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Systemic Risk in the Global Energy Sector: Structure, Determinants and Portfolio Management Implications

The energy sector is one of the most crucial sectors of any economy as it involves the energy resources necessary for the advancement of modern society and its distress damages almost all economic sectors through their heavy dependence on energy. Energy companies are a key player in meeting global energy demand and ensuring the stability and efficient functioning of the economy. Understanding the interdependence and mechanisms of transmission of information and risk across energy companies and, hence, the level of systemic risk in the global energy sector is a matter of undeniable relevance as it can greatly influence not only the performance of the overall stock market, but also the world supply of energy and, hence, the real economy and the socio-economic development of many countries. The main aim of this paper is to provide a comprehensive overview of the structure of dependence in the global energy sector during tranquil and extreme bearish and bullish market conditions. In particular, we analyse mean and lower and upper tail dependence among stock returns of 105 large energy companies from 26 developed and developing countries spanning three geographical regions, namely America, Asia Pacific, and Europe, in both static and dynamic settings. A partial correlation-based dependence measure is used to quantify the underly-ing relationships between energy firms under diverse market states, controlling for common market factors. Then, a dependence network based on the Triangulated Maximally Filtered Graph (TMFG) technique is constructed to assess the level of systemic risk in the energy sector. Special attention is also paid to the analysis of the stability of the dependence structure in the energy sector over time under different market circumstances. Lastly, a simple portfolio trading strategy based on the ranking of dependence of energy firms is formulated and evaluated. The empirical results show a high interdependence in the worldwide energy sector regard-less of market conditions and geographical proximity seems to play a major role in this dependence network. The strongest dependence between energy stock returns is observed under extremely bearish market conditions, in line with the commonly held idea that the co-movement of stocks intensifies in times of very adverse market states. Overall, American and European energy