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The Perils And Pitfalls Of Oil Price Forecasting

A Kuwaiti trader follows the market's movements.
A Kuwaiti trader follows the market's movements.
A decade ago, many oil analysts thought $10 a barrel was the new normal. Just six months ago, when prices were just below $150, forecasters said $200 oil was not out of the question.

This year's sharp drop in crude prices from $147 a barrel in July to approximately $44 today has rattled the economies of oil exporters and prompted OPEC on December 17 to cut production by 2.2 million barrels.

It has also sent oil-price forecasters scrambling to figure out what happens next.

The financial services firm Merrill Lynch says oil could dip as low as $25 a barrel next year as the global recession takes hold. Goldman Sachs, which has revised its 2009 projections three times, has a slightly more bullish outlook, forecasting that crude prices will average $45.

But does anybody really know for sure?

"Look back 10 years," says Robert Ebel, a senior adviser on energy and national security at the Center for Strategic and International Studies in Washington. "What was the price in 1998? It was $11. Would you have ever suggested that the price would hit almost $150 in the summer [of 2008] and then crash down to below $50 a barrel? You would be laughed out of the room."

Analysts say a whole host of unknown factors that are independent of classic supply-and-demand calculations -- from the weather, to unexpected fluctuations on the financial markets, to civil wars and major geopolitical crises -- account for oil forecasters' spotty record.

Douglas Macintyre, a senior analyst for the Energy Information Administration, which provides statistics and forecasts to the U.S. government, says that while prognoses are mostly accurate during periods of stability, "the track record is fairly murky" in times of volatility.

"What we try to do is look at the global balance since oil is a global commodity," Macintyre says. "We try to look at the factors that influence either global oil supply or global oil demand. The problem is that there are a number -- too many to even know -- of factors that influence either supply or demand."

Known Unknowns

Macintyre and other analysts say geopolitical crises tend to disrupt supply and cause prices to rise while economic downturns depress demand, driving prices down. Recent cases of price volatility starkly illustrate the point. And such crises are, more often than not, unpredictable.

The first big oil shock came in 1973 with the Arab oil embargo. In retaliation for the United States' decision to resupply the Israeli army during the Yom Kippur War, Arab members of OPEC, plus Egypt and Syria, launched an embargo. As a result, the price of oil, just under $5 a barrel in 1973, shot up to nearly $15 in 1978.

The price spiked again, reaching $37 in 1980, following supply disruptions caused by the 1979 Iranian Revolution and the subsequent Iran-Iraq War. Prices fell steadily in the early 1980s, going as low as $14 in 1986, as consumers adjusted and conservation efforts took hold.

The Asian financial crisis depressed demand in the late 1990s, sparking a sharp price drop from just under $20 a barrel in 1997 to $11 in 1998. China's spectacular economic growth and high U.S. consumption combined with post-September 11, 2001, instability in the Middle East then sent prices soaring to their record high of $147 this summer.
The problem is that there are a number of factors -- too many to even know -- that influence either supply or demand.

The global economic crisis, analysts say, is responsible for prices nosediving in the second half of this year.

In such a volatile environment, forecasters say the best they can do is to be as transparent as possible about their methodology and assumptions.

"What we try to do is also explain the story behind our forecast and explain the assumptions," Macintyre says. "We try to be very transparent and say: 'This is what we are assuming for the global economy. This is what we are assuming for non-OPEC supply. This is what we're assuming is going to happen in this country or that country.' And then, if people disagree with our assumptions, they should modify the resultant forecast."

The World Over A Barrel

Nevertheless, governments must rely on this imperfect science as they plan their budgets. Oil producers, meanwhile, have attempted -- often in vain -- to influence the price with production cuts.

"Countries like Venezuela and Iran badly need a higher price to fund their federal budget," Ebel says. "For most of these countries, the income that they get from oil exports [accounts] for a very high percentage of their federal budgets. But they have been depending on a higher price and they come up short. So they are going to cut [production] and see if that cut is sufficient to put their budgets in the black again."

Iraq announced in October that it was planning to cut $13 billion from its 2009 budget due to lower oil revenues.

"With the significant drop in the prices of oil, we won’t continue to spend as much as we have become accustomed to in last two years," Haider el-Idadi, head of the Economics and Reconstruction Committee in Iraq's parliament, said in a recent interview with RFE/RL's Iraqi Service. "There will be huge deficit in the budget, and we have to think about how to bridge that deficit."

In an effort to reverse the downward trend, OPEC on December 17 agreed to cut production by 2.2 million barrels a day at its conference in Oran, Algeria, the 12-member cartel's largest cut ever. Non-OPEC member Russia, the world's second-largest producer after Saudi Arabia, also said it would cut production next year, but stopped short of agreeing to closer collaboration with the cartel.

OPEC officials said they hoped to drive the price of oil up to $75, a level Saudi Arabia's King Abdullah has said is "fair."

At its last two meetings in September and October, the cartel cut production by a cumulative 2 million barrels a day, but the move had little effect on prices. Analysts like Macintyre say the global oil market has become so large that the ability of exporting countries to set prices -- even acting in concert -- is limited.

"I think even major players like Saudi Arabia have less of an impact than many people might assume, just simply because of the size of the global oil market," Macintyre says. "Obviously there is some influence governments can have, but I don't think to the extent of being able to target a price and guarantee that is what is going to happen."

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