Does the U.S. stock market reliably decline in response to a positive crude oil price shock? In their March 2007 paper entitled “The Impact of Oil Price Shocks on the U.S. Stock Market”, Lutz Kilian and Cheolbeom Park investigate complexities in the relationship between U.S. stock returns and crude oil prices according to the causes of oil price shocks. Using data for crude oil prices, aggregate (value-weighted) stock returns and inflation over the period January 1975 through September 2005, they conclude that:
- On average, crude oil price shocks explain 13% of the variation in aggregate stock returns over the sample period, with most of this explanatory power driven by oil demand shocks.
- The conventional wisdom that higher oil prices depress stock returns applies only to demand shocks specific to the crude oil market, such as increases in the precautionary demand for crude oil that reflect fear about the availability of future oil supplies. Precautionary crude oil demand shocks explain the negative relationship between stock returns and inflation over the sample period.
- In contrast, positive crude oil price shocks driven by wider global demand for industrial commodities (real global economic expansion) lead to higher real oil prices and higher stock prices.
- Shocks to crude oil production have no significant effect on cumulative stock returns.
- Regarding specific industries:
- Oil and natural gas industry stocks, and gold and silver mining stocks, respond positively to oil demand shocks specific to the crude oil market, while the automobile industry and the retail sector respond negatively.
- However, the stocks of all four industries respond positively to oil demand shocks driven by real global economic expansion.
The following charts, taken from the paper, depict the average cumulative responses (with one and two standard error bands) of real aggregate U.S. stock returns to three types of oil price shocks: (1) oil supply shocks; (2) oil demand shocks driven by real global economic expansion; and, (3) oil demand shocks specific to the crude oil market. Disruptions of crude oil production (Oil Supply Shock) tend not to have a significant effect on U.S. stock returns. Widespread increases in global demand for industrial commodities (Aggregate Demand Shock) tend to boost U.S. stock returns for nearly a year. However, increases in the precautionary demand for oil reflecting sudden increased uncertainty about the political stability of the Middle East (Oil-Market Specific Demand Shock) tend to depress U.S. stock returns for about six months.
Additional charts in the paper depict the impacts of oil shocks on stock returns by industry.
In summary, an oil price shock can be good, bad or indifferent for the overall U.S. stock market according to the cause of the shock. A shock driven by global economic expansion is a good sign for stocks.
