THE ROLE OF HIGHER OIL PRICES:

A CASE OF MAJOR DEVELOPED

COUNTRIES
T. J. ONeill, J. Penm and R. D. Terrell
ABSTRACT
The primary aim of this chapter is to examine whether the recent increase
in world oil prices has affected inflation expectations and stock market
returns in major OECD countries. The key findings are as follows. First,
we found no evidence to support the presence of a long term relationship
between oil prices and inflation expectations measured by the difference
between yields of inflation indexed and non-inflation indexed government
bonds over the sample between early 2003 and late 2006. Second, higher
oil prices are found to lead to expectations of higher inflation. This
evidence is stronger over the period where oil prices had been higher and
signs of capacity constraints in the economy were emerging. Third, the
impact of higher oil prices on stock market returns differs among
countries. While higher oil prices are found to adversely affect stock
market returns in the United States, the United Kingdom and France, the
effects are positive in Canada and Australia as these countries are
significant exporters of energy resources.

Research in Finance, Volume 24, 287299

Copyright r 2008 by Emerald Group Publishing Limited
All rights of reproduction in any form reserved
ISSN: 0196-3821/doi:10.1016/S0196-3821(07)00211-0

287

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T. J. ONEILL ET AL.

1. INTRODUCTION
Ination expectations play an important role in the determination of
actual ination and stock market valuations. Recent research has suggested
that ination expectations may have declined over the past decade (BIS,
2006). While the decline in ination expectations could be attributed
to several economic developments, including improved creditability in
monetary policy setting and reduced wage pressure due to increased labour
market exibility and productivity growth, an issue of interest is the impact
of recent signicant increases in world oil prices on ination expectations
and stock market returns.
World oil prices have increased signicantly since 2003. For example, the
price of commonly quoted West Texas Intermediate (WTI) crude oil rose
from approximately US$28 a barrel in early 2003 to a high of approximately
US$78 a barrel in mid-August 2006 before a partial reversal to approximately US$60 dollar a barrel in December 2006.
The importance of oil to economic activity has been well documented in
economic literature (for a survey, see Jones & Leiby, 1996; Barsky & Kilian,
2004). Energy, especially oil, expenditures account for a relatively large
proportion of gross domestic product in most developed countries. As such,
a signicant increase in oil prices will lead to a substantial rise in production
costs and hence upward pressures on wages and ination. The resultant
changes in investors ination expectations will have important implications
for their portfolio investment.
There has been signicant research interest in the role and impact that oil
and other energy sources have on stock market returns. Papers such as Faff
and Brailsford (1999), Jones and Kaul (1996), and Al-Mudhaf and Goodwin
(1993) examined the inuence of oil price movements in the determination
of prices in the stock markets of the United States, Canada, the United
Kingdom and Australia. While their ndings indicate a negative response
from many industries to higher oil prices, the issue is complicated by the
ability of rms to pass on the cost increases to consumers or by the extent to
which rms hedge against oil price risk.
While the negativity of higher oil prices on ination and stock market
performance was evident in the previous oil price shocks, the effect of the
recent oil price spike appears to be less clear. Notwithstanding the recent
signicant increase in world oil prices, inationary pressures in major
OECD countries have remained relatively modest. In the United States, for
example, the ination rate is estimated to have been approximately 3.2 per
cent in 2006 and 3.4 per cent in 2005. This compares with annual ination of

The Role of Higher Oil Prices: A Case of Major Developed Countries

289

over 13 per cent in the late 1970s and early 1980s (during which oil price
spiked to approximately US$80 dollar a barrel in 2006 dollar terms).
Similarly, ination in the euro area has been well below an annual rate of
3.0 per cent.
Despite the signicant increase in world oil prices, stock market
valuations in major OECD countries have increased signicantly. Between
early 2003 and late 2006, for example, the Dow Jones industrial average in
the United States increased by approximately 55 per cent, while rises of 87,
73 and 110 per cent were recorded in Canada, the United Kingdom and
France respectively over the same period.
Given these movements, an important question emerges as to whether oil
prices remain a signicant factor affecting ination expectations and stock
market returns. As mentioned earlier, there have been suggestions that
ination expectations may have declined in recent time due to labour market
reforms and creditable monetary policy management. Under this economic
environment, whether oil prices remain an important factor in investors
decision making is a question that requires an investigation.

1.1. Managerial Implications for Financial Services and Standards

In this chapter, the techniques of autoregression with exogenous variables
are utilised to examine whether the recent increase in world oil prices has
affected ination expectations and stock market returns in major OECD
countries. While the modelling techniques are applicable to other nancial
market analyses, several key ndings in this chapter provide managers with
important information for decision-making.
First, no evidence is found to support the presence of a long term
relationship between oil prices and ination expectations measured by the
difference between yields of ination indexed and non-ination indexed
government bonds. Second, higher oil prices are found to lead to
expectations of higher ination. This is especially the case when oil prices
are higher and signs of capacity constraints in the economy are emerging.
Third, the impact of higher oil prices on stock market returns, in aggregate,
differs among countries. While higher oil prices adversely affect stock
market returns in the United States, the United Kingdom and France, the
effects are positive in Canada and Australia as these countries are signicant
exporters of energy resources.
In recent years, there has been increased exposure of nancial services
companies and investment and superannuation funds to international stock

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T. J. ONEILL ET AL.

and money markets. As such, the content of this chapter provides important
information and a useful tool for decision-making.
In this chapter, we examine the relationships between oil prices and
ination expectations and stock market returns for a number of OECD
countries, including the United States, Canada, the United Kingdom,
France and Australia. To examine the effect of oil price movements on
ination expectations, we employ daily observations on the difference
between yields of ination indexed and non-ination indexed government
bonds. Specically, we test whether an increase in oil prices will lead to a
widening between yields of these bonds. Because bond yields are market
determined, they are expected to provide superior approximation of
ination expectations than the results obtained from surveys. To our
knowledge, such a relationship has not been examined in previous studies.
For stock market returns, we estimate the relationship between movements
in oil prices and stock market indices. This estimation is also undertaken
using daily observations.
The remainder of this chapter is organised as follows. In Section 2, an
examination of changes in ination expectations and oil price movements is
presented. The estimation results of the relationship between oil price
movements and ination expectations are discussed in Section 3. In Section 4,
the sensitivity of stock market returns to oil prices is estimated. A summary is
given in Section 5.

2. CHANGES IN INFLATION EXPECTATIONS

World oil prices have exhibited considerable volatility over the past few
years (Fig. 1). Reecting strong growth in demand and concerns in
marketplace about actual and potential supply disruptions, the price of WTI
crude oil increased steadily between early 2003 and late 2004. After late
2004, the WTI price continued to rise with somewhat larger uctuations,
before a signicant decline in late 2006.
In Figs. 25, measures of ination expectations in four OECD countries,
namely the United States, the United Kingdom, Canada and France, are
presented. These measures are obtained by calculating the difference
between yields of ination indexed and non-ination indexed government
bonds. These bond yields were obtained from central banks of the above
named countries. For the United States and Canada, yields of the 10 year
government bonds were adopted. For the United Kingdom, yields of the

291

2006-01-18

2006-03-30

2006-06-12

2006-08-23

2006-03-30

2006-06-12

2006-08-23

2005-11-02

2005-08-19

2005-06-07

2005-03-23

2005-01-07

2004-10-22

2004-08-11

2004-05-28

2006-01-18

Fig. 1.

2004-03-17

2004-01-05

2003-10-15

2003-08-01

2003-05-21

90
80
70
60
50
40
30
20
10
0
2003-03-10

US$

The Role of Higher Oil Prices: A Case of Major Developed Countries

West Texas Intermediate Oil Price.

3.5
3
%

2.5
2
1.5

Fig. 2.

2005-11-02

2005-08-19

2005-06-07

2005-03-23

2005-01-07

2004-10-22

2004-08-11

2004-05-28

2004-03-17

2004-01-05

2003-10-15

2003-08-01

2003-05-21

2003-03-10

US Ination Expectations.

5 year government bonds were used. For France, we used the implied
ination rates released by Banque De France, which were calculated based
on yields of ination and non-ination indexed government bonds. The
sample period covers 10 March 2003 to 29 September 2006.
Interestingly, ination expectations in the four OECD countries exhibit
similar movements over the sample period. Ination expectations were
relatively subdued, or in most cases declined, in the rst half of 2003, before

292

T. J. ONEILL ET AL.
3.50
3.00

2.50
2.00
1.50

10/09/2005

10/12/2005

10/03/2006

10/06/2006

10/09/2006

10/12/2005

10/03/2006

10/06/2006

10/09/2006

10/06/2005

10/03/2005

10/12/2004

10/09/2004

10/09/2005

Fig. 3.

10/06/2004

10/03/2004

10/12/2003

10/09/2003

10/06/2003

10/03/2003

1.00

UK Ination Expectations.

3.5
3
%

2.5
2
1.5

Fig. 4.

10/06/2005

10/03/2005

10/12/2004

10/09/2004

10/06/2004

10/03/2004

10/12/2003

10/09/2003

10/06/2003

10/03/2003

Canada Ination Expectations.

a signicant increase between mid-2003 and mid-2004. Between mid-2004

and late 2006, ination expectations appear to have been uctuating around
a certain level in each country. For the United States, ination expectations were centred on an annual rate of approximately 2.5 per cent. For
the United Kingdom and Canada, the expectations were around annual
ination of 2.53.0 per cent. In France, ination expectations were relatively
low, uctuating around an annual rate of 2.0 per cent.

The Role of Higher Oil Prices: A Case of Major Developed Countries

293

2.4
2.2

2
1.8
1.6
1.4
1.2

Fig. 5.

10/09/2006

10/06/2006

10/03/2006

10/12/2005

10/09/2005

10/06/2005

10/03/2005

10/12/2004

10/09/2004

10/06/2004

10/03/2004

10/12/2003

10/09/2003

10/06/2003

10/03/2003

France Ination Expectations.

Compared with the price of WTI crude, the measures of ination

expectations demonstrate a different movement in trend terms. While oil
prices and ination expectations both increased over the period mid-2003
to mid-2004, ination expectations did not rise signicantly after mid-2004.
This is in contrast to oil price movements which exhibit a further upward
trend after mid-2004.

3. OIL PRICES AND INFLATION EXPECTATIONS

3.1. Long Term Relationship
The examination of data movements suggests that there is no long term
relationship between ination expectations and oil prices over the sample
period investigated. To conrm this conclusion, we also utilise the test for
co-integration developed by Engle and Granger (1987). In this test, we rst
test for the presence of unit roots in the ination expectations series using
the Dickey and Fuller (1979) test. The results indicate that the series are all
integrated of order 1 (the so-called I(1) series).
For crude oil, we took the benchmark price for each individual country
and convert it into local currency terms. We used the price of WTI crude for
the United States, the price of North Sea Brent crude for the United
Kingdom and France and the price of Lloyd Blend crude for Canada. These

294

T. J. ONEILL ET AL.

prices were sourced from the US Department of Energy and Datastream.

All the oil price series were converted into local currency terms and in
logarithms. The Dickey and Fuller test results indicate that all of the oil
prices in local currency terms are characterised as I(1) series.
Applying the Engle and Granger test, the results indicate that the series,
ination expectations and oil prices are not co-integrated over the sample.
This suggests that, while oil prices are an important factor that can inuence
ination, there is no long term relationship between oil prices and ination
expectations.

3.2. Short Term Influence

To examine the short term effect of oil price movements on ination
expectations, we utilised a model of autoregression with exogenous variables
(ARX). Because it is unlikely for ination expectations to affect oil price
movements, the ARX model is regarded as a suitable representation for
such estimation.
There are, of course, other factors that can also inuence ination expectations, such as the prospects for economic growth etc. However, the use of
daily observations has limited the availability of data for economic
variables. To approximate the effect of changing economic prospects on
ination expectations, we included the stock market index of each country
in the associated ARX model. The ARX model is expressed as follows:
dF t a

n
X
i1

dF t
i

m
X
j0

d lnPOt
j

l
X

d lnI t
k
t

(1)

k0

where Ft, POt and It denote ination expectations, oil price and the stock
market index respectively at period t.
The stock market indices (sourced from Datastream) are the index of
Dow Jones industrial average for the United States, the TSX composite
index for Canada, the FTSE 100 index for the United Kingdom and the
CAC 40 index for France. We utilised the techniques developed by Penm,
Penm, and Terrell (1994) to determine the specications of the ARX models.
For Canada, the initial results using the TSX composite index was
unsatisfactory with coefcient signs inconsistent with a priori expectations.
To improve the estimation, we replaced the TSX composite index by the
Dow Jones index. Because the Canadian economy is closely linked to the US
economy, it is likely that developments in the US economy, and hence

The Role of Higher Oil Prices: A Case of Major Developed Countries

295

movements in the US stock market index, provide leading information for

ination expectations in Canada.
The estimation results are presented as follows:
United States
dF t 0:0002 0:1636 d lnPOt 0:3293 d lnI t

(2)

dF t
0:0004 0:0359 d lnPOt 0:5293 d lnI t

(3)

United Kingdom
dF t 0:0003 0:0436 d lnPOt
1 0:2838 d lnI t

(4)

0:30

4:07

2:59

Canada
0:46

0:39

1:25

1:45

4:10

3:49

France
dF t 0:0000 0:0006 d lnPOt 0:0020 d lnI t
0:16

2:17

(5)

3:29

t-statistics in brackets.
To ensure serial correction is not a problem in the estimations, we applied
the order selection procedure developed by Penm and Terrell (1984) to each
residual series. The results indicate that serial correction is not a problem.
The specications determined for the four OECD countries indicate that
ination expectations adjust rapidly based on oil price movements and changes
in the economic prospects, as measured by the stock market index. For all
countries, lagged ination expectations were not selected in the specications,
indicating that lagged ination expectations contain little information about
current ination expectations. Except for the United Kingdom, movements
in oil prices are found to instantaneously affect ination expectations.
On the basis of the coefcient estimates, ination expectations in the
United States are most sensitive to changes in oil prices. This result is
consistent with a priori expectations because the United States is the worlds
largest oil consumer and its economy relies heavily on imports to meet its
domestic oil and energy consumption. For all the countries investigated,
ination expectations are found to be relatively sensitive to changes in
economic prospects measured by changes in the stock market index.
The coefcient estimates of the oil price variables for Canada and the
United Kingdom are not statistically signicant at the 5 per cent level.
One hypothesis to explain these results is that, in these two countries,

296

Table 1.
Country

T. J. ONEILL ET AL.

Impact on Ination Expectations: Early 2006 to Late 2006.

US

Canada

UK

France

0.3836
(5.00)

0.2498
(2.23)

0.0894
(2.17)

0.1219
(1.99)

Note: t-statistics in brackets.

ination expectations will be signicantly affected by oil prices only when oil
prices rise to certain high levels. To test this hypothesis, we re-estimated the
models using a latter period of the sample (between 17 January and 29
September 2006). Interestingly, all the coefcients of the oil price variables
are statistically signicant over this latter sample. The coefcient estimates
of the associated oil price variables are presented in Table 1.
It is noteworthy that the estimates presented in Table 1 are generally
larger than those obtained for the whole sample period. This suggests that,
in the latter sample, the sensitivity of ination expectations to oil price
movements increased, as oil prices rose to higher levels and the price
increases had been sustained.
There appear economic grounds to support this nding. Between 2003
and 2005, inationary pressures were relatively subdued in many OECD
countries. In 2006, however, there were increased market concerns about the
inationary impact of higher oil prices, as continued economic growth led to
emerging signs of capacity constraints (IMF, 2006). As the economy
approaches to its productive capacities, there will be a greater risk for higher
oil prices to incur a signicant increase in inationary pressures.

4. STOCK MARKET IMPACTS

Higher oil prices have the potential to affect stock market returns. In this
study, we focus on the aggregate effect, rather than the sensitivity of equity
returns on different industries. Higher oil, or more broadly energy, prices
will lead to an increase in production costs, which will place downward
pressures on industry equity returns. In energy exporting countries,
however, higher energy prices will boost returns from the oil and gas, coal
and diversied resources industries. Depending on the relative importance
of these industries, higher oil prices may result in a rise in stock market
valuations for energy exporting countries.
To examine the sensitivity of stock market returns to oil price movements,
we adopted the same techniques as used in the above analysis. An ARX

The Role of Higher Oil Prices: A Case of Major Developed Countries

297

model including three variables stock market index, oil price in local
currency terms and ination expectations was utilised. In most cases,
however, the variables of present and lagged ination expectations were not
selected in the specications.
We also include Australia in this estimation, as it is a signicant energy
exporter. We used the All Ordinaries index for Australias stock market
valuation and the price of Tapis crude in Australian dollar terms. In the
cases of Canada and Australia, we also included the Dow Jones index in the
models because the inuence of this index to the respective stock markets.
The estimation results are presented as follows:
United States
us
d lnI us
t 0:0006
0:0502 d lnPOt
0:0559 d lnI t
1
2:22

4:75

1:67

(6)

Canada
d lnI ct 0:0004 0:0797 d lnPOt 0:5643 d lnI us
t
1:89

9:68

0:1042 d
4:10

22:15

lnI us
t
1

0:0117 dF t
1

1:66

United Kingdom
uk
d lnI uk
t 0:0007
0:0253 d lnPOt
0:1510 d lnI t
1

(8)

d lnI ft 0:0009
0:0381 d lnPOt
1
0:0820 d lnI ft
1

(9)

2:65

2:05

4:55

France
2:61

2:38

2:43

Australia
d lnI at 0:0007 0:0451 d lnPOt 0:0366 d lnPOt
1
2:28

2:71

0:1695 d
5:09

lnI at
1

2:19

0:2703 d lnI at
2

8:56

us
0:4488 d lnI us
t
1 0:1213 d lnI t
2
10:23

10

2:63

t-statistics in brackets.
The estimation results conrm our hypothesis that the impact of higher
oil prices on stock market returns, in aggregate, differs between countries.
For signicant energy consuming countries, such as the United States, the

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T. J. ONEILL ET AL.

United Kingdom and France, the aggregate impact is found to be negative.

In contrast, higher oil prices provide support for aggregate stock market
returns in Canada and Australia, both of which are signicant exporters
of energy resources. As expected, movements in the Dow Jones index are
found to have signicant inuences on stock market returns in Canada and
Australia.
In the United States and the United Kingdom, the impacts of higher oil
prices on stock market returns are instantaneously, while the effect in
France is lagged. On the basis of the coefcient estimates, the adverse
impact of higher oil prices is most signicant in the United States, followed
by France and the United Kingdom.

5. SUMMARY
Over the past few years, world oil prices have increased signicantly. But
inationary pressures remain modest in the major world economies and
stock market valuations continue to rise. An important question associated
with these movements is whether oil prices remain an important factor in
determining ination expectations and stock market returns.
In this chapter, we examine the impacts on ination expectations and
stock market returns of recent increases in world oil prices. For a number of
OECD countries, we found no evidence to support a long term relationship
between oil prices and ination expectations. However, an increase in oil
prices, in local currency terms, is found to lead to expectations of higher
ination. This evidence is stronger over the latter sample period where oil
prices had been signicantly higher and capacity constraints were emerging
in the economy.
For stock market returns, we found the impact of higher oil prices is
different between countries. While higher oil prices adversely affect aggregate
stock market returns in major oil consuming countries, such as the United
States, the United Kingdom and France, the effects are positive for the
exporters of energy resources, including Canada and Australia.
An interesting extension will be to investigate the sectoral or industrial
effects of higher oil prices on stock markets. Such an analysis is, however,
outside the scope of the current study. In recent years, many superannuation
and investment funds have chosen to target the stock market index as
performance benchmarking or have increased their exposure to the so-called
index funds. As such, an analysis of the impact of higher oil prices on
aggregate stock market returns has its own importance.

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299

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