Oil Prices and the Stock Market

Abstract:     
This paper develops a novel method for classifying oil price changes as supply or demand driven and documents several new facts about the relation between oil prices and stock returns. Oil supply shocks are significantly negatively correlated with equity returns, and can explain 6% of the monthly variance in the aggregate U.S. Market Return from 1983 to 2012 (10% when the financial crisis is excluded), while demand shocks can explain an additional 38%. The negative effect of supply shocks is not concentrated in industries with heavy oil use, but instead is strongest for consumer goods producers, suggesting that oil shocks act through a restriction on consumer spending. Supply and demand shocks have similar explanatory power for international stock returns, with the strongest effects in oil importing countries. Oil supply shocks are defined as changes in the oil price orthogonal to contemporaneous returns of an index of oil producing firms, with the remaining variation classified as demand shocks. Theoretical and empirical evidence are presented in support of this strategy.

Number of Pages in PDF File: 57

Keywords: Oil Prices, Stock Returns, Supply and Demand

JEL Classification: J12, Q43

working papers series