Forecasting crude oil returns with oil-related industry ESG indices

Abstract

We construct North American oil-related industry ESG indices based on Elastic Net and PCA/SPCA/PLS dimensionality reduction techniques. We discover that the ESG indices show significant forecasting power for crude oil returns both in- and out-of-sample, and their ability to significantly predict oil returns remains when the delayed ESG release is considered. Additionally, our analysis suggests that the predictive abilities of ESG indices remain robust and unaffected by stock returns in the oil-related industry. The ESG indices can provide information that is heterogeneous and complementary to macroeconomic variables and technical indicators. Based on the analysis over the business cycle, ESG indices show predictability in forecasting crude oil returns during economic expansions rather than recessions. Moreover, ESG indices' predictive ability is also of economic significance, as shown by the substantial economic value it generates for mean-variance investors. Finally, we explore the potential economic channels, and the result reveals that the predictive power of ESG indices arises from speculative behavior in the oil market and oil demand.