The effect of oil price volatility on strategic investment
Research Highlights
► There is a U shaped relationship between oil price volatility and firm investment. ► The U shaped relationship is robust to a number of different estimation techniques. ► Current period oil price volatility inflection points range from 32.45% to 33.60%.
Introduction
Strategic investments are defined as investments which can provide benefits to the whole organization and not just the operating unit making the investment decision (Milgrom and Roberts, 1992, p.454). Strategic investments are one of the most important decisions that businesses make since such investments can lead to competitive advantage through cost reduction and product differentiation which in turn leads to value creation (e.g. Porter, 1980, Porter, 1998, Makadok, 2003). In an ideal situation (i.e., perfect information, no uncertainty), profit maximizing firms can determine the optimal amount of investment. In reality, however, it is often very difficult for firms to determine the optimal amount of investment and, in practice, investment decisions are often characterized by either over or under investment. This is particularly the case when investment decisions are made with less than perfect information. Businesses face uncertainty from a host of different sources including output price uncertainty, factor input cost uncertainty, exchange rate uncertainty or even regulatory uncertainty (Pindyck, 1991, Dixit and Pindyck, 1994). Uncertainty can affect not only the value of a specific investment decision but also the value of the firm (Miller, 1998). One source of uncertainty, oil prices, has in the past demonstrated its importance in affecting firm decision making and is likely to be of even greater concern in the future. A 2005 conference titled “The Top Ten Financial Risks to the Global Economy: A Dialogue of Critical Perspectives” sponsored by Goldman Sacks provides one example of how important oil prices are to the business community (Goldman, 2005). At this conference the world oil supply and rising oil prices topped the list of concerns by the conference participants.
Bernanke (1983) is one of the earliest papers to show that it is optimal for firms to postpone irreversible investment expenditures when they experience increased uncertainty about the future price of oil. Bernanke (1983) develops a fairly stylized model of a firm faced with the decision of choosing between adding energy-efficient capital or energy-inefficient capital. Increased oil price uncertainty raises the option value of waiting to invest. As the firm waits for new information regarding the oil price uncertainty, the firm gives up any returns from making the early investment. Waiting for more information, on the other hand, improves the chances of making the correct investment decision. As the level of oil price uncertainty increases, the option value of waiting to invest increases and the incentive to invest declines.
Oil price volatility can impact investment decisions because higher oil price volatility is associated with more energy input uncertainty which affects the marginal product of capital (Pindyck, 1991). Consistent with the literature on real options, in the face of increased uncertainty, companies often postpone investment decisions because there is an option value of waiting to resolve uncertainty (Pindyck, 1991, Dixit and Pindyck, 1994). The more recent literature on strategic growth options and compound options emphasizes that when firms do not have monopolistic control over the investment opportunity and product markets are not perfectly competitive, there are two option value effects (the option of waiting to resolve uncertainty and an option to grow the business) (Kulatilaka and Perotti, 1998). In the face of uncertainty, companies often postpone investment until the uncertainty is resolved. Not investing, which delays the possibilities of gaining market share or growing the company, may allow another competitor to seize the opportunity. These two effects give rise to a U shape relationship between investment and uncertainty. The purpose of this paper is to test this real options theory by empirically investigating the effects of oil price volatility on strategic investment. This is a topic which does not seem to have been previously investigated.1
Oil price volatility is an important topic to study because on the production side, oil is an essential input into the production of most goods and services. While most companies do not consume crude oil, they do consume petroleum products such as gasoline, heating oil and jet fuel which are all made from crude oil. Moreover, the prices of these petroleum products closely move in line with the price of oil. In the United States, for example, the cost of crude oil accounts for 53% of the retail price of gasoline (Economic Report of the President, 2006, p.239) and movements in the price of crude oil is the primary driver behind gasoline price movements. Fig. 1 shows end of the year future closing prices for NYMEX crude oil, gasoline and heating oil over th period 1985 to 2009.2,3 Notice how closely the three energy future prices move together. The close relationship between energy future prices is supported by correlation coefficients. The correlation coefficient between oil and gasoline is 0.994. The correlation coefficient between oil and heating oil is 0.986. The correlation coefficient between gasoline and heating oil is 0.981.
In addition, nearly 98% of everything that consumers buy uses oil at some point in the value chain. For companies not involved in the oil industry, rising oil prices represent an increased cost of doing business and without an offsetting increase in revenues, leads to a reduction in profits (Sadorsky, 2008). Oil price volatility represents a source of uncertainty affecting the cost of an important input, oil and this creates uncertainty regarding firm profitability, valuations and investment decisions.
This paper develops and estimates a model of a company's strategic investment and shows how changes in oil price volatility can impact strategic investment decisions. Using a panel data set of approximately 1000 non-financial US firms followed over a sixteen year period, we find that there is a U shaped relationship between oil price volatility and firm investment. This result is consistent with the predictions from the literature on strategic growth options. The results should be useful to decision makers, investors, managers, policy makers and others who need to make strategic investment decisions in an uncertain world.
Section snippets
Literature on investment under uncertainty
Investment is a key component of aggregate demand and investment contributes to the build up of the capital stock which, according to economic growth models, can lead to economic growth and prosperity (Mankiw, 2006). In the United States, for example, business fixed investment (which includes investment in plants, machinery and equipment) accounted for 12% of GDP in 2008 (Economic Report of the President, 2009, Table B-2). Since most businesses need to make investment decisions in a world
Empirical specification
Tobin's q theory of investment, which relates investment to the ratio q, provides a starting point for the empirical specification used in this paper (Tobin, 1969). Tobin's q is the ratio of the market value of the firm to the replacement value of its assets and can be justified using transaction cost economics. Tobin's q is a measure of the value being created in a firm. If q is greater than one, the market value of the firm is greater than the replacement costs and managers can raise the
Data
The data set is an unbalanced panel of non-financial publicly traded U.S. companies covering the years 1990–2007. The company list is drawn from the S&P 1500. The S&P 1500 consists of 500 large capitalization stocks, 600 midsize firms, and 400 small firms. The S&P 1500 covers approximately 85% of the United States stock market (in terms of capitalization).7 The data set is selected to follow a large number of companies across a relatively long period of time (a
Empirical results
Empirical results for investigating the impact of oil price volatility on firm level investment are reported in Table 5. Estimation results are presented for two OLS models, a GMM model, and five system GMM models. The OLS model ignores any unobserved panel-level effects or simultaneity bias while the OLS-FE controls for fixed effects. The GMM and GMM system models allow for unobserved panel-level effects and control for endogeneity in (I / K), cash flow, and Q. The GMM estimators differ
Discussion and implications
The purpose of this paper is to investigate the relationship between oil price volatility and strategic investment to gain a better understanding of how oil price volatility can affect strategic investment. The theoretical model is developed using transaction cost economics, agency theory and real options theory. Transaction cost economics is used to establish a positive relationship between Tobin's Q and strategic investment. Agency theory is used to establish a positive relationship between
Conclusions
The strategic investment decision is one of the most important decisions that a business can make because strategic investments can lead to competitive advantage. Uncertainty regarding the pricing of an important input can make the strategic investment decision more difficult. Using key insights from the real options literature, this paper develops and estimates a model of a company's strategic investment and shows how changes in oil price volatility can impact strategic investment decisions.
Acknowledgements
We thank an anonymous reviewer and participants at the 2009 Strategic Management Society conference in Washington, DC for helpful comments. We thank the Social Sciences and Humanities Research Council of Canada, Grant #410-2005-2188, for partial funding of this research.
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