Supply and Demand Shocks in the Oil Market and their Predictive Power

Abstract

This paper identifies supply and demand shocks that are specific to the oil-market, and separates them from economy-wide shocks that affect the demand for many asset classes, including oil. The shocks are identified by the sign and magnitude of the correlation between daily oil price percent changes and the aggregate stock market total returns, excluding internationally diversified oil companies. Shocks that are specific to the oil market - prominently due to geopolitical events in the Middle East or changes in the expectations thereof - are identified as inducing a negative contemporaneous correlation between oil price changes and stock market returns. On the other hand, economy-wide shocks - prominently due to unexpected global economic booms or busts - are identified as inducing a positive correlation. The paper employs a reduced-form methodology to show empirical evidence regarding the macroeconomic effects of these shocks on the future realizations of the US stock market excess return, dividend growth rate, and real GDP growth rate. Intuitively, the effects are of opposite sign depending on whether the oil-price change originated from an oil-market-specific or from an economy-wide shock. I show these shocks also have predictive power over future realizations of the spot-oil price change and oil futures excess return.

Keywords: Oil, Shocks, Predictability, Risk Premium, Excess Return, Supply, Demand

JEL Classification: C22, C32, E32, E44, G12