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Forecasting Crude Oil Prices

Bhamy V Shenoy (bhamysuman@gmail.com) is a Mysuru-based consumer activist, working on issues such as education for slum children, energy and development. He has previously worked for Conoco Inc and been on the board of the National Oil Company of Georgia.

The history of oil forecasting has shown that no oil expert has been successful in predicting oil prices. This is due to the inability to either anticipate or accurately predict geopolitical scenarios, world oil supply/demand, and the impact of the spare capacity of oil exporters. Moreover, the oil futures market has not only failed to predict prices, but caused higher volatility and converted the oil market into a veritable gambling casino.

There has not been much appreciation of how the National Democratic Alliance government got lucky as a result of falling oil prices worldwide, since it came to power in 2014. The net oil import cost has fallen from a high of $112 billion in 2012 to $53 billion in 2016. As a result, the total subsidies doled out by the government have fallen from ₹1.61 lakh crore in 2012–13 to just ₹22,738 crore in 2016–17 (Government of India 2018). It was only ₹4,076 crore in the second quarter of 2017–18. The reason for this bonanza to the Narendra Modi government is the fall in oil prices from a high of $111 per barrel (bbl) in 2011 to $44/bbl in 2016 and $54/bbl in 2017 (USEIA 2018d).

Similarly, other oil-importing countries have benefited too. In 2012, oil-importing countries paid $1,070 billion to oil exporters which fell to $420 billion in 2016, a whopping reduction in transfer of wealth. The million dollar question, however, is: Will oil prices remain around the current price of $70/bbl (during the first quarter of 2018, it was $67/bbl [USEIA 2018e]) or zoom above $100/bbl or fall below $30/bbl to $50/bbl? The importance of the expertise to forecast oil prices accurately can hardly be overemphasised. But do we have the ability to forecast oil prices?

Limitations of Existing Models

The author has had the opportunity to watch and forecast oil prices during the first three oil shocks—1973, when prices jumped from $15/bbl to $55/bbl (in 2015 dollars), 1978–79, when prices jumped to $105/bbl, and 1986, when oil prices collapsed to $30/bbl—as a manager at a leading multinational oil company. Though in the early 1970s there was some expectation of oil price increase, no one had expected such a massive increase that precipitated a world economic recession. Since then, oil prices have been uncertain and highly volatile. Many attempts have been made to develop different types of statistical models to forecast oil prices. But, none have succeeded.

The five models used most often are oil futures prices, regression-based structural models, time-series analysis, Bayesian autoregressive models and dynamic stochastic general equilibrium graphs. Since no single model gives reliable forecasts, economists use a weighted combination of them to get the most accurate answer (Investopedia nd). A research report by experts at the International Monetary Fund (IMF), after carrying out an ex post assessment of different econometric models to forecast oil prices, shows that there is no one single model that can give credible forecasts for all possible scenarios and periods (short term versus long term) (Beckers and Beidas-Strom 2015).

It, thus, becomes apparent from recent research that neither the price forecasts of futures markets nor the econometric models have any better ability than no-change price forecasts. It is true that models can be developed with some tweaking to predict what has happened in the past. However, none of them have proven useful to predict the future. A study of Figure 1 (p 19), which shows the movement of oil prices between 1970 and 2016, reveals the complexity of price forecasting. Often, it is the geopolitical forces and not just world oil supply/demand which has influenced the oil price movement (USEIA 2018a).

Till the early 1970s, oil prices were relatively stable and mostly controlled by the so-called seven sister oil companies—Exxon, Mobil (now part of Exxon), Shell, BP, Chevron (formerly Standard Oil Company of California), Texaco (now part of Chevron) and Gulf Oil (now part of Chevron). However, after the first oil shock in 1973, the Organization of the Petroleum Exporting Countries (OPEC) got into the driver’s seat and started to influence the oil price movement (see Figure 1). As oil price volatility increased, the futures market was born in the early 1980s and since then it seems to have wielded more power in controlling oil prices. According to economic theory, the futures market is expected to result in reducing volatility. However, when one compares the oil price movement before and after the introduction of the futures market in the early 1980s, price volatility seems to have increased as a result of the futures market because of computer-driven trading (Piotrowski 2015). However, there are several studies which argue that there is no proof to show that the futures market has increased volatility per se (Fattouh et al 2012).

It is against this background that this article seeks to study what will happen to oil prices in 2018 and in the medium term.

Geopolitics and Production Quotas

Out of the blue in 2014 when oil prices were above $90/bbl (Figure 2, p 20), Saudi Arabia decided to go after their market share rather than defending higher prices. In just three months, oil prices fell below $50/bbl. In January 2016, it fell below $30/bbl. Still the Saudis continued to defend its policy of maximising production. Then, all of a sudden in November 2016, they changed their policy and led 13 other OPEC members to cut production by 1.2 million bbl/day, starting January 2017. It was followed by an agreement with 10 non-OPEC countries which agreed to reduce their production by another 0.6 million bbl/day (Table 1).

 

Among OPEC members, it was Saudi Arabia which took the maximum hit of 0.5 million bbl/day, and among non-OPEC members, Russia took the leadership to reduce by 0.3 million bbl/day (El Gamal et al 2016). The contribution of most non-OPEC members, numbering 10, is only symbolic since their reduction is because of natural decline and not deliberate reduction. There were not many in the oil industry who believed that oil-exporting countries would adhere to their quotas. Historically, there have been no instances when all OPEC and non-OPEC members have complied with the agreement.

However, contrary to all expectations, OPEC and non-OPEC members have been successful in enforcing quotas during this time. In February 2018, compliance by OPEC members was 147% while for non-OPEC members, it was 86% (IEA 2018). As a result of such high compliance, excess stocks built during the period of supplies exceeding demand have started to come down. As of mid-April 2018, oil stocks in the developed countries were just 43 million barrels above the five-year average level (Zhdannikov 2018). This indicates a reasonable balance between world oil supply and demand.

One of the reasons for oil price increase from June 2017 (see Figure 3, p 20) may be the realisation thatOPEC is serious in enforcing its quota. While manyOPEC and non-OPEC members enforced the quota by design, for some countries it was forced upon them because of civil unrest. Venezuela is one such country. Its cash-strapped national oil company has not been able to invest enough to maintain production and it has fallen from a high of 2.5 million bbl/day in 2015 to less than 1.6 million bbl/day (IEA 2018: 15). It is anticipated that their production may fall to less than 1.34 million bbl/day by the end of 2018.

 

The International Energy Agency (IEA) forecasts that the world oil demand is to go up by 1.5 million bbl/day in 2018, which is slightly less than the increase of 1.6 million bbl/day in 2017 (IEA 2018). Thus, the robust world oil demand has also supported higher oil prices besides self-imposed cuts by the OPEC.

Another important factor that is considered to have an influence on oil prices is the surplus or spare oil production capacity mostly with OPEC. Oil pundits explain the reason for crude oil price increase during 2003–08 by pointing at the spare capacity of OPEC, which was less than 1 to 2.0 million bbl/day (USEIA 2018b). When we look at the OPEC surplus during 2014–16, it was less than 2 million bbl/day. Still, oil prices were low.

This clearly demonstrates that OPEC surplus, though an important factor in determining oil prices, by itself does not influence the oil price movement. Also, assessing OPEC surplus capacity is not an objective exercise. For example, in countries like Libya, Nigeria and Iraq, where there is severe civil unrest, it is not easy to estimate oil production capacities. According to the IEA, the OPEC surplus capacity as of end February 2018 is 3.24 million bbl/day. Saudis alone account for 2.12 million bbl/day while Iraq, Kuwait and the United Arab Emirates (UAE) have a spare capacity of 0.27 million bbl/day, 0.24 million bbl/day and 0.34 million bbl/day, respectively (IEA 2018).

If we consider the OPEC spare capacity estimated by the United States Energy Information Administration (USEIA), it is 2 million bbl/day during the first quarter of 2018 and likely to decrease to 1.27 million bbl/day by the fourth quarter of 2019. The USEIA’s estimate of OPEC’s spare capacity is less than that of the IEA.

Other Determinants of Prices

Ever since the development of the oil futures market since the early 1980s, it is not the physical supply/demand of oil that has major influence on oil prices, but the paper barrels as discussed earlier. Open interest in oil futures during the last three years is more than 1,600 million barrels (EIA 2018a), when the daily world oil demand is only around 99 million bbl/day. Soon after Saudi Arabia declared its policy to defend its market share, even though physical supply/demand was reasonably in balance, oil prices started to fall. Within three months of the announcement, oil prices were below $50/bbl from a high of $90/bbl.

Since it is paper barrels which influence the oil price movement, oil prices will continue to be influenced by what the oil futures market assesses by way of the chances of OPEC and non-OPEC members enforcing oil production quotas. In addition, geopolitical factors such as the Yemen and Syrian war, likely action by the United States (US) in reimposing sanctions on Iran after dropping the nuclear agreement, etc, also bear an effect.

Yet, not many oil experts had expected the high oil price of $74/bbl in April 2018. This is almost double of what it was before the change in the Saudi strategy of maximising market share to secure high oil prices. In that sense, no one has the perfect model to predict how the futures market will assess the probability of oil exporters adhering to their quota. If history were to guide us, then it is more than likely that oil exporters will fail and oil prices may remain low. However, with the aggressive stand taken by the Saudis to go beyond their agreed reduction, the odds of OPEC succeeding look high.

Also, with an impending initial public offering of the Saudi oil company, Aramco, they have every reason to promote high oil prices. In fact, the Saudis have expressed their desire to aim for $100 per barrel (Finance Twitter 2018). Though Saudi Arabia is the most influential OPEC member and has the maximum spare capacity, it does not have the ultimate power to push for higher prices.

Ever since mid-2014, when there was a drop in oil prices, there is another additional factor affecting oil prices in the medium term. Investments, needed to replace the reserves (Rapier 2018) and the natural decline in production, have gone down by 50%. In 2017, new discoveries were just 4 billion barrels versus the 36 billion barrels of production (DiLallo 2018). This is a record low reserve replacement and is bound to have an impact on oil production. On the other hand, with the improved economics of renewables, faster penetration of electric vehicles, greater urgency to fight global warming, the oil demand may turn out to be less robust than expected. In other words, there is more uncertainty in international oil markets, which quantitative models are unable to capture to predict oil prices.

Conclusions

On 11 April 2018, Prime Minister Narendra Modi, while making a presentation at the International Economic Forum, called for “responsible pricing” to balance the interest of oil consuming and producing countries (Business Today 2018). Within a few days, US President Donald Trump threatened OPEC for “artificially” increasing oil prices (Krauss 2018). How can one define what is responsible pricing in the case of oil? Is it the marginal cost of production? Should there be a risk premium? When oil prices were above $110/bbl a few years ago, can $70/bbl be considered as artificial now? Though the futures market responded soon after Trump’s critical comment against OPEC, it decided to ignore it and prices increased because of factors discussed in the article.

One of the purposes of the futures market is to “discover” prices for the commodity. As argued in this article, the oil futures market has not been good at such price discovery. On the other hand, though experts differ, there is a compelling argument to show that the futures market has increased price volatility. This has resulted in the futures market acting like huge gambling casinoes generating billions of earnings for its owners and dealers. The gambling that is taking place may be a zero-sum game for those who play there. However, their gambling has unnecessarily resulted in greater uncertainty and sometimes even higher crude oil prices than warranted by supply/demand fundamentals. It is high time we started questioning the usefulness of the oil futures market or at least tried to limit the volatility through better regulation. India can take the lead in the subsequentG20 meetings on this subject.

References

Beckers, Benjamin and Samya Beidas-Strom (2015): “Forecasting the Nominal Brent Oil Price with VARs: One Model Fits All?” IMF Working Paper WP /15/251, Research Department, International Monetary Fund, https:// www.imf.org/external/pubs/ft/wp/2015/wp15251.pdf.

 

Business Today (2018): “PM Modi Calls for Responsible Pricing for Affordable Energy to All,”
11 April, https://www.businesstoday.in/sectors/energy/pm-modi-calls-for-responsible-pricing-for-affordable-energy-to-all/story/274611.html.

Cunningham, Nick (2016): “The OPEC Deal: Here Are the Details,” OilPrice.com, 30 November, https://oilprice.com/Energy/Energy-General/The-OPEC-Deal-Here-Are-The-Details.html.

DiLallo, Matthew (2018): “The Oil Market Problem No One Is Talking About—Yet,” MSN, 30 March, https://www.msn.com/en-us/money/markets/the-oil-market-problem-no-one-is-talking-about-%E2%80%93-yet/ar-BBKG2pZ.

El Gamal, Rania, Alex Lawler and Ahmad Ghaddar (2016): “OPEC In First Joint Oil Cut with Russia Since 2001, Saudis Take ‘Big Hit,’ ” Reuters,
30 November, https://www.reuters.com/article/us-opec-meeting-idUSKBN13P0JA.

Fattouh, Bassam, Lutz Kilian and Lavan Mahadeva (2012): “The Role of Speculation in Oil Markets: What Have We Learned So Far,” Oxford Institute for Energy Studies, WPM 45, https://www.oxfordenergy.org/wpcms/wp-content/uploads/2012/08/WPM-45.pdf.

Finance Twitter (2018): “Saudi’s Dream for $100 Oil in Jeopardy as Trump Warns OPEC about Fake High Price,” 23 April, http://www.financetwitter.com/2018/04/saudi-dream-for-100-dollar-oil-in-....

Government of India (2018): “Under Recoveries to Oil Marketing Companies (OMCs) on Sale of Sensitive Petroleum Products (Rs Crore): Historical,” Petroleum Planning and Analysis Cell, Ministry of Petroleum and Natural Gas, Government of India, New Delhi, http://ppac.gov.in/content /150_1_Subsidy.aspx.

IEA (2016): “Oil Market Report,” International Energy Agency, 13 December, https://www.iea.org/media/omrreports/fullissues/2016-12-13.pdf.

— (2018): “Oil Market Report,” International Energy Agency, 15 March, https:// www.iea.org/media/omrreports/fullissues/2018-03-15.pdf.

Investopedia (nd): “Crude Oil,” https://www.investopedia.com/terms/c/crude-oil.asp.

Krauss, Clifford (2018): “Trump Criticizes OPEC, Calling Oil Prices ‘Artificially’ High,” 20 April, https://www.nytimes.com/2018/04/20/business/energy-environment/trump-opec-oil-prices.html.

Piotrowski, Matt (2015): “Oil Market Volatility and the Quants: What to Know,” Fuse, 25 September, http://energyfuse.org/oil-market-volatility-and-the-quants-what-to-know/.

Rapier, Robert (2018): “Are We Sleepwalking into the Next Oil Crisis?” OilPrice.com, 2 April, https://oilprice.com/Energy/Energy-General/Are-We-Sleepwalking-Into-The-Next-Oil-Crisis.html.

USEIA (2018a): “What Drives Crude Oil Prices?” United States Energy Information Administration, Washington, DC, 10 April, https://www.eia.gov/finance/markets/crudeoil/reports_presentations/crude....

— (2018b): “What Drives Crude Oil Prices?” United States Energy Information Administration, Washington, DC, 10 April, https://www.eia.gov/finance/markets/crudeoil/supply-opec.php.

— (2018c): “Europe Brent Spot Price FOB (Dollars per Barrel),” United States Energy Information Administration, 25 April, https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n= pet&s=rbrte&f=m.

— (2018d): “Petroleum and Other Liquids,” United States Energy Information Administration,” 2 May, https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RBRTE&f=A.

— (2018e): “Petroleum and Other Liquids,” United States Energy Information Administration, 2 May, https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx ?n=pet&s=rbrte&f=m.

Zhdannikov, Dmitry (2018): “IEA Says ‘Mission Accomplished’ for OPEC as Oil Stocks Shrink,” Rigzone, 13 April, https://www.rigzone.com/news/wire/iea_says_mission_accomplished_for_opec_as_oil_stocks_shrink-13-apr-2018-154239-article/.

Updated On : 14th May, 2018

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