1.1 Background to the Study
From the middle of twentieth century onwards, crude oil has become one of the main indicators of economic activity worldwide, due to its outstanding importance in the supply of the world’s energy demands. Nigeria as one of the major suppliers of crude oil in the international market has depended so much in the oil price in making their annual budgets.
According to Odusami (2006:1), fluctuations in the price of crude oil have significant implications for a Varity of economic activities. For example, Hamilton (1983) showed that significant increase in oil price preceded every post World War 11 recession in the U.S. Mork (1989:20) examined the evidence of asymmetric response of output to oil price increase and decrease and find evidence of negative correlation between oil prices increase and output growth. Lee and Ratti (1995:53) scrutinized the effect of real oil price on output and show that in long periods of economic stability, oil price shock affects output in U.S., Japan, Germany, Canada, France, UK and Norway.
It could be seen that the public has been particular concerned about oil price fluctuations. These fluctuations have become one of the current affairs published on the front pages by the vast majority of the world’s newspapers (especially in US), mainly from the Yom Kippur War of October 5, 1973. Thus, the prevailing view among economists is that there is a strong relationship between the growth rate of a country and oil price changes.
Agren (2006:4) states that the oil price influence on stock markets is an interesting and important issue, even more so recently when the world oil price has displayed great instability. He further maintains that during April of 2006, the price of crude oil was in the neighborhood of (U.S) $70 per barrel, which is well above the price of $20 during most of the 1990’s. In a recent survey of oil in the Economist, Vaitheeswaran (2005:16) proposes that the explanation for the rise is that oil markets have seen an abnormal combination of tight supply, surging demand, and financial speculation. One might also consider the unstable political situation in the Middle East. And the activities of militant groups in the Niger Delta region of Nigeria a candidate cause for the rise in oil prices.
Thus, as posited by Jones, Leiby and Paik (2004:8) that the stock market has been viewed as an information collection and processing institution. The asset prices it establishes depend on information about future prospects as well as current conditions facing firms. The efficiency with which stock markets process information has been a subject of intense study for several decades.
If stock-price or rate-of-return forecasts cannot be improved upon by use of any of other information, the case can be made that the stock market is already using all publicly and privately available information in the formation of those prices. Reasonable to expect that the stock market would absorb the information about the consequences of an oil price shock and incorporate it into stock prices very quickly. Since asset prices are the present discounted value of the future net earnings of firms, both the current and the future impacts of such a shock should be absorbed into prices and returns without having to wait for those impacts to actually occur.
There exist a few research works that links oil prices to stock markets. Jones and Kaul (1996) test whether stock markets are rational in the sense that they fully adjust to the impact of oil Shocks on dividends. In their study of the U.S, Canadian, Japanese, and U.K stock markets, initially show that all the markets respond negatively to oil shocks. Huang, Masulis, and Stoll (1996) looked at the oil futures market and the stock market using daily data. Sadorsky (1999) on the other hand studies the impact of real oil price shocks on real stock returns by estimating vector auto regressions, including U.S industrial production and short interest rates. The study separates positive from negative oil shocks, and, contrary to Huang et al (1996), presents evidence that shocks to the oil price do affect aggregate stock returns Basher and Sadorsky (2004), using a multifactor arbitrage pricing model, find strong evidence that oil price risk impacts returns of emerging stock markets.