The Futility of Oil Price Forecasting

The plunge in crude oil prices has led analysts and commentators to offer a variety of reasons for the steep drop and to speculate how long it will last. On the way down forecasters have been embarrassed because each bottom is only a brief stop to the next one. Most commentators focus on new supplies coming from Iran, as well as the decisions of China and Saudi Arabia to maintain high levels of production. That is an oversimplification.

Forecasting oil prices, like forecasting economic growth, is a herd endeavor. No one wants to be an outlier, so forecasters look at what others—the experts—are predicting and make sure that theirs is consistent. When forecasts of 4% economic growth proved overly optimistic, forecasters retreated to the actual 2% range. They will stay there until the economy has a growth spurt. The same is true of oil price forecasting. Most forecasts have oil staying low for a prolonged period or even falling lower because it has been falling. The few optimists, like Continental Resources CEO, Harold Hamm, see prices returning to $60 by fall. The reality is that no one knows what the actual floor will be or when there will be a price recovery.

High oil prices are an incentive to produce more and for consumers to look for alternatives and efficiency gains to reduce the quantity consumed. Except when external political events keep prices high, reflecting a risk premium, the dynamics of supply and demand produce a new equilibrium. The corollary is also true. When prices are low, consumption increases as consumers meet their wants by substituting oil products for other ways to spend their income. That creates an incentive to produce more until a new equilibrium price is reached.

Historically, crude oil prices have been cyclical and always will be. In the past, it was easier to explain the ups and downs. Recessions led to reduced demand and prices declined. Recoveries or interruptions in supply had the opposite effect.

Today’s situation is more complex because production has not responded to the drop in demand caused by the slowdown in China’s growth and the slow growth in the rest of the world. In the United States, a large number of shale producers are facing bankruptcy and shale production is falling.

The apparent economic paradox is why Saudi Arabia has not reduced production to reflect market fundamentals. There is no shortage of speculation as to the reason, but only the Saudis understand their strategy, and only time will tell whether it will change in the face of persistent low prices. There are at least three reasons why the Saudis may not reduce production soon. Lower prices will limit how much revenue Iran will gain when it soon starts exporting oil. Additionally, low oil prices are halting the shale revolution and making alternatives even less competitive.

Instead of forecasters speculating about Saudi Arabia’s and China’s economies, they should be looking at the combination of market forces, historic inventory levels, the financialization of oil (its role as a financial instrument), and the history of oil prices. 

In 1980 when President Reagan decontrolled oil and removed regulatory barriers that produced high prices, crude prices fell from $39 a barrel to $13 and remained under $20 until late 1990. After that prices ranged from $30 to $33 for almost a decade. From 2001, a bubble developed, taking oil prices to $134 in 2008, in large measure because of conflict in the Middle East, a weak dollar and speculation. 

When the bubble burst because of the Great Recession, oil collapsed to $39. As economies recovered, China produced double digit economic growth, and the shale boom began, the bubble began to re-inflate, taking prices up to $103. With rising oil prices and the force of the Peak Oil myth, oil became a financial instrument for investors, some whom believed that unlike stocks that experience volatility, oil investments would only go up. 

Last year, Gluskin Sheff Chief Economist and Strategist David Rosenberg observed, "Well, with perfect hindsight, oil was in a classic bubble: parabolic price moves, tremendous excitement, widespread participation by the investing public, a ton of leverage." Lavan Mahadeva of the Oxford Institute for Energy Studies concludes there has been tremendous growth in the futures market by “financial players with no interest in the physical commodity.” 

The financialization of oil has affected oil prices on the upside and now is contributing to its fall as investors sell to avoid greater losses. In addition, global inventories are at their highest level since 1998, and it is easy to conclude that low prices will be with us for some time. But oil prices continually surprise, and 2016 is likely to be no exception.

William O'Keefe is the President of Solutions Consulting. You can follow him on Twitter here.

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