section eight concludes
the thesis.
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2 Literature Review and Hypotheses 
Among other methods for determining the price of a corporate stock is the present value
of the (appropriately discounted) expected future cash flows. In line with this Fama
(1990) concludes that the tests he did on stock returns, to a large extent, can be
explained by time-varying expected returns and forecasts of real activity. Jones and
Kaul (1996) test whether the reaction of international stock markets (Canada, Japan, the
U.K., and the U.S.) to oil price shocks can be justified by current and future changes in
real cash flow and/or expected returns. When including future industrial production into
the analysis, they find that the reaction of Canadian and U.S. stock prices to oil price
shocks can be completely accounted for by the impact of these shocks on real cash
flows. The results for Japan and the U.K. are, however, not as strong. Hence, since
crude oil by-products may be a rather large item in the working conditions of companies
in at least some sectors, the value of these companies should, all things being equal,
react on fluctuating oil prices – or at least on oil price shocks. The reason is that higher
energy prices or more volatile energy prices can affect the discounted stream of
dividend payments through increasing uncertainty about product demand2, and by
increasing uncertainty about the future return of investments. It is argued that firms
faced with increased uncertainty may delay implementing investment in capital
equipment3.
As expected, going through previous studies on OPEC announcements and general oil
price fluctuations and shocks show different impact on corporate stocks. However, since
a main activity for OPEC is to secure a stable and continual income to the member
countries, to which it has instruments as raising and cutting production, it is expected
that oil prices react significantly to such actions. Generally seen, the price mechanism is
basic supply and demand. That is, by raising the production the result should be lower
prices and vice versa. As Brent oil, and WTI for that matter, correlates nearly 1:1 with
the OPEC basket, these crudes should react contemporaneously and just as significantly
to production announcements as does the OPEC basket. This leads to the following
hypothesis.

2 Davis and Aliaga-Diaz (2008).
3 Pindyck (1991).
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Hypothesis I: Brent Crude reacts positively to OPEC cuts and negatively
to OPEC raises.
Park and Ratti (2008) used a multivariate vector auto regression (VAR) model to study
how oil price shocks influence the U.S. stock market and the stock markets in thirteen
European countries from 1986-2005. Their findings show that oil price shocks have a
statistical significant impact on stock returns across all focus countries in the same
month or within the following month. In continuation their findings imply that markets
anticipate significant and pervasive effects of oil price shocks in most countries and
markets, which will have implications for the national companies and will be reflected
in their stock prices. As oil price shocks leads to increased volatility the study shows
that this increase depresses stock returns in most European countries. Additionally, the
reaction to positive and negative shocks seems to be asymmetric for oil exporting
countries like Norway, for which there is little evidence in oil importing countries. For
Norway being an exporter of crude oil and a non-member of the OPEC organization this
might mean that the country will benefit from OPEC cuts by means of rising oil prices,
and be insignificantly touched in other circumstances since drilling costs and national
production does not change, or they might even increase the production and maintain
the same revenue by selling more at a lower price.
Hypothesis II: The cross-sectional indices for the focal countries react to
production announcements from OPEC.
Hypothesis III: Norway, as the only oil exporting country in this study,
reacts asymmetrically to OPEC announcements. That is, it is
expected to observe a cross-sectionally positive reaction to
cuts and an insignificant reaction otherwise.
Sawyer and Nandha (2006) find that stock prices appear remarkably insensitive to oil
prices. However, they studied nine sectors in three countries in Oceania and found
significant but disaggregated and heterogeneous effects. Additionally, Nandha and Faff
(2008) studied 35 sectors based on the FTSE Global Classification System and found
generally that oil price changes have negative impact on stock prices from all industries
with the exception of mining, and oil and gas. They conclude that the reason for the
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