Persian Gulf War's effects on U.S. oil prices and stock markets

Persian Gulf War

Effects of war in the Persian Gulf on the U.S. Economy

Okruhlik notes that "state strategies chosen to manage crises- like price booms and busts, worldwide recession, and war- have very real, though unintended, social and political consequences" (p. 297). This essay analyzes the relationship between Persian Gulf War and its impact on U.S. economy. The writer tries to explore impacts of conflict in Middle East and how it results as an increase in oil prices as well fluctuation in stock markets.

The previous research show that, oil price shocks have an asymmetric effect on economic activity and the stock market such that increases in oil prices have a larger impact than oil price decreases.

As the Gulf Coast was hit and many of the oil production and distribution facilities were damaged, world oil prices experienced a dramatic increase in the aftermath of the hurricanes. A few months after the hurricanes, major oil giants posted record high profits; thereby coming under fire. The price of oil is one of the major topics debated today and millions of people wonder whether the prices will go down or keep on climbing to the real levels of the late 1970s and early 1980s.

Persian Gulf War and Oil Prices

Since oil price changes are one of the most significant supply shocks which hit the world economy after World War II, a special consideration has been given to oil prices in the literature. There have been numerous studies related to the interaction among oil prices, the stock market and the overall economy.

As oil prices are denominated in the U.S. dollars, it is of interest to see how the effective exchange rate is affected by the real price of oil. As the real world is never a two variable model, this paper will take into account not only the real price of oil, but other variables in its attempt to examine the role played by economic fundamentals in explaining the behaviour of the U.S. real effective exchange rate.

Theoretical studies on the impact of oil prices

According to economic theory, oil price changes influence economic activity through both supply and demand channels. Supply side effects could be explained based on the fact that oil is an important input in production. Therefore, oil price increases reduce the demand for oil, decreasing productivity of other input factors which induce firms to lower output. Furthermore, oil price changes have demand side effects through consumption and investment. Consumption is affected indirectly by its positive relation with disposal income. When the oil price increases, an income transfer occurs from oil importing countries to oil exporting countries. Therefore, consumption in oil importing countries decrease and the magnitude of this effect is greater the more the shocks are perceived to be long-lasting. Oil price increases also have an adverse effect on investment by increasing firm's cost. In addition to these supply and demand effects oil price changes could influence the economy through foreign exchange markets and inflation.

Impact of Oil Prices on Economy

It is not easy to find a factor which had a greater impact on an economy than oil prices since 1970. After the oil price increase caused by the oil embargo of OPEC in 1974 most economies experienced an economic recession, and similar situations continue to occur. Therefore, the relationship between oil prices and the economy has been and continues to be a keen interest to lay people as well as economists.

Therefore, I want to analyze the relationship between oil prices and the stock market for U.S. with the recent data. In particular, I am interested in the asymmetric effect of oil price changes on the stock market because the pattern of oil price fluctuations has changed since the mid-1990's and oil price increases occur more frequently than oil price decreases, while the average magnitude of increases is smaller for decreases. (Table 1.1)

Figure 1-World real oil price

< Date of substantial spot oil price change > [footnoteRef:2] [2: "Measuring oil-price shocks using market-based information" by Michele Cavallo and Tao Wu (2006)]

1986. 2 May -- Soviet nuclear reactors were closed some in wake of Chernobyl disaster

30 October -- Yamani ousted as Saudi Oil Minister.

1988. 18 July -- Iran accepts UN calls for cease fire.

1989. 12 December -- Frigid temperatures in the U.S.

20 December -- U.S. invasion of Panama.

1990. 2 August -- Iraq invasion of Kuwait; U.S. led oil boycott.

September to December -- Middle East tensions.

1991. January -- First Gulf war.

19 August -- Soviet coup.

1996. 13 February -- Freezing temperatures in the U.S. northeast and in northern Europe.

23 February -- Iraq accepted UN resolution 986: exchange of oil for food.

17 June -- UN-Iraq weapons inspection standoff; Many believe that the oil-sale deal may be in jeopardy.

3 September -- U.S. bombing on southern Iraq.

16 December -- Frigid weather across the U.S.

1998. 26 January -- U.S. comments that patience with Iraq is running out.

3 September -- Disruption to Russian and Nigerian crude oil supplies; U.S.-Iraq tension on weapon inspection.

16 December -- UN weapons inspections withdraw from Iraq, a military strike in Iraq may be possible; however, despite the air strike, Iraqi oil continues to flow.

2002. 2 January -- Cold weather in the U.S.

16 December -- Strikes in Venezuela continue.

The impact of Oil Prices fluctuation on Stock Market

In the sub-sample period (1996.5-2005.12) when oil price increases more recurrently than oil price decreases and the average enormity of oil price increases is lesser than that of oil price decreases, stock markets in most part of the world are more affected by oil price decreases than oil price increases in the discrepancy breakdown analysis. In particular, statistically significant evidence at the 5% level is found that oil price decreases have a greater impact on real stock returns than oil price increases after the mid-1990's in the U.S.

Hamilton (1988) analyzed a common symmetry model of unemployment and business cycle model where it is expensive to move labour and capital inputs flanked by sectors. In such a model he shows that energy price shocks can reduce aggregate employment by inducing workers in adversely affected sectors to remain unemployed while they wait for labor conditions to improve in their sector, rather than move to a sector not adversely affected.

Rotemberg and Woodford (1996) study the impact of oil price shocks on output and real wages with a simple aggregative model by assuming imperfect competition in the product market. Allowing for a modest degree of imperfect competition (such as an implicit collusion between oligopolists) can account for declines in output and real wages after oil price shocks. According to them, an imperfect competition model can explain the effects of oil price shocks on the U.S. economy greater extent than a stochastic growth model (which assumes a perfectly competitive product market).

Finn (2000) shows that perfectly competitive model can also explain the effect of oil price shocks. He uses the concept of utilization rates for productive capital. The main idea of his model comes from the relationship between energy usage and capital services. Specifically, energy is essential to obtain the service flow from capital. Capital utilization rates are determined by energy use. Due to the oil price shocks, the decline of energy use reduces output and labour's marginal product, leading to a decline in wages and labour supplied. According to him, an oil price shock is like an adverse technology shock in inducing a contraction in economic activity.

Kling (1985) investigates the relationship between crude oil price changes and stock market activity for the period of 1973-1982 in the U.S. And finds that crude oil price changes affect the future stock prices in the industries which use oil as input factors.

Jones and Kaul (1996) test on the rationality of stock prices as to whether they reflect the impact of news on current and future real cash flows, thereby finding that oil price increases in the post war period have a significant detrimental effect for the U.S., Canadian, Japanese and UK stock market.

Sadorsky (1999) investigates the dynamic interaction between oil price and other economic variables including stock returns using an unrestricted VAR with U.S. data. He presents variance decompositions and impulse response functions to analyze the dynamic effect of oil price shocks. Variables include industrial production, interest rate of a 3-month T-bill, oil price (measured using the producer price index for fuels), and real stock returns (calculated using the difference between the continuously compounded returns on the S&P 500, and the inflation measured using the consumer price index). Data are monthly from 1947.1 to 1996.4. After unit root and co integration tests, he runs an unrestricted VAR with ordering of interest rates, real oil price, industrial production and real stock returns. For oil price changes he uses the growth rate of real oil price and oil price volatility (SOP) which is calculated by a GARCH (1-1). He finds that oil price changes and oil price volatility have a significantly negative impact on real stock returns. He also finds that industrial production and interest rates responded positively to real stock returns shocks. In particular, he split the full sample period into two sub-periods, pre-1986 and post-1986, because in 1986 the oil price declined significantly and the oil price has been more volatile since 1986. In post-1986 period oil price changes and oil price volatility have a larger impact on the economy than in the pre-1986 period. According to him, the response of the stock market to oil price shocks is asymmetric. When he uses asymmetric oil price shocks (positive oil price changes and negative oil price changes), positive shocks explain more forecast error of variance in real stock returns, industrial production and interest rates than negative shocks during the full sample period. For the post-1986 period, positive and negative oil price shocks explain almost the same fraction of forecast error variance of real stock returns, while in the pre-1986 period positive oil price shocks contribute more to the forecast error variance in real stock returns than negative oil price shocks. In the case of oil price volatility over the full period and two sub-periods, positive oil price volatility shocks (SOPI) had a greater influence on stock returns and industrial production than negative oil price volatility shocks (SOPD). In the post-1986 period, oil price movements explain more forecast error variance in stock returns than interest rates.