Do Corrupt Oil Countries Have Higher Rates Of Return?

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Celan Bryant

Summary

Oil inventories are running at 80-year highs, pushing prices into a historic dive this year.

This post reviews a recent paper published by the Fed that looks at the predictability of returns for oil-producing countries with a higher level of corruption.

While the evidence suggests investors may see a short-term increase in returns, there is no evidence to suggest this strategy makes sense in the long run.

Oil inventories are running at 80-year highs, pushing prices into a historic dive this year.

Brent Crude Oil Spot Price Chart

Brent Crude Oil Spot Price data by YCharts

It's no wonder the Fed's staff is looking at the effect a drop in oil prices has on the global financial markets. One such article entitled Institutions and Return Predictability in Oil-exporting Countries published in February claims that "stock market returns in oil-exporting countries can be predicted by oil price changes". The authors actually find a higher rate of predictability in countries with a higher level of corruption. In this article we'll look at what implications this has for the average investor. In particular, if investing in oil producing countries with a higher rate of corruption can produce higher returns.

First, the authors set a literary baseline so that readers understand the context of what they're trying to prove. The first assumption is that weak institutional quality is synonymous with corrupt practices. They also assume that institutional quality or corruption impacts fiscal policy, and not vice versa. In other words, the policy makers create fiscal policy; though it has been argued that fiscal policy can attract the type of person interested in creating new policy. It has also been shown by Alesina, Tabellini, and Campante that corrupt democracies have more pro-cyclical fiscal policies; that is, fiscal policy is aimed at perpetuating the current economy. This is contrary to fiscal policy that may be aimed at slowing down an economy that is growing too fast or stimulating an economy that may be slowing down.

The Investigation

The authors use a sample of countries for which oil exports are a significant source of revenue, measured as a percentage of GDP calculated as the value of oil exports divided by gross domestic product. The value of oil exports is calculated by multiplying the average annual price of a barrel by the number of barrels exported in any given year. It is important to note that some countries like Iran and Trinidad and Tobago are excluded due to lack of data. In total the authors confined the study to 15 oil-producing countries in the Middle East, Africa, the Americas, Asia, and Europe.

Transparency International's Corruption Perceptions Index ("CPI") is used as a proxy for measuring corrupt activity. Stock returns were obtained from Thomson Reuters' Datastream and it is assumed that dividends are reinvested -- though that had no impact on the outcome of the investigation.

The results showed that oil prices can predict stock market behavior in 7 out of the 15 countries. It also suggests that predictability is due to the slow spread of information rather than the perceived risk premium in the corrupt market. The authors found that within the 7 countries identified, the lower the corruption index the higher the level of predictability. That is, corruption adds to the predictability not the return potential. In addition, the authors found that countries with a low degree of leverage were actually more predictable.

So What

The authors found that a 1% increase in oil prices translates into 0.1% higher stock market returns for those countries with low institutional quality/higher corruption relative to those with high institutional quality/lower corruption. Nigeria, Oman and Saudi Arabia appear to have the highest 1-month return percentages even though Nigeria, Venezuela and Russia have the worst scores for corruption.

All this suggests, from a common sense perspective, that corrupt oil producing countries tend to spend more oil revenue within their own countries and markets rather than on investments outside of their own country or to pay back debt. In other words, corruption breeds financial silos that retain oil revenue in the country rather than investing it in other markets or paying back debts -- this increases the country's expenditures. These countries consume oil profits rather than invest them. The result is an increase in GNP, at least in the short-term (less than one year). Here's an excerpt from the paper:

...the relation between predictability and institutional quality reflects the preference of countries with weaker institutions to consume oil windfalls locally through pro-cyclical fiscal policies, rather than smooth out the impact of windfalls by, for instance, investing the proceeds abroad.

For instance, countries like Norway (CPI of 86; higher is better) invest windfalls internationally and therefore see smaller fluctuations when oil prices change. Whereas countries like Mexico (CPI of 35) whose fiscal policies allow for greater incidence of corruption tend to spend those oil windfalls within the country which boosts GNP, if only for the year in question. The more corrupt a country is, the more apt they are to spend oil revenues in their own markets. The paper does not provide much insight into the long term effects of this phenomena, but our guess is that the strategy of investing in oil countries with higher rates of corruption is better for investors trying to capitalize off of short-term movements. The implication for long-term investors is to invest your money in those countries, oil producing or not, with the lowest rates of corruption.

Ebeke, C., L. Omgba, and R. Laajaj, 2015, "Oil, governance and the (mis)allocation of talent in developing countries," Journal of Development Economics, 114, 126-141.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.