We support the recommendation of Norges Bank of excluding the oil and gas sector from the reference index of SPU, "the oil fund" hereafter. Our reasoning follows.
The wealth of the Norwegian state is directly exposed to oil and gas risks via the value of future oil and gas taxes and stakes in the sector, such as the State's Direct Financial Interest (SDFI) and Statoil. In addition comes the risk through the ownership of oil and gas stocks in the oil fund. There are also indirect exposures. One is that the value of future income taxes depends on the valuation of human capital, which in some segments of the Norwegian economy is high due to oil extraction. Another is that a recession caused by a fall in the oil price could create a need for counter cyclical fiscal policy.
Given a high exposure to oil and gas in the state's portfolio outside the oil fund, intuition about diversification suggests that the oil fund should not take on direct oil and gas risk. Research by van den Bremer et al. (2016) supports this intuition. The essential point is that the investment strategy of the oil fund should take into account the state's exposure to oil and gas still in the ground. van den Bremer et al. (2016) point out that the fund should reduce exposure to oil and gas assets and other assets positively correlated with the oil and gas price. Norges Bank refers in their letter of 14 November 2017 to their finding that oil and gas stocks are exposed to changes in the oil price to a much larger degree than other stocks. They also find that oil and gas stocks perform better than the overall market in periods with increasing oil prices and the opposite in periods with decreasing oil prices. We support this conclusion, which is in line with the finding of the literature review by Smyth and Narayan (2018). If movements in the oil price and the value of oil and gas shares are strongly positively correlated, investing in oil and gas shares is not helpful from a diversification or hedging point of view.
We support Norge's Banks wider perspective of taking into account the other parts of the state's portfolio when deciding on the appropriate reference portfolio for the fund. This represents an important improvement compared to evaluating the fund in isolation. Taking further steps and evaluating the fund's investment strategy in light of the total national wealth seems practically more challenging and requires more analysis.
We also agree with Norges Bank that the implication of the wider perspective of the state's wealth is to exclude oil and gas stocks from the reference portfolio of the oil fund. This implication relies on i) that the Norwegian state's portfolio outside of the oil fund is already highly exposed to the oil price and ii) that the value of oil and gas stocks are positively correlated with the oil price. i)-ii) are empirical questions that warrant careful analysis, but it seems highly plausible that both of these conditions are true. We therefore support Norges Bank's recommendation.
Gernot Doppelhofer, Professor, NHH
Torfinn Harding, Associate professor/Statoil chair, NHH
Klaus Mohn, Professor II, NHH
Krisztina Molnar, Associate professor, NHH
Smyth, Russell og Paresh K. Narayan (2018), What do we know about oil prices and stock returns? International Review of Financial Analysis 57, 148-156.
van den Bremer, Ton, Frederick van der Ploeg and Sam Wills (2016), The Elephant In The Ground: Managing Oil And Sovereign Wealth, European Economic Review 82, 113–131.