Bridge over ocean
30 May 2019 CFA Institute Journal Review

Do Macroeconomic Conditions and Oil Prices Influence Corporate Risk-Taking? (Digest summary)

  1. Marc L. Ross, CFA

Rising oil prices tend to make firms risk averse, although this tendency depends on the macroeconomic outlook. When the outlook is favorable (unfavorable), corporate risk-taking increases (decreases). A firm’s industry competitiveness levels and country location in a high or low oil-producing market are also important determinants of a firm’s risk-taking response to changes in oil prices.

What Is the Investment Issue?

The price of oil meaningfully affects the global economy. Oil price shocks have accompanied most recessions. Given oil’s prominence in the economic cycle, the authors consider whether oil price changes affect corporate risk-taking. Their findings contribute to the literature on firm-level determinants of corporate risk-taking.

How Did the Authors Conduct This Research?

The authors begins with an overview on the role of oil prices in the economy along with a literature survey on corporate risk-taking. Rising oil prices can influence a firm’s degree of risk aversion because of increased operating costs that reduce cash flow and profitability. Higher oil prices also translate into higher inflation and, eventually, higher interest rates. Both developments affect firm profitability.

The authors use four measures of firm-level risk-taking: (1) factors such as the five-year standard deviation of the difference between a firm’s annual EBITDA and the firm’s country EBITDA average; (2) an estimate of a firm’s idiosyncratic risk using the Fama–French three-factor model; (3) the choice of a one-year or a five-year risk estimation period; and (4) risk as a maximum and minimum return on assets over a five-year period.

The authors use the New York Mercantile Exchange one-month oil price for global oil and gas prices. They use such control variables as firm size (the larger the firm, the greater its risk-taking capacity), leverage, growth (price-to-book-value and sales growth), profitability (return on assets or ROA), and the level of tangible assets. The authors also include market-level variables that measure the quality of institutions and economic conditions because they, too, affect a firm’s willingness to take risk. Finally, they account for the level of industry competition (Herfindahl–Hirschman Index). The authors use regression analysis in a multivariate framework to model the relationship between oil price changes and corporate risk-taking.

The dataset includes 190,490 firm-year observations from 56 countries—both developed and developing—from 1990 to 2013. The sample contains 28,688 unique firms, including both extant and defunct entities in an effort to eliminate survivorship bias. The results are robust to numerous tests concerning alternative measures of competition, risk-taking, macroeconomic conditions, sample selection, and modeling issues.

What Are the Finding and Implications for Investors and the Investment Professionals?

The authors conclude that macroeconomic outlook and oil prices bear meaningfully on corporate risk-taking. In upbeat (downbeat) economic conditions, oil prices positively (negatively) influence risk taking. These results, however, are conditional on a firm’s country location and the degree of industry competition. Firms in competitive industries tend to be risk averse even when the economy is strong. By contrast, firms in non-competitive industries tend to assume greater (lesser) risk with rising oil prices and in strong (weak) economic conditions. Importantly, the firm’s country oil production influences the relationship between oil price changes and risk-taking.

Even during periods of positive macroeconomic outlook, increases in oil prices increase corporate risk-taking for firms located in high oil-producing countries, regardless of a firm’s competitive situation. In contrast, increases in oil prices during a positive macroeconomic outlook tend to decrease corporate risk-taking for firms based in low oil-producing countries, especially in competitive industries. In bad macroeconomic outlooks, an increase in oil prices reduces corporate risk-taking for all firms, irrespective of country location and competitive situation.

Equity and fixed income analysts will find these insights helpful for valuation and credit risk assessment during periods of oil price changes. So, too, will policymakers and economists, whose opinions inform critical debate on economic issues.

Abstractor’s Viewpoint

Given oil’s prominence, it would be interesting to consider to what extent a firm would alter its risk profile in the presence of viable alternative energy sources.

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