Thesis 8-2-16

OIL PRICE DETERMINANTS AND CO-MOVEMENT DYNAMICS
A THESIS
submitted by
SRINIVASAN.N
for the award of the degree
of
MASTER OF SCIENCE
(By Research)
DEPARTMENT OF MANAGEMENT STUDIES

INDIAN INSTITUTE OF TECHNOLOGY MADRAS, INDIA
FEB, 2016
THESIS CERTIFICATE
This is to certify that the thesis titled OIL PRICE DETERMINANTS AND CO-MOVEMENT
DYNAMICS, submitted by Srinivasan.N, to the Indian Institute of Technology Madras,
Chennai for the award of the degree of Master of Science (by Research), is a bonafide record of
the research work done by him under my supervision. The contents of this thesis, in full or in
parts, have not been submitted to any other Institute or University for the award of any degree or
diploma.
Prof. M. Thenmozhi
Research Guide
Professor
Dept. of Management Studies
IIT-Madras, 600 036
Place: Chennai
Date:
ACKNOWLEGDMENTS
I would like to express my sincere gratitude to Prof. M. Thenmozhi for guiding me throughout
my research work. I would also like to thank my General Test Committee members, Dr. P.
Krishna Prasanna and Dr. UmaKanth Dash for their insightful comments. I would also like to
thank Prof. T.J. Kamalanabhan for his valuable suggestions. I would like to thank all the faculty
of the Department of Management Studies for helping me to gain knowledge through their
teaching. I would like to thank all the staff of the Department of Management Studies,
Venkatraman Sir, Rajendran Sir and Vasudevan Sir for all their help and support. I would also
like to thank Meenakshi Maam and Azhar for their help in the systems lab. I would like to thank
Sreenivasan and all the other staff of the Department.
My Grandmother, Mrs. A.K. Thayaramma and my parents, Late Mrs. Revathi Narasimhan and
Mr. V. Narasimhan, and my brother Mr. N. Raghuraman have always supported me to pursue
higher studies, and stood by me throughout and also helped me to go forward in academics. No
amount of thanks would convey my gratitude for them.
I would like to thank Shyaam, Shipra, Lakshmi akka, Abhijeeth Sir, Narend Sir, Shashank,
Kayal akka, Hema for making my stay most memorable. I would like to thank my friends in the
department Sumeet, Shalini, Giri sir, sharoon for their support.
Srinivasan.N
ABSTRACT
3
Keywords Crude oil Speculation Markov Regime Switching Model Stock market Exchange rate Comovement Wavelet Analysis Continuous wavelet transform
This study investigates the impact of fundamental, financial and speculative factors on crude oil
prices and analyzes the behavior of the various determinants with respect to regimes. The
fundamental factors included in the study are OPEC production, OECD stocks, OECD
consumption, OECD Net Imports, industrial production of China (in $) and industrial production
of India (in $). Financial factors incorporated in the study are basis, S&P 500 and trade-weighted
US dollar Index and the speculative component is captured using net long positions of noncommercial traders. The study is conducted over the period April 1995 to May 2014. Markov
regime-switching model is used analyze the impact as it captures both non- linearity and breaks.
Our empirical findings indicated that speculation affects the oil price positively in high-volatile
state and has inverse effect in low-volatile state. At low-volatility regimes, fundamental, financial
factors have significant impact on the oil price, whereas at high volatility regimes, speculation
has a significant effect on the oil price.
The study further investigated the relationship of oil price with exchange rate and stock market
by examining the co-movement between oil price and exchange rate of nine oil importing
countries / stock market indices of fifteen major oil importing countries. The differ from previous
studies as the study examines the macroeconomic dynamics of major oil-importing countries
during various economic cycles across different frequencies. The study includes fifteen major oil
importing countries over the period 2003-14. Wavelet Coherence analysis is used to extract the
coherency. Empirical results indicate a high coherence between oil price and macroeconomic
indicators across all the countries during the financial crisis. The exchange rates have negative
relationship with benchmark oil prices except for the exchange rate of Japan in the long run and
for
the exchange rate of South Korea in the medium run. Stock indices have positive
relationship with benchmark oil prices in both long and medium run. S&P is leading the oil
price, whereas SSE50, Nikkei 225, NIFTY, KOPSI, DAX, CAC, IBEX, FTSSI, FTSEMIB,
AEX, TWSE, XU 100, LQ45 and BEL 20 are lagging the oil price in the long run. In the
medium term, except for NIFTY, oil price is leading the stock market index. Overall, the results
indicate that the oil price and stock indices of the major oil-importing countries are correlated in
long and medium term, but not in short term. The leadlag relationship between oil price and
4
macroeconomic indicators are observed to change across frequency and time. Exchange rate
offers diversification benefits, but stock market indices provide no diversification avenues since
the pattern of co-movement of stock market indices and oil prices are similar across all oil
importing countries.
The study has implications for regulators and policymakers. The study contributes to the
literature in the field of oil price determination and coherency of oil price with macroeconomic
indicators. The study used nominal price instead of real price to provide insight for traders and
institutional investors. The results aid the individual traders and institutional investors in
designing their portfolio for short, medium and long term time horizons.
TABLE OF CONTENTS
ACKNOWLEGDMENTS..........................................................................................................................iii
5
ABSTRACT...............................................................................................................................................iv
LIST OF TABLES....................................................................................................................................viii
LIST OF FIGURES.....................................................................................................................................x
ABBREVIATIONS....................................................................................................................................xi
CHAPTER 1 INTRODUCTION...............................................................................................................1
1.1. Major Oil Price Shocks.................................................................................................................2
1.2. Determinants of Crude oil.............................................................................................................3
1.3. Inter-relationship between crude oil and and macro-economy......................................................6
1.4. Need for the study ........................................................................................................................7
1.5. Objectives of study ......................................................................................................................8
1.6. Hypothesis ...................................................................................................................................9
1.7. Data and Sample...........................................................................................................................9
1.8 Measurement of Variables 10
1.9 Methodology 11
1.10 Outline of the thesis.12
CHAPTER 2 DETERMINANTS OF OIL PRICE: A MARKOV REGIME SWITCHING
APPROACH............................................................................................................................................10
2.1.
Importance of oil price determinants......................................................................................10
2.2.
Literature on factors influencing oil price..............................................................................13
2.3.
Framework of the study ........................................................................................................16
2.4.
Data and Sample....................................................................................................................17
2.5.
Methodology..........................................................................................................................24
2.5.1. BDS test for Non-Linearity.................................................................................................25

2.5.2. Markov Regime Switching Model......................................................................................29
2.6.
Empirical results....................................................................................................................31
2.6.1. Hypothesis 1: Test for Non-linearity...................................................................................34

2.6.2. Hypothesis 2: Effect of speculation on oil price- measuring the marginal effect of
speculation....................................................................................................................................35
2.6.3 Hypothesis 3:Effect of speculation on the oil price controlling for financial faactors .....36
2.6.4 Hypothesis 4: Relative importance of determinants of oil price37
2.7. Summary ....................................................................................................................................38
CHAPTER 3 WAVELET DYNAMICS FOR THE OIL PRICE, EXCHANGE RATES, AND
STOCK INDICES OF THE MAJOR OIL IMPORTING
COUNTRIES39
6
3.1.
Introduction...........................................................................................................................39
3.2
Literature Review.....40
3.3.
Data.......................................................................................................................................41
3.4
Conceptual flow 42
3.5
Methodology43
3.5.1. Continous wavelet transform..............................................................................................41
3.2.2. Wavelet Coherence (WTC).................................................................................................41
3.6. Wavelet coherence -Inference.. 43

3.7. Empirical Results..44
3.7.1. Relationship between benchmark oil price and exchange rate of oil importing countries...48
3.7.2. Relationship between benchmark oil price and stock indices of oil importing countries....49
3.8.
Summary................................................................................................................................61
CHAPTER 4 CONCLUSION..................................................................................................................9
4.1 Findings of the study...................................................................................................................98
4.1.1. Effect of speculation on oil price: Measuring marginal effects of speculation....................48
4.1.2. Effect of speculation on the oil price controlling for financial factors................................49
4.1.3. Relative importance of determinants of oil price..50
4.1.4. Oil price and exchange rate: wavelet coherence (WTC)......51
4.1.5. Oil price and stock indices: WTC.52
4.2.
Conclusions...........................................................................................................................99
4.3.
Contributions of the study...................................................................................................101
4.4.
Implications.........................................................................................................................101
4.5.
Limitations of the study.........................................................................................................102
REFERENCES.......................................................................................................................................102
PUBLICATIONS.....................................................................................................................................109
1 Presentations in Conferences............................................................................................................109
2 Papers Communicated to Refereed Journals.....................................................................................109
LIST OF TABLES
Tables
Title
Page No.
1.1 Energy Market Share...............................................................................................................

1.2 Proved reserves of oil at the end of 2013.................................................................................
1.3 Data Description......................................................................................................................
1.4 Energy rate Data......................................................................................................................
1.5 Stock index data.......................................................................................................................
2.1 Summary of literature on determinants of crude oil................................................................
2.2 Data Description......................................................................................................................
2.3 Descriptive statistics of fundamental, financial and speculative variables..............................
2.4 BDS test results........................................................................................................................
2.5 Estimation results of Markov Regime Switching Regression -1 ............................................
2.6 Estimation results of Markov Regime Switching Regression - 2............................................
2.7 Estimation results of Markov Regime Switching Regression - 3............................................
3.1 Recent literature on relationship between the oil price and exchange rate..............................
3.2 Recent literature on relationship between the oil price and stock indices...............................
3.3 Frequency identification..........................................................................................................
3.4 Wavelet inference.....................................................................................................................
3.5 Descriptive statistics of exchange rates of oil importing countries.........................................
3.6 Descriptive statistics of stock indices of oil importing countries............................................
3.7 Relationship during financial crisis.........................................................................................
4.1 Summary of hypothesis results................................................................................................
LIST OF FIGURES
Figures
Title
Page No.
1.1 Framework of the study...........................................................................................................

2.1 Impact of speculation on WTI crude oil price @ low and high variance states .....................
2.2 Impact of speculation on WTI crude oil price series controlling for financial variables @
low and high variance states..........................................................................................................
2.3 Impact of fundamental, financial and speculative factors on WTI crude oil price @ low
and high variance states ................................................................................................................
2.4 Plot of determinants of WTI crude oil.....................................................................................
2.5 Conditional means, Volatilities and Smoothed transition probabilities for model 1 ..............
2.6 Conditional means, Volatilities and Smoothed transition probabilities for model 2...............
2.7 Conditional means, Volatilities and Smoothed transition probabilities for model 3 ..............
3.1 Major oil importing countries..................................................................................................
3.2 Normalized oil price and exchange rate of oil importing countries.........................................
3.3 Normalized oil price and stock indices of oil importing countries .........................................
3.4 Benchmark oil prices and exchange rates Wavelet coherence (WTC).................................
3.5 Benchmark oil prices and stock indices wavelet coherence (WTC).....................................
ABBREVIATIONS
Following are the commonly used abbreviations in the thesis
OECD - Organization for Economic Co-operation and Development
OPEC - Organization of Petroleum Exporting Countries
TRC - Texas Railroad Commission
VAR Vector Auto Regression Model
SVAR Structural VAR models
GARCH-M - Generalized Autoregressive Conditional Heteroskedasticity in-Mean
USD US Dollar
WTI - West Texas Intermediate
NYMEX - New York Mercantile Exchange
USDCNY Chinese Yuan
USDEUR - US dollar-Euro
USDIDR - US dollar-Indonesian Rupiah
USDINR - US dollar-Indian Rupee
USDJPY - US dollar-Japanese Yen
USDKRW - US dollar-South Korean Won
USDSGD - US dollar-Singapore dollar
USDTRY - US dollar-Turkish Lira
USDTWD - US dollar-New Taiwan Dollar
NKY - Nikkei 225 index
NIFTY - NIFTY 50 (India)
LQ45 - LQ45 index (Indonesia)
KOSPI - Korea Composite Stock Price Index (South Korea)
10
IBEX - IBEX 35 (Spain)

FTSEMIB - FTSEMIB 40 (Italy)
FSSTI - Straits Times Index (Singapore)
DAX - DAX 30 (German)
CAC - CAC 40 (France)
BEL20 - BEL20 index (Belgium)
AEX - Amsterdam Exchange index (The Netherlands)
US SPX - Standard & Poor's 500 (US)
SSE50 - Shanghai Stock Exchange 50 (China)
TWSE - Taiwan Stock Exchange-Weighted Index (Taiwan)
XU100 - Borsa Istanbul 100 Index (Turkey)
NC NET LONG POS - non-commercial traders net long position
MS-VAR Markov Switching Vector Auto Regression Model
MS-AR - Markov Switching Auto Regression Model
OLS Ordinary Least Squares
CWT - Continuous wavelet transform
XWT - Cross wavelet transform
WTC - Wavelet coherency
11
Chapter 1
Introduction
Crude oil constitutes a major part in the world energy markets and supplies 30 percent of the
total world energy consumption and 90 percent of the vehicular fuel consumption. Several
countries in the world are either producers or consumers of crude oil. Hence, it is the key driver
of a nations economy and it also triggers economic cycles. Instability in oil price affects both
developed as well as developing countries and volatility in oil price leads to potential
ramifications over a countrys economy and its financial markets.
Previous research has focused more on the impact of demand and supply factors influencing oil
price. But oil is one of the highly traded commodities in the world with high participation from
financial institutions in the derivative segment and speculation in crude oil options and futures
can play an active role in establishing the price of crude oil. Precise estimation of the factors that
affect the crude oil price helps in understanding the dynamics of crude oil price movements and
helps in managing the risk pertaining to volatile oil prices. Oil price series exhibit structural
breaks and non-linearity (Reboredo, 2010) and may exhibit dynamic behavior with respect to the
financial events such as crisis, changes in government policy, changes in the business cycles and
economic downturns. The economy becomes more difficult to manage when oil prices remain
highly volatile, as higher volatility in crude oil prices, have greater ramifications for different
players in the economy and managing current account balance for governments becomes a
challenge. The determinants of crude oil price in high-volatile period might be different from
low-volatile period, and may differ during different economic phases. Hence, an attempt is made
in this study to examine the effect of fundamental, financial and speculative factors on crude oil
prices during high and low volatile regimes.
Fluctuations in crude oil price impacts macroeconomic factors such as growth rate, interest rate,
inflation and exchange rate. Crude oil is actively included in the portfolio of various hedge funds
and variability in oil price has significant linkage with various macroeconomic indicators of a
country. Oil price has influence on a countrys economic growth and thus on inflation and
interest rate. Oil prices affect the stock prices either directly by influencing future cash flows of a
12
company or indirectly by affecting the interest rate that is used to discount the future cash flows
of a company. Change in stock prices and exchange rates also impacts oil prices. But, the nature
and extent of relationship between oil price and macroeconomic indicators may vary from time
to time and understanding the pattern of relationship across time and frequency horizon becomes
essential for traders and investors. Hence, we attempt to examine the co-movement between (i)
oil price and stock index and (ii) oil price and exchange rate to capture the pattern of relationship
across different time horizon.
Economic growth and demand for energy products
Industrialization led to the growth in the demand for energy resources. Economic growth since
20th century is mainly due to the non-renewable energy resources. Crude oil serves as base
product for many indispensible goods such as gasoline and jet fuel. Crude oil constitutes the
major part in the world energy markets. It supplies 30% of the total world energy consumption
and 90% of the vehicular fuel consumption.
The share of oil in world major fuel resources is presented in Table 1.1. The table presents annual
supply growth in each type of fuel. Share of different type of fuel to the total world energy
resource is indicated in the table. The table also presents the future forecasts of each fuel in the
world energy market. It is observed from the table that oil, coal, and gas are the major
components of the world energy market. Approximately 32% of world energy requirement is met
by oil, 28% is met by coal, and 20% is met by Gas and the rest by hydro, biomass, and other
renewable resources.
Table 1.1: Energy market share
Oil
Coal
Gas
Nuclear
Hydro
Biomass
Other renewables
Total
Growth in supply (% P.a.)

201040
0.7
1.4
2.4
1.6
1.8
1.5
7.7
1.6
2010
31.9
28.2
21.5
5.6
2.3
9.7
0.7
100
13
share in world fuel

2020
2035
29.6
27.2
29.1
28.4
23.1
25
4.6
5
2.5
2.5
9.7
9.7
1.4
2.4
100
100
2040
24.3
27.1
27
5.7
2.4
9.4
4
100
The above table presents the major fuel resources of the world. The annual increase in the supply of each fuel is
presented. It also shows the current and forecasted share of each fuel in world energy market.
World oil reserves as indicated in the BP Statistical Review of World Energy (June 2014) report
is presented in Table 1.2. Proved reserves of oil are the estimated quantities of oil that are
obtained from geological and engineering information. These reserves are indicated with
reasonable accuracy and can be recovered in the future from known reservoirs under existing
economic and operating conditions. Proved reserves in the world at the end 1993, 2003, and
2013 is indicated in the table. It also presents the total quantity in terms of both tones and barrels
and the share of world reserves of major oil producing nations.
Table 1.2: Proved Reserves of oil at the end of 2013
Proved reserves of oil
End of 2013
1993
2003
2013
(Thousand
(Thousand
(Thousand
Thousand
World
million
million
million
million
Reserves
barrels)
barrels)
barrels)
tones
OECD
140.8
247.5
249.6
37.3
Non-OECD
900.6
1086.6
1437.7
200.9
OPEC
774.9
912.1
1213.8
170.2
Non-OPEC
206.3
325.2
342.6
50.1
European
Union#
8.1
8
6.8
0.9
Former Soviet Union
60.1
96.8
130.9
17.9
Total World
1041.4
1334.1
1687.3
238.2
The data was collected from BP Statistical Review of World Energy June 2014
thousand
million
Barrels
248.8
1439.1
1214.2
341.9
6.8
131.8
1687.9
share of
world
14.70%
85.30%
71.90%
20.30%
0.40%
7.80%
100.00%
Reserves /
production
ratio
33.2
59.5
90.3
26
13
26
53.3
Reserves to production ratio indicate the length of time that remaining reserves would last if
production were to continue at the same rate. It is observed from the table that Organization for
Economic Co-operation and Development (OECD) contributes to approximately 15% of the
reserves. Organization of Petroleum Exporting Countries (OPEC nations) contributes to the
major world oil production it accounts to a total share of 71%. Former Soviet Union constitutes
7.8% of world oil. The European Union contributes to 0.4% of the world oil.
Several countries in the world are either producers or consumers of crude oil. Hence, it is the key
driver of a nations economy and it also triggers economic cycles. Instability in the oil price
14
affects both developed as well as developing countries. Volatility in the oil price leads to
potential ramifications over a countrys economy and its financial markets.
Economic recessions, inflation upsurge, and trade deficits are due to the large movements in oil
price. Price of crude oil in 2003 was at $29 a barrel. From 2003 there was steady growth in the
price till global financial crisis 2008. The price of crude oil in early 2008 was $147 a barrel.
During the global financial crisis the prices dropped to $33 a barrel. The price reverted slowly to
$105 in 2011. The price was stable at $105 per barrel from 2011 to 2014. Fluctuations in crude
oil price impacts macro-economic factors such as growth rate, interest rate, inflation, exchange
rate etc. In this context, understanding the relationship between the oil price and macroeconomic factors is crucial.
1.1 Major Oil Price Shocks
The major events that led to major oil price shocks after the World-War-II include the Suez Crisis
of 19561957, the OPEC oil embargo of 19731974, the Iranian revolution of 19781979, the
IranIraq War initiated in 1980, the first Persian Gulf War in 1990-91, and the oil price spike of
20072008 (Hamilton, 2011).
In the initial post-war era, Texas Railroad Commission (TRC) played an important role in the
world oil market. The permissible production level was set by TRC based on the current market
demand. As a result, the nominal oil price was constant from month to month. Unexpected
variations in the oil price were witnessed during the extreme events.
Suez Crisis (19561957): The president of Egypt, Nasser, has nationalized the Suez Canal in
1956. To counteract the Egyptian president, Brittan and France have encouraged the Israel to
wage a war on Egypt. During this battle 40 ships were sunk, which blocked the canal through
which 1.5 million barrels of oil per day was transported. It constitutes two-third of the total
Brittan oil supplies. Supply disruption during this period led to sharp increase in oil price during
the Suez Crisis.
OPEC Embargo (19731974): Arab members of OPEC extended their support to Israel against
Syria and Egypt by announcing an embargo on oil exports only to selected countries. As a result,
15
OPEC has cut its total oil production which led to shortfall of world oil output by 7.5%. Due to
this the Gulf countries doubled the price of oil in 1974. Geopolitical factors played a major role
in price spike during this period.
Iran revolution (19781979): In order to fill the gap in the oil production due to Arab OPEC
members embargo, Iran increased its total oil production during the 19731974.But, in 1978,
Iran was contended with large public protests which spread to the oil sector. The total oil
production of Iran fell down by 4.8 million barrels per day which constituted 7% of world
production at the time, led to a price hike during 19781979.
IranIraq War (19801981): The oil supply from both the countries was lost during the war
between Iran and Iraq in 1980. The total production loss accounted to about 6% of world oil
production at the time. However, this short fall in production was recovered from the other parts
of the world with in a very short span.
The great price collapse (19811986): The oil demand of major oil importing countries
declined due to the price hike in 1970. The nominal oil price fell by 25% by 1980. Saudi Arabia
has cut its three-fourth of its production during 1981 and 1985. But this did not improve the price
of oil. In 1986, Saudis lifted its production cuts. This led to a further collapse in oil price from
$27/barrel in 1985 to $12/barrel in 1986. This was promising for oil importing countries but for
oil exporting countries this was the major shock.
Persian Gulf War (19901991): In 1990, Iraq invaded Kuwait. The oil production from both
countries accounted for 9% of the total world oil production was lost during the war. The price of
crude oil was doubled during this time. But, this spike sustained for very short span.
East Asian Crisis (19971998): In the mid of 1997, South Korea, Thailand, and some other
Asian countries were subjected to financial stress. The price of oil soon followed their downfall
since major oil demand was from these countries. The price of oil has fallen below $12 a barrel
by the end of 1998.
Global Financial Crisis (20072008): Global economy was booming during 2004 and 2005.
Growth in economy led to an increase in world oil consumption by 5 million barrels per day. As
16
a result oil price increased rapidly; the oil production slowly declined after 2005. The low
production further added to the increase in the oil price during the global financial crisis.
Plunge in oil price (2014): Long-term trend in oil prices was determined by demand and supply
factors. Short-term movements are explained using market sentiment and expectations.
Geopolitical risks, supply disruptions, and production controls exercised by OPEC led to sharp
decline of oil price from $105 per barrel. This decline was intensified due to policy change by
OPEC. In 2014, due to geopolitical conflicts in some oil producing countries, OPEC announced
its policy change which led to the appreciation of the US dollar. Chen (2015) postulated that oil
prices remain low in 2015 and will rise in 2016 marginally. Long-term trend of oil production
and consumption have also played crucial roles in the recent decline in oil prices.
1.2 Determinants of crude oil
The dynamics of oil price has received much attention since the oil market witnessed rapid
movements in its price. Oil price from $29 a barrel in 2003 rose to $133 a barrel in 2008 and
have fallen again to $37 a barrel in 2015. Some studies argue that the fluctuations in oil price
were due to the structural transformations in oil market. Other studies attributed this behavior to
the seasonal and cyclical behavior of oil price. Stevens (2005) postulated that these different
views about the volatility in oil price reflect the divergent views of the future change in oil
prices.
Previous studies on oil price studied basic correlations, causality relations, or economic linkages
to oil price. But, these short-term relationships cannot adequately capture the different shocks
that influence the oil market. And the long-term models are extremely sensitive to the underlying
assumptions of the models.
Few studies argue that the fundamental forces such as supply and demand forces are responsible
for the change in the price of crude oil (Fan and Xu 2011). Kilian (2009) attributed these shocks
to the growth in the demand of crude oil. Strong growth in oil demand in the countries like china
was responsible for the rise of oil price. Kaufmann (2011) postulated that the recent spike during
the 2010 crisis was caused due to supply shock (Gately et al., 1977; Kaufmann, 1995). The two
17
sources of supply of crude oil are non-OPEC nations and OPEC nations. There is a sudden
increase in non-OPEC production during 2010 crisis.
The association between the fundamental factorsdemand and supply and the oil price was
approximated using a linear relationship in the most of the studies. But, non-linear relationship
exists between the determinants of crude oil price and the volatility of crude oil price. It is
imperative to accurately estimate the determinants of crude oil price using a non-linear model.
According to the International Energy Agency report 2014, the growth in the world demand for
oil was approximately 2% per year over the last two decades; whereas the oil price fluctuation
per year is way above 2%. This imbalance can be explained using the factors other than
fundamental factors. The other factors include speculative factors, financial factors, and supply
disruption factors. Hence, the present study investigates the fundamental, financial, and
speculative factors that explain the volatility in crude oil price.
1.3 Inter-relationship between crude oil and macro-economy
Crude oil spot prices, as indicated by West Texas Intermediate crude oil, at the end of the year
2002 was at $29.42 per barrel; in June 2008, spot oil prices had risen to $146.12 per barrel, and
in August 2015 it was at $38.78 per barrel. The recent fluctuations in oil prices over the past
15 years have lead to the study of relationship among oil prices, financial markets, and the
economy (Blanchard and Gali, 2007; Herrera and Pesavento, 2009).
Oil price has major influence on countrys economy, especially for oil importing countries like
India, which consumes 3.7 million barrels per day. Increase in oil price leads to a decrease in
economic activity, and also contributes to level of inflation. Economic growth comes along with
increasing demand for energy products. The demand for oil in developed economies is
unchanging, but for emerging economies, it is rapidly increasing.
Oil prices affect stock prices by influencing future cash flows of a company or by impacting the
interest rate that used to discount the future cash flows of the company in order to arrive at stock
price. Most of the research on the relationship between oil prices and stock prices has been
conducted for developed economies. There is little research on the relationship between oil
18
prices and emerging stock markets (Basher and Sadorsky, 2006; Hammoudeh and Aleisa, 2004;
Hammoudeh and Huimin, 2005).
Kilian and Park (2009) investigated the relationship between the US stock prices and crude oil
price shocks for the period 19732006. They observed asymmetric effect of oil price shocks on
stock market. They found that oil supply shocks have much less impact on stock prices but oil
demand shocks depressed stock prices. Apergis and Miller (2009) analyzed the effect of oil price
shocks on the stock prices using a SVAR approach. They considered the monthly data of eight
developed economies (Australia, Canada, France, Germany, Italy, Japan, the United Kingdom,
and the United States) over the period 19812007. They found that oil market shock has
insignificant impact on the stock prices. In the light of contradicting studies, the present study
analyzes the relationship between crude oil price and stock market.
The US dollar (USD) is the settlement currency in international oil markets. Variations in the
USD exchange rate affect both oil-exporting and oil-importing countries (Zhang et. al., 2008).
Strong theoretical arguments asserting that exchange rates affect oil prices and other argue that
oil prices affect exchange rates. Empirical analysis should accomplish the relationship between
these two variables.
Empirical research by Pindyck and Rotemberg (1990) and Sadorsky (2000) supports that change
in exchange rate has significant impact on oil price. Zhang et al. (2008) found that the US dollar
exchange rate has an impact of the on international oil price in the long run, but in short-run the
effects are limited. Past empirical research has examined the influence of oil priceexchange rate
interaction on macro-economic variables and currency policies.
Huang and Guo (2007) suggested that oil price shocks led to a minor appreciation in Chinas real
exchange rate. A non-negative relationship exists between the oil price and exchange rate
(Akram, 2004; Cifarelli and Paladino, 2010; Lizardo and Mollick, 2010). Real oil prices were a
dominant source of real exchange rate movements and had significant forecasting power (Chen
and Chen, 2007; Amano and van Norden, 1998). Camarero and Tamarit (2002) found that the
one of the main determinants of the long-term real exchange rate for the Spanish peseta is the
real oil price.
19
Cifarelli and Paladino (2010) used a multivariate generalized autoregressive conditional

heteroskedasticity in-mean (GARCH-M) model to estimate the effect of oil price shifts on
exchange rate. Akram (2009) suggested that a weaker USD led to higher oil prices and that USD
fluctuations accounted for volatility in oil price. Most of the empirical literature on oil and
exchange rate dependency provides evidence of oilexchange rate co-movement (Reboredo,
2012) only in time domain. It is also important to understand the relationship between oil price
and exchange rate in frequency domain as it indicates short and long term dynamics. But very
little literature exists on oilexchange rate dependency in both time and frequency domains.
Oil prices and exchange rates co-movements have implications for a central bank that aims to
achieve a desired level of appreciation/depreciation for its currency against foreign currencies.
Comprehending the relation between oil and exchange rate markets is crucial as it impacts many
key financial and economic aspects of a country. The impact of oil price shock is significant
mainly for oil-importing countries. Hence, understanding the correlation between oil prices,
exchange rates, and stock market is important.
1.4 Need for the Study
Factors influencing Crude Oil
Most of the previous studies focused on oil supply and demand factors and provide evidence that
fundamental factors are the key drivers of oil prices (Chevillon and Rifflart, 2009; Isabel
Vansteenkiste, 2011; Kilian, 2009). With respect to crude oil, supply factors such as OPEC
production (Chevillon and Rifflart, 2009; Lin and Tamvakis, 2010) and OECD inventory (Ye et
al., 2002) are found to have inverse relationship with oil prices. In the demand side, most of the
studies have used only OECD consumption and OECD net imports for determining the residual
demand shock and these shocks are found to have positive impact on oil prices (Kilian and Lee,
2014; Kilian, 2009). Since past studies considered only shocks and studied their effect on oil
price, the main effect of OPEC production, OECD inventory, OECD consumption and OECD net
imports individually has been ignored. Moreover, previous studies paid little attention to the
demand from emerging markets. Hence, there is a need to empirically examine the effect of
individual supply related variables such as OECD inventory and OPEC production and demand
related variables such as OECD consumption and OECD net imports. But, considering OECD
20
consumption alone is not appropriate, since it excludes major oil consuming countries like China
and India. Hence, use of proxy variables to account for the increasing consumption from
emerging economies such as China and India is pertinent to capture the global consumption
effectively.
Contemporary research in the field of oil price dynamics indicates that financial factors also
affect oil price apart from fundamental factors. Many studies have shown significant impact of
exchange rate on crude oil prices (Amano and Van Norden, 1998; Basher et al., 2012; Beckmann
and Czudaj, 2013), but most of them have used NEER (Breitenfellner et al., 2009), REER
(Oriavwote and Eriemo, 2012; Breitenfellner et al., 2009) and US dollar exchange rate, which is
based on the transaction between US and its trading partners. Examining the impact of effective
exchange rate of dollar index has limitations in accounting for the global trading of oil in dollars.
However, using a comprehensive measure such as Dollar index (broad) would capture the
complete dynamics of oil trading. Hence, it is pertinent to examine the impact of dollar index
(broad) on oil price than looking at the impact of effective exchange rate on oil prices.
Prior research have also found significant impact of stock index on crude oil prices (Basher et al.,
2012; Cifarelli and Paladino, 2010; Breitenfellner et al., 2009). With the advancement of
fianancialisation, forward and futures market impact oil prices. If the expected future oil spot
price is greater than the futures price, there will be a premium to extract oil from well. But, the
impact of spread between the current spot price and a year ahead futures price of oil has not been
considered by prior studies. Considering 12-month basis which measures the premium of
holding/ storing a crude oil rather than a derivative product may provide more insight on crude
oil price discovery.
Sornette et al., (2009) postulated that the oil price shocks during crisis are due to speculative
factors and speculative trading can influence the oil prices without any change in fundamental
factors (Hamilton, 2009). Speculation variable such as feedback trading was found to have
negative effect on oil prices (Cifarelli and Paladino, 2010). While, non-commercial net long
positions (futures) are found to have positive effect oil price (Fattouh et al., 2012). With the use
of call option and put option and extensive building up of positions in put or call can impact oil
prices significantly. Hence, capturing speculation ignoring options will not be meaningful.
21
Speculative activity based on non-commercial net long positions (futures and options) may
capture the impact of speculation on oil price more effectively.
Oil price series exhibit structural breaks and non-linearity (Reboredo, 2010) and may exhibit
dynamic behavior with respect to the financial events such as crisis, changes in government
policy, changes in business cycles and economic downturns. As the behavior of the oil price
determinants change over time, understating the oil price and its determinants behavior with
respective regimes becomes crucial. Using ordinary regression model fails to identify the
dynamic linkage between oil prices and its determinants across regimes. Most of the existing
literatures examine the relationship using traditional linear time series models such as VAR/
VECM, co-integration and structural VAR. However, oil price is found to have structural breaks
and may not be linear and most of the studies examine casual/ long term relationship of crude oil
with only one or few variables. Linear models could suffer from possible misspecification or
omitted variable bias and the relationship between oil price and determinants may vary over
time. Incorporating or using the model, which accounts for structural break and capturing the
effect at different periods would help in accurate estimation of oil price. Very few studies have
used nonlinear models such as CCC - GARCH-M and Bayesian Model averaging (Breitenfellner
et al., 2009). However, these models cannot estimate the relationship with respect to different
market phases and fail to address structural breaks in the data. Markov Regime-switching model
provides a flexible framework to model structural breaks, dynamic shifts and dynamic
relationships. Markov-regime switching methodology is largely used for finding non-linear
causality (Firouz Fallahi, 2011) and volatility (Naifar and Dohaiman, 2013), but has not been
used to estimate the effect of multiple factors on oil prices at different regimes. Hence, there is a
need to investigate the nonlinear relationship and comovement between crude oil and its
determinants at different volatile regimes using Markov switching model which will account for
structural breaks, nonlinearity and various regimes.
Co-movement of oil price with macroeconomic factors
Previous studies that examined the relationship between the crude oil and exchange rates/stock
indices indicated inconsistency in results. Long-run equilibrium exists between the crude oil
price and exchange rate (Amano and Van Norden, 1998; Chaudhuri and Daniel, 1998; Chen and
Chen, 2007; Oriavwote and Eriemo, 2012). Some argued that increase in oil prices is associated
22
with the appreciating exchange rate (Amano and Van Norden, 1998; Benassy-Quere et al., 2007;
Narayan et al., 2008; Basher et al., 2012; Beckmann and Czudaj, 2013). But other studies argued
that increase in oil prices is associated with the depreciating exchange rate (Wang and Wu,
2012). While bi-directional causality exists between oil price and exchange rates after crisis
(Ding & Vo, 2012), at large time horizons (Benhmad, 2012) and at higher time scales (Tiwari et
al., 2013), Iwayemi and Fowowe (2011) there is no impact of oil price on exchange rates.
Few studies (Cong et al., 2008; Park and Ratti, 2008) found that, oil price shocks have no impact
on the real stock returns and during crisis oil shocks do not affect stock market phases (Jammazi
and Aloui, 2010). However, Miller and Ratti (2009) and Jammazi (2012) found that stock market
reacts negatively to increase in oil price in the long-run. There is also evidence that increase in
emerging market stock prices increases oil prices (Basher et al., 2012), but the impact of oil price
shocks on stock prices for emerging countries is mixed partly in contrast to developed stock
markets. Moreover, the stock returns of large oil producing and consuming countries have
relatively strong dependence with oil price (Sukcharoen et al., 2014) and the dependence
between commodity and stock market is time varying and symmetrical (Delatte and Lopez,
2013).
Traders and institutional investors have varied investment horizons and different risk profiles and
co-movement between oil prices and macroeconomic indicators becomes important to assess the
risk profile of countries and the market movements. While traders would prefer analysis based on
nominal prices, most of the studies have focused on real prices.
Previous literature examines the co-movement using traditional time series models such as OLS,
VAR/ VECM, co-integration and de-trended correlation analysis, which look into the time scale
of the variables. However, co-movement between variables may vary across time and the effect
could change at different time horizons. Very few studies have used wavelet analysis to capture
the co-movement dynamics across time and frequency scales (Rua and Nunes, 2009; Tiwari et
al., 2013; Loh, 2013). Moreover, existing studies have examined the relationship between oil
prices and exchange rates/ stock indices for one country/ few countries, which are mostly
developed markets. Very few studies have focussed on the relationship between the oil prices and
emerging stock markets (Basher and Sadorsky, 2006; Hammoudeh and Huimin, 2005). Besides,
prior studies have not focused on oil importing countries and also analyzed from traders
23
perspective considering nominal prices. Hence, there is a need to focus on traders and
institutional investors perspective and examine the co-movement between benchmark oil price
with (i) nominal exchange rates and (ii) stock indices of major oil-importing countries using
wavelet coherence approach.
1.5 Objectives of the Study
The purpose of this study is to examine the factors that determine the crude oil price and the
comovement dynamics with macroeconomic factors. It is important to understand the factors
affecting crude oil price to accurately model crude oil price behavior with respect to the changes
in the economic cycles and volatile regimes. It is also pertinent to understand the impact of crude
oil price on the economy and explore the link between oil prices and various macroeconomic
variables for a large set of oil-importing countries. Hence, the specific objectives of the study
are
1. to examine the impact of fundamental, financial, and speculative factors on WTI crude oil
prices at high and low volatile regimes.
2. to examine the co-movement between oil price and exchange rate of oil importing
countries across different time and frequency horizons.
3. to examine the existence of co-movement between oil price and Stock Indices of oil
importing countries across different time and frequency horizons.
In this study, co-movement between oil price and exchange rates, and oil price and Stock Indices
is perceived from perspective of both the traders and institutional investors. Traders and
institutional investors have varied investment horizons, as they have varied risk profiles.
1.6 Hypothesis
Hypothesis for the study has been formulated and tested based on the gap from the existing
literature. The hypothesis is as follows
H1: Presence of linear relationship
24
H2: There is no significant impact of speculative factors on WTI oil prices

H3: There is significant impact of speculative factor on WTI oil prices controlling for financial
factors
H4: There is no significant impact of speculative factors on WTI oil prices controlling for
fundamental, financial, and supply disruption factors
H5: The effect of WTI crude oil prices on exchange rate of oil importing countries is not
statistically significant
H6: The effect of WTI crude oil prices on Stock Index of oil importing countries is not
statistically significant
Figure 1.1: Framework of the study
FUNDAMENTAL
Oil Benchmark
WTI - Spot price (NYMEX)
DEMAND
OECD Imports
OECD Consumption
Industrial production - India
Industrial production - China
SUPPLY
OPEC Production
OECD Stocks
SPECULATON
Non-Commercial net Long positions (FUTURES & OPTIONS, NYMEX)
Crude oil price (Spot)
FINANCIALIZATION
U.S. Dollar Index Broad
S & P 500
12 month BASIS - (Futures, NYMEX)
SPECULATON
25
Exchange
Rate
Stock Index
Major Oil Importing countries1
United States
India
South Korea
France
Singapore
Netherlands
Turkey
Belgium
China
Japan
Germany
Spain
Italy
Taiwan
Indonesia
1.7 Data and Sample

The sample used for the study comprises of monthly WTI crude oil spot price traded at New
York Mercantile Exchange (NYMEX). The WTI crude oil data is collected from Energy
Information Agency. The variables effecting crude oil price are grouped into four broad
categories, namely: (i) demand factors, (ii) supply factors, (iii) financial factors, and (iv)
speculative factors. The demand factors include and for the variables such as OECD
consumption, OECD imports, China Industrial Production, and India Industrial Production. The
supply factors include Total oil Rigs, OPEC production, and OECD inventory. Financial
variables include Dollar index, S&P 500, Basis Oil (Futures; NYMEX). The speculation
factors include Net Long Positions (Non-Commercial) Oil (Futures and Options; NYMEX).
The supply disruption variables include dummy variables such as Hurricane and War. The
sample period spans from April 1995 to May 2014, yields a total of 230 observations.
WTI crude oil spot price, Basis oil Futures, OECD Consumption, OECD Imports, OECD
Inventory, and OPEC production are collected from Energy Information Agency. Industrial
production of china and industrial production of India are collected from the World Bank. Total
oil rigs data is collected from Baker Hughes BHI International Rig Count. Dollar index and S&P
500 data are collected from St. Louis Federal Reserve (USA). The Net Long Positions (NonCommercial) Oil (Futures and Options; NYMEX) data is collected from database US
Commodity Futures Trading Commission. Table 1.3 summarizes the variables, sample period,
and source it is taken from.
Table 1.3: Data Description
DETERMINANTS
SAMPLE PERIOD
SOURCE
04/1995 05/2014
Energy Information Administration
Oil Benchmark
Lagged WTI - SPOT (NYMEX)
Fundamental Variables
Demand Variables
Consumption (OECD)
04/1995 05/2014
26
Imports (OECD)
04/1995 05/2014
CHINA Industrial Production (US$)
04/1995 05/2014
World bank
INDIA Industrial Production (US$)
04/1995 05/2014
World bank
OPEC Production
04/1995 05/2014
OECD Inventory
04/1995 05/2014
Supply Variables
Financialization - Variables
Dollar Index
04/1995 05/2014
St. Louis Federal Reserve (U.S.A.)
S&P 500
04/1995 05/2014
Basis - Oil (Futures) (NYMEX)
04/1995 05/2014
Speculation - Variables
Net Long Positions (Non-Commercial) Oil
(Futures & Options) (NYMEX)
04/1995 05/2014
Commodity Futures Trading Commission
To analyse the co-movement between the oil price macro-economic variables such as exchange
rate and Stock indices, the study considered daily WTI crude oil spot price traded at NYMEX.
Major oil importing countries that are considered in the study are United States of America
(USA), China, Japan, India, South Korea, Germany, France, Spain, Singapore, Italy, The
Netherlands, Taiwan, Turkey, Indonesia, and Belgium.
The exchange rates considered are dollar across the other fourteen countries. They are US dollarChinese Yuan (USDCNY), US dollar-Euro (USDEUR), US dollar-Indonesian Rupiah
(USDIDR), US dollar-Indian Rupee (USDINR), US dollar-Japanese Yen (USDJPY), US dollarSouth Korean Won (USDKRW), US dollar-Singapore dollar (USDSGD), US dollar-Turkish Lira
(USDTRY), and US dollar-New Taiwan Dollar (USDTWD). The sample period spans from 4th
January 2000 to 30th December 2014 for a period of 15 years. Table 1.4 summarizes the
exchange rate, country and data period.
27
Table 1.4: Exchange rate Data

Exchange
Country
Currency Name
USDCNY
China
Chinese Yuan
USDEUR
Euro Region
Euro
USDIDR
Indonesia
Indonesian Rupiah
USDINR
India
Indian Rupee
USDJPY
Japan
Japanese Yen
USDKRW
South Korea
South Korean Won
USDSGD
Singapore
Singapore dollar
USDTRY
Turkey
Turkish Lira
USDTWD
Taiwan
New Taiwan Dollar
Relationship between oil price and exchange rate is extensively studied (Amano and Van
Norden, 1998; Chen and Chen, 2007; Basher et al., 2012; Beckmann and Czudaj, 2013).
Chinese Yuan (CNY) is the currency for china. Chinese Yuan is pegged with US Dollar. It
follows a fixed exchange rate system. Huang and Guo (2007) studied the impact of oil price
shock on the trend movements of China's real exchange rate.
Euro (EUR) is the currency for the following countries Austria, Belgium/Luxembourg,
Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Malta, Netherlands, Portugal,
Slovenia, Slovakia, and Spain. Reboredo and Castro (2013) studied the interdependence between
oil and USDEUR market interdependence for the period spanning from 4 January 2000 to 7
October 2011.
Indonesian rupiah (IDR) is the official currency of Indonesia. It follows floating or fluctuating
exchange rate system. Nandha and Hammoudeh (2007) investigated the effect of oil price
changes on exchange rate (Australia, China, Hong Kong, India, Indonesia, Japan, Malaysia, New
Zealand, Pakistan, Philippines, Singapore, South Korea, Sri Lanka, Taiwan, and Thailand) over
the period May 1994 to June 2004.
28
Indian Rupee (INR) is the official currency of India. Indian currency is a managed float. RBI
trades frequently on USD/INR, thus it is a de facto controlled exchange rate. Other rates (such as
the EUR/INR and INR/JPY) have the volatility typical of floating exchange rates. Ghosh (2011)
studied relationship between the crude oil price and USD-INR for the period starting from 2nd
July 2007 to 28th December 2008.
Japanese Yen (JPY) is the currency for Japan. The country adopted a floating or fluctuating
exchange rate system. Nakajima and Hamori (2012) studied the casualty between crude oil and
JPY/USD exchange rate. The data period considered for the study spans from 1st September
2005 to 29th July 2011.
South Korean Won (KRW) is the currency of South Korea. They have allowed free-float
exchange rate from 1997. Masih et al. (2011) studied the implications of oil price fluctuations
and oil price volatility on exchange rate of South Korea.
Singapore Dollars (SGD) is the currency of Singapore. It follows a managed float exchange rate
system.
Turkish Lira (TRY) is the official currency of Turkey and the Turkish Republic of Northern
Cyprus. It follows free-float exchange rate system. Soytas (2011) examined the long-run and
short-run transmissions of information between the world oil price, Turkish interest rate, Turkish
liraUS dollar exchange rate, and domestic spot gold and silver price.
New Taiwan dollar (TWD) is the official currency of the Taiwan Area of the Republic of China.
They adopted free-float exchange rate system since 1989. Rafiq et al. (2009) empirically
examined the impact of oil price volatility on key macroeconomic indicators of Thailand.
The sample stock indices that were considered for the study are as follows. Nikkei 225 index
(Japan NKY), NIFTY 50 (India NIFTY), LQ45 index (Indonesia LQ45), Korea Composite Stock
Price Index (South Korea KOSPI), IBEX 35 (Spain IBEX), FTSEMIB 40 (Italy FTSEMIB),
Straits Times Index(Singapore FSSTI), DAX 30 (German DAX), CAC 40 (France CAC), BEL20
index (Belgium BEL20), Amsterdam Exchange index (The Netherlands AEX), Standard &
Poor's 500 (US SPX), Shanghai Stock Exchange 50 (China SSE50), Taiwan Stock ExchangeWeighted Index (Taiwan TWSE), Borsa Istanbul 100 Index (Turkey XU100). The sample period
29
includes from 4th January 2000 to 30th December 2014 for all the indices except for SSE 50.
Sample period for Stock index of china (SSE50) starts from 5th January 2004 to 30th December
2014. The exchange rate and stock index data is collected from the Bloomberg database. Table
1.5 summarizes the stock index data.
Table 1.5 Stock Index data
Index
Country
Index name
NKY
Japan
Nikkei 225
NIFTY
India
NIFTY 50
LQ45
Indonesia
LQ 45
KOSPI
Korea
Korea Composite Stock Price Index
IBEX
Spain
IBEX 35
FTSEMIB
Italy
FTSE MIB 40
FSSTI
Singapore
Straits Times Index
DAX
Germany
DAX 30
CAC
France
CAC 40
BEL20
Belgium
BEL20
AEX
Netherland
Amsterdam Exchange index
SPX
US
Standard & Poor's 500
SSE50
China
Shanghai Stock Exchange 50
TWSE
Taiwan
XU100
Turkey
Taiwan Stock Exchange Weighted

Index
Borsa Istanbul 100
NIFTY 50 is a most liquid and benchmark index for an Indian equity market. The NIFTY is
traded on National Stock Exchange (NSE). It comprises of 50 large stocks listed on NSE. It
covers 22 sectors in Indian Economy also represents major sectors such as automobile, banking,
information technology, infrastructure, oil & gas, and pharmaceuticals, etc. It started in the year
1995 and the base value was set at 1000. It is a free-float market capitalization-weighted index.
30
Standard & Poor's 500 is an American Stock Market index. It comprises of 500 large
companies (based on their market capitalization), that are listed on either New York Stock
exchange (NYSE) or National Association of Securities Dealers Automated Quotations
(NASDAQ). It is a free-float capitalization-weighted index. The index was in existence from
1957. The components of the S&P 500 are selected based on eight parameters. They are market
capitalization, liquidity, domicile, public float, sector classification, financial viability, length of
time publicly traded, and listing exchange.
LQ 45 index is Indonesian index. It was launched in February 1997. It comprises of 45 most
liquid companies listed on the Indonesia Stock Exchange. It is a market capitalization-weighted
index. 13 July 1994 was used as the base day, with an index base value of 100. It consists of
major sectors such as agriculture, finance, mining, infrastructure, etc. It captures 70 % of the
domestic market capitalization.
Nikkei 225 index is a stock market index for Japan. It comprises of 225 top companies that are
traded on the Tokyo Stock Exchange (TSE). The components of the index are reviewed once a
year. It is a price-weighted index. The Nikkei 225 Started on 7 September 1950.
Korea Composite Stock Price 200 Index (KOSPI 200) is the index of South Korea. It
comprises of 200 large publicly-traded companies on the Korean Stock Exchange. This is market
capitalization-based weighted index. KOSPI was introduced in 1990. The base value of the index
was 100. It has over 70% market value of the composite stock price index which includes all the
stocks that are traded on the Korean Stock Exchange, and so moves along with the KOSPI index.
IBEX 35 is the benchmark stock market index of Spain. The index comprises of 35 most liquid
Spanish stocks that are traded on Madrid Stock Exchange General Index. It was initiated in 1992.
It is a market capitalization-weighted index. The index is reviewed twice annually.
FTSE MIB 40 is the primary bench mark stock market index of Italy. The index consists of the
40 top liquid stocks that are traded on the Borsa Italiana, the Italian national stock exchange. It
represents the large cap component of the FTSE Italia All-Share Index. It captures approximately
80% of the domestic market capitalization. It replicates the sectorial weights of the Italian stock
market. It is free-float market capitalization-based index.
31
Straits Times Index (STI) is the benchmark index for the Singapore stock market. It is market
capitalization-weighted stock market index. It constitutes the top 30 liquid companies that are
listed and traded on the Singapore exchange. It is jointly calculated by Singapore Press Holdings
(SPH), Singapore Exchange (SGX), and FTSE Group (FTSE). STI replaced the Straits Times
Industrials Index (STII) and began trading on 31 August 1998 at 885.26 points. It represents 75%
of the total market capitalization
Deutscher Aktienindex (DAX 30) is the benchmark index of Germany. It consists of 30 major
German companies trading on the Frankfurt Stock Exchange. The Base date for the DAX is 30
December 1987 and it was started with a base value of 1,000. It is market capitalizationweighted index.
Cotation Assiste en Continu (CAC 40) is the benchmark index of France stock market. It
started with a base value of 1,000 on 31 December 1987. The index represents a free-float
market capitalization-weighted measure of the 40 most significant stocks among the highest
hundred market capitalization stocks on the Euronext Paris.
BEL20 index is the benchmark index of Euronext Brussels. In general, the index consists of a
minimum of 10 and a maximum of 20 top companies traded at the Brussels Stock Exchange
(Belgian Equity Market). Since 20 June 2011, the BEL20 has contained 20 constituents. It is a
capitalization-weighted index and is reviewed annually.
Amsterdam Exchange index (AEX) is the benchmark index of the Netherlands. The index is
composed of Dutch companies that trade on NYSE Euronext Amsterdam Exchange (Amsterdam
Stock Exchange). This index began in 1983 with a base index value of 100. It contains a
maximum of 25 of the most actively traded securities on the exchange. It is a market
capitalization-weighted index.
Shanghai Stock Exchange 50 (SSE 50) is the stock market index of China. The index is
composed of 50 most representative stocks of the Shanghai security market. It was launched in
2004 with a base value of 1000. It is a free-float market capitalization-weighted index.
32
Taiwan Stock Exchange-Weighted Index (TAIEX) is a stock market index for Taiwan. It
comprises of all the companies that are traded on the Taiwan Stock Exchange (TWSE). It covers
all of the listed stocks excluding the stocks, which are listed for less than one calendar month. It
began in 1967 with 1966 as the base year with a base value of 100. It is a market capitalizationweighted index.
Borsa Istanbul 100 Index (XU 100) is the stock market index of Turkey. It tracks the
performance of hundred major companies that are traded in Istanbul Stock Exchange. It is a
market capitalization-weighted index. The index was started in January 1986.
1.8 Measurement of Variables
WTI oil price: Different crude oil benchmarks available, the price of that benchmark wary based
on the API gravity and sulfur quantity. These prices are highly correlated and modeling using any
one benchmark crude oil price does not affect the analysis substantially (Dauvin, 2014). The
study has used West Texas Intermediate (WTI). WTI crude oil gives the benefit of measuring the
speculative activity by using the data released by CFTC on the non-commercial traders activity
(Isabel Vansteenkiste, 2011; Fattouh and Mahadeva, 2012). Fattouh (2007) compares the
dynamics of different crude oil benchmarks and concludes that they are strongly co-integrated.
OPEC production measures the actual production of the OPEC nations. OECD Inventory acts
as balance for oil importing country from any supply disruptions. Past studies have built
inventories based forecasting models (Ye et al., 2002, Breitenfellner et al., 2009; Chevillon and
Rifflart 2009).
OECD consumption and imports measure the actual demand from developed economies and
demand from emerging economy. Industrial production of China and India, are included as
they are the two major oil consuming and importing countries outside the OECD region.
Supply Disruption variables such as Hurricane and War. Basis is the proxy for the net
convenience yield. It is the marginal gain out of holding physical commodity. The basis is
calculated as the difference between spot price and futures contract price for 12 months ahead,
which is traded now.
33
Stock market Index (S&P 500) is the proxy for the growth of the economy and is an alternate
investment vehicle (Cifarelli and Paladino, 2010; Breitenfellner et al., 2009)
Trade-weighted US dollar index (Broad) as a measure of strength or weakness of US dollar
against major currencies. As world crude oil market transaction happens in US dollars, it is
important to take note of the dollar into account, so the study has incorporated trade-weighted
US dollar index into the model. He et al. (2010) investigate the relationship between real
economic activity and oil prices and found that real oil future prices are co-integrated with the
real economic activity index and a trade-weighted US dollar index.
Fattouh and Mahadeva (2012) used Non-commercial Net long position in their paper as
measure of speculation activity and found highly leveraged speculators could disrupt oil price
movements.
1.9 Methodology
The study analyzes the relative importance of the determinants of crude oil in both high- and
low-volatility regimes. Past studies have used Markov regime switching models to analyze
structural breaks, non-linearity and asymmetry (Hamilton, 1989; Gray, 1996; Krolzig, 1998;
Krolzig, 2000; Artis et al., 2004). Markov Regime Switching methodology was applied to
investigate the key determinants of crude oil price.
Measuring the Marginal Effect of Speculation
The speculative factors that impact the crude oil price are examined using the following model:
WTI oil=Intercept + 1 NC NET LONG POS +
WTI crude oil price is used as dependent variable. NC NET LONG POS represents noncommercial traders net long position.
have to be estimated.
is the coefficient of the independent variable and
represents the error term.
Speculation on Oil Price

The effect of speculative factors on crude oil price after controlling for the financial factors is
estimated using the following model:
34
WTI oil=Intercept + 1 NC NET LONG POS + 2 SP500+ 3 Dollar Index+ 4 12 M Basis+

WTI crude oil price is used as dependent variable. NC NET LONG POS represents noncommercial traders net long position, S&P500 represents the S&P 500 index, Dollar index
represents the Trade-weighted US dollar index (Broad) and 12M Basis represents the 12-month
basis between WTI crude oil Futures and Spot.
1, 2, 3 , 4
independent variable respectively, and have to be estimated.
are the coefficients of the
represent the error term.
Relative Importance of Determinants of Oil Price

The fundamental, financial, and speculative factors of crude oil are analyzed to understand the
relative importance of these factors. It is investigated using the following model:
WTI oil=Inte rcept + 1 NC NET LONG POS + 2 SP 500+ 3 Dollar Index+ 4 12 M Basis+ 5 Lagged WTI + 6
WTI crude oil price is used as dependent variable. NC NET LONG POS represents noncommercial traders net long position, S&P500 represents the S&P 500 index, Dollar index
represents the trade-weighted US dollar index (Broad), 12M Basis represents the 12-month basis
between WTI crude oil Futures and Spot, lagged WTI represents the lagged values of the crude
oil price, OPEC Prod represents the OPEC Production, OECD Cons represents the OECD
Consumption, OECD stk represents the OECD Stock, Net Imp represents the total Net Imports,
Ind Prod India represents the Industrial production of India, and Ind Prod China represents the
Industrial production of China.
1 , 2 , 3 , 4 , 5 , 6 , 7 , 8 , 9 , 10 , 11
the independent variable, respectively, that have to be estimated.
are the coefficients of
represents the error term.
1.10 Outline of the Thesis

The remainder of the thesis is organized as follows. A detailed review of literature and empirical
framework on the determinants of crude oil is presented in Chapter 2. Chapter 3 presents the
interdependence of the crude oil with macro-economic variables such as exchange rate and stock
35
market indices. A detailed discussion on the results of each objective is discussed in the
respective chapters. Chapter 4 summarizes the study and presents the implications, contributions
and conclusions. Limitations of the study and scope for further research are also discussed in
Chapter 4.
Chapter 2
36
Determinants of oil price: A Markov-regime switching

approach
2.1 Importance of oil price determinants
Crude oil price plays a significant role in the world economy and has always been in the
forefront of discussions, regardless of the macroeconomic situation that prevails in both
developed and developing economies. Historically, during 1980s and 1990s oil price was
relatively stable and low. As a result, very minimal attention was paid to understand the price
dynamics of crude oil (Isabel Vansteenkiste, 2011). Surge in oil price is driven by strong demand
factors as well as by the production cuts announced by some of the OPEC member countries.
Increased participation from financial institutions in the derivative segment, which does not
require the physical delivery of commodities, played an active role in establishing the price of
crude oil. As the oil prices are largely determined by market forces, they are subject to high
variability. The economy becomes more difficult to manage when the oil prices remain highly
volatile, as higher volatility in crude oil prices, have greater ramifications for different players in
the economy and managing current account balance for governments becomes a challenge.
Precise estimation of the factors that affect the crude oil price helps in understanding the
dynamics of crude oil price movements and helps in managing the risk pertaining to volatile oil
prices. The determinants of the crude oil price in the high-volatile period might be different from
low-volatile period, and may differ during different economic phases. We differ from prior
research, by investigating the effect of fundamental, financial and speculative factors on the
crude oil prices.
Specifically, the objectives that are addressed in this chapter are as follows:
(i)
(ii)
The effect of speculative factors on the oil price,

The effect of speculative factors on the oil price controlling for financial factors, and
finally,
37
(iii)
The impact of fundamental, financial and speculation factors on WTI oil price at highand low volatility regimes.
policy, changes in the business cycles and economic down turns. As the behavior of the oil price
determinants changes over time, understating the oil price and its determinants behavior with
respective regimes becomes crucial. Using ordinary regression models fail to identify the
dynamic linkage between oil prices and its determinants across regimes. Markov Regimeswitching model provides a flexible framework to model structural breaks, dynamic shifts and
dynamic relationships. Hence, Markov Regime-switching model was used to examine the
determinants of WTI oil prices at high and low volatile regimes.
Empirical results of our study indicate that speculative factor plays an important role only in high
volatile state. Whereas in low volatile state fundamental, and financial factors a major role in
determining the oil price. The study provides a holistic view about price formation in the crude
oil market by incorporating determinants from fundamental, financial and speculative factors.
The study has implications for policymakers, financial institutions and investors, as we indicate
the determinants that affect the crude oil price for each regime separately.
The remainder of this chapter is organized as follows: Section 2.1 describes a brief literature on
determinants of crude oil, elaborates research gap and motivation. Section 2.3 discusses the
framework of the study. Section 2.4 presents the data. Section 2.5 explains the Methodology.
Section 2.6 discusses the empirical results and Section 2.7 concludes the chapter.
2.2 Literature on factors influencing Crude Oil
The price fluctuations in the crude oil market are either due to changes in fundamental factors or
financial factors or due to speculation activities. Previous literature analyzed the crude oil price
to determine the factors affecting the crude oil price (Ye et al., 2002; Breitenfellner et al., 2009;
Isabel Vansteenkiste, 2011). But, the literature is inconclusive in demonstrating what drives the
crude oil prices.
38
Ye et al. (2002) forecasted the WTI crude oil spot price considering OECD petroleum inventory
levels as independent variable. They have used monthly data of the oil price and petroleum
inventory over the period starting from January 1992 to February 2001. Their results indicated
that change in oil price is better estimated using the level of Petroleum inventory.
Isabel Vansteenkiste (2011) analyzed the significance of speculative and fundamental demand
factors on the oil price and volatility over the period January 1992April 2011. Markovswitching model was used to investigate the relative importance of underlying speculative and
fundamental factors on the oil price and volatility. They found that fundamental factors has
significant role in accounting the change in the price of crude oil price compared to the
speculative factors.
Askari and Krichene (2008) used daily Brent futures oil price from 2nd January 2002 to 7th July
2006 to study the dynamics of the oil prices using Jump diffusion process and levy process. They
found that dynamics in the oil prices are due to strong upward drift and frequent jumps.
Breitenfellner et al. (2009) used fundamental and speculative factors to identify the factors that
drive the oil prices. The fundamental and speculative factors include Federal fund rate, 10-year
bond, US inflation, M2 growth, EMBI, EMBI spread, Energy intensity (world ), Energy intensity
(North America), Temp., GDP growth (China), GDP growth (EURO,G7,OECD,OECD Europe),
GDP growth (OECD Europe), Oil rigs, Gas rigs, Refining capacity, Oil reserves, Oil supply, Oil
stocks, Capacity utilization, Exploration cost, Baltic dry index, Dummy (hurricane, war), OPEC
reserves, Saudi quota, S&P 500, NEER, REER, Lagged oil price, and variables pertaining to
OPEC structure. Bayesian model averaging technique is used for their study. The data period
considered spans from 1985 to 2008. He found that in 1990s and in 2000s, fundamental factors
played a significant role in driving the oil prices.
Lin and Tamvakis (2010) applied event study methodology to study the effect of OPEC
announcements on the World Oil prices. The study used daily data of different crude oil
benchmarks such as Alaska North Slope, Brent blend, Bonny Light, Dubai Fateh, Flotta, Forties,
Iranian Heavy, Iranian Light, Minas, Oseberg, Sahara blend, Tapis, Urals, CPC , WTI, and West
Texan Sour. The sample considered is from 1st May 1982 to 31st December 2008 and OPEC
conference/Announcements days from 21st May 1982 to 31st December 2008. They found that
39
OPEC announcements have significant effect on the oil prices. But the magnitude of the effect is
based on the previous price regime. They also found that Quota cuts lead to positive price
returns. Quota increases lead to negative price returns in weak and normal price regimes. No
change in Quota leads to insignificant or negative price returns.
Cifarelli and Paladino (2010) investigated the effect of speculation on oil price fluctuations. They
have considered the weekly prices of the WTI Oil Spot, Futures, Dow Jones Industrial Index, and
US Dollar nominal effective exchange rates for their study. The data period spanned from 6th
October 1992 to 24th June 2008. Their empirical results indicated that oil price has significant
Inverse or negative relationship with stock price as well as with exchange rate changes. They
also alleged that speculation plays an important role in the oil market.
Santis (2003) analyzed the fundamental factors that affect the crude oil price. The supply and
demand shocks considered are created by simulating world oil demand, Non-Saudi oil supply
and Saudi oil supply for 1990s Social accounting matrix of Saudi Arabia. The author explained
the fluctuations in the crude oil prices using computable general equilibrium model and indicated
that there is an incentive to intervene in case of negative demand shock and disincentive to
intervene in case of positive demand shock. The author also found that there is no incentive in
case of either positive or negative supply shock.
Kilian and Lee (2014) analyzed the role of Inventories in the determination of real oil prices.
Supply and demand factors over the period starting from February 1973 to May 2012 are
considered for the study. They used VAR, and sensitivity analysis to model the oil price. They
found that Flow Demand shock is the primary driver in all periods and has positive effect on oil
price. They also indicated that Flow supply shock has positive impact on oil price. They alleged
that speculative demand shock has positive impact on oil price, but persists only for very short
span.
Chang et al. (2013) analyzed interactive relationships between the crude oil prices, gold prices,
and the NTUS dollar exchange rate. The data sample spans from 9th March 2007 to 28th
December 2011. They have used various methodologies to find this relationship. The
methodologies are Granger causality test, Johansen co-integration test, VAR model, impulse
response analysis, and variance decomposition method. They found bi-directional relationship
40
between the oil and exchange rate. No Co-integrating relationship is observed among these
factors. The Oil and exchange rate had Inverse relationship; rise in the oil price depreciates the
Dollar exchange rate against Taiwan currency.
Basher et al., (2012) studied the dynamic relationship between the oil price, exchange rate, and
emerging market stock prices during the period January 1988 to December 2008. They have
considered supply, demand and financial variables for the study. They have estimated the
relationship using Structural VAR. No Co-integration has been found among the variables. They
also observed that the rise in the oil price tend to depress emerging market stock prices. They
noted that positive oil price shock lead to an immediate drop in the trade-weighted exchange rate
and depreciation of currencies of oil importers in the long run.
Miller and Ratti (2009) analyzed the long-run relationship between the world price of crude oil
and stock markets over the period starting from January 1971 to March 2008. Variables used in
the study are stock indices, interest rates, Industrial production, and World crude oil price. Vector
Error correction model is used to study the relationship. Their empirical results confirmed the
existence of long-run relationship among the variables and structural Breaks They also found that
the increase in oil price has negative effect on stock Indices.
Chevillon and Rifflart (2009) analyzed the real rice of crude oil focusing on physical market.
Their data spans from 1st quarter 1989 to 4th quarter 2005. VAR methodology is applied to
analyze the real oil price using supply and demand variables. They found that the expected
demand coverage ratio, Non-OECD Stocks has negative effect on oil price. Whereas, OECD oil
demand, Non-OECD oil demand has positive effect on oil price. It is also found that Invasion of
Kuwait has positive effect whereas the Invasion of Iraq has negative effect on oil price. They
also found that Co-integrating vectors of OPEC quotas and price and target has negative effect
oil price whereas the Co-integrating vectors of OECD stocks and demand has positive effect on
the oil price
Kaufmann and Ullman (2009) examined the causal relationships between prices of the crude oil
in various markets. The sample data of their study consists of spot oil data starts from2nd
January 1986 for WTI and Dubai-Fateh, 20th May 1987 for Brent-Blend, 22nd August 1988 for
Bonny Light, and 2nd January 1991 for Maya. The futures data starts from 1st July 1986 for
41
WTI, 3rd April 2006 Dubai-Fateh, and 23rd June 1998 for Brent-Blend. Spot, near month and far
month oil prices are considered for the study. Modified Test for Co-Integration (Granger and Lee,
1989) is used for finding Long-run relationship and decomposing the residual for getting the rate
of adjustment. They confirmed the existence of Co-integration relationship among all the crude
oil benchmarks.
Kilian (2009) examined the role of Demand and supply shocks in explaining fluctuation in the
real oil price over the period starting from January 1973 to December 2007. The author used
Structural VAR methodology and found that the crude oil supply shocks effects positively. But
the magnitude of the effect is minimal with respect to supply shocks. Finally, the author alleged
that the oil-specific demand shock also has positive effect on the crude oil price.
Fattouh and Mahadeva (2012) analyzed the role of speculative factors in determining the price of
the crude oil. Their empirical results indicated that the surge in the oil price is due to the
fundamental factors rather than financialization of oil.
Kilian and Murphy (2010) developed a structural model to analyze the impact of fundamental
and speculative factors on the global crude oil market. They postulated that the oil price shock
during 20032008 is due to the increased consumption of the oil price but not due to speculative
trading. Monthly data of the real crude oil price, crude oil production, crude oil inventory,
fundamental supply and demand, and speculative demand over the period February 1973 to
September 2009 are considered for the study.
Hamilton (2008) examined the factors responsible for the oil price shock of 2008. They found
three important features that accounted for the increase in oil price. They are:(i) increased oil
consumption from china, Middle East and some other countries, (ii) failure to increase global
production, and(iii) low price elasticity. The author postulates that in theory, speculative trading
can influence the oil prices without any change in fundamental factors if the short-run price
elasticity of demand is very low
Hamilton (2009) investigated the causes of price shock and its impact on economy. The oil price
shock of 20072008 is compared with the earlier oil price shocks. The author postulated that
market participants have miscalculated the long-run price elasticity of oil demand. The author
42
also hypothesized that speculative investing in oil futures might have contributed to that
miscalculation.
Sornette et al. (2009) analyzed the oil prices during the global financial crisis (2008). They
postulated that the oil price shock during 20062008 is due to the speculative factors rather than
due to the oil supply and demand dynamics.
Fan and Xu (2009) analyzed the structural transformation of market mechanism and its impact
on the oil prices and volatility. The study sample starts from 07 January 2000, to 11 September
2009. They have divided the data into three periods, namely: (i) calm market, (ii) Bubble
accumulation, and (iii) Global crisis. Their empirical results indicated that speculation is the
main key driver during the Relatively calm market period, i.e., from 7 January 2000 to 12
March 2004, speculation and episodic events were the main drivers affecting the oil price
changes. During the Bubble accumulation period, i.e., from 12 March 2004 to 6 June 2008, as
large amounts of funds flooded energy markets, speculation became important drivers affecting
oil price changes. The supplydemand fundamental played a less role than financial market
fundamentals, and speculative factors before 2008. After 2008, the supply and demand
fundamentals and recovery level of the world economy dominated the trend of the oil price,
whereas other financial market fundamentals such as speculation hardly affected oil price
changes due to the withdrawal of speculative funds.
Qiang Ji (2012) analyzed the important factors driving the crude oil prices using integrated
partial least squares vector error correction model. The author investigated contemporaneous
information transmission mechanism, explanatory power of factors for the oil price trend and
their contributions to the oil price volatility. Results indicated that the relationship between
various factors and the oil price was strengthened after the global financial crisis (2008). The
author postulated that before the crisis, speculation contributed to the oil price volatility in the
short-run. But, in the long run the fundamental factors played a crucial role. Spillover effect of
various markets contributed to the volatility of oil price after the crisis. Data are divided into two
sub-periods: before crisis 2 January 200425 July 2008 and after crisis 1 August 200826
November 2010.
43
2.2.1
Research Gap and Motivation
Previous studies examined the role of fundamental, financial and speculative factors in
estimating the crude oil price. But, there is no consensus on factors that determines crude oil
price.
Most of the previous studies focused on oil supply and demand factors and provide evidence that
fundamental factors are the key drivers of oil prices (Chevillon and Rifflart, 2009; Peltonen et
al., 2011). With respect to crude oil, supply factors such as OPEC production (Chevillon and
Rifflart, 2009) and OECD inventory are found to have inverse relationship with oil prices. In the
demand side, most of the studies have used only OECD consumption and OECD net imports for
determining the residual demand shock and these shocks are found to have positive impact on oil
prices (Kilian and Lee, 2014). Since past studies considered only shocks and studied their effect
on oil price, the main effect of OPEC production, OECD inventory, OECD consumption and
OECD net imports individually has been ignored. Moreover, previous studies paid little attention
to the demand from emerging markets. Hence, there is a need to empirically examine the effect
of individual supply related variables such as OECD inventory and OPEC production and
demand related variables such as OECD consumption and OECD net imports. But, considering
OECD consumption alone is not appropriate, since it excludes major oil consuming countries
like China and India. Hence, use of proxy variables to account for the increasing consumption
from emerging economies such as China and India is pertinent to capture the global consumption
effectively.
Contemporary research in the field of oil price dynamics indicates that financial factors also
affect oil price apart from fundamental factors. Many studies have shown significant impact of
exchange rate on crude oil prices (Basher et al., 2012; Beckmann and Czudaj, 2013), but most of
them have used NEER (Breitenfellner et al., 2009), REER (Oriavwote and Eriemo, 2012;
Breitenfellner et al., 2009) and US dollar exchange rate, which is based on the transaction
between US and its trading partners. Examining the impact of effective exchange rate of dollar
index has limitations in accounting for the global trading of oil in dollars. However, using a
comprehensive measure such as Dollar index (broad) would capture the complete dynamics of
oil trading. Hence, it is pertinent to examine the impact of dollar index (broad) on oil price than
looking at the impact of effective exchange rate on oil prices.
44
Prior research have also found significant impact of stock index on crude oil prices (Basher et
al., 2012; Cifarelli and Paladino, 2010; Breitenfellner et al., 2009). With the advancement of
financialization, forward and futures market impact oil prices. If the expected future oil spot
price is greater than the futures price, there will be a premium to extract oil from well. But, the
impact of spread between the current spot price and a year ahead futures price of oil has not been
considered by prior studies. Considering 12-month basis which measures the premium of
holding/ storing a crude oil rather than a derivative product may provide more insight on crude
oil price discovery.
Sornette et al., (2009) postulated that the oil price shocks during crisis are due to speculative
factors and speculative trading can influence the oil prices without any change in fundamental
factors (Hamilton, 2008). Speculation variable such as feedback trading was found to have
negative effect on oil prices (Cifarelli and Paladino, 2010). While, non-commercial net long
positions (futures) are found to have positive effect oil price (Fattouh et al., 2012). With the use
of call option and put option and extensive building up of positions in put or call can impact oil
prices significantly. Hence, capturing speculation ignoring options will not be meaningful.
Speculative activity based on non-commercial net long positions (futures and options) may
capture the impact of speculation on oil price more effectively.
policy, changes in business cycles and economic downturns. As the behavior of the oil price
determinants change over time, understating the oil price and its determinants behavior with
respective regimes becomes crucial. Using ordinary regression model fails to identify the
dynamic linkage between oil prices and its determinants across regimes. Most of the existing
literatures examine the relationship using traditional linear time series models such as VAR/
VECM, co-integration and structural VAR. However, oil price is found to have structural breaks
and may not be linear and most of the studies examine casual/ long term relationship of crude oil
with only one or few variables. Linear models could suffer from possible misspecification or
omitted variable bias and the relationship between oil price and determinants may vary over
time. Incorporating or using the model, which accounts for structural break and capturing the
effect at different periods would help in accurate estimation of oil price. Very few studies have
45
used nonlinear models such as CCC - GARCH-M and Bayesian Model averaging (Breitenfellner
et al., 2009). However, these models cannot estimate the relationship with respect to different
market phases and fail to address structural breaks in the data. Markov Regime-switching model
provides a flexible framework to model structural breaks, dynamic shifts and dynamic
relationships. Markov-regime switching methodology is largely used for finding non-linear
causality (Fallahi, 2011) and volatility (Naifar and Dohaiman, 2013), but has not been used to
estimate the effect of multiple factors on oil prices at different regimes. Hence, there is a need to
investigate the nonlinear relationship and comovement between crude oil and its determinants at
different volatile regimes using Markov switching model which will account for structural
breaks, nonlinearity and various regimes.
Most of the previous studies focused on Supply and demand variables and indicated that
fundamental factors are the key drivers of oil prices (Chevillon and Rifflart, 2009; Isabel
Vansteenkiste, 2011; Kilian, 2009). Demand shock have positive effect on oil price (Kilian and
Lee, 2014; Kilian, 2009). Cuts in OPEC quota leads to increase in oil prices and increase or
stagnant OPEC quota tend to have negative effect on oil price (Chevillon and Rifflart, 2009; Lin
and Tamvakis, 2010). Contemporary Research in the field of oil price dynamics indicates that the
speculative factors and financial factors also have significant impact on oil price apart from
fundamental factors.
Financial factors such as exchange rate and stock returns determine the crude oil price (Amano
and Van Norden, 1998; Narayan et al., 2008; Basher et al., 2012; Beckmann and Czudaj, 2013;
Wang and Wu, 2012). Increase in emerging market stock prices increases oil prices (Basher et
al., 2012). Moreover, the stock returns of large oil producing and consuming countries have
relatively strong dependence with oil price (Sukcharoen et al., 2014). Speculative trading can
influence the oil prices without any change in fundamental factors (Hamilton, 2008). Sornette et
al. (2009) postulated that the oil price shocks during crisis are due to speculative factors.
Some studies argue that fundamental factors play major role compared to speculative factors
(Breitenfellner et al., 2009; Fan and Xu, 2009). Whereas other studies suggested that speculative
factors play a significant role compared to fundamental in the oil market (Askari and Krichene,
2008; Cifarelli and Paladino, 2010, Sornette et al., 2009). Hence, it is required to determine the
drivers of crude oil in different market phases to understand the oil price dynamics.
46
To ascertain the effect of fundamental factors, we have used the variables such as OPEC
production, OECD stocks, OECD Net Imports. The major demand for oil comes from emerging
economies and OCED countries. To estimate the demand from OECD countries we consider
OECD consumption. Since the consumption data for the emerging economies is non-existing,
Industrial production of China (in $) and industrial production of India (in $) is considered as
proxy for the demand from emerging countries. However, variables such as industrial production
of China (in $) and industrial production of India (in $) were not used in the literature. We find
the relative effect of the variables across periods of low and high volatility.
Existing literature used financial variables such as S&P 500 (Cifarelli and Paladino, 2010), Realemerging equity prices (Basher et al., 2012), Dollar Index (Basher et al., 2012), NEER, REER
(Breitenfellner et al., 2009), Lagged oil price (Breitenfellner et al., 2009), OPEC implicit price
target (Chevillon and Rifflart, 2009). In our study, we have included financial variables such as
S&P 500, Dollar Index and a 12-month basis. In order to capture the speculative effect we have
included non-commercial net long position (both futures and options), as existing net long
position influences the price movements of the security.
Most of the existing literature examined this relationship majorly using traditional linear time
series models such as VAR/ VECM, co-integration and structural VAR. Oil price is also found to
have Breaks and long-run relationship in the variables (Miller and Ratti, 2009). Hence these
linear models suffer from possible misspecification or omitted variable bias. Moreover, the
relationship between oil price and other determinants may vary over time. Incorporating or using
the model, which accounts for structural break and the effect could change at different periods
would help in accurate estimation of oil price.
Very few studies have used nonlinear models such as CCC - GARCH-M and Bayesian Model
averaging. However, these models cannot estimate the relationship with respect to different
market phases; also, they fail to address breaks. Markov-regime switching methodology is
largely used for finding non-linear causality (Firouz Fallahi, 2011) and enables one to estimate
the relationships at different regimes. Hence, the study used Markov regime switching model to
investigate the nonlinear relationship between the crude oil and its determinants at different
regimes. The literature is summarized in Table 2.1.
47
Table 2.1: Summary of literature on determinants of the crude oil
Authors
Kilian and
Lee (2014)
Chang et al.
(2013)
Sample
February
1973 to May
2012
9th March
2007 to 28th
December
2011
Objective
Determinants
Role of Inventories for

the determination of the
real oil prices
Fundamental:
Global crude oil
production; Global real
economic activity
Other factors:
Real price of the crude
oil, global crude oil
inventories, and EIG alternate inventory proxy
1. Flow supply
Shock,
2. Flow demand
shock,
3. Speculative
demand shock.
Interactive relationships
between the crude oil
prices, gold prices, and
the NTUS dollar
exchange rate
Financial:
NTUS dollar exchange
rate (Nominal)
Other factors:
Gold price @ LME spot
price and oil price Arab
and Brent
48
Model
Results
VAR and sensitivity

analysis
1. Flow Demand shock

(+) primary driver in
all periods
2. Flow supply shock (+)
3. speculative demand
shock (+) for very
short span
Granger causality,
Johansen cointegration, VAR,
impulse response
analysis, and
variance
decomposition
1. Bi-directional
relationship between
Oil and Exchange rate,
Gold Causes Exchange
rate.
2. No Co-integrating
Relationship
3. Oil and Exchange rate
had Inverse
relationship (i.e.) rise
in oil price will lead to
Dollar exchange rate to
depreciate against
Taiwan currency
Basher et al.,
(2012)
Lin and
Tamvakis
(2010)
January
1988
December
2008
Relationship between oil

price, exchange rate, and
emerging market stock
prices
1st May 1982

to 31st
December
2008
Investigate the effects of

OPEC announcements on
the World oil prices
Fundamental:
Global crude oil
production; Global real
economic activity
Structural VAR
1. No co-integration
among the variables.
2. Rise in oil price tend to
depress emerging
market stock prices
3. Positive oil price shock
leads to an immediate
drop in the tradeweighted exchange rate
and in the long-Run
Depreciation of
currencies of oil
importers
Event study
methodology (Brown
and Warner, 1980)
1. Cuts (+)
2. Increase()
3. No change ()
Multifactor
behavioral ICAPM
(CCC-GARCH-M
Procedure)
1.
2.
3.
4.
Vector error
correction model
1. Presence of Breaks and

Long-run relationship
2. Increase in oil price has
an negative effect on
stock Indices
Financial:
Real oil price and US
dollar index
Supply: OPEC Quota

(Cut, Increase and No
change)
Fundamental:
Dow Jones Industrial
Index
Cifarelli and
Paladino
(2010)
Miller and
Ratti (2009)
6th October
1992 to 24th
June 2008
January
1971March
2008
Examine the relationship

between the Oil prices ,
Stock prices, US NEER
Analyze long term

relationship between
world price of crude oil
and stock markets
Financial:
US NEER
Other factors:
dummy for 0708 oil
price spike
Stock indices (US,UK,
Canada, France,
Germany, and Italy),
interest rates and
industrial production
49
CAPM Coefficient (+)

Feedback trading()
dummy(+)
lagged futures (+)
Chevillon
and Rifflart
(2009)
1Q 19894Q
2005
Analyze the real rice of

crude oil with focus on
physical market
Fundamental:
OECD crude oil demand,
Non OECD crude oil
demand, OPEC
production Quotas,
OECD crude stocks and
Non-OECD crude stocks
VAR
Others:
OPEC implicit price
target
Examine causal
relationships between
prices of crude oil in
various market
Near month and far moth

futures for WTI, Brent,
Dubai, spot price of WTI,
Brent, Bonny, Maya and
Dubai
Kilian (2009)
January 1973
to December
2007
Identify Demand and

supply shocks for
explaining fluctuation
in the real oil price
Fundamental:
Crude oil supply shocks,
aggregate demand shockand oil-specific demand
shock
Breitenfellne
r et al.,
(2009)
January 1983
to December
2008
Understand the factors

driving the crude oil
prices
Kaufmann
and Ullman
(2009)
Spot and
futures data
Fundamental:
Federal fund rate,10-year
bond, US inflation,M2
growth, EMBI, EMBI
spread, Energy intensity
(World and North
America),Temp, GDP
growth (china, euro, G7,
OECD, OECD Europe),
oilrigs, gas rigs, refining
50
1. Expected demand
coverage ratio()
2. Non OECD Stocks()
3. OECD Oil Demand(+)
4. Invasion of Kuwait (+)
5. Invasion of Iraq ()
6. Co-integrating vectors
of OPEC quotas and
price and target ()
7. Co-integrating vectors
of OECD stocks and
demand(+)
Modified Test for CoCo-integration exists between

Integration(Granger
all the crude oil benchmarks
and Lee, 1989)
Structural VAR
Bayesian Model
averaging
1. Crude oil supply

shocks (+) Very
minimal increase
2. aggregate demand
shock (+)
3. oil specific demand
shock (+)
1. Saudi prod Quota ()
2. US Inflation ()
3. GDP OECD (+)
4. Refining capacity ()
capacity, oil reserves, oil

supply, oil stocks, capacity
utilization, exploration
cost, Baltic dry index,
dummy (hurricane, war),
OPEC reserves, OPEC
quota, Saudi quota and oil
supply (OPEC share)
Other factors:
NEER, REER,S&P, Net
positions, and Lagged oil
price.
Akram
(2009)
Santis (2003)
January 1990
April 2007
1990 (Social
Accounting
Matrix)
Examine the
relationship among
commodity prices,
interest rates and the
dollar
Why crude oil price

fluctuate
Financial:
Real Interest rate, Real
Exchange rate and Real
price of Crude oil, Food,
Metals and Industrial raw
materials
Fundamental:
World oil Demand, Saudi
oil exports and Non-Saudi
oil supply
51
Structural VAR
CGE Model
Reductions in real interest

rates and Weaker dollar leads
to increase in commodity
prices.
1. Negative demand
shock ()
2. Positive demand shock
(+)
3. Shocks cause
overshooting effect on
the oil prices
The hypothesis of our study is as follows:

a. Null hypothesis for the presence linear relationship
H0a: Presence of linear relationship
b. Null hypothesis for the impact of speculative factors on the WTI oil prices
H0b: The coefficient of the speculative variable is zero
c. Null hypothesis for the impact of speculative factor on the WTI oil prices controlling for
financial factors
H0c: The coefficient of the speculative variable is zero controlling for financial factors
d. Null hypothesis for the impact of speculative factors on the WTI oil prices controlling for
Fundamental and Financial factors
H0d: The coefficient of the speculative variable is zero controlling for fundamental and
financial variables.
2.3 Framework of the Study
The determinants of the WTI Oil price such as fundamental, financial, and speculative factors are
analyzed using Markov-regime switching approach. The study examines (i) the effect of
speculative factors on oil price, (ii) the effect of speculative factors on oil price controlling for
financial factors, and (iii) the impact of fundamental, financial, and speculative factors on the
WTI oil price at high- and low-variance/Volatility regimes. The conceptual framework of the
study illustrates the relative importance of fundamental, financial, and speculative factors on the
WTI oil price at high- and low-variance regimes
2.4 Data and Sample
The study focuses on WTI crude oil traded at NYMEX exchange. The fundamental variables
considered in the study are Lagged WTI oil price, OPEC production, OECD Stocks, OECD
consumption, OECD Net Imports, industrial production of China and Industrial production of
India. The speculative variable used in the study is net long positions of non-commercial traders.
The financial variables include 12-month basis, S&P 500 and trade-weighted US dollar Index
(Broad).
52
The data is collected from databases such as Energy Information Agency, World Bank, St. Louis
Federal Reserve (USA) and the US Commodity Futures Trading Commission. Table 1
summarizes the Variables, measurement and its source. Monthly data has been collected for April
1995 to May 2014 and the final sample comprises 229 observations. The monthly returns are
calculated as the difference in the logarithm of two consecutive prices for all the variables.
The data are collected from databases such as Energy Information Agency, World Bank, St.
Louis Federal Reserve (USA) and US Commodity Futures Trading Commission. Table 2.2
summarizes the variables, sample period, and source it is taken from. The monthly returns are
calculated as the difference in the logarithm of two consecutive prices for the entire variables.
ln(yt) ln(yt 1).
2.4.1
Variables:
WTI oil price: The price of oil benchmarks vary based on the API gravity and sulfur quantity.
These prices are highly correlated; hence modeling using any one benchmark crude oil price
does not affect the analysis substantially (Dauvin, 2014). Since the WTI crude oil gives the
benefit of measuring the speculative activity using the data released by CFTC on the Noncommercial traders activity (Isabel Vansteenkiste, 2011; Fattouh and Mahadeva, 2012), the
study has used the WTI crude oil price.
Fattouh (2007) compares the dynamics of different crude oil benchmarks and concludes that they
are strongly co-integrated. Lagged oil prices are used in the literature as an important
determinant of oil price (Breitenfellner et al., 2009; Chevillon and Rifflart, 2009).
Fundamental factors that measure the supply and demand dynamics are incorporated in the study.
OPEC production measures the actual production of the OPEC nations. If the OPEC production
is higher than the equilibrium level then we expect a negative relation () with oil price. If the
OPEC production is lower than the equilibrium level then we expect a positive relation (+) with
oil price.
OECD Inventory acts as balance for the oil-importing country from any supply disruptions. Past
studies have built inventories based price forecasting models (Breitenfellner et al., 2009;
53
Chevillon and Rifflart, 2009; Ye et al., 2002). High Inventory is expected to have negative effect
on the oil prices in the short run ().
OECD Consumption and Imports, measure the actual demand from developed economies and
from emerging economies. Industrial production of China and Industrial production of
India are included in the study, as they are the two major oil consuming and importing countries
outside the OECD region. The demand factors are expected to have a positive effect onthe oil
price (+).
Financial factors which measure oil spot price as an alternate investment vehicle are incorporated
in the study.
Basis is the proxy for the net convenience yield. It is the marginal gain out of holding physical
commodity. The basis is calculated as the difference between spot price and futures contract
price for 12 months ahead, which is traded now. Basis is expected to have a negative relationship
with the WTI oil price in short-run, whereas in the long-run it is expected to have positive
relationship.
Stock market Index (S&P 500) is the proxy for the growth of the economy and it also acts as an
alternate investment vehicle (Cifarelli and Paladino, 2010; Breitenfellner et al., 2009). An
inverse relationship is expected between the oil price and change in stock market Index ().
Relationship between the oil price and exchange rate is extensively studied (Amano and Van
Norden, 1998; Chen and Chen, 2007; Basher et al., 2012; Beckmann and Czudaj, 2013). Tradeweighted US dollar index (Broad) measures the strength or weakness of the US dollar against
major currencies. As the World crude oil market transaction happens in the US dollars, it is
important to take note of the dollar into account, so the study has incorporated trade-weighted
US dollar index into the model. Appreciation of the US dollar is expected to have Negative effect
() on oil price, whereas Depreciation of the US dollar is expected to have positive effect (+) on
the oil price (Basher et al., 2012; Cifarelli and Paladino, 2010; Breitenfellner et al.,2009).
Fattouh and Mahadeva (2012) used Non-commercial Net long position in their paper to
measure of speculation activity. They found that highly leveraged speculators could disrupt oil
price movements. Positive net long positions is expected to increase the oil price (+) and
54
negative net long positions is expected to decrease the oil price ().Table 2.2 summarizes the
variables that are used, sample period considered for each variable and source it is taken from.
Table 2.2: Data Description

DETERMINANTS
SAMPLE PERIOD
SOURCE
04/1995 05/2014
Oil Benchmark
Lagged WTI - SPOT (NYMEX)
Fundamental Variables
Demand Variables
Consumption (OECD)
04/1995 05/2014
Imports (OECD)
04/1995 05/2014
CHINA Industrial Production (US$)
04/1995 05/2014
World bank
INDIA Industrial Production (US$)
04/1995 05/2014
World bank
OPEC Production
04/1995 05/2014
OECD Inventory/ Stock
04/1995 05/2014
Supply Variables
Financialization variables
Dollar Index (Broad)
04/1995 05/2014
S&P 500
04/1995 05/2014
Basis - Oil (Futures) (NYMEX)
04/1995 05/2014
Speculation variables
Net Long Positions (Non-Commercial) Oil
04/1995 05/2014
Commodity Futures Trading Commission
(Futures & Options) (NYMEX)
The table presents the fundamental, financial and speculative variables considered in the study. It also includes their
respective sample periods and the sources from which they are obtained.
55
Fig. 2.1: Impact of Speculation on WTI Crude oil price @ low and high variance states
SPECULATION
WTI Crude oil price
(Spot NYMEX)
Non-Commercial net Long positions - (FUTURES

& OPTIONS, NYMEX)
Fig. 2.2: Impact of Speculation on WTI Crude oil price series controlling for financial
variables @ low and high variance states
FINANCIALZATION
S & P 500
Crude oil price

(Spot NYMEX)
SPECULATION
56
Fig. 2.3: Impact of fundamentals, financial and speculative factors on WTI crude oil price
@ low and high variance states
Fundamental
Oil Benchmark
WTI - Spot price (NYMEX)
DEMAND
OECD Imports
OECD Consumption
Industrial production - India
Industrial production China
SUPPLY
OPEC Production
OECD Stocks
SPECULATON
WTI Crude oil price

(Spot NYMEX)
FINANCIALIZATION
S & P 500
57
2.5 Methodology
2.5.1
BDS Test for Non-linearity
Presence of non-linear dependence in the data is tested using the BDS non-linearity test proposed
by Brock et al. (1987, 1996).The presence of non-linearity is confirmed if the test statistic is
greater than the critical value of the standard normal distribution at the specified confidence
levels. The BDS non-linearity test based on the correlation integral of the time series is as
follows:
Wm ( , T ) =
Where,
T Cm ( , T ) C1 ( , T ) m
m ( , T )
Wm ( , T )
.
(2.1)
represents the BDS test statistic,
m ( , T ) stands for the
standard deviation of Cm ( , T ) , m is the embedding dimension, and represents the maximum

difference between pairs of observations considered in calculating the correlation integral. The
BDS test statistic is asymptotically normally distributed with zero mean and unit variance
[i.e.,N(0,1)]. The null hypothesis of the BDS procedure is that the data are independently,
identically distributed (i.i.d). The null hypothesis of linearity is rejected if the computed test
statistic exceeds the critical value at the convention level. The rejection of the null hypothesis
indicates the presence of non-linear dependence in the data.
2.5.2
The Markov-Switching model

58
Several studies in the literature have used Markov-regime switching models to investigate
nonlinearity and asymmetry (Hamilton, 1989; Gray, 1996; Krolzig, 1998; Krolzig, 2000; Artis et
al., 2004). Hamilton (1989) proposed that Regime shifts in mean and variance in a time series
variable yt can be modeled using Markov-regime switching autoregressive model (MS-AR) of
pth order as follows
yt (st ) +
(y
i
i 1
t 1
(st i )) ( st ) t .
(2.2)
Where i is the slope coefficient of the autoregressive term (y t 1).
and are the mean and
standard deviation based on the state at time t (st. yt represents the WTI crude oil spot price, this
MS-AR methodology allows us to model the potential regime shifts in the crude oil spot price.
Krolzig (1998) developed MS-VAR, which is a generalization of the MS-AR model (Hamilton,
1989) and used to find the causal relationship between endogenous variables. Several existing
literature used MS-VAR for this purpose (Krolzig, 1997; Warne, 2000; Ehrmann et al., 2003;
Psaradakis et al., 2005). In these models, the intercept term, autoregressive slope coefficient and
the error variance are regime dependent. The MS-VAR is modeled as follows:
1
k 1
k 1
k 1
k 1
rt 1 2 j ( st )rt k 3 j ( st ) xt k v( st )ur ,t ,
xt 4 5 j ( st ) xt k 6 j ( st )rt k v( st )u x ,t .
Lets assume
(2.3)
(2.4)
rt and xt are two endogenous variables. utis the innovation process, with variance
v(st) based on the state st at time t, follows an irreducible two-state Markov process defined by
the transition probabilities (Pij) between states as follows:
2
Pij p[ st j s(t 1) i ],
ij
With
j 1
for all i, j {1, 2},
Where,
59
P11 = p(st = 1|s(t 1) = 1)

P12 = 1 P11 = p(st = 1|s(t 1) = 2)
= 1- P21 = 1 P22 = p(st = 2|s(t 1) = 1)
P22 = p(st = 2|s(t 1) = 2).
The MS-VAR model captures potential regime shifts in the data. But ignoring structural breaks in
explaining the data may lead to misleading conclusions. Incorporating the regime switching
feature of the economic process leads to a better forecasting result (Krolzig, 2000). Our model is
the generalization of the MS-VAR model proposed by Krolzig (1997). Using this model, we
explain the dynamics of the WTI crude oil spot price using potential determinants from
fundamental and speculation factors.
n
k 1
k 1
xt 0 kj ( st ) xkt 1 kj d k v( st )u x,t .
(2.5)
Where
kj
is the slope coefficient of the independent variables, which is state dependent (st;
kj
is the slope coefficient of the dummy variables; ut is the innovation process with variance v(st)
based on the state (st). The slope coefficient of the independent variables and the variance of the
error term is state dependent (st). But the intercept and dummy variables are not state dependent.
2.6 Empirical Results
It is evident from the Figure 2.4 (in the appendix) that OECD Consumption, OECD Net Imports
and Inventory are reducing post the financial crisis. It is also observed that supply determinants,
OPEC production and Total oil rig count measure, which measures the level of current
production are increasing post the 2008 financial crisis. The demand factors, i.e., Industrial
production in India and China that measures demand from emerging economies are increasing
with the crude oil prices.
60
The Financial and speculative determinants, i.e., S&P 500 and Non-commercial Net long
positions are moving along with WTI crude oil price. The basis had inverse relationship with the
oil prices before financial crisis but post crisis it has a positive relationship. Trade weighted
dollar index has an inverse relationship (i.e.) Weak dollar tends to increase oil price.
The summary statistics and unit root tests for the logarithmic return series are presented in the
Table 2.3. Excess kurtosis persisted in almost all the variables except OECD consumption and
OECD Net Imports. JarqueBera test statistic confirms that all the determinants are normally
distributed except OECD consumption and OECD Net Imports.
Unit root analysis is accomplished using Augmented Dickey Fuller, Phillip Perron and KPSS
tests to confirm stationarity of the variables. The results indicated that all the variables are
stationary in at least two of the tests and most of the variables are stationary in all the three tests.
Thus the results of these three tests confirm that the variables are free from unit root and can be
used for further analysis.
Fig 2.4: Plot of Determinants of WTI oil
61
WTI CRUDE OIL SPOT PRICE

140
2.0
120
1.5
100
1.0
0.5
0.0
-1
-0.5
-2
-1
-1.0
-1
-3
-2
-1.5
-2
-3
-2.0
80
60
-1
40
-2
-1
-3
-2
20
0
-4
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
-3
-4
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
TOTAL OIL RIG COUNT
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

OECD CONSUMPTION

OPEC PRODUCTION
4 2.8
2.4
2.0
1.6
1 1.2
0.8
-1
0
-1
0.4
-2
-1
-2
-1 0.0
-1
-3
-2
-3
-2
-0.4
-2
-0.8
-3
-4
-3
-4
-3 -1.2
-4
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

OECD IMPORTS
-1
-1
-2
-2
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
TRADE WEIGHTED DOLLAR INDEX
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
WTI CRUDE OIL SPOT PRICES

OECD INVENTORY
-1
0
-1
-3
2.0
1.5
1.0
0.5
0.0
-0.5
-1
-1.0
-2
-1.5
-3
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

INDUSTRIAL PRODUCTION IN INDIA
-2
-3
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
-2

INDUSTRIAL PRODUCTION IN CHINA
-1
-2
-3
-1
-1
-1
-4
-2
-2
-2
-3
-3
-5
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
WTI

S & P 500
62
BASIS
-3
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
NON COMMERCIAL NET LONG POSITION
Table 2.3: Descriptive statistics of fundamental, financial and speculative variables
Determinants
Mean
Std. Dev.
Skewness
Kurtosis
Jarque-Bera
ADF
PP
KPSS
WTI SPOT OIL PRICE
0.007144
0.081903
-0.77216
4.88251
56.57035*
-11.85362*
-11.83093*
0.036135*
OPEC PRODUCTION
0.001263
0.015505
-0.465211
5.998215
94.03293*
-15.39638*
-15.49786*
0.086145*
OECD INVENTORY
0.000406
0.008967
-0.501476
4.574866
33.26335*
-3.552168*
-14.84646*
0.046155*
OECD CONSUMPTION
-0.000182
0.028483
-0.214342
2.989326
1.754559
-2.916049**
-32.53229*
0.285203*
OECD NET IMPORTS
-0.000651
0.039688
-0.029506
2.543648
2.020347
-17.74676*
-30.41094*
0.5*
0.009582
0.056493
0.702814
4.493807
40.1442*
-2.301233
-28.4986*
0.235417*
PRODUCTION CHINA
0.004629
0.054431
-0.408255
3.75903
11.85852*
-3.013915**
-44.14877*
0.143771*
S&P 500
0.005786
0.04503
-0.877515
4.530197
51.73146*
-13.6528*
-13.73022*
0.184718*
DOLLAR INDEX
0.000435
0.012268
0.386009
4.800334
36.61341*
-10.36025*
-10.45809*
0.340712*
INDUSTRIAL
PRODUCTION INDIA
INDUSTRIAL
63
12 M BASIS
0.010592
0.698915
0.04897
7.448997
188.9553*
-16.40647*
-20.58826*
0.116019*
NC NET LONG POSITION
0.009224
0.560974
0.869
10.46097
559.969*
-18.22633*
-18.4153*
0.113867*
Notes: *** - 10% significance, ** - 5% significance, * - 1% significance
64
2.6.1 Hypothesis 1: Test for Non-linearity

The non-linearity in the returns series is tested using BDS test. The results of the BDS test are
presented in the Table 2.4. The test statistics are presented in the same table. The test statistics
are significantly greater than the critical values. Thus, the null hypothesis of I.D.D is rejected.
The residuals of linear OLS model are also tested for non-linearity and found that the residual
series is non-linearly dependent on the oil prices.
Table 2.4: BDS Test Results
Dimension
BDS Statistic
Prob.
0.014999
0.003
0.021711
0.0069
0.025868
0.0069
0.025151
0.0118
0.022178
0.0214
Note: This table reports the results of BDS test.

*Denotes the rejections of the null hypothesis at 10% significance level; **Denotes the rejections of the null
hypothesis at 5% significance level;*** Denotes the rejections of the null hypothesis at 1% significance level.
The study considered two states in the Markov-regime switching model. These two states
represent the high- and low-volatility regimes in the model. Chen and Chen (2007) used twostate Markov-regime switching model to differentiate bull and bear markets. Li (2007) used twostate Markov-Regime Switching Model to distinguish low and high uncertainty in stock markets.
In our model the two regimes are classified as high- and low-volatile regimes. The regimes are
classified based on their model variance. Higher the model variance the state termed as high
volatility state and lower the model variance the state termed to be low volatility state.
2.6.2 Hypothesis 2: Effect of Speculation on the Oil Price Measuring the Marginal Effect
of Speculation
65
The impact of speculative factors on the WTI oil price is estimated using Markov-regime
switching regression model. State 1 is low-volatile regime and state 2 is high-volatile regime.
The results are presented in Table 2.5. It is observed from the results that in low-volatile regime
the impact of non-commercial traders net long positionon the WTI oil price is insignificant,
whereas in high-volatile regime it is significant at 10%. This indicates that speculative factor has
a negligible effect on the oil price. The difference in the model variance between the two states is
minimal which indicates that the variations in the crude oil price explained by speculative factor
in both the states is nearly the same and have minimal significance.
The duration of the regime 1 is 175.47 and regime 2 is 5.2. This shows that volatility of crude oil
conditioned on speculative factor remained in the low-volatile regime for most of the times. The
level of speculation captures by non-commercial traders net long position is consistent
irrespective of the regime.
Table 2.5: Estimation results of Markov-Regime Switching Regression 1
Determinants
State 1
State 2
INTERCEPT
*0.01242
*-0.246028
0.007961
***-0.279252
*0.005303
0.005438
Expected duration of Regime
175.47
5.2
Transition Probabilities Matrix (std. error, p-value)
0.9954
0.0046
Model variance
Time periods
Fig 2.5: Conditional means, Volatilities and Smoothed transition probabilities for model 1
66
0.4
Explained Variable #1
0.2
0
-0.2
-0.4
50
100
150
200
250
0.0745
Conditional Std of Equation #1
0.074
0.0735
S m o o th e d S ta te s P ro b a b ilitie s
0.073
0.0725
50
100
150
200
250
1.5
State 1
State 2
1
0.5
0
50
100
Time
150
200
250
It is observed from the Figure 2.4that the transition between the states have occurred only once,
i.e., in the middle of 2007 and returned to its initial state by 2008. The regression results
indicates that speculation is not only the factor that contributes to the changes in the WTI oil
price
2.6.3 Hypothesis 3: Effect of Speculation on the Oil Price Controlling for Financial Factors
The impact of speculative factor on the WTI oil prices controlling for financial factors is
estimated using Markov-regime switching regression model. The results are presented in the
Table 2.6. The financial variables included are dollar index, basis, and S&P 500 index. It is
observed from the result that in both low-volatile regime and high-volatile regime the impact of
non-commercial traders net long position on the WTI oil price is significant at 1%.It implies
that interaction between the financial factors and the speculative factor explains the WTI oil
price formation.
The impact of dollar index on the WTI oil price in high-volatile regime is insignificant, whereas
in low-volatile regime it is significant at 1%. This indicates that dollar index plays a significant
role in the times of normal market phases. But, during bullish and bearish market periods dollar
index fails to explain the change in the oil price. The negative sign in the low-volatile regime
indicates that the US dollar appreciation have negative effect () on oil price, whereas
depreciation of the US dollar have positive effect (+) on the oil price.
67
Basis has insignificant impact on the WTI oil price in both high-volatile regime and low-volatile
regime. This indicates that basis have no significant role in the determination of oil price during
all times market phases (Normal, Bearish, and Bullish).
The impact of S&P 500 on WTI oil price is insignificant in low-volatile regime, whereas in highvolatile regime it is significant at 1%. This indicates that stock market index explains crude oil
price only in the times of normal market phases. But, during bullish and bearish market periods
stock market index fails to explain the dynamics in the oil price. It is expected to have an inverse
relationship with oil price, but a positive relationship is observed between stock market index
and oil price. Rise in the price of oil might be due to the increased consumption of the crude oil
during economic expansion.
The duration of the regime 1 is 1.28 and regime 2 is 5.02. This shows that volatility of the crude
oil conditioned on combined speculative and financial factor is high, that is oil price is more
fluctuating. The level of speculation is significant irrespective of the regime when controlled for
financial factors. The difference in the model variance between the two states indicates that the
variations in the crude oil price is better explained by speculative and financial factor in highvolatile states compared to the low-volatile state.
Determinants
State 1
State 2
INTERCEPT
-0.017704
*0.014666
S&P 500
*1.353912
-0.168533
DOLLAR INDEX
*-2.36167
0.609047
12 M BASIS
0.012282
-0.002821
*-0.041312
*0.030444
68
Model variance
*0.002333
*0.004916
1.28
5.02
0.1235
0.8765
Time periods
Notes: *** denotes 10% significance, ** denotes 5% significance, * denotes 1% significance
0.4
0.2
0
-0.2
-0.4
50
100
150
200
250
0.08
0.07
0.06
0.05
Smoothed States Probabilities
0.04
50
100
150
200
250
1
State 1
State 2
0.5
50
100
Time
150
200
250
It is observed from the Figure 2.5 that there is a frequent switchover between the two states. The
regression results indicates that speculation combined with financial factors explains the changes
in the WTI oil price
69
2.6.4 Hypothesis 4: Relative importance of determinants of oil price

The impact of speculative factors on the WTI oil prices controlling for both fundamental and
financial factors is analyzed using Markov-Regime Switching Model. The results are presented
in the Table 2.7. The financial variables included are dollar index, basis, and S&P 500 index.
Fundamental variables considered are the lagged WTI crude oil price, OPEC production, OECD
stock, OECD consumption, OECD net imports, Industrial production of India, and Industrial
production of China.
Empirical results indicated that the impact of non-commercial traders net long position on the
WTI oil price is insignificant in low-volatile regime, whereas it is significant at 1% in highvolatile regime. It implies the speculative factor explains the WTI oil price formation only in
high volatile when combined with both financial and fundamental factors.
The dollar index is significant at 5% in low-volatile regime, whereas in high-volatile regime it is
significant at 1%. This indicates that the dollar index has significant impact on the WTI oil price
regardless of state. This implies that dollar index plays a significant role in all market phases. In
low-volatile regime it has significant negative impact, whereas in high-volatile regime it has
significant positive impact.
Basis has insignificant impact on the WTI oil price in low-volatile regime, whereas it is
significant at 1% in high-volatile regime. This indicates that basis have significant role in
determining the oil price in bearish and bullish market phases. It effect is insignificant during
normal market phase.
S&P 500 has significant impact on the WTI oil price irrespective of its state. It is significant at
1% in both regimes. This indicates that stock market index explains changes in crude oil price in
all market phases. A significant positive relationship is observed in low-volatile period, whereas
a significant negative relationship is observed in high-volatile regime.
Empirical results indicate that the Lagged WTI oil price plays a vital role in estimating the price
of crude oil. Lagged WTI oil price is significant at 1% in both regimes. There is a significant
positive relation between lagged oil price and oil price in low-volatile regime whereas in highvolatile regime it is negative relation.
70
OPEC production has significant positive relationship in both high and low-volatile regimes. It
implies that the OPEC production is lower than the equilibrium level. Our result suggests that
OPEC production is one of factor in determining the oil price in all market phases. The impact
OECD stock on oil price in both high- and low-volatile regimes is significant at 1%. In lowvolatile period the relationship is negative, whereas in high-volatile period it is positive.
OECD consumption has insignificant impact on the WTI oil price in low-volatile regime,
whereas in high-volatile -regime it is significant at 1%. This indicates that OECD consumption
has significant role in the oil price determination only during bearish and bullish market phases.
Its impact is insignificant during normal market phase.
The impact of OECD net imports on WTI oil price in low-volatile regime is insignificant,
whereas in high-volatile regime it is significant at 1%. The relationship between the crude oil and
OECD import is negative. OECD consumption plays a significant role in determination of oil
price only during bearish and bullish market phases.
The relationship between the crude oil and Industrial production of India is negative and is
significant at 1% in high-volatile regime. In low-volatile regime, it is positive and is significant
at 1%. This implies that Industrial production of India plays a key role in estimating the WTI
crude oil price.
The impact of Industrial production of china is insignificant in low-volatile regime, whereas it
is negative and is significant at 1% in high-volatile regime. This implies that Industrial
production of China plays a significant role in determination of the oil price only during bearish
and bullish market phases.
The duration of the state 1 is 16.68 and state 2 is 1.61. This indicates that the volatility of crude
oil is moderately explained by combined speculative, fundamental, and financial factors. The
level of speculation is significant in high-volatile regime indicating that speculative factor has
significance in determining the oil price only in high-volatile phase when combined with other
factors.
71
The difference in the model variance between the two states indicates that the variations in the
crude oil price is better explained by speculative, fundamental, and financial factors in lowvolatile states compared to the high-volatile state.
Determinants
State 1
State 2
INTERCEPT
-0.0026
*-0.0186
Lagged WTI SPOT OIL PRICE
*0.2050
*-0.1286
* *0.6273
*0.6723
*-2.8084
*8.6105
OECD CONSUMPTION
-0.1244
*1.9411
OECD NET IMPORTS
-0.1984
*-1.0853
INDUSTRIAL PRODUCTION INDIA
* 0.2164
*-1.3195
INDUSTRIAL PRODUCTION CHINA
-0.1084
*-0.2137
S&P 500
*0.4047
*-0.5342
**-0.9107
*2.3189
12 M BASIS
-0.0076
*-0.0193
-0.0017
*0.0118
OPEC PRODUCTION
OECD STOCKS
DOLLAR INDEX
72
Model variance
**0.004089
*0.000005
16.68
1.61
0.94
0.62
0.06
0.38
Time periods
It is observed from the graphs that the transition between the states is less compared to the
previous case.
73
0.5
0
-0.5
50
100
150
200
250
S m o o t h e d S t a t e s P ro b a b ilit ie s
0.1
0.05
0
50
100
150
200
250
2
State 1
State 2
1
0
50
100
Time
150
200
250
2.7 Summary
This paper has analyzed the impact of fundamental, financial and speculative factors on the WTI
crude oil prices in high and low volatility periods using regime-switching methodology.
Empirical results of Hypothesis 2 suggest that speculation has a minimal effect on WTI oil price.
Hence, speculative factors alone cannot explain oil price changes. Minimal difference in variance
in states suggested that speculation does not change hugely across states. The estimates from
Hypothesis 3 indicated that speculative factors (Non-commercial traders net long position) when
controlled for financial factors significantly explain the WTI oil price in both the regimes. This
implies that speculation has greater explaining power when incorporated with other factors.
It is also observed from the results (Hypothesis 4) that the speculative variable, when controlled
for fundamental and financial factors have a significant role in explaining the WTI oil price in
high volatility state. At low volatility regimes, fundamental, and financial have significant role in
price discovery of oil price. While at the high volatility regimes, we observe that factors
pertaining to speculation combined with financial and fundamental factors have a significant
effect on the oil price.
74
The results are of greater significance for the policy makers and regulators. The three important
findings from the study are: (i) Speculation has minimal explanatory power; (ii) Speculation
affects oil price positively during low-volatile state and negatively during high-volatile state
when controlled for financial variables; and (iii) Speculation has significant impact on oil price
only in high volatility regime.
The results suggest that the effect of speculation on oil price can only be seen in high-volatile
regimes. Whereas, during low-volatile regimes, supply and financial factors plays a significant
role in explaining oil price. Hence, it required for the regulators and policy makers to look into
supply dynamics, financial factors as well as speculative factors of the oil prices based on the
current in order to track or predict the movements of the oil price.
75
Chapter 3
Wavelet dynamics for the oil price, Exchange rates, and Stock
Indices of the major oil-importing countries
3.1 Introduction
Oil being a primary energy source, is the highly traded commodities in the world. Global energy
demand is set to grow by 37% by 2040, but the global energy system is in danger of falling short
of the hopes and expectations placed on it. Turmoil in parts of the Middle East, which remains
the only large source of low-cost oil, has rarely been greater since the oil shocks in the 1970s.
Conflict between Russia and Ukraine has reignited concerns about gas security World Energy
Outlook (WEO2014).
The crude oil acts a financial instrument. It also acts as a hedging instrument since many
financial derivatives based on various benchmarks of the crude oil. Oil is considered as an asset
and hence it is actively included in portfolios of various funds such as hedge funds. Since the oil
prices are determined by market forces, there exists high variability in its prices. To model this
uncertainty, understanding the relationship of the oil prices with exchange rate and stock indices
for broad range of countries is crucial.
The study proposes to identify the co-movement that exists between (i) the oil price and
exchange rates and (ii) oil price and Stock Indices of the major oil-importing countries 1. The
countries include USA, Japan, India, South Korea, Germany, France, Spain, Singapore, Italy, The
Netherlands, Taiwan, Turkey, Indonesia, and Belgium. The study period starts form 6th January
2003 to 30th December 2014, except for china. The sample period for china starts from 5th
January 2004 to 30th December 2014.
Past literature on co-movement predominantly looked in to time domain. In this study, we look
into both time and frequency domain. We also find the effect/strength of the co-movement across
frequency and over time. Literature largely used Real prices, we use Nominal prices. The study
extends the literature by including diverse range of the oil-importing countries of various
importing levels.
76
The research questions that are addressed in this chapter are as follows:
1. Does co-movement exists between the oil price and Exchange rates of the oilimporting countries?
o What is the strength of the co-movement between the oil price and
Exchange rates?
o How it evolves across frequency and over time?
2. Does co-movement exists between the oil price and Stock Indices of the oilimporting countries?
o What is the strength of the co-movement between the oil price and Stock
indices?
o How it evolves across frequency and over time?
This study focuses on the major oil-importing countries, thus providing holistic picture about
how the oil-importing countries and their varied importing levels/quantity impacts various
macro-economic indicators. As oil being the one of the primary source of energy in these
countries, the price of oil has a major influence on the economy and that has various effects on
different macro-economic variables. Traders and institutional investors have varied investment
horizons, so both have different risk profiles. Hence, in the current study, the relationship/comovement between (i) the oil price and Exchange rates and (ii) the oil price and Stock Indices is
investigated from traders and institutional investors perspective.
Using wavelets, we can capture both short-run and long-run movements in time and frequency
space. The study of the co-movement between (i) the oil price and Exchange rates and (ii) oil
price and Stock Indices returns is crucial for risk assessment in financial industry. By using
wavelets, we study the lifecycle of co-movements between variables, which is essential for risk
assessment to traders and institutional investors. previous Studies have used wavelet to measure
77
the co-movements across different variables (Reboredo and Castro,2013a, b; Graham et al.,
2013; Tiwari et al., 2013a, b).Traditional time series models only look into the time scale of the
variables, whereas wavelets consider both time and frequency domain. There by using wavelets
eliminate the limitations of the standard time series model.
Fig 3.1: Major oil importing countries
Source: EIA - Top world oil net importers, 2012;
The Figure 3.1 presents the major oil-importing countries and their importing quantity as of
2012. United States stands as the major oil-driven nation. The industrialization of country is
related with the energy usage of the country. As can be seen, USA, China, Japan, and India
occupy the top positions in importing oil.
The remainder of this paper is organized as follows: the next Section 3.2 presents the literature
review. Section 3.3 provides a data description. Section 3.5provides the Hypothesis, Section 3.6
presents methodology and some preliminary analysis. Section 3.7 reports the empirical results. In
the last Section 3.8, we summarize this paper.
3.2 Literature Review
78
Previous empirical literature on the interaction between (i) the oil prices and stock markets and
(ii) the oil prices and Exchange rates indicated conflicting results. These literatures primarily
focused on real returns, which were addressed to policy makers, and regulators. In the current
study, we focus on nominal prices, catering to traders and institutional investors community. A
significant relationship has been found between the oil price and various macro-economic
indicators.
Few studies argue that the oil price shocks spillover to equity market (Jammazi, 2012; Cunado
and Gracia, 2014) others argue that volatility shocks from equity markets spillover to the crude
oil futures market (Thuraisamy et al. 2013). Empirical results of few studies indicated that the oil
price has significant and negative impact on stock market returns (Park and Ratti, 2008; Miller
and Ratti, 2009). Other studies indicated that the oil price changes have no effect on stock market
returns (Reboredo and Castro, 2013; Sukcharoen et al., 2014).
Long-run equilibrium exists between the oil price and exchange rate (Chaudhuri and Daniel,
1998; Amano and Norden, 1998; Chen and Chen, 2007); they found that the oil price is the
source of shocks. Some studies argue that rise in the oil prices is associated with the US dollar
appreciation (Amano and Van Norden, 1998; Chen and Chen, 2007; Basher et al., 2012;
Beckmann and Czudaj, 2013), and few other studies argue that rise in oil prices is associated
with the US dollar depreciation (Narayan et al., 2008; Zhang et al., 2008; Akram, 2009; Wu et
al., 2012).
Overall summary of literature on the correlation between the economic variables and crude oil
price is presented in the Tables 3.1 and 3.2.
79
Table 3.1: Recent literature on relationship between the oil price and exchange rate.
Author
Sample
Country
Methodology
Findings
Amano and van
1973M1
Germany,
OLS estimator, co-
Co-integration exists between the oil price and the real
Norden (1998)
1993M6
Japan and the
integration, and
effective exchange rate for Germany and Japan, but not
United States
Granger causality
for the United States
Chaudhuri and
1980M1
16 OECD
Co-integration and
Non-stationary behavior of the US dollar real bilateral
Daniel (1998)
1996M3
countries
causality tests
exchange rates is due to the non-stationary behavior of

real oil prices
Rautava (2004)
1995Q1
Russia
2002Q3
Dawson (2007)
VAR and Co-
Russian economy is influenced significantly by
integration
fluctuations in the oil prices and the real exchange rate

Increasing oil prices depreciate the peso
1991M1
Dominican
Multivariate
2005M1
Republic
regression model
and Co-integration
Benassy-Quere
1974M1
et al. (2007)
2004M11
Chen and Chen
1972M1
USA
Co-integration and
Causality runs from the oil to the dollar.
causality tests
G7 Countries
Co-integration
80
Real oil prices may have been the dominant source of
(2007)
2005M10
Narayan et al.
2003 to 2004
(2008)
Daily
real-exchange rate movements.

Fiji Island
EGARCH
Rise in the oil prices lead to an appreciation of the

Fijian dollar vis--vis the US dollar Nominal prices
were used
Zhang et al.
2000M1:04
(2008)
2005M5:31
USA
Co-integration,
The US dollar depreciation is a key factor in driving up
VAR, ARCH, and
the international the crude oil price
Granger causality
Coleman et al.
1970Q1
African
Co-integration and
Real-exchange rates are determined by the shocks in
(2010)
2004Q4
Countries
Non-linear
the real price of oil
Dynamics
Huang and
1983M6
Tseng (2010)
2008M3
USA
Two-step regression
Bi-directional
non-linear
causality
relationships
approach and VEC
between the petroleum prices and exchange rates after

crisis
Nikbakht (2010)
Ghosh (2011)
2000M1
7 OPEC
Panel Co-
Long run and positive linkage between the real oil
2007M12
members
integration tests
prices and real exchange rates
2007M7:02
I6ndia
GARCH
Increase in the oil-price returns leads to the

81
2008M11:28
Iwayemi and
1985 Q12007
Fowowe (2011)
Q4
Nigeria
(EGARCH) models
depreciation of the Indian currency.
VAR and Granger
The oil price shocks do not have a major impact on
causality
most macro-economic variables, including the

exchange rate
Behmiri and
19762009
OECD
Manso (2012)
Panel Co-
Bidirectional causality relationship exists between
integration tests,
crude oil Consumption and GDP in the short and long
and Granger
runs
causality
Wang and Wu
2003M1:02
(2012)
2011M6:03
Nakajima and
2005M9:01
Hamori (2012)
2011M7:29
USA
Japan
VEC and Granger
Pre-crisis, unidirectional linear causality running from
causality
petroleum prices to exchange rates
Cross-correlation
Granger causality in variance from the exchange rate
function and
to the oil price, in the data prior to the financial crisis.
Bivariate Granger
No Granger causality is found in data from the midst
causality
of the crisis
in mean and
variance
82
Ferraro et al.
1984M12:14
(2012)
2010M11:05
Ding and Vo
2004M7:28
(2012)
2009M9:28
Canada
USA
Threshold
Short-term relationship at daily frequencies between
asymmetric model
oil prices and the exchange rate
Bivariate VAR and
During turbulent or crisis time, there is bidirectional
Bivariate
volatility interaction between oil market and the
GRACH(1,1),
foreign exchange market
structural breaks
Selmi et al.
1972Q2
Morocco,
GARCH
The real price of oil is negatively and significantly
(2012)
2010Q4
Tunisia
specifications
related to the variability of the real exchange rate.
Oriavwote and
19802010
Nigeria
VAR, Johansen
Long-run equilibrium relationship between the real oil
Eriemo (2012)
price and the REER

Co-integration test
Turhan et al.
13 emerging
2003 M1:03
VAR Models and
A rise in oil price leads to a significant appreciation in
(2013)
countries
2010 M6:02
Granger Causality
emerging economies currencies against the US dollar
approach
Benhmad (2012)
1970M2
US
Wavelet approach,
2010M2
Bidirectional causal relationship exists between the

real oil price and the real dollar exchange rate for large
83
linear and nonlinear
time horizons.
Granger causality
Tiwari et al.
1993M4
(2013)
2010M12
India
Wavelet approach,
Causality exists between the oil price and the real
linear and non-
effective exchange rate of the Indian currency, at
linear, and Granger
higher time-scales only.
causality
Reboredo and
4 January 2000
Euro, Australia, Wavelet multi-
Evidence of contagion and negative dependence post-
Castro (2013)
to 7 October
Canada, Japan,
crisis. The oil prices led exchange rates and vice versa
2011
Mexico,
resolution analysis
in the crisis period.
Norway and the

United
Kingdom
Brahmasrene et
January 1996 to
Canada,
Granger causality
al. (2014)
December 2009
Mexico,
tests, VAR, Variance oil prices while in the long-run crude oil prices
Colombia, the
decomposition, and
Granger-caused the exchange rates. In the medium and
United
Impulse responses
long run, oil price shocks had a significant impact on
Kingdom, and
In short run, the exchange rates Granger-caused crude
exchange rate changes. Exchange rate shock has a

84
Venezuela
significant negative impact on the crude oil prices
Reboredo et al.
January 2000 to
EUROPEAN
Detrended cross
The cross-correlation analysis indicated that in longer
(2014)
May 2012
UNION(EUR),
correlation analysis
time scales, oil priceexchange rate correlations were
Australia
negative and low
(AUD), Canada
Second, negative dependence between oil and the US
(CAD), Japan
dollar increased after the onset of the global financial
(JPY), Mexico
crisis for all time scales
(MXN),
Norway (NOK)
and the United
Kingdom(GBP)
Compilation of Literature: Appended to the previous work of Tiwari et al. (2013).

Existing literature summarizes that oil price increase has significant negative effect on stock returns (Jones and Kaul, 1996; Sadorsky, 1999; Kilian
and Park, 2007; Nandha and Faff, 2008; O'Neill et al., 2008; Park and Ratti, 2008). Ciner (2001) and also concludes that a statistically significant
non-linear relationship exists between the real stock returns and oil price futures.
Table 3.2: Recent literature on relationship between oil price and stock indices.
Author
Sample
Country
Cong et al. (2008) January, 1996 to China

December, 2007
Methodology
Findings
Multivariate
Increase in the oil volatility may increase the speculations in
vector auto-
mining index and petrochemicals index, which raise their
85
Park and Ratti
1986:12005:12
(2008)
regression
stock returns
Austria, Belgium,
Vector
Norwaypositive response of real stock returns to an oil price
Denmark, Finland,
autoregressive
increase. European countries - Increased volatility of oil
France, Germany,
model (VAR)
prices significantly depresses real stock returns. Increase in
Greece, Italy,
the real oil price is associated with a significant increase in
Netherlands, Norway,
the short-term interest rate in the US and eight out of 13
Spain, Sweden, UK,
European countries.
and USA
Real prices were used
Miller and Ratti
1971:12008:3
(2009)
Canada, France,
Co-integrated
Stock market indices respond negatively to increases in the
Germany, Italy, the
vector error
oil price in the long run Real prices were used
UK and the US
correction
model
Aloui and
January 1989 to
UK, France, and
Two regime
The net oil price increase variable play a significant role in
Jammazi (2009)
December2007
Japan
Markov-
determining both the volatility of real returns and the
switching
probability of the transition across regimes
EGARCH
model
86
Jammazi and
January 1989 to
UK,
Aloui (2010)
December2007
Japan
France,
and Wavelet
Oil shocks do not affect the recession stock market phases;
analysis and
they significantly reduce moderate and/or expansion stock
Markov-
market phases temporarily. We find Negative relationship
Switching VAR
during the pre-1999 period
Aloui et al.
29 September
Egypt,
Morocco, Multifactor
(2012)
1997 to 2
South Africa, China, model:
and that the oil impact is asymmetric with respect to market
November2007
India,
Indonesia,
phases
Korea,
Malaysia,
Pakistan, Philippines,
Taiwan,
Thailand,
Jordan,
Turkey,
Czech
Republic,
Hungary,
Poland,
Russia,
Argentina,
Brazil,
Colombia,
Chile, Mexico, Peru,

and Venezuela
Two-step
process:
Time-series
rolling
regression
estimation of
risk factor
loadings and
Cross-sectional
analysis of risk
factor loadings
and excess
returns
87
The oil price risk is significantly priced in emerging markets,
Basher et al.
1988:01
Real
emerging Structural VAR
(2012)
2008:12
market stock prices model
positive shock to real economic activity increases the oil
(MSCI
prices. There is also evidence that increases in emerging
Emerging
Index - 23 Emerging
Positive oil production shock lowers oil prices while a
market stock prices increase oil prices.
Markets)
Jammazi (2012)
1989:01
to USA,
2007:12
Canada, Wavelet
The oil-exporting countries highly transient (scale 1)
Germany, Japan, and analysis
positive/negative causalities flowing from TSX stock market
UK
to oil changes are detected, highly persistent (scale 6)

positive causality running from FTSE to the CO changes are
found
Higher scales become interconnected in a negative

unidirectional pattern running from oil to stock market
returns for only two oil-importing countries
Thuraisamy et al.
05 July 200514 Indonesia,
(2013)
December 2011
India, Bi-variate
Volatility shocks from developed equity markets, such as the
Singapore, Malaysia, BEKK-GARCH
Japanese market, spillover to the crude oil and gold futures
the
markets. Sri Lankan and Thailand equity markets, tend to
Vietnam,
Philippines,
Taiwan,
have spillover effects from the crude oil futures market

88
Japan, China, South

Korea,
Pakistan,
Thailand, Sri Lanka,

and Hong Kong
Delatte and Lopez
January 1990 to Goldman
Sachs Copula
Dependence between commodity and stock markets is Time
(2013)
January 2012
Index
varying and symmetrical
Commodity
and the Dow-Jones

UBS
Index
Commodity
(their
sub-
Index),
CAC40,
DAX30,
FTSE100
and
SP500.
Individual
commodity
futures
covering agricultural,
industrial metals and
energy markets
Naifar and
July 7, 2004 to GCC
Dohaiman (2013)
November
2011
10, (Qatar,
Bahrain,
countries Copula
and GCC stock market returns and OPEC oil market volatility is
Oman, Markov-regime
Saudi
89
regime dependent.
Arabia, Kuwait and switching model

UAE)
Reboredo and
1 June 2000 to USA
Castro (2013)
29 July 2011
and
Europe Wavelets
Oil price changes had no effect on stock market returns in the
(S&P 500 and Dow
pre-crisis period, evidence of contagion and positive
Jones Stoxx Europe
interdependence between these markets. The oil price leads
600
stock prices and vice versa for higher frequencies
indexes
and
sectoral indexes)
Aloui and Hkiri
June 7th, 2005 to Gulf
(2014)
February
2010
Cooperation Wavelet
22nd, Council
(GCC) coherence
Countries
(Bahrain, analysis
Frequent changes in the pattern of the co-movements

especially after 2007 for all the selected GCC markets at
relatively higher frequencies. We further note an increasing
Kuwait, Oman, Qatar,
strength of dependence among the GCC stock markets
Saudi Arabia, and the
during the last financial crisis
United
Arab
Emirates)
Cunado and
1973:02
Gracia (2014)
2011:12
to Austria,
Belgium, VAR and Vector Existence of a negative and significant impact of the oil price
Denmark,
France,
Italy,
Finland, Error Correction changes

Germany, Models
Luxembourg, (VECM)
Netherlands,
Spain,
90
on
most
European
stock
market
returns.
Furthermore, we find that stock market returns are mostly

driven by the oil supply shocks.
Portugal, and the UK

Fang and You
2001/12012/5
(2014)
China,
India,
and VAR
The impact of oil price shocks on stock prices in these large
Russia
NIEs is mixed, partly in contrast to the effects on the US and

developed countries' stock markets
Gil-Alana and
January 2000 to Nigeria
Long
Yaya (2014)
December 2011
regression
Significant evidence of a positive relationship between the
model
two variables found though with a short-memory effect
Madaleno and
Pinho (2014)
1992
memory The oil prices acting as a weakly exogenous variable.
December World indices (MSCI Continuous time Higher coherence among series for higher scales thus
to
15 - By Sectors)
wavelets
October 2012
supporting the interdependence hypothesis, showing that

long run market dynamics are more uncertain. Bidirectional
relationship between both series for large time horizons
Olson et al.
(2014)
1stJanuary US
Multivariate
Low S&P 500 returns cause substantial increases in the
1985to 24thApril
volatility
volatility of the energy index. Weak response from S&P 500
2013
GARCH models volatility to energy price shocks

such as BEKK,
diagonal,
constant
conditional
91
correlation, and
dynamic
conditional
correlation
Sukcharoen et al.
7 January 1982 Canada,
(2014)
to
31December Germany,
2007
France, Copula
Weak dependence between oil prices and stock indices
Hong
found. But the stock index returns of large oil consuming and
Kong, Italy, Japan,
producing countries (USA and Canada), which have a
Netherlands,
relatively strong dependence with the oil price series
Switzerland,
UK,
USA, China, Czech

Republic,
Finland,
Hungary,
Poland,
Russia, Spain, and

Venezuela
Liu et al. (2015)
January 1975 to USA
TVP regression The forecasting accuracy can be improved after adding oil
December 2012
and
Dynamic variables to the traditional predictors
model selection
Narayan and
1859:10
Gupta (2015)
2013:12
USA
Time-series
The oil price is persistent and endogenous predictor variable

and negative oil prices predict the US stock returns more
92
predictive
regression
model
93
than do positive oil prices
Wavelet analysis provides a framework to measure co-movement between variables. Studying

either time or frequency domain does not provide the complete dynamics in co-movement
relationship. In this study, we examine the relationship between (i) the benchmark oil prices and
Exchange rates and (ii) benchmark oil prices and stock indices of the oil-importing countries in
the timefrequency space using wavelet analysis. By using wavelets, we can simultaneously
examine the strength of the co-movement at different frequencies and find out how much
strength has evolved over time.
Recent empirical works analyzed the relationship between several macro-economic variables
using Wavelets (Ramsey and Lampart, 1998; Reboredo and Castro, 2013a, b; Graham et al.,
2013; Tiwari et al., 2013a, b; Loh, 2013; Akoum et al., 2012; Jammazi, 2012; Gallegati, 2012;
Graham et al., 2012; Rua and Nunes, 2009).
Our study contributes the literature in three ways, namely:
(1) First, previous literature extensively focused on time series methodologies to measure comovement, while we study the relationship between the crude oil and macro-economic
indicators using wavelet coherence. In order to understand the co-movement between the
crude oil and macro-economic indicators, we examined the coherency at both time and
frequency domain this is the main contribution of the study.
(2) Second, the study has used different crude oil benchmarks such as WTI, Brent, and
OPEC basket crude oil prices. For example, OPEC basket crude is used for Asian
countries, Brent oil price is used for European countries and WTI oil price is used for
USA.
(3) Third, existing literature focused more on real prices (Tiwari et al., 2013a, b; Benhmad,
2012). Whereas we used nominal prices of oil, instead of real prices, that enable investors
to shift their positions quickly in stock and foreign exchange market in order to mitigate
the risk arising from oil prices.
94
3.3 Data
This study used daily time series data of various benchmark crudes such as WTI, Brent, and
OPEC basket crude oil spot price; Stock Indices of the oil-importing countries such as USA
(SPX), China (SSE50), Japan (NKY), India (NIFTY), South Korea (KOSPI), Germany (DAX),
France (CAC), Spain (IBEX), Singapore (FSSTI), Italy (FTSE MIB), The Netherlands (AEX),
Taiwan (TWSE), Turkey (XU100), Indonesia (LQ45),and Belgium (BEL20); and Exchange rates
of the oil-importing countries such as China (USDCNY), Japan (USDJPY), India (USDINR),
South Korea (USDKRW), Germany (USDEUR), France (USDEUR), Spain (USDEUR),
Singapore (USDSGD), Italy (USDEUR), The Netherlands (USDEUR), Taiwan (USDTWD),
Turkey (USDTRY), Indonesia (USDIDR), and Belgium (USDEUR) over the period starting
from 6th January 2003 to 30th December 2014 except for Chinese stock market index.
The following stock indices of the respective countries are considered: Japan Nikkei225 index,
India NIFTY50, Indonesia LQ45 index, South Korea Korea Composite Stock Price Index
KOSPI, Spain IBEX35, Italy FTSEMIB 40, Singapore Straits Times Index FSSTI,
Germany DAX 30, France CAC40, Belgium BEL20 index, The Netherlands AEX, US
Standard& Poor's 500, China Shanghai Stock Exchange 50, Taiwan Taiwan Stock ExchangeWeighted Index TWSE, Turkey Borsa Istanbul 100 Index (XU100). Sample period for Stock
index of china (SSE50) starts from 5th January 2004 to 30th December 2014. The effect of shock
dies down after few days, and the correlation vanishes. Hence, to study co-movement, we need
to use daily data which provides more insights than weekly or monthly data (Gallegati, 2012).
The data are collected from Bloomberg database.
The returns are computed as follows:
pti
R ln i
pt 1
i
t
95
3.4 Conceptual Flow

Macroeconomic Indicators
1. WTI Crude oil price
2. Brent Crude oil price
3. OPEC Basket Crude oil price
Exchange Rate
Stock Index
Major Oil Importing countries1

Countries
Stock Index
Exchange Rate
United States
SPX
USD
China
SSE50
USDCNY
Japan
NKY
USDJPY
India
NIFTY
USDINR
South Korea
KOSPI
USDKRW
Germany
DAX
USDEUR
France
CAC
USDEUR
Spain
IBEX
USDEUR
Singapore
FSSTI
USDSGD
Italy
FTSE MIB
USDEUR
Netherlands
AEX
USDEUR
Taiwan
TWSE
USDTWD
Turkey
XU100
USDTRY
Indonesia
LQ45
USDIDR
Belgium
BEL20
USDEUR
Source: EIA - Top world oil net importers, 2012;
96
Hypothesis of the study of the effect of the WTI crude oil prices on macro-economic indicators
of the oil-importing countries is formulated as follows:
The co-movement between the crude oil prices on Exchange rate of the oil-importing as follows:
H00: the coherence coefficients between the crude oil prices and Exchange rates are Zero
The co-movement between the crude oil prices on Stock Index of the oil-importing countries as
follows:
H01: the coherence coefficients between the crude oil prices and Stock indices are Zero
3.5.
Methodology
We used continuous wavelet transform in this study to examine the macro-economic series for
orthogonal wavelet bases, where the choice is in between discrete and continuous. In analyzing
macro-economic data the wavelet transform provides a three dimensional diagram that illustrates
time series information at different frequencies, time, and strength. Where the frequency could
range from low to high, time could range from of short to long term and finally the strength of
association measured by color coding. In this study, we follow Grinsted et al. (2004) framework
of continuous wavelet transform (CWT), cross wavelet transform (XWT), and wavelet
coherency (WTC).
3.5.1. Continuous Wavelet Transform
A wavelet is a function with zero mean and that is localized in both frequency and time. The
CWT of a time series (
convolution of
, n = 1,, N) with uniform time steps
with the scaled and normalized wavelet, defined as
97
, is defined as the
wxn ( s )
t N
(n n ) t
xn 0
.
s n
s
(3.1)
We define the wavelet power as
wxn ( s)
n
.The complex argument of wx ( s) can be interpreted as
the local phase. Since the wavelets are not completely localized in time, CWT has edge effects to
addresses Cone of Influence (COI) is introduced, where edge effects are ignored. The statistical
significance of wavelet power can be assessed relative to the null hypotheses that the signal is
generated by a stationary process with a given background power spectrum (
). We follow
the procedure used by Torrence and Compo (1998) for data generation using Monte-Carlo
simulation process. According to Torrence and Compo (1998), regarding the white noise and red
noise wavelet power spectra, under the null, the corresponding distribution for the local wavelet
power spectrum at each time n and scale s is as
(3.2)
3.5.2. Wavelet coherence (WTC)
Wavelet coherence (WTC) is used as a tool for finding the relationships between two series. The
relationship of these series is found through frequency bands and time intervals. The wavelet
coherence can be seen as a localized correlation coefficient in time frequency space. Wavelet
coherence of the change in the oil price and macro-economic indicators differential series can be
defined as:
98
S ( s1 wnx ( s )2) . S (s1 wny ( s )2 )
S (s1 wnxy ( s )) 2
R 2n ( s ) =
(3.3)
We follow Wavelet Coherence as defined by Torrence and Webster (1999), Where, S is a

smoothing operator and
is the value of Wavelet squared coherency. The numerator,
which explains the squared absolute value of the smoothed cross-wavelet spectrum and
denominator, represents the smoothed wavelet power spectra.
3.6
Wavelet Coherence Inference
Wavelet transform coherence (WTS) is a method for analyzing the coherence and the phase lag
between two time series as a function of both time and frequency (Chang and Glover, 2010). The
wavelet Coherence method allows us to estimate the presence of a simple cause-effect
relationship between the phenomena recorded in the time series.
The cone of influence tests for the phase differences between the components of the two time
series (the series are in anti-phase position or not). Wavelet transform coherence (WTS) is also
considered as a localized correlation. The color code for coherency ranges from blue (close to
zero) to red (close to one), where blue refers to low coherency/Correlation and red refers to high
coherency/Correlation.
The WTC chart, the horizontal axis represents Time and the vertical axis shows time scales in
days as Frequencies. Time scale 1 denote 24 days; Time scale 2 denotes 48 days, Time scale 3
denotes 816days, and so on.
99
Table 3.3: Frequency identification

Time Scales (In Days)
Frequencies
Freq. Descriptions
High
Short Run
Medium
Medium Run
Low
Long Run
24
4 -16
16 -32
32 64
64 128
128 256
256 - 1024
Table 3.4: Wavelet Inference
Right
Oil price
In the phase
Up
Exchange rates/ Stock

Indices
Cyclical effect Positive Effect

Lagging Oil price
&
Down
Exchange
rates / Stock
Indices

Indices
Leading Oil price
Arrows
pointing
towards
Left
Anti/ out of the phase
Up

Indices
Leading Oil price
100
Anti cyclical effect Negative

Effect
Down

Indices
Lagging Oil price
The time scales are classified as High, Medium, and Low frequency time scales. Where High
represents the short-run dynamics, Medium represents the Medium run and the Low represents
Long run. Arrows pointing to the right indicates that the variables, i.e., benchmark oil prices and
exchange rates/stock indices are in the phase; to the right and up implies that exchange
rates/stock indices are lagging and to the right and down implies that exchange rates/stock
indices are leading; Arrows pointing to the left indicates that the variables are out of the phase; to
the left and up implies that exchange rates/ stock indices are leading and to the left and down
implies that exchange rates/stock indices are lagging; In the phase denotes that variables will
be having cyclical effect or positive effect. In other words, an increase in the benchmark oil
prices causes an increase of exchange rate/stock index. Out of the phase denotes that variable
will be having anti-cyclical effect or negative effect. In other words, an increase in benchmark oil
prices causes a decrease of exchange rate/stock index.
3.7.
Empirical Results
Table 3.5 presents the summary statistics and unit root test results of the return series of
Exchange rates of the oil-importing countries. USDTRY is observed to have highest standard
deviation and USDCNY is observed to exhibit lowest standard deviation. We also find that
USDCNY is skewed to the left and USDTRY is skewed to the right. Almost all the exchange
rates are found to have excess kurtosis. The null hypothesis, of JarqueBera test, that the series
are normally distributed is rejected, which is normally a case in financial variables. JarqueBera
test statistic confirms that the Exchange rates are not normally distributed.
101
Augmented Dickey Fuller, Phillip Perron, and KPSS tests were used to confirm stationarity of
the variables. The Null hypothesis of ADF and PP tests were rejected; and the Null hypothesis of
KPSS test was accepted. The null hypothesis of ADF and PP is presence of unit root and the null
hypothesis KPSS test being series is stationary. Thus the results of these three tests conform that
the variables are stationary and free from unit root.
Table 3.5: Descriptive statistics of Exchange rates of Oil Importing Countries
Std.
Jarque-
Variables
Mean
Median
Dev.
Skewness Kurtosis
Bera
ADF
PP
OIL
0.000196
0.000984 0.024302 -0.26125 8.022996
4000.859 0.0001* 0.0001*
USDCNY
-7.67E-05
0 0.000886 -3.53031 82.60273
1001874 0*
0.0001*
USDEUR
-4.66E-05 -0.000134 0.006306 -0.10693 4.959536
609.5403 0.0001* 0.0001*
USDIDR
0.000151
0 0.007538 0.285981 25.09923
76665.3 0*
0.0001*
USDINR
0.0001
0 0.004154 0.227519 11.99054
12712.67 0.0001* 0.0001*
USDJPY
4.29E-05
9.27E-05
0.00647 -0.21668 6.131687
1568.007 0.0001* 0.0001*
USDKRW -6.79E-06 -0.000217 0.007108 0.248853 32.65977
138042.1 0*
0.0001*
USDSGD
-5.99E-05 -0.000119 0.003272 -0.02681 8.042974
3990.031 0.0001* 0.0001*
USDTRY
0.000388 -5.04E-05 0.011821 7.767309
230.982
8191557 0*
0.0001*
USDTWD
2.89E-06
0 0.002608 -0.07191 11.62528
11674.04 0.0001* 0.0001*
The above table presents the descriptive statistics of Exchange rates of Oil Importing Countries. * indicates
significance at 10% level. ** indicates significance at 5% level.
KPSS
0.158719*
0.866871*
0.156216*
0.097042**
0.238164*
0.240431*
0.057599**
0.145047*
0.262793*
0.099586**
Table 3.6 presents the summary statistics and unit root tests for the return series of stock indices
of the oil-importing countries; we observe that almost all the stock indices are symmetric and
have excess kurtosis. JarqueBera test statistic confirms that stock indices are not normally
distributed. We have used augmented Dickey Fuller, Phillip Perron, and KPSS tests to confirm
stationarity of the variables and we found that all the variables are stationary in all three tests.
Table 3.6: Descriptive statistics of Stock Indices of Oil Importing Countries

JarqueVariables
OIL
Mean
0.000167
Median
Std. Dev.
0.000786
0.023141
Skewness
-0.009804
102
Kurtosis
8.31155
Bera
ADF
3250.367
0.0001*
PP
0.0001*
KPSS
0.158719*
NKY
0.000183
0.015228
-0.554916
11.67691
8815.803
0.0001*
0.0001*
0.312146*
NIFTY
0.000522
0.000458
0.015884
-0.35219
13.77126
13423.64
0*
0.0001*
0.125163*
LQ45
0.000632
0.000461
0.016509
-0.543998
10.1022
5947.622
0.0001*
0.0001*
0.143543*
KOSPI
0.000309
0.000283
0.013808
-0.472962
10.67451
6888.635
0.0001*
0.0001*
0.118422*
IBEX
9.62E-05
0.000575
0.014942
0.055768
10.25676
6068.364
0.0001*
0.0001*
0.101506*
FTSEMIB
-0.000132
0.00035
0.015513
-0.111588
8.542054
3544.289
0.0001*
0.0001*
0.069051**
FSSTI
0.000235
0.000357
0.011518
-0.269898
9.731106
5253.404
0.0001*
0.0001*
0.181461*
DAX
0.000327
0.000761
0.013723
-0.074382
10.52291
6522.67
0.0001*
0.0001*
0.231125*
CAC
6.00E-05
0.000261
0.014189
-0.038182
10.41501
6335.092
0*
0.0001*
0.128887*
BEL20
0.000133
0.000353
0.012597
-0.248382
10.13169
5888.045
0.0001*
0.0001*
0.13536*
AEX
7.49E-05
0.000488
0.013391
-0.278989
12.73027
10943.59
0*
0.0001*
0.186987*
SPX
0.000228
0.000738
0.012471
-0.338365
14.5602
15449.01
0.0001*
0.0001*
0.310356*
SSE50
0.000331
0.017523
-0.077798
6.447665
1372.201
0.0001*
0.0001*
0.171298*
TWSE
0.000155
0.000116
0.01264
-0.38113
6.840836
1766.497
0.0001*
0.0001*
0.152821*
XU100
0.000537
0.000462
0.017707
-0.237159
6.333343
1306.019
0.0001*
0.0001*
0.07239**
The above table presents the descriptive statistics of Stock Indices of Oil Importing Countries over the period 20002014. * indicates significance at 10%, ** indicates significance at 5%.
103
Fig 3.2: Normalized Oil price and Exchange rate of oil importing countries
104
-1.6
-1.2
-1
-0.8
-0.4
-1
-1
-2
0.4
6
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
WTI OIL PRICE
USDCNY
WTI OIL PRICE
-3
-1
-2
-2
-1
-1
-2
-1
-1
-2
-2
4
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
USDINR
-1
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
WTI OIL PRICE
USDIDR
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
USDEUR
-2
-2
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
WTI OIL PRICE
-1
-2
0
0.8
1.2
-4
-2
0.0
-2
WTI OIL PRICE
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
USDJPY
3
2
WTI OIL PRICE
USDKRW
1
1
0
-1
-3
-1
-1
-2
-2
-2
-2
-1
-1
-2
-1
0
0
1
-2
2
2
3
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
WTI OIL PRICE
USDSGD
2
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
WTI OIL PRICE
105
USDTRY
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
WTI OIL PRICE
USDTWD
Fig 3.3: Normalized Oil price and Stock Indices of oil importing countries
106
-2
-1
-3
-1
-1
-2
-2
-2
00
01
02
03
04
05
06
07
08
WTI OIL PRICE
09
10
11
12
13
14
00
01
02
03
04
XU100
05
06
07
08
WTI OIL PRICE
09
10
11
12
13
14
WTI OIL PRICE
12
13
14
00
01
02
03
04
05
06
07
08
WTI OIL PRICE
09
10
11
12
13
08
WTI OIL PRICE
09
10
11
12
13
01
02
03
04
05
06
07
08
09
10
11
12
13
-2
-2
-1
WTI OIL PRICE
09
10
CAC
11
12
13
14
00
-1
-3
-2
-2
03
04
05
06
07
08
09
10
11
12
13
14
00
FSSTI
0
-2
-1
-1
-2
0
1
2
3
03
04
05
06
07
WTI OIL PRICE
08
09
10
11
12
13
BEL20
14
00
01
02
03
04
05
06
07
08
WTI OIL PRICE
09
10
11
12
13
14
AEX
The oil price, Exchange rates, and stock indices of the major oil-importing countries are plotted across
time. Oil series versus exchange rates(USDCNY, USDEUR, USDIDR, USDINR, USDJPY,
USDKRW, USDSGD, USDTRY, and USDTWD) were cross plotted in the Figure 3.1. Oil series
versus stock indices (NKY, NIFTY, LQ45, KOSPI, IBEX, FTSEMIB, FSSTI, DAX, CAC, BEL20,
AEX, SPX, SSE50, TWSE, and XU100) in normalized form were presented in the Figure 3.2.
It is inferred from the Figure 3.1., that the stock indices of the oil-importing countries are negatively
related to the oil price both before and after the financial crisis and the magnitude of the relationship
varies across the stock indices. It is inferred from the Figure 3.2, that the exchange rates are positively
107
05
06
07
08
01
02
03
04
05
06
07
08
WTI OIL PRICE
02
04
3
02
01
03
2
01
00
02
WTI OIL PRICE
-2
01
LQ45
3
08
14
2
07
13
06
12
2
05
11
04
10
WTI OIL PRICE
03
09
FTSEMIB
-2
08
-1
00
-1
07
-1
-3
06
14
-1
02
08
-2
01
07
3
00
-1
00
06
05
WTI OIL PRICE
04
IBEX
-1
03
14
-2
02
3
07
05
2
01
3
06
05
04
-1
03
-2
04
-2
00
03
-1
-1
WTI OIL PRICE
-1
02
NIFTY
-2
01
WTI OIL PRICE
-2
14
02
00
SSE50
-2
01
14
-2
00
13
-1
-1
12
NKY
-3
11
11
10
10
09
09
08
08
07
07
06
06
05
-2
05
04
-1
04
03
-2
03
02
-1
02
4
01
-1
01
WTI OIL PRICE
-2
-2
0
TWS E
-1
00
-2
00
-2
-4
-1
-1
0
-1
0
-2
related to the oil price during and after financial crisis except USDIDR and USDTRY and the
magnitude of the relationship varies across the exchange rates.
The results from the wavelet coherence were presented in the Figures 3.13.9 and 4.14.15. Horizontal
axis refers to time horizon, and the vertical axis refers to the frequency horizon. The curved line refers
to the 5% significance level which is estimated using Monte Carlo simulations.
3.7.1
Relationship Between Benchmark Oil Prices and Exchange Rates of the Oil-Importing Countries
Wavelet coherence is used to estimate the co-movement between the exchange rate and oil prices. The
coherency was depicted in the Figures 3.4.13.4.9. A weak relationship at higher frequencies is found
in both medium and long run. A greater significant co-movement is found during financial crisis than
in other periods.
The association between Euro against the US Dollar (USDEUR) and oil price as observed from the
Figure 3.4.1 is found to be high in both in medium and short term. The correlation is found to be high
from 2007 to 2012. It is also observed from the graph that during the crisis period the exchange rate
USDEUR is leading the oil price in the medium term, whereas in the long term, exchange rate
USDEUR is lagging the oil price. Anti-cyclical effect is observed in all the three frequencies (Short,
Medium, and Long).
Figure 3.4.2 depicts the correlation between Chinese Yuan against the US Dollar (USDCNY) and oil
price. The correlation is found to be low, as the USDCNY is closely administered by the central bank
of China. Only during the second half of 2008, a high coherency is observed. It is also observed from
the figure that during the same period, the exchange rate (USDCNY) is leading the oil price.
The relation between Indonesian rupiah against the US Dollar and oil price is represented in Figure
3.4.3.A significant negative relationship between Indonesian rupiah against US Dollar (USDIDR) and
oil price is found during crisis in both medium and long term. The period from 2006 to 2010 is
observed to have high coherency. It is also observed from the figure that during the crisis period, the
exchange rate USDIDR is leading the oil price. Anti-cyclical effect is observed in both long and
medium term.
108
Figure 3.4.4 presents the cohency between US Dollar and Indian Rupee. A high coherency between the
India exchange rate (USDINR) and oil price is observed during crisis in both medium and long term.
It is also observed from the graph that during the crisis period, the exchange rate USDINR is lagging
the oil price in the long term, whereas in the medium term exchange rate USDINR is leading the oil
price.
The correlation between Japanese exchange rate against the US Dollar (USDJPY) and oil price is
found to be high (Figure 3.4.5) in the long term. A high coherency and cyclical effect is observed
during 20072010. It is also observed from the figure that during the same period the exchange rate
USDJPY is leading the oil price.
Figure 3.4.6 depicts the association between the South Korea exchange rate against US Dollar
(USDKRW) and oil price. The correlation is found to be high during all times. It is also observed from
the figure that, during the crisis period, the exchange rate USDKRW is lagging the oil price in the long
term, whereas it is leading the oil price in medium term. Anti-cyclical effect is observed in all the three
frequencies.
The relation between the Singapore exchange rate (USDSGD) and oil price is represented in Figure
3.4.7. A high coherency is witnessed during crisis in the long term. During crisis, the exchange rate
USDSGD is leading the oil price in the medium and long term. Anti-cyclical effect is also observed
during the crisis.
The association between Turkey exchange rate against the US Dollar (USDTRY) and oil price is
depicted in the Figure 3.4.8. A high coherency is found during crisis in both in medium and long term.
It is also observed from the graph that, during crisis, the exchange rate USDTRY is leading the oil
price in the medium and long term.
The correlation between the New Taiwan Dollar against US Dollar (USDTWD) and oil price is
presented in Figure 3.4.9. The correlation is found to be high in the long term, medium term and short
term. The short-term correlation is high during 2010. The correlation in medium term is high during
2005, 2007, and 2009. Long-term correlation is high during 20072010. Anti-Cyclical effect is
observed in the long term. It is also observed from the graph that in the long term, the exchange rate
USDTWD is lagging the oil price.
109
Fig 3.4: Benchmark oil prices and exchange rates - Wavelet Coherence (WTC)
Fig 3.4.1: BRENT CRUDE OIL Vs USDEUR
Fig 3.4.2: OPEC CRUDE OIL Vs USDCNY
Fig 3.4.3: OPEC CRUDE OILVs USDIDR
Fig 3.4.4: OPEC CRUDE OIL Vs USDINR
110
Fig 3.4.5: OPEC CRUDE OIL Vs USDJPY
Fig 3.4.6: OPEC CRUDE OIL Vs USDKRW
Fig 3.4.7: OPEC CRUDE OIL Vs USDSGD
Fig 3.4.8: OPEC CRUDE OIL Vs USDTRY
111
Fig 3.4.9: OPEC CRUDE OIL Vs USDTWD
112
Note: The Figures presents the wavelet coherency plot between oil price and Exchange rate of oil importing
countries. The data spans from 6th January 2003 to 30th December 2014. Monte Carlo simulations are used to obtain
values for the significance. Wavelet-squared coherencies are indicated by contour, the 5% significance level is
denoted by a dashed black line contour and the area outside this line is the boundary affected zone. The area affected
by edge effects are denoted by the cone of influence and the area outside the cone of influence has no statistical
significance. The color code for coherency ranges from blue (close to zero) to red (close to one), where blue refers to
low coherency and red refers to high coherency.
It is found that during crisis, the oil price is highly correlated with almost all the exchange rates.
The Chinese and Singapore exchange rates have minimal coherency with oil price in all short,
medium and long term except during crisis. The South Korea and Taiwan exchange rates are
highly correlated with oil price of all times. A portfolio of smaller horizon with oil as an asset can
have better diversification by adding USDCNY, USDIDR, USDINR, USDJPY, USDSGD, and
USDTRY.Whereas a medium term portfolio can add USDCNY, USDJPY, and USDSGD to ensure
diversification. In the long term, adding USDCNY USDEUR, USDSGD to the portfolio, offers
diversification benefits.
3.7.2
Relationship Between the Benchmark Oil Prices and Stock Indices of the Oil-importing Countries
Wavelet coherence has been used to estimate the co-movement between Stock indices of the
major oil-importing countries and oil price. The results presented in a graph, i.e., from Figure
3.5.1 to Figure 3.5.15 indicate the level of coherency, cyclical effect and lead-lag pattern between
the variables. Co-movements were observed during the medium and long term for most of the
countries. The wavelet coheence plotsof stock indices and oil price show that, there is little or no
relationship in the short run or in higher frequencies. Possible co-movements are found in
medium and long run. In the time scale, we found high coherency during crisis but this coherency
in other periods found to be weak.
The coherency dynamics between the S&P 500 and oil price is presented in Figure 3.5.1. There
exists a significant relationship between S&P 500 and oil price during 2006 to 2012 in the short,
medium and long term. It is observed that during this period, S&P 500 is leading oil price and has
a positive effect on oil price. Cyclicality is also witnessed during 2007 to 2011.
The correlation between SSE 50 and oil price as observed from the Figure 3.5.2 is found to be
high in the long term and medium term. The medium term correlation is high during 2007-08. The
correlation in long term is high from 2006-2010.It is observed from the figure that in the long
term the stock index (SSE 50) is lagging the oil price.
113
Figure 3.5.3 depicts the association between the Japan Stock market Index (Nikkei 225) and oil
price. The correlation in long term is high during 20072010. The correlation in medium term is
high during 2008. It is observed from the graph that during this period the Nikkei 225 is lagging
the oil price in the long term. A positive cyclical effect is also observed in the long term.
The association between the NIFTY and oil price is presented in Figure 3.5.4. The correlation is
found to high in all frequencies. The correlation in medium term is high during 20072009. In the
long term, high correlation is observed from 2005 to 2012. It is also observed from the graph that
in the long term the NIFTY is lagging the oil price, whereas in the medium term it is leading the
oil price.
The correlation between the KOSPI and oil price is represented in Figure 3.5.5.A high coherency
is witnessed in all the frequencies. The high correlation in the long term is observed from 2006
2012. During this period, KOSPI is lagging the oil price in the long term. Positive cyclical effect
is observed during the crisis.
The coherency dynamics between the DAX 30 and oil price is presented in Figure 3.5.6. The
correlation between DAX 30 and oil price is found to high in the long term, medium term, and
short term. The correlation in short term is high during 2009. The correlation in medium term is
high during 20072008 and in long term it is high during 20072010. It is also observed from the
graph that in the long term, DAX is lagging the oil price.
Figure 3.5.7 presents the coherency between CAC and oil price. There exists a significant
relationship between the CAC and oil price in short, medium and long term. During 2008, 2009,
and 2012, a high correlation is observed between oil price and CAC in medium term. In the long
term, high coherenccy is observed during 20072010. It is observed that during this period CAC
is lagging oil price.
The correlation between the IBEX and oil price as observed from the Figure 3.5.8 is found to be
high in the long term. In the long term, high correlation is observed during 20062012. It is also
observed from the graph that, in the long term, the IBEX is lagging the oil price. A positive
cyclical effect is observed from the graph.
114
The correlation between the FSSTI and oil price is depicted in Figure 3.5.9.A high coherency is
found in all frequencies. The high correlation in long term is observed from 20062012. In the
medium term, high coherency is observed during 2005, 2008, and 2012. In the long term, FSSTI
is lagging the oil price. Positive cyclical effect is also observed.
Figure 3.5.10 presents the correlation between the FTSEMIB and oil price. The correlation is
found to be high in the long run. The correlation in medium term is high during 2008. In the long
term, high correlation is observed during 20062012. It is also observed from the graph that in the
long-term FTSEMIB is lagging the oil price. Positive cyclical effect is also observed during the
crisis.
The correlation between the AEX and oil price is depicted in Figure 3.5.11. A high correlation is
found in both long and medium term. The correlation in medium term is high during 20092010.
In the long term, high correlation is observed from 2006 to 2012. It is also observed from the
graph that, in the long term, the AEX is lagging the oil price. A positive cyclic effect is also
observed from the graph.
The coherency dynamics between the TWSE and oil price is presented in the Figure 3.5.12. A
high coherency is witnessed between Taiwan stock market index (TWSE) and oil price in the long
term, particularly from 2006 to 2012. During this period, TWSE is lagging the oil price in the
long term.
The correlation between XU 100 and oil price as observed from the Figure 3.5.13 is found to be
high in the long term. Correlation in long term is high during 20062011. It is also observed from
the graph that, in the long term, the XU 100 is lagging the oil price.
The correlation between LQ 45 and oil price is presented in the Figure 3.5.14. A high coherency is
found in both long and medium term. The correlation in medium term is high during crisis 200708. In the long term, high correlation is observed from 2006 to 2010. It is also observed from the
graph that in the long term the LQ 45 is lagging the oil price.
Figure 3.5.15 depicts the correlation between BEL 20 and oil price. A high coherency is witnessed
between Belgium stock market index (BEL 20) and the oil price in short, medium, and long term.
115
The high correlation in the long term is observed during 20062011. In the long term, BEL 20 is
lagging the oil price. A Positive cyclical effect is also observed.
Fig 3.5: Benchmark oil prices and stock indices - Wavelet Coherence (WTC)
Fig 3.5.1: WTI CRUDE OIL Vs SPX
Fig 3.5.2: OPEC CRUDE OIL Vs SSE50
Fig 3.5.3: OPEC CRUDE OIL Vs NKY
Fig 3.5.4: OPEC CRUDE OIL Vs NIFTY
116
Fig 3.5.5: OPEC CRUDE OIL Vs KOSPI
Fig 3.5.6: BRENT CRUDE OIL Vs DAX
Fig 3.5.7: BRENT CRUDE OIL Vs CAC
Fig 3.5.8: BRENT CRUDE OIL Vs IBEX
117
Fig 3.5.9: OPEC CRUDE OIL Vs FSSTI
Fig 3.5.10: BRENT CRUDE OIL Vs FTSEMIB
Fig 3.5.11: BRENT CRUDE OIL Vs AEX
Fig 3.5.12: OPEC CRUDE OIL Vs TWSE
118
Fig 3.5.13: OPEC CRUDE OIL Vs XU100
Fig 3.5.14: OPEC CRUDE OIL Vs LQ45
Fig 3.5.15: BRENT CRUDE OIL Vs BEL20
Fig 4: Wavelet coherency plot between oil price and Stock Indices of oil importing countries. Data spans from 6 th
January 2003 to 30th December 2014 except for Chinese stock index (SSE50). For SSE50 the sample period starts
from 5th January 2004.Values for the significance were obtained from Monte Carlo simulations using phase
randomized surrogate series. Contours denote wavelet-squared coherencies, the dashed black line contour is the 5%
significance level and outside of the thin line is the boundary affected zone. The cone of influence indicates the
119
region affected by edge effects and the results outside this show no statistical significance. The color code for
coherency ranges from blue (close to zero) to red (close to one), where blue refers (low) and red refers (high)
coherency.
Table 3.7: Relationship during financial crisis

Oil price and Stock Indices
Time /
Medium
Run/
Medium
Long Run/
Low
USDCNY
(-)
(-) Lead
(+) Lag
USDEUR
(-) Lead
(-) Lag
(+) Lag
(+) Lag
USDIDR
(-) Lead
(-) Lead
(+) Lag
(+) Lag
USDINR
(-) Lag
(-) Lag
(+) Lag
(+) Lag
USDJPY
(+) Lead
(+)
(+) Lag
(+) Lag
USDKRW
(+) Lead
(-)Lag
(+) Lag
(+) Lag
USDSGD
(-) Lead
(-)
(+) Lag
(+) Lag
USDTRY
(-)Lag
(-) Lead
(+) Lag
(+) Lag
USDTWD
(-)Lead
(-)Lag
(+) Lag
(+) Lag
(+) Lag
(+) Lag
SPX
(+) Lag
(+) Lag
SSE50
(+) Lag
(+) Lag
TWSE
(+) Lag
(+) Lag
XU100
(+) Lead
(+) Lag
Frequency
Scale
Short Run/
High
Oil price and Exchange Rates
NKY
NIFTY
LQ45
KOSPI
Weak or
IBEX
FTSEMIB
NO
FSSTI
DAX
CAC
Visible
BEL20
AEX
Relationship
Medium
Run/
Medium
Long Run/
Low
Time /
Frequency
Scale
(+) Lag
(+) Lead
(+) Lead
Short Run/
High
Weak or
NO
Visible
Relationship
*Discontinuity in relationship is prevalent in medium and high frequencies across all time periods
120
3.8 Summary
In this paper, we examined the co-movement between the nominal oil price and macro-economic
indicators such as exchange rate and stock index of the oil-importing countries. Our sample starts
from 6th January 2003 to 30th December 2014 except for china. The sample period for China
(SSE50) starts from 5th January 2004 to 30th December 2014. In this study, we investigated the
inter relationship between the nominal oil price and macro-economic indicators both in the time
and frequency domains simultaneously. The wavelet analysis allows us to measure the comovement in the timefrequency space. This study has important findings, (i) we found
discontinuity in the co-movement at both time and frequency scales. (ii) Weak or no relationship
is found in the short run (i.e.) high frequency and visible relationship found in medium and long
run. (iii) The leadlag relationship changes across frequencies and time. (iv) During the period
of high coherence (i.e.) during financial crisis, the Nominal Exchange rates of the oil-importing
countries are in Out of the phase (Negative relationship) except Japan in the long run and
South Korea in the medium run. (v) Stock Indices are in in the phase (Positive relationship) in
both long and medium run.
121
Chapter 4
Conclusion
Understanding the determinants and their association with the crude oil helps in estimating the
price and the volatility of crude oil. The determinants include fundamental, financial, and
speculative factors. Most of the past studies concentrated on the supply and demand factors to
estimate the changes in the crude oil price. In order to have a better estimate of the crude oil, it is
required to capture all the factors that affect the crude oil. It is also required to capture the interrelationships among the factors to predict the crude oil price with minimal forecast error.
Markov-regime switching methodology is used to identify the determinants of the crude oil
price.
The date sample consists of monthly WTI crude oil spot price traded at NYMEX. The
fundamental factors include OECD consumption, OECD Imports, Industrial Production of
China, and Industrial Production of India, Total oil Rig Count, OPEC production, and OECD
inventory. The financial factors include Dollar index, S&P 500, and basis. Speculation factors are
Net Long Positions. The data sample spans from April 1995 to May 2014, yielding a total of 230
observations. Data is collected from different sources that include Energy Information Agency,
World Bank, Baker Hughes BHI International Rig Count, St. Louis Federal Reserve (USA) and
the US Commodity Futures Trading Commission.
Volatility in the crude oil price impacts economic cycles. Since many countries in the world are
either consumers or producers of oil, the volatility in the oil price impacts inflation, growth and
exchange rate of a country. Hence, it is required to understand the coherency between the oil
prices and macro-economic indicators. The study investigated the correlation between macroeconomic indicators of the major oil-importing nations and crude oil price. The macro-economic
indicators considered in the study are the Stock Market Index and Exchange Rate. Wavelet
coherence methodology is used estimate the co-movement between the macro-economic
indicators and crude oil.
The data sample for analyzing the co-movement include daily crude oil spot rate traded at
NYMEX, exchange rate of eight oil-importing countries against USD, and stock Index of 15
122
countries. The study is conducted over the period starting from 4thJanuary 2000 to
30thDecember 2014. The sample period is same for all exchange rates and indices except for
SSE 50. China (SSE50) sample period starts from 5th January 2004 to 30thDecember 2014.
4.1
Findings of the Study
The findings of the study are summarized as follows:

4.1.1
Effect of Speculation on the Oil Price: Measuring the Marginal Effect of Speculation
It is observed from the estimates of the Markov-regime switching regression, that noncommercial traders net long position has insignificant or weak effect on oil price in low-volatile
regime, whereas in high volatility regime, it has significant impact on the oil price at 90%
confidence level. This suggests that speculation has a marginal role in the WTI crude oil price
formation. It is also observed that only one state is significant and the difference in variance
between the states is minimal. These results suggest that speculation individually cannot explain
the WTI oil price changes and we need to further assess to understand how far speculation can
explain, if interacted with other fundamental and financial factors. It is observed from the figure
that the transition between the states have occurred in the middle of 2007 and reverted back to its
initial state at the end of first quarter of 2008.
4.1.2
Effect of Speculation on the Oil Price Controlling for Financial Factors
Markov-regime switching regression is used to analyze the effect of speculation controlling for
financial factors. It is observed from the results that speculation has a significant effect on the oil
price after controlling for financial factors in both high- and low-volatile regimes. In the previous
regression estimation, the partial effect of speculation on the oil price was weak. But when
controlled for financial variables the speculation is found to have significant marginal effect on
the crude oil price. This indicates that the non-commercial traders have significant impact on the
oil price formation when incorporated along with financial factors. The impact of dollar index
and S&P 500 on the crude oil is insignificant during bullish and bearish market periods but it has
significant impact in normal market phases. It is observed from the results that basis has minimal
123
role in explaining the price of the crude oil. It is observed from the graphs that the transition
between the states is more frequent.
4.1.3
Relative Importance of Determinants of Oil Price
Speculative factors has significant role at high-volatile regime but is insignificant at low-volatile
regime when controlled for financial and fundamental factors. Dollar index, Lagged WTI oil
price, OECD stock, Industrial production of India, and S&P 500 plays a significant role in
predicting the changes the crude oil regardless of the state. The impact of Basis, OECD net
imports, Industrial production of china, and OECD consumption on the crude oil is significant in
bullish and bearish market periods but it has insignificant impact in normal market phases.
It is also observed that Lag of oil price, S&P 500, Industrial production of India and OECD stock
has a positive impact on oil prices in low-volatile regime. Lag of oil price, Industrial production
of India, S&P 500, Industrial production of china and OECD stock has negative effect on oil
prices in the high-volatile state. During high-volatile state, Dollar Index is found to have positive
impact on oil price. Dollar Index is observed to have negative effect on the oil prices in lowvolatile state. OPEC production has significant positive relation with the crude oil price in both
the states. It is observed from the graphs that the transition between the states is comparatively
less frequent. Speculation has active role when combined with financial and fundamental factors
in high-volatile regime.
4.1.4 Oil price and Exchange rate: Wavelet Coherence (WTC)
The co-movement between exchange rate of the oil-importing countries against the US dollar
and oil price is investigated using wavelet coherence. The results are depicted in a pictorial form
and are presented in Chapter 3. A low coherency is observed between the oil price and exchange
rate of china (USDCNY). But during crisis a high coherency is observed between the oil price
and USDCNY. It is also found that during crisis USDCNY is leading the oil price.
Relationship between the oil price and euro zone exchange rate (USDEUR) was consistent
throughout the high and medium term but high coherence witnessed during financial crisis.
During crisis USDEUR is leading oil but in other periods USDEUR is lagging the oil price.
124
Correlation between the oil price and exchange rate of Indonesia (USDIDR) is high during
financial crisis. USDIDR is leading and that the oil price in long term.
Correlation between the oil price and exchange rate of India (USDINR) is high coherence during
financial crisis in both medium and long term. USDINR is lagging in long term, whereas it is
leading the oil price in medium term. A high coherency is witnessed between the oil price and
Japanese exchange rate against the US Dollar (USDJPY) during crisis. During the same period
USDJPY is leading the oil price. Singapore exchange rate (USDSGD) is highly correlated with
oil price during crisis. USDSGD is leading the oil price in the both medium and long term.
Other exchange rates that have higher coherence during all the times include exchange rate of
Korea (USDKRW), exchange rate of Turkey (USDTRY), and exchange rate of Taiwan
(USDTWD).USDKRW is it is leading the oil price in medium term, whereas lagging the oil price
in the long term. USDTRY is leading the oil price in both medium and long term. USDTWD is
lagging the oil price in all three terms.
4.1.5
Oil price and Stock Indices: WTC
Wavelet coherence was used to estimate the co-movement between the Stock indices of the
major oil-importing countries and oil price. The results were present in a graph in Chapter 3.
Correlation between the stock indices and oil price is high during crisis in short, medium and
long term for the US stock market index (S&P 500), Indian stock market index (NIFTY),
Korean stock market index (KOSPI), German stock market index (DAX 30), French stock
market index (CAC), Singapore stock market index (FSSTI), and Belgium stock market index
(BEL 20). High coherency is witnessed between stock indices and oil prices in the long and
medium term for Chinese stock market index (SSE 50), Netherland stock market index (AEX),
and Indonesian stock market index (LQ 45). The other countries indices correlation with oil
price is high during crisis only in long term. Those stock markets include Japan Stock market
Index (Nikkei 225), Spain stock market index (IBEX), Italian stock market index (FTSEMIB),
Taiwan stock market index (TWSE), and Turkey stock market index (XU 100).
It is observed from the graph that during crisis oil price is leading, KOSPI, DAX, NIFTY, CAC,
IBEX, FSSTI, FTSEMIB, AEX, TWSE, XU 100, BEL 20, LQ 45, and Nikkei 225 in the long
125
term. It is observed from the graph that NIFTY is leading the oil price in the medium term .It is
also observed from the graph that in the long term S&P 500 is leading the oil price.
4.2 Conclusion
The study examined the determinants of crude oil and their impact on the WTI oil price. Markovregime switching methodology was used to analyze the significance of various factors in the
presence of high- and low-volatile regimes. The hypothesis that the coefficient of speculative
variables is zero is could not be rejected. This implies that Speculation individually cannot
explain the changes in the crude oil price and the results have not differed across the regimes.
The hypothesis that The coefficient of the speculative variable is zero controlling for financial
factors is rejected. This implies that speculative factors can explain the variations in the crude
oil price when controlled for financial factors. This is true for both the regimes.
The hypothesis thecoefficient of the speculative variable is zero controlling for fundamental
and financial variables, is rejected. This indicates that speculative factors explain the variations
in the WTI crude oil price when controlled for both financial and Fundamental determinants.
This holds only in the high-volatile regime, whereas in low-volatile regime, fundamental and
financial factors are responsible for the fluctuations in the oil price.
Co-movement between WTI oil price and macroeconomic variables such as stock index and
exchange rate was analyzed for the major oil-importing countries using Wavelet Coherence
methodology. The hypothesis The effect of the WTI crude oil prices on Exchange rate of the
oil-importing countries is not statistically significant, was strongly rejected. This indicates that
the oil price and exchange rate of the major oil-importing countries are correlated, especially in
the long term. For most of the countries exchange rate against the dollar is leading the oil price.
For countries such as India, Korea, Taiwan, and Euro region the oil price is leading individual
country exchange rate against the US dollar in the long term, whereas in medium term oil price is
lagging exchange rate.
The hypothesis The effect of the WTI crude oil prices on Stock Index of the oil-importing
countries is not statistically significant, is rejected. This indicates that oil price and stock indices
126
of the major oil-importing countries are correlated in long and medium term but not in short
term. Oil price is leading most of the stock market indices except S&P 500 in the long term. In
medium term except NIFTY in all other cases oil price is leading stock market index.
Table 4.1: Summary of Hypothesis results
High
Number
Hypothesis
Low regime
H01
Presence of linear relationship
Rejected
Rejected
Supported
Supported
Rejected
Rejected
Rejected
Supported
Short term
Long term
Supported
Rejected
Supported
Rejected
There is no significant impact of speculative factors on
H02
WTI oil prices

There is significant impact of speculative factor on
H03
WTI oil prices controlling for Financial factors
regime
There is no significant impact of speculative factors on

H04
WTI oil prices controlling for Fundamental, Financial

and Supply disruption factors
Number
H05
H06
4.3
Hypothesis
The effect of WTI crude oil prices on Exchange rate of
oil importing countries is not statistically significant
The effect of WTI crude oil prices on Stock Index of
oil importing countries is not statistically significant
Contribution of the Study
Most of the previous studies have used linear models to estimate the factors influencing
the price of the crude oil. The present study used Markov-Switching Methodology which
addresses the non-linearity and structural breaks issues. Hence this study contributes to
the literature by using superior methodology in determining the factors affecting the
crude oil price.
127
The interaction among the speculative, fundamental, and financial variables was not
analyzed in most of the literature and also there was no consensus on the significance of
speculation in the determination of the oil price.
Central Banks are concerned with the oil price stability, as the fluctuations in the oil price
effects various macro-economic variables such as inflation, interest rate, and exchange
rate. The study provides important insights to central banks and government as
understanding co-movements between the oil price and macro-economic variables
analyzed helps in maintaining a stable interest rate and the countries exchange rate.
To plan an effective energy policy, International oil companies rely on the projections of
the oil price. The study provides inputs to the institutions by providing the factors
affecting the crude oil price. The study also provides insights to policy makers.
4.4
Implications
Role of speculation in the oil price

(1) The speculative factors alone cannot explain the variations in the crude oil.
(2) The speculative factors determine the crude oil price when financial and fundamental
factors controlled in high-volatile regimes.
The long-term correlation between the oil price and macro-economic factors implies that
(1) The exchange rate is leading the oil price. This shows that the oil price can be determined
using the lag of exchange rate.
(2) The stock market index is the lagging oil price. This implies that the stock index can be
estimated using the oil price lags.
4.5
Limitations of the Study
128
(1) Various determinants were incorporated into the model to see how speculative variables
behave with respect to other determinants such as fundamental and financial factors.
While we know political factors such as type of Government (democracy, monarchy
etc) and type of economy (open economy, closed economy etc) play a key role in
determination of the oil prices, we discontinued these factors due to unavailability of data
and ambiguity in measurement.
(2) The short-run relationships in wavelet coherence analysis were not captured due to high
frequency daily data. But using weekly or monthly data could better visualize the shortrun movements or relationship between variables.
4.6
Scope for Future Research
Apart from Non-commercial Net long position, other speculative variables have to be identified
and included in the analysis of impact of speculative factors on the crude oil price.
Asymmetric effects of the crude oil on macro-economic variables provide a better understanding
on the correlation between the oil price and economic variable. A future scope of the work can be
estimation of asymmetric effects.
The co-movement is observed only for the stock indices and exchange rate. The correlation with
other macro-economic variables such as interest rate and inflation with the oil price might
provide more insights on fluctuations in the crude oil price.
129

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OIL PRICE DETERMINANTS AND CO-MOVEMENT DYNAMICS

for the award of the degree

DEPARTMENT OF MANAGEMENT STUDIES

Importance of oil price determinants......................................................................................10

Literature on factors influencing oil price..............................................................................13

Framework of the study ........................................................................................................16

Data and Sample....................................................................................................................17

2.5.1. BDS test for Non-Linearity.................................................................................................25

2.6.1. Hypothesis 1: Test for Non-linearity...................................................................................34

3.6. Wavelet coherence -Inference.. 43

Contributions of the study...................................................................................................101

Limitations of the study.........................................................................................................102

1.1 Energy Market Share...............................................................................................................

1.1 Framework of the study...........................................................................................................

IBEX - IBEX 35 (Spain)

Growth in supply (% P.a.)

share in world fuel

Cifarelli and Paladino (2010) used a multivariate generalized autoregressive conditional

H2: There is no significant impact of speculative factors on WTI oil prices

Crude oil price (Spot)

Major Oil Importing countries1

1.7 Data and Sample

Energy Information Administration

Energy Information Administration

Energy Information Administration

CHINA Industrial Production (US$)

INDIA Industrial Production (US$)

Energy Information Administration

Energy Information Administration

St. Louis Federal Reserve (U.S.A.)

St. Louis Federal Reserve (U.S.A.)

Basis - Oil (Futures) (NYMEX)

Energy Information Administration

Commodity Futures Trading Commission

Table 1.4: Exchange rate Data

South Korean Won

New Taiwan Dollar

Korea Composite Stock Price Index

Straits Times Index

Amsterdam Exchange index

Standard & Poor's 500

Shanghai Stock Exchange 50

Taiwan Stock Exchange Weighted

is the coefficient of the independent variable and

represents the error term.

Speculation on Oil Price

WTI oil=Intercept + 1 NC NET LONG POS + 2 SP500+ 3 Dollar Index+ 4 12 M Basis+

independent variable respectively, and have to be estimated.

are the coefficients of the

represent the error term.

Relative Importance of Determinants of Oil Price

the independent variable, respectively, that have to be estimated.

are the coefficients of

represents the error term.

1.10 Outline of the Thesis

Determinants of oil price: A Markov-regime switching

The effect of speculative factors on the oil price,

Research Gap and Motivation

Table 2.1: Summary of literature on determinants of the crude oil

Role of Inventories for

VAR and sensitivity

1. Flow Demand shock

Notes: * - 10% significance, - 5% significance, * - 1% significance

Notes: * - 10% significance, - 5% significance, * - 1% significance

Notes: * denotes 10% significance, denotes 5% significance, * denotes 1% significance