The following are theoretical transmitting channels between oil prices
and stock markets, namely stock valuation, monetary,  

 

 

Literature review will begin by investigating how oil prices can
directly influence stock markets.

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Stock valuation is the process of calculating the total value of a
company’s shares. Huang et al (1996)
suggest that stock prices reflect the discounted future cash flows of a particular
stock. Oberndorfer (2009) studies how the changes in oil price could alter a
company’s future cash flows. The study reveals that

 

 

Filis et al (2011) study the correlation
between stock markets and oil prices in oil-importing and oil-exporting
countries. The study shows that for any oil-consuming company, when oil is one
of their major production factors, resultantly high oil price would result in
high production costs, and eventually would reduce profit and future cash
flows. As for oil-producing companies, high oil price would result in high
profit margins and cash flows. Theoretically, the study gives an indication that
during any high oil price period, oil-consumers should have a declining
behaviour in stock markets, while an inclining behaviour for oil-producers.

 

 

 

Basher and Sadorsky (2006) explains that, as a result of high oil price,
the high production costs would be transferred to consumers, therefore
resulting in an increase in both retail prices and inflation. In response to
increasing inflation pressures, the monetary policymakers will be expected to
increase short-term interest rates. Theoretically, this would lead to an
increase in borrowing discount rates for any future company investments,
therefore increasing the company’s borrowing costs. When borrowing costs
increased, this will result in reduced future cash flows and fewer positive net
present value (NPV) projects. For this reason, stock prices could decrease in
value. But the study notes that the effects would be determined by monetary
authority’s credibility to contain inflation. If monetary authority’s
credibility is high, inflation should not be unstable, despite high oil price.

 

Additionally, studies by Hamilton (1983) and Hamilton (2003) both claim
that oil price fluctuations affect aggregate output. Because of an increase in
retail prices as a result of high production costs, there is a tendency for
high oil price to reduce households’ discretionary income. Edelstein and Kilian
(2009) reports that an increase in gasoline and heating oil also reduce
households’ discretionary income. Put succinctly from the viewpoint of Svensson
(2005 and 2006), an increase in oil price will worsen the terms-of-trade for an
oil-importing economy, which will result in lower income and a negative wealth
effect on consumption, and eventually lower aggregate demand. In order words,
there is a tendency that the response of stock markets will be negative, as low
aggregate demand causes low profits and cash flows for companies, therefore a
decrease in stock prices. However, Svensson (2005 and 2006) also explain that these
effects are determined whether an economy is oil-importing or oil-exporting.
These effects apply to oil-importing economy, but for oil-exporting economy,
although the high production costs would still have an impact due to high oil
price, oil-exporting economy would profit from high income effect, because of
an increase in oil profits gained from exporting, therefore resulting in high
aggregate demand and higher output. This will happen as long as high income
effect can offset high production costs impact. When that happens, there should
be a tendency that the response of stock markets will be favourable due to the
increased output, since it would raise the company’s cash flow operating in
oil-exporting economy.

 

 

 

 

Another study on oil-exporting by Farzanegan (2011) investigates the oil
revenue shocks and government spending behaviour in Iran. The result of an
increase in oil price means a transfer of wealth from oil-importing to
oil-exporting countries. This will enable oil-exporting countries to increase
government spending. This can stimulate additional economic activity, which is
a principle known as the “Fiscal Multiplier” and it should be
considered, because when the government spends a lot on infrastructure, for
instance, this leads to demand for goods required to produce the infrastructure,
therefore private companies will expand to meet this demand and new jobs will
be created. In this process, household spending increases therefore private
companies’ profit and cash flow also increases. This will cause the stock
prices to increase and the stock market to exhibit a bullish behaviour. On the
contrary, the opposite will happen when the government borrows to finance its
deficits, as it competes with private borrowers and bids up the interest rate,
which is a principle knows as “Crowding Out Effect” and it should be
considered as well.

 

Apart from all above, Brow and Yücel (2002) suggest that an increase in oil
price will cause higher uncertainty of oil in the economy, due to the aforementioned
effects of inflation, output, household expenditure and discount rate. Brow and
Yücel (2002) claims that uncertainty will decrease the company’s demand for
risky, irrecoverable investments, which in time, will decrease expected cash
flows. Also, Edelstein and Kilian (2009) states that an increase in uncertainty
of future oil prices would increase motivation for households to save up
instead of consuming.