FIN 615 MAKE-UP PROJECT

Submitted by

Ashutosh Garga

December 16, 2011

INTRODUCTION
This paper analyzes how liquidity differs across eight oil and gas Canadian stocks, which are grouped into four
large-cap stocks and four small-cap stocks. The following three liquidity measures were calculated for the eight
stocks for each month from November 24, 2006-Novmeber 24, 2011:
1. Amihud Illiquidity Ratio
2. Pastor-Stambaugh’s measure
3. Liquidity betas based on two multi-variable data regressions on:
a. Amihud Illiquidity Ratio to Overall Market Return and Market Volatility
b. Bid/Ask Spread to Overall Market Return and Market Volatility
The eight oil and gas stocks were selected based on varying market capitalization and stock beta. Table 1 identifies
the eight companies and sorts them in order of decreasing market capitalization.1
Table 1: Market Cap and Stock Beta of Eight Oil and Gas Canadian Stocks
COMPANY STOCK TICKER SYMBOL MARKET CAPITALIZATION STOCK BETA
(in millions)
Suncor Energy SU 44,171 1.368
Canadian Natural Resources Limited CNQ 37,178 3.026
Imperial Oil IMO 33,356 0.573
Penn West Petroleum PWT 7,767 1.543
TransAtlantic Petroleum TNP 439 1.809
Second Wave Petroleum SCS 192 1.599
Border Petroleum BOR 3.63 0.553
Archer Petroleum ARK 0.51 0.274

Based on market capitalization, SU, CNQ, IMO, and PWT are identified as large-cap stocks whereas TNP, SCS,
BOR, and ARK are identified as small-cap stocks. BOR and ARK trade on the TSX Venture exchange whereas the
other six stocks trade on the TSX. On some trading days, zero trading volume is observed for BOR and ARK as
daily trading volumes on the TSX Venture exchange are frequently lower than the TSX. As of November 2011, the
TSX Venture Exchange had a combined market capitalization of approximately $50 billion dollars compared to
approximately $2.0 trillion dollars for the TSX.2

Amihud Illiquidity Ratio (AIR)

The AIR was calculated for each stock and plotted in Figures 1 to 8. The monthly AIR was calculated by taking the
average of these daily AIR values and reported in Table 2 in order of decreasing AIR (increasing liquidity). Trading
days with no changes in price or zero trading volume were omitted from these monthly AIR calculations. The results
illustrate that the AIR accurately predicts the highly illiquid nature of small-cap stocks (ARK, BOR, SCS, and TNP)
and vice-versa (IMO, PWT, CNQ, and SU).

1
http://www.globeinvestor.com, accessed November 28, 2011
2
http://www.newswire.ca/en/story/891045/tmx-group-equity-financing-statistics-november-2011, accessed December 14, 2011

2
Table 2: Average AIR for Eight Oil and Gas Canadian Stocks
COMPANY AIR (10^6)
Archer Petroleum 99.851
Border Petroleum 81.526
Second Wave Petroleum 13.481
TransAtlantic Petroleum 3.012
Imperial Oil 0.018
Penn West Petroleum 0.017
Canadian Natural Resources Limited 0.006
Suncor Energy 0.005

Figures 1-4 clearly display AIR maxima in December 2008 for the large-cap stocks (SU, CNQ, PWT, and IMO,
respectively) when the Canadian economy was mired in recession as depicted by the TSX Composite Index and
price of crude oil trending lower during this time period (Figure 9). However, with the exception of TransAtlantic
Petroleum (Figure 5), no such AIR maxima exist for the small-cap stocks (BOR, SCS, and ARK) in December 2008
(Figures 6-8, respectively). This discrepancy suggests that large-cap stocks are prone to high degrees of illiquidity
when market returns are negative. This illiquidity shock can be attributed to large-cap stocks perhaps representing a
safe haven for investors during times of market distress. This explanation is consistent with the absence of any
reduction in trading volume in December 2008 for both large-cap stocks (Figures 10 to 13) and small-cap stocks
(Figures 14-17). It is worth noting that the daily trading volume for the Canadian market as a whole (TSX
Composite Index) remained steady from 2006 to 2009 despite this December 2008 economic downturn (Figure 18).
Since the AIR is directly proportional to price impact and inversely proportional to trading volume, the main driver
for increased illiquidity of large-cap stocks during market distress is price impact and not reduced trading volume.
This suggests that although liquidity providers trade large volumes, they arguably add no natural liquidity to
Canadian markets.

Finally, correlation coefficients for each of the eight stocks was calculated using the CORREL Excel function with
monthly AIR values to better understand the degree of liquidity co-movement that exists between large-cap stocks
with other large-cap stocks, large-cap stocks with small-cap stocks, and small-cap stocks with other small-cap
stocks. The AIR correlation coefficients for each of the 28 possible stocks pairings are displayed for the five year
period in Figure 19, down market (October 2008 to June 2009) in Figure 20, and up market (June 2007 to September
2008) in Figure 21. The average AIR correlation coefficients between large-cap stocks with other large-cap stocks,
large-cap stocks with small-cap stocks, and small-cap stocks with other small-cap stocks were obtained from Figures
19-21 and reported in Table 3.

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Table 3: AIR Correlation Coefficients for Various Stock Pairings
5 Year Period Down Market Up Market
(November 2006 to (October 2008 to (June 2007 to
Stock Pairing November 2011) June 2009) September 2008)
Large-cap/Large-cap 0.690 0.867 0.295
Large-cap/Small-cap 0.211 0.074 0.090
Small-cap/Small-cap 0.252 -0.120 0.111

During the five year period, Table 3 illustrates that the liquidity co-movement of large-cap stocks generally move
together (average correlation coefficient = 0.690). High liquidity co-movement in down markets (average correlation
coefficient = 0.867) is easily explained by stocks facing heavy selling pressure as dealers accumulate inventory
declining in value. The reduced value of collateral increases the borrowing costs of dealers so liquidity co-
movement increases. Furthermore, liquidity co-movement within an industry increases during an industry downturn
or when markets are very volatile.3 Figure 22 depicts market volatility by plotting the VIX or volatility index based
on the Chicago Board Options Exchange (CBOE) Volatility Index, a widely used measure of market risk and often
referred to as the "investor fear gauge".4 Figure 22 clearly illustrates that market volatility increased dramatically
during the 2008 recession when liquidity co-movement increased. Finally, Table 3 also illustrates that the average
correlation coefficients for both the large-cap/small-cap and small-cap/small-cap stock pairings are essentially
unchanged for both up and down markets (0.074 versus 0.090, and -0.120 versus 0.111, respectively). The co-
movement liquidity analysis demonstrates that although market-wide liquidity is time varying (i.e. there are times
when trading for stocks is liquid and times when it is illiquid); it appears to be time-varying for large-cap stocks
only.

Pastor-Stambaugh Measure (P-S)

The monthly γ associated with the P-S measure was calculated for all eight stocks. The average γ for November
2006 to November 2011 is reported in Table 4 for each stock in order of increasing γ (increasing liquidity). With the
exception of the highly illiquid ARK, Table 4 illustrates that the P-S measure also predicts the highly illiquid nature
of small-cap stocks and vice-versa. However, the low R2 values (range from 0.0369 to 0.1377) obtained for all eight
stocks in deriving the linear relationship to determine the slope (γ) suggests that the implied price impact (absolute
value of γ) is subject to a high degree of statistical error and uncertainty.

3
Liquidity PowerPoint slides, Slide 43, Aditya Kaul, accessed December 14, 2011
4
http://www.investopedia.com/terms/v/vix.asp#axzz1g3kirapp, accessed December 9, 2011

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Table 4: Average γ of Eight Oil and Gas Canadian Stocks
2
COMPANY R γ
Border Petroleum 0.1368 -6.524E-07
Second Wave Petroleum 0.0579 -4.798E-07
TransAtlantic Petroleum 0.0607 -8.751E-08
Imperial Oil 0.0497 -8.826E-10
Suncor Energy 0.0454 -4.436E-10
Canadian Natural Resources Limited 0.0369 -2.471E-11
Penn West Petroleum 0.0544 3.576E-10
Archer Petroleum 0.1377 4.662E-07

Liquidity Betas
Liquidity betas were calculated for each of the eight stocks by performing the following two data regressions:

1. AIRi,avg mo = β1M avg mo + β2VIXavg mo + b

2. SPRi,avg mo = β1M avg mo + β2VIXavg mo + b

Where:
AIRi,avg mo = Average monthly AIR for stock i
β1 = Liquidity beta associated with market return for stock i
M avg mo = Average monthly market return based on TSX Composite Index
β2 = Liquidity beta associated with volatility index for stock i
VIXavg mo = Average monthly VIX
SPRi,avg mo = Average monthly bid/ask spread for stock i calculated as follows: (Ask - Bid)/[0.5*(Ask + Bid)]
b = y-intercept of multi-variable data regression

The liquidity betas for each of the two data regressions are reported in Tables 5 and 6, respectively.
Table 5: Liquidity Betas for Eight Oil and Gas Canadian Stocks using AIR Data Regression

2
COMPANY R β1 β1 t Statistic β2 β2 t Statistic
Second Wave Petroleum 0.0272 -393.4 -0.340 0.393 1.520
Imperial Oil 0.6156 -0.415 -1.533 4.826E-04 7.981
Suncor Energy 0.3448 -0.208 -2.091 8.509E-05 3.835
Canadian Natural Resources Limited 0.6342 -0.102 -1.707 1.103E-04 8.229
Penn West Petroleum 0.5122 -0.097 -0.374 4.056E-04 6.979
TransAtlantic Petroleum -0.0194 37.603 0.112 0.0648 0.867
Border Petroleum 0.0082 3870 0.214 -6.772 -1.495
Archer Petroleum -0.0066 3011 1.182 0.849 1.122

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Table 6: Liquidity Betas for Eight Oil and Gas Canadian Stocks using SPR Data Regression

2
COMPANY R β1 β1 t Statistic β2 β2 t Statistic
TransAtlantic Petroleum 0.1194 -0.170 -0.113 9.290E-04 2.773
Penn West Petroleum 0.6893 -0.161 -3.161 9.653E-05 8.477
Canadian Natural Resources Limited 0.6022 -0.087 -2.415 5.747E-05 7.170
Suncor Energy 0.7141 -0.078 -2.131 8.057E-05 9.797
Imperial Oil 0.7424 -0.077 -2.082 8.806E-05 10.64
Second Wave Petroleum 0.3344 1.020 0.335 3.528E-03 5.179
Border Petroleum -0.0109 10.498 1.092 -6.511E-04 -0.273
Archer Petroleum 0.1614 20.055 0.570 0.0267 3.436

For the large-cap stocks, the R2 values are considerably higher than the small-cap stocks indicating a higher degree
of accuracy and reliability compared to the P-S measure. In general, the values of β1 and β2 and associated t statistics
using both data regressions are negative and positive, respectively. These results demonstrate that a stock becomes
less liquid and the bid-ask spread widens when the market is down (negative β1 values) or when market volatility
increases (positive β2 values). Additionally, Figure 23 illustrates that during times of market distress; the individual
firm spreads widened considerably compared to times of market prosperity. This is consistent with numerous
financial models that predict that large market declines increase the demand for liquidity as agents liquidate their
positions across many assets and reduce the supply of liquidity as liquidity providers hit their wealth or funding
constraints.5 The observed positive correlation between VIX and liquidity measures such as ARR and SPR appears
reasonable as the compensation required by liquidity providers will be greater when volatility is higher. Finally,
positive β2 values can be explained by some of the findings from the AIR analysis. Since VIX increases during
market downturns, prices of stocks become volatile. This subsequently causes monthly AIR values to rise since it is
sensitive to price impact and not reduction in trading volume.

CONCLUSION
This paper analyzes the liquidity of eight oil Canadian stocks from November 24, 2006 to November 24, 2011 using
three different liquidity measures. The AIR and two liquidity beta data regressions appear to yield reliable results
while the P-S reversal measure’s high degree of non-linearity appears less reliable. In an effort to enhance the
validity of the above findings, the following recommendations are proposed:
Increase the number of stocks from eight to a more representative sample size.
Modify the analyses to include only TSX stocks and exclude any TSX Venture stocks. TSX Venture stocks
exhibited numerous trading days of zero volume, which led to fewer data points for the calculation of the
three liquidity measures.
Finally, the 2008 financial crisis clearly demonstrates the importance of liquidity because many investors
underappreciated the speed that liquidity dried up. Consequently, investors were forced to sell assets to meet margin

5
http://cbe.anu.edu.au/schools/FAS/documents/Hameed_Apr04_006.pdf, accessed December 9, 2011

6
calls but found that they could not find willing buyers. During times of market distress, liquidity provides investors
the comfort of knowing that they are well positioned to ride out a difficult period. This suggests that while
conventional investment wisdom dictates diversifying portfolios by investing in stocks covering a wide variety of
different sectors and industries to boost returns, the need to shift focus on balancing such portfolios with an eye on
liquidity diversification merits increased attention.

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APPENDIX 1: Figures

Figure 1: Suncor Energy Monthly Average Amihud Illiquidity Ratio (AIR)

0.012

0.010

0.008
AIR

0.006

0.004

0.002

0.000
Nov-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11
Time

Figure 2: Canadian Natural Resources Limited Monthly Average Amihud

Illiquidity Ratio (AIR)
0.014

0.012

0.010

0.008
AIR

0.006

0.004

0.002

0.000
Nov-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11
Time

8
 Figure 3: Penn West Petroleum Monthly Average Amihud Illiquidity Ratio
(AIR)
0.045
0.040
0.035
0.030
0.025
AIR

0.020
0.015
0.010
0.005
0.000
Nov-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11
Time

Figure 4: Imperial Oil Monthly Average Amihud Illiquidity Ratio (AIR)

0.050
0.045
0.040
0.035
0.030
AIR

0.025
0.020
0.015
0.010
0.005
0.000
Nov-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11
Time

9
 Figure 5: TransAtlantic Petroleum Monthly Average Amihud Illiquidity
Ratio (AIR)
35

30

25

20
AIR

15

10

0
Nov-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11
-5
Time

Figure 6: Border Petroleum Monthly Average Amihud Illiquidity Ratio (AIR)

2000

1500

1000
AIR

500

0
Nov-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11

-500
Time

10
 Figure 7: Second Wave Petroleum Monthly Average Amihud Illiquidity Ratio
(AIR)
100
90
80
70
60
AIR

50
40
30
20
10
0
Nov-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11
Time

Figure 8: Archer Petroleum Monthly Average Amihud Illiquidity Ratio (AIR)

1200

1000

800

600
AIR

400

200

0
Nov-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11
-200
Time

11
 Figure 9: TSX Composite Index and Crude Oil WTI Cushing Closing Day Values
16000 160

14000 140
TSX Composite Index Closing Value

12000 120

Crude Oil WTI Cushing (US$/bbl)

10000 100

8000 80

6000 60

4000 40

2000 20

0 0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

TSX Composite Index Crude Oil WTI Cushing

12
 Figure 10: SU Trading Volume
30,000

25,000

20,000
SU Trading Volume
(in thousands)

15,000

10,000

5,000

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

Figure 11: CNQ Trading Volume

16,000

14,000

12,000
CNQ Trading Volume

10,000
(in thousands)

8,000

6,000

4,000

2,000

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

13
 Figure 12: PWT Trading Volume
18,000
16,000
14,000
PWT Trading Volume

12,000
(in thousands)

10,000
8,000
6,000
4,000
2,000
0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

Figure 13: IMO Trading Volume

4,500

4,000

3,500

3,000
IMO Trading Volume
(in thousands)

2,500

2,000

1,500

1,000

500

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

14
 Figure 14: TNP Trading Volume
7,000

6,000

5,000
TNP Trading Volume
(in thousands)

4,000

3,000

2,000

1,000

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

Figure 15: SCS Trading Volume

3,000

2,500
SCS Trading Volume

2,000
(in thousands)

1,500

1,000

500

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
-500
Time

15
 Figure 16: BOR Trading Volume
3,000

2,500
BOR Trading Volume

2,000
(in thousands)

1,500

1,000

500

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

Figure 17: ARK Trading Volume

2,500

2,000

1,500
ARK Trading Volume
(in thousands)

1,000

500

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

16
 Figure 18: TSX Composite Index Trading Volume
700,000
TSX Composite Index Trading Volume

600,000

500,000
(in thousands)

400,000

300,000

200,000

100,000

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

Figure 19: 5 Year AIR Co-Movement Liquidity Analysis between Eight Canadian Stocks
CORRELATION COEFFICIENT (Nov 2006 to Nov 2011)
SU TNP CNQ PWT IMO BOR SCS ARK
SU
TNP 0.160
CNQ 0.629 0.059
PWT 0.676 0.029 0.733
IMO 0.547 -0.042 0.809 0.744
BOR 0.157 0.101 0.045 0.130 0.149
SCS 0.326 0.051 0.171 0.515 0.193 0.423
ARK 0.650 -0.042 0.091 0.513 0.234 0.509 0.471

Average Correlation Coefficient

Large-cap stock/Large-cap stock correlation coefficient 0.690
Large-cap stock/Small-cap stock correlation coefficient 0.211
Small-cap stock/Small-cap stock correlation coefficient 0.252

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Figure 20: Down Market Co-Movement Liquidity Analysis between Eight Canadian Stocks

CORRELATION COEFFICIENT (Oct 2008 to June 2009)

SU TNP CNQ PWT IMO BOR SCS ARK
SU
TNP 0.223
CNQ 0.848 0.200
PWT 0.748 0.188 0.927
IMO 0.799 0.192 0.977 0.903
BOR 0.081 -0.271 0.745 0.302 0.350
SCS -0.278 0.381 -0.323 -0.148 -0.351 -0.470
ARK NA NA NA NA NA NA NA

Average Correlation Coefficient

Large-cap stock/Large-cap stock correlation coefficient 0.867
Large-cap stock/Small-cap stock correlation coefficient 0.074
Small-cap stock/Small-cap stock correlation coefficient -0.120

*ARK was excluded from the analysis due to a high number of trading days with zero volume.

Figure 21: Up Market Co-Movement Liquidity Analysis between Eight Canadian Stocks

CORRELATION COEFFICIENT (June 2007 to Sept 2008)

SU TNP CNQ PWT IMO BOR SCS ARK
SU
TNP 0.007
CNQ 0.591 -0.011
PWT 0.067 -0.100 0.468
IMO -0.051 -0.266 0.429 0.267
BOR -0.114 0.065 0.264 0.074 0.490
SCS -0.165 -0.204 0.234 0.616 0.419 0.473
ARK NA NA NA NA NA NA NA

Average Correlation Coefficient

Large-cap stock/Large-cap stock correlation coefficient 0.295
Large-cap stock/Small-cap stock correlation coefficient 0.090
Small-cap stock/Small-cap stock correlation coefficient 0.111

*ARK was excluded from the analysis due to a high number of trading days with zero volume.

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 Figure 22: Market Volatility
90

80

70

60
VIX Closing Value

50

40

30

20

10

0
Nov-06 May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11
Time

Figure 23: Large-Cap Stock Bid/Ask Spread vs. TSX Composite Index Market
Return
1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
Return

0.2%
0.0%
Nov-06
-0.2% May-07 Dec-07 Jun-08 Jan-09 Jul-09 Feb-10 Sep-10 Mar-11 Oct-11

-0.4%
-0.6%
-0.8%
-1.0%
-1.2%
Time

SU PWT IMO CNQ TSX

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