Forecasting Oil Prices

in today's market is mission impossible

There exists no agreement among analysts on why oil prices have registered such an erratic path in the past few years, and what or who were behind it. The widely quoted suspects are oil market fundamentals (supply, demand and inventory levels) and speculators.

Economic theory tells us that in efficient markets (where players are assumed to have perfect knowledge and behave rationally) the prices reflect the true state of the market fundamentals. Prices are assumed to deviate from efficiency based on those fundamentals. If price deviations are significant enough then volatility is created.

In practice, however, efficient market hypothesis has collapsed following repeated failures to align underlying strength of fundamentals and market perceptions with reality. Moreover, humans by nature are irrational and none of the market players have perfect knowledge. The reality doesn’t fit the conventional economic theory any more.

This may be hard to digest but examples are too many to prove why this is so. Consider the followings:

On 19 May 2004 the Saudi oil minister, Ali al-Naimi told the press the OPEC to increase quotas by at least 1.5 mbd in its June meeting, in order to ease the prices. A few days later, prices surged to 13-year high, instead of going down.

When oil hit $85 on 15 October 2007, the main culprit in the news headlines was Turkey-PKK tensions and fears of a Turkish military intervention in northern Iraq. The same day Gold rose to 27-year high. What gold has had anything to do with that tension was beyond comprehension, but in the following months the dollar euro exchange rate appeared more and more in the news headlines as the main scapegoat.

Crude oil futures surged more than $4 a barrel on 28 November 2007 right after an explosion and fire on a pipeline sending Canadian oil to the US Midwest refineries. Two days later prices resumed the pre-explosion level even though US crude imports were still cut by 20 percent.

A decision not to increase OPEC production on 5 December 2007 meeting was believed to send prices toward $100, but prices settled back below $90. And that happened despite the US crude inventories dropped an unusually large amount ahead of the peak winter season, imports notably on the Gulf Coast declined remarkably, and about 600 kbd UAE production was shut in for field maintenance.

Right before the military clash between Russia and Georgia in 8 August 2008, the Baku-Tbilisi-Ceyhan pipeline, carrying around 0.9 mbd of oil was shut in. About a week later BP Plc, the operator of the Baku-Supsa pipeline, declared force majeure on oil exports through the pipeline and closed it for security concerns. At the end of August around 1 mbd of oil production in Gulf of Mexico was shut in due to Tropical Storm Gustav. Also around 1 mbd of Nigerian oil production was shut in due to unrest and technical disruptions. But the oil prices continued sliding from $120 towards $100 per barrel.

On 22 September 2008, oil prices soared more than 15%, the biggest one day gain on record, and closed the day above $120 a barrel. There was no bad news in the market that particular day, except that it was expiry of the front-month futures contract.

In its 24 October 2008 meeting OPEC announced to cut the production by 1.5 mbd. In the same day, US gasoline inventories had dropped to their lowest level since 1967. Instead of going up, the prices declined $5 immediately after the announcement and closed the day with a dollar loss compared to the previous day. Three days later the price of WTI was below $100 per barrel.

In fact, neither speculation nor fundamentals have had any systematic impact on prices over the past five years. The erratic oil price dynamics are indeed due to the weighted combination of market fundamentals and speculation, which are affected by many impulses including economic, technological, geological, political, and physiological factors. However, to quantify them in terms of their impact on prices with any degree of accuracy are somewhere between difficult and impossible.

The price of oil in futures exchanges and off-exchange in exempt or over-the-counter (OTC) markets is set (in the short to medium term) by traders’ expectations which are based on their assessments on, reaction to and perceptions about current and future market conditions.

This does not necessarily imply that any attempt to understand to which direction oil prices are moving should take its starting point in the derivatives markets. It also does not mean that speculators are the sole culprit in the oil price movements. For instance, while crude prices rose sharply in May and June 2008, net speculative positions declined.

Both market fundamentals and speculators have contributed to unusual elevations and swings observed recently in oil prices. We are witnessing a structural shift with strong cyclical components in the pricing of oil. The conventional market fundamental underpinnings are still valid today but additional variables should also be factored in. Traders’ expectations will continue to put additional pressure on prices.

The main driver of market sentiment should be the facts, and not fears, concerns and worries of traders against perceived risks. The bad news is that the oil market lacks transparency and true consensus from production, consumption to stocks and to trading.

(a longer version can be found in January 2009 issue of Global Energy for the Mediterranean magazine.)

Why all reputable institutions which had been forecasting three digit figures for 2009 oil prices only six months ago are revising permanently their estimates downwards now?

In fact, how analysts have been making their forecasts over the past are not too different from the story below, which is a classic (this version is from washingtonpost)

It was autumn, and members of a Native American tribe asked their new Chief if the coming winter was going to be cold or mild. Since he was a new Chief in a modern society and had never been taught the old secrets of Nature, he looked up at the sky and had no clue what to do. To play it safe, he replied to his tribe that the winter could definitely be cold and that they should collect firewood early, just to be prepared. So, the members began gathering wood.

Being a practical leader, he figured he should also use the resources available to the modern society. He went to the phone booth, called the National Weather Service and asked, "Will this winter be cold?"

"As of now, it looks like this winter is going to be quite cold," the forecaster said.

So the Chief went back to his tribe and told them to collect even more wood. A week later he called the National Weather Service again and asked for an update.

"Yes," the man at National Weather Service again replied, "based on incoming data, this winter is looking to be colder than we expected." The Chief was surprised, but again went back to his tribe, told them that this might be a very cold winter, and asked them to collect every scrap of wood they could find.

One week later, the Chief called the National Weather Service yet again, hoping for a new answer. "Are you absolutely sure that the winter is going to be very cold?"

"Positive," the man replied. "It's going to be one of the coldest winters ever."

"Really?" the shocked Chief exclaimed. "How can you be so sure?"

"First," the forecaster replied, "The Indians are collecting firewood like crazy."