Alternative Investments: How to take Advantage of the Correlation of Oil Price and Alternative Energy Companies Valuation

Abstract

Research PurposeThis research aim to build a financial viable product on the idea that the price of energy commodities has a predictive power on the stock value of renewable energy focused companies.Research DesignThe research will first give a look at the green energy market, and show the growth potential it bears. Then by creating a green companies fund on objective criteria, we will have a base on which to test the relation between this fund and the price of energy commodities (Crude oil Brent will be used for practical purposes). The research will use linear regression and logarithmic monthly returns as a basis for the computation of the relation. Furthermore, the returns used for assessing tthe relation between the portfolio and oil will be corrected for the benchmark return (S&P 500).FindingsThe research has provided some interesting results:a) The portfolio has over-performed its benchmark (S&P500) during the period, possibly meaning that the green energy market is growing quicker than the economy.b) The R squared of the corrected returns is above 11%, showing us a strong relation between the two types of assets.c) The R squared of the corrected returns with one month lag is about 4%, giving our model some predicative value that might be converted in some excess return possibility for a financial product.Research Limitationsa) One of the reasons of the outperformance of the portfolio ( 280% compared to -25% for S&P 500) could be the criteria for the selection of the companies to be put in the fund. Indeed, by selecting only companies that have existed for 10 years at least and have a minimum market capitalisation, we chose only the successful ones, hence not representing the market in its full picture.b) Considering the price of oil as an indicator for the whole fossil energy market might put a bias on the model.c) Using the S&P 500 as a benchmark for the portfolio’s return is bias, as the companies’ size and country aren’t all comparable to the components of the S&P 500Research ImplicationsThis research is based on the intuition that green energy is an alternative to fossil fuels, and that one of the motivations for people to switch to renewable energy from fossil fuels is the price of the latter. The research also implies that the value of the companies’ stocks is related to short term trends.Originality and ValueThe results that came out of this study are positive as they tend to show a link between the returns of oil and the returns of our portfolio. Furthermore, a relation of these returns when a lag is imposed shows that some part of the market takes time to adapt to the news, and thus creating an opportunity to build an investment model on this basis.