Oil prices and the stock prices of alternative energy companies
Introduction
“In the long run, households and businesses respond to higher fuel prices by cutting consumption, purchasing products that are more efficient, and switching to alternative energy sources. Higher energy prices also encourage entrepreneurs to invest in the research and development of new energy-conserving technologies and alternative fuels, further expanding the opportunities available to households and businesses to reduce energy use and switch to low-cost sources”. Economic Report of the President (2006, page 243).
Energy security issues (dwindling global oil supplies in the face of increased global demand, and political insecurity in oil rich countries), coupled with increased concern about the natural environment (climate changes like global warming and local air quality issues), are driving factors behind oil price movements and rising oil prices should help spur greater demand and supply of alternative energy (see for example, Rifkin, 2002, Bleischwitz and Fuhrmann, 2006, McDowall and Eames, 2006, New Energy Finance, 2007).
Concerns about future oil shortages stem from current estimates that predict world oil production will peak somewhere between 2016 and 2040 (Appenzeller, 2004). Oil is a globally traded commodity and the price of oil is determined by global oil demand and global oil supply conditions. Rapidly increasing demand for oil from emerging market economies like China and India, coupled with oil supply shortages will lead to much higher oil prices in the future and eventually a substitution away from oil to alternative energy sources. In the short to medium term, the outlook for oil is complex because the largest consumers of oil are not the countries with the largest reserves. Close to 60% of the world's proved oil reserves are contained in just five countries (Saudi Arabia, Iran, Iraq, Kuwait, and United Arab Emirates) (BP, 2006). The largest oil consuming region, North America (which accounts for approximately 30% of world consumption), has just 5% of the world's proved oil reserves. Moreover, 75% of the world's proved oil reserves are located in the Organization of the Petroleum Exporting Countries (OPEC) and most of the oil reserves in these countries are controlled by national oil companies which give these oil producing countries a disproportional amount of diplomatic leverage in world affairs. The eleven members of OPEC, Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and, Venezuela (www.opec.org), are for the most part, located in geopolitical hot spot regions of the world. Geopolitical uncertainty in regions of the world where large oil deposits are located creates a security issue for the large oil consuming nations. Scarce resources command a price and oil prices respond to the economics of global demand and supply conditions, geopolitics, institutional arrangements (OPEC), and the dynamics of the oil futures market.
Stress on the natural environment is also a major concern. The concentration of CO2 levels in the atmosphere had remained roughly constant for many thousands of years before taking a sudden upturn which coincides with the development of the modern industrialized economy. Over the past 140 years, atmospheric CO2 concentrations have risen by approximately 100 parts per million (ppm) from approximately 275 ppm to nearly 375 ppm (Glick, 2004). The increased concentration of CO2 contributes to global warming and global warming has the very real potential to disrupt the relationship between business and society as we know it (see for example, Duncan, 2006, Duncan, 2007). According to the United Nations sponsored Intergovernmental Panel on Climate Change (IPCC), a price of carbon in the range of $20 to $50 a ton by 2020–30 should stabilize CO2 concentrations in the atmosphere at an acceptable value of 550 ppm by the end of the century (Duncan, 2007). A carbon price can be established either through a carbon tax or a cap and trade system. With a cap and trade system, companies that hold their emissions below the cap can sell their remaining allowance on a carbon market. Companies that exceed their cap can purchase allowances on the carbon market. The introduction of a cap and trade system increases the costs of producing a carbon intensive good. Producers of carbon based products either cut production or incur abatement costs to reduce carbon emission. In either case, the supply curve for carbon based energy sources shifts to the left, raising price and reducing quantity. A carbon tax is a tax levied on carbon emissions generated from the combustion of fossil fuels (Poterba, 1993, Harris, 2006). A carbon tax is a specific tax determined to be a fixed amount per ton of coal or barrel of oil. The supply curve for carbon based energy sources shifts to the left, raising the price of carbon based energy sources (fuels) and reducing the quantity demanded (Harris, 2006, Fig. 18-7). The tax burden that is shared between producers and consumers of carbon based energy sources depends upon the relative elasticities of demand and supply. The carbon tax would appear to consumers as an energy price increase.
Energy security issues coupled with increased concern over the natural environment are driving factors behind oil price movements. While it is widely accepted that rising oil prices are good for the financial performance of alternative energy companies, there has been relatively little statistical work done to measure just how sensitive the financial performance of alternative energy companies are to changes in oil prices. Rising oil prices provide a strong stimulus for substituting from petroleum based energy production and usage to alternative energy based production and usage. Although the alternative energy industry may still be small compared to other more established industries (in 2004, approximately 6% of the total energy used in the United States came from renewable sources (Economic Report of the President, 2006, p.233), investors, consumers, governments and other industries will be seeking alternatives to current energy sources. Although this bodes well for the industry in the long run, a better understanding of the relationship between oil prices and the financial performance of alternative energy companies is critical to understanding the development of the alternative energy industry in the years to come. The purpose of this paper is to provide an empirical analysis of the relationship between oil prices and the stock prices of alternative energy companies. This paper is organized as follows. The following sections discuss the research methodology, data, and results. The final section of the paper presents the concluding comments.
Section snippets
Empirical methodology
A vector autoregression (VAR) is used to empirically investigate the relationship between the stock prices of alternative energy companies and oil prices. One of the advantages of using a VAR is that the researcher does not need to provide prior assumptions about which variables are response variables and which variables are explanatory variables because in a VAR all variables are treated as endogenous. This means that in a VAR, each variable depends upon the lagged values of all the variables
Data
The stock market performance of alternative energy companies is measured using the WilderHill Clean Energy Index (ECO). ECO was the first index for tracking the stock prices of clean renewable energy companies and has become a benchmark index. Further details of this index are available at www.wilderhill.com. Individual investors can not directly buy the ECO index but can invest in an exchange traded fund which mirrors the ECO. At the end of February 2005, an exchange traded fund (ETF) with
VAR results and discussion
The VAR model consists of four variables, the WilderHill Clean Energy Index (ECO), the Arca Technology Index (PSE), U.S. West Texas Intermediate crude oil futures prices (OIL), and the interest rate (RATE). To reduce unwanted variability (heteroskedasticity) in the data, natural logarithms are taken of each data series (LECO, LPSE, LOIL, LRATE).
In order to apply the Toda and Yamamoto (1995) lag augmented VAR (LA-VAR) testing procedure it is necessary to determine the order of integration of
Conclusions
There are several important factors, like energy security issues and environmental concerns, shaping the interaction between business, society and the environment which should generate a positive business environment for companies engaged in the production and distribution of alternative energy. Although this bodes well for the industry in the long run, a better understanding of the relationships between oil prices and financial performance of the alternative energy industry is critical to
Acknowledgement
We would like to thank an anonymous reviewer for helpful comments.
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