Price Discovery in a Financialized Oil Market

Abstract

We postulate that financialization expands price discovery for crude oil and test this hypothesis by examining causal relations between daily returns to prices for crude oil and stocks of nine oil companies. We find that daily returns to stocks of oil companies ‘Granger cause’ daily returns to the price of crude oil ( $\mathrm{Stock}\to \mathrm{Price}$ ), which indicates that stock returns have information about future and spot prices beyond variables that represent market fundamentals and financial conditions. This result suggests that financialization expands price discovery for crude oil beyond market fundamentals. We also find that returns to futures and spot prices for crude oil ‘Granger cause’ returns to oil companies ( $\mathrm{Price}\to \mathrm{Stock})$ . This extends previous results that returns to oil prices correlate with the profitability of oil companies, which drive returns to oil companies. Furthermore, we find that strength of financialization changes over time due to changes in the returns to holding oil as a commodity, which we proxy by convenience yields. Both the $\mathrm{Stock}\to \mathrm{Price}$ and the $\mathrm{Price}\to \mathrm{Stock}$ causal relations weaken when convenience yields are high, which suggests that higher returns to holding crude oil as a commodity weaken the relative importance of financialization. Finally, a $\mathrm{Stock}\leftrightarrow \mathrm{Price}$ bidirectional causal relation may allow institutional investors to influence the transition from oil and may allow the Federal Reserve Board of Governors to dampen inflation with smaller interest rate hikes.

JEL Classification: G13 Contingent evaluation, futures pricing, Q4 Energy, Q41 Demand and Supply, Prices.