CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The international oil market has repeatedly posed serious concerns for Nigeria's fiscal outlook. Sharp movements in crude oil prices, whether they result from global recessions, from changes in demand and supply, or from geopolitical events, are transmitted to the Nigerian economy through government revenue, the exchange rate, investment decisions and the capital market. Overdependence on oil revenue has left the economy exposed to oil price variations (Musa et al., 2022). Because oil is both a major source of national income and a major determinant of investor sentiment, the performance of firms in the oil and gas sector of the stock market is closely watched by policy makers, investors and analysts.

The effect of oil prices on stock markets differs between oil-exporting and oil-importing countries. In an oil-exporting country, a rise in oil prices improves the trade balance, raises the current account surplus and strengthens the net foreign asset position. It also tends to raise private disposable income, which lifts corporate profitability and domestic demand and, in turn, stock prices. In oil-importing countries the process works broadly in reverse. Evidence from Nigeria is consistent with the exporter pattern. Musa et al. (2022), using quarterly data from 2009 to 2016, found that positive and negative oil price shocks both exert a positive long-run influence on the stock prices of listed oil and gas firms, and that oil and gas stock prices are therefore susceptible to oil price shocks. Muhammad, Auwal, Kumo and Fadimah (2023), using monthly data from 2014 to 2023, found that in the long run, oil price increases, together with interest rate and exchange rate movements, tend to raise stock price levels in Nigeria, and that in the short run only oil price increases raise stock prices while decreases lower them.

The nature of an oil price shock matters. Prices move because of changes on the demand side or the supply side of the market, and the two do not have the same consequences (Kilian, 2009). Ojeyinka and Aliemhe (2023), using monthly data from 2000 to 2019, found a long-run relationship between sectoral returns and oil price changes in Nigeria. They also found that oil-specific demand and global oil demand have positive and significant effects on aggregate and sectoral stock returns, whereas global oil supply is inconsequential for most sectors, the exception being the oil and gas sector, where global production has a positive and significant effect. Two features of a shock are therefore important: its source and its magnitude, which can be measured in absolute terms or as a percentage change.

The response may also be asymmetric, so that price increases and decreases do not have mirror-image effects, and it may change over time. Fasanya, Adekoya and Ajayi (2023), using monthly data on selected Nigerian sectors, found strong support for asymmetry and for structural breaks in the response of some sectors to oil price movements, and they note that few studies have examined the behaviour of sectoral stocks in Nigeria. Okodua, Urhie, Erhi, Hassan and Fasanu (2022) examined listed energy companies and concluded that the risk premium that investors attach to the shares of oil companies is central in explaining the short-run effect of oil price volatility on their equity valuation.

The exchange rate is an important channel through which oil prices reach the stock market (Musa et al., 2022). Owuru and Olabisi (2023), using monthly data from 2000 to 2020, found that a 1% devaluation of the naira against the dollar reduces stock market returns in the short run by 0.16%, while its long-run effect was inconsequential. For an import-dependent economy such as Nigeria, a weaker currency raises input costs but can also improve the naira value of foreign-currency earnings, so its effect on the stock market is not obvious in advance. Other channels include foreign portfolio flows, foreign direct investment and investor confidence, each of which responds to the condition of the oil sector and of the economy generally.

The stock market plays an important part in assessing economic conditions, since improved stock returns usually reflect higher profits for firms, which in turn supports growth. A stock exchange channels surplus funds from lender-savers to borrower-spenders, so volatility in stock prices can affect the performance of the financial sector and of the wider economy. Policy makers are interested in the determinants of these movements and their spillover effects on real activity, while financial analysts are interested in their effect on the pricing and hedging of financial instruments. Forecasting stock market dynamics is difficult, but it is a basic tool for managing the risks that institutions face.

The following table summarises episodes of shocks that have affected the Nigerian economy, which provide the historical background to the oil price shocks examined in this study.

It is therefore of interest to explore the effect of oil price shocks on the dynamics of the stock market in Nigeria, and in particular on the stock prices of the oil sector. This study examines the impact of oil price shocks on oil sector stock prices in Nigeria.

1.2 Statement of the Problem

The relationship between oil prices and economic activity has been studied for decades, and the literature has identified several channels through which oil price movements affect output, inflation and financial markets. The most basic is the supply-side effect, in which a rise in oil prices signals reduced availability of a basic input to production. Other explanations include income transfers from oil importers to oil exporters, real balance effects and monetary policy. The impact of oil price changes is likely to be more severe in countries that depend heavily on oil or carry heavy debt burdens, which describes the Nigerian economy. Economies that rely heavily on oil exports can also become vulnerable to Dutch disease. In oil-exporting countries such as Nigeria, where the oil industry is largely government-owned, the extent to which the world price passes through to the domestic price depends on how the government sets domestic prices, so pass-through may be complete or incomplete.

Nigerian studies of the oil–stock relationship have grown, but they do not agree on the nature of the effect. Musa et al. (2022) found that both positive and negative oil price shocks raise oil and gas stock prices in the long run, while Muhammad et al. (2023) found that oil price increases raise stock prices and decreases lower them in the short run. Fasanya et al. (2023) found that the response depends on asymmetry and structural breaks that differ across sectors, and Ojeyinka and Aliemhe (2023) found that the source of the shock matters. Musa et al. (2022) also point out that using a composite stock index mutes the idiosyncratic response of individual sectors. Most of these studies use monthly or quarterly data and data samples that end before the most recent episodes of price volatility, and few of them trace the dynamic impact of past oil prices on oil sector stock prices or measure how much of the variation in oil sector returns is accounted for by oil price shocks.

The issue has been of concern to policy makers and financial experts because the oil sector is central to the Nigerian economy and its stock prices reflect investors' assessment of its prospects. Rapid and large changes in oil prices, driven by global demand, supply decisions by producers and geopolitical events that are beyond the control of producers and consumers alike, make a study of this kind timely. This study therefore seeks to determine the dynamic impact of oil price shocks on oil sector stock prices in Nigeria using high-frequency data.

Against this background, the study seeks answers to the following research questions:

1. What are the causal links between oil prices and oil sector stock returns in Nigeria?
2. What is the dynamic impact of previous oil prices on fluctuations in oil sector stock prices in Nigeria?
3. Do oil price shocks contribute significantly to changes in oil sector stock returns in Nigeria?

1.3 Objectives of the Study

The broad objective of this study is to determine the impact of oil price shocks on oil sector stock prices in Nigeria. The specific objectives are to:

1. determine the impact of oil price shocks on oil sector stock prices in Nigeria;
2. determine the dynamic impact of previous oil prices on oil sector stock price fluctuations in Nigeria;
3. determine whether oil price shocks contribute significantly to changes in oil sector stock returns in Nigeria; and
4. determine the policy implications of these responses for the Nigerian economy.

1.4 Statement of Hypotheses

The hypotheses, stated in null form, are:

H₀₁: Oil price shocks have no significant impact on oil sector stock prices in Nigeria.

H₀₂: Previous oil prices have no significant dynamic impact on fluctuations in oil sector stock prices in Nigeria.

H₀₃: Oil price shocks do not contribute significantly to changes in oil sector stock returns in Nigeria.

1.5 Significance of the Study

The study is relevant because it provides insight into the direction and size of the effect of oil price shocks on oil sector stock prices in Nigeria. By focusing on the oil sector, and not on a composite index that can mask sectoral responses (Musa et al., 2022), it offers information that is useful to government and policy makers in Nigeria, to investors who must price the risk attached to oil company shares (Okodua et al., 2022), and to regulators concerned with the stability of the capital market.

In addition, the findings and recommendations will serve as a reference source and a point of departure for further research.

1.6 Scope of the Study

The study covers the period 2000 to 2024 and uses high-frequency weekly data, with its focus on a detailed analysis of the effect of oil price shocks on oil sector stock prices in Nigeria.

References

Fasanya, I. O., Adekoya, O. B., & Ajayi, F. O. (2023). Oil price shocks and sectoral stocks in Nigeria: How relevant are asymmetry and structural breaks? International Journal of Energy Sector Management, 17(3), 595–616. https://doi.org/10.1108/IJESM-09-2021-0005

Kilian, L. (2009). Not all oil price shocks are alike: Disentangling demand and supply shocks in the crude oil market. American Economic Review, 99(3), 1053–1069.

Muhammad, S. Y., Auwal, I., Kumo, B. A., & Fadimah, Y. (2023). Oil price and stock market nexus in Nigeria: An asymmetric cointegration based on non-linear ARDL approach. International Journal of Research and Innovation in Social Science, 7(11), 573–591.

Musa, D., Awolaja, O., Jerry, K., Okedina, I., Uduakobong, E.-E., & Olayinka, I. (2022). Is the influence of oil prices changes on oil and gas stock prices in Nigeria symmetric or asymmetric? Cogent Economics & Finance, 10(1), 2154311. https://doi.org/10.1080/23322039.2022.2154311

Ojeyinka, T., & Aliemhe, A. E. (2023). Disaggregated crude oil prices and stock market behaviour in Nigeria: Evidence from sectorial analysis. Economic Journal of Emerging Markets, 15(1). https://doi.org/10.20885/ejem.vol15.iss1.art4

Okodua, H., Urhie, E., Erhi, M. A., Hassan, C. O., & Fasanu, E. A. (2022). Oil price volatility and equity valuation of listed energy companies in Nigeria: A panel ARDL model. International Journal of Energy Economics and Policy, 12(5). https://doi.org/10.32479/ijeep.13423

Owuru, J. E., & Olabisi, O. E. (2023). Dynamic response of emerging market stock returns to exchange rate and oil price: A case of Nigeria. Romanian Journal of Economics, 57(2), 114–130.