Forecasting Oil Prices: It’s Easy to Beat the Experts

Most economists are used to being button-holed at parties and asked about some specific feature of the economy. And the more distant the topic is from your research, the more likely it is that you will be asked about it. Right now, I’m getting plenty of questions about what is happening to oil prices.

I recently dug into the recent oil literature and discovered something amazing: It is easy to do better than the experts. At least this is what I learned from a recent working paper, “What Do We Learn From the Price of Crude Oil Futures?” by Michigan economists Ron Alquist and Lutz Kilian.

The authors compare a whole range of different ways of forecasting oil prices: they look up the Consensus Forecast (from a survey of expert economic forecasters), oil futures, the difference between the oil price in futures and spot markets, and also a range of more or less complicated econometric models that take account of recent trends, as well as variables like the interest rate.

And it turns out that they all do worse than one simple forecast: the current oil price. That’s right: the most accurate forecast of oil prices over the next month, year, or quarter is the current oil price. We call this the no-change forecast.

The Alquist-Kilian finding was the subject of my latest commentary for American Public Media’s Marketplace (available here; or here for the audio version). Here’s the highlight:

Amazingly, this simple rule did better than the average of dozens of professional forecasters! In fact, the no-change forecast was 34 percent more accurate at predicting oil prices in 3 months time, and 18 percent more accurate at predicting prices in a year’s time. While professional prognosticators might argue that this difference isn’t statistically significant, it sure is embarrassing.

It turns out that the so-called experts add too much variance to their forecasts, leading them to do worse than the no-change rule.

I was more surprised by the poor performance of the oil futures prices as forecasts. My usual response to being asked about the future of oil simply involved looking up the futures market and calling those prices a forecast. However this isn’t quite right: the spot price embeds in it an option value or “convenience yield” that isn’t factored into futures prices. And if this convenience yield moves about (and it tends to move up and down with economic uncertainty), then this causes the futures price to fluctuate in ways unrelated to the future oil price.

If you are interested in learning more about oil prices, Kilian’s recent papers are a useful starting point. The longer Marketplace story is available here.


David Kirk

@mao - yeeess, but the transformation to make a security price a martingale is important. For many instruments, it is the discounted value that is a martingale. In other words, tomorrow's price is expected to differ from today's price by one day of interest. For oil, it's a matter of convenience yields, storage costs and interest. So today's price is not strictly a martingale.

@brian - for generic widgets, maybe. But in the long run (this mysterious time when price = marginal cost) the marginal cost of oil could be exceptionally high. When there is virtually none of it left, the marginal cost of extracting it and transporting it to where it needs to be could be massive. There are courses after micro 101 they should be studied :P

@tim power - mostly agree, but on a pedantic note, I wouldn't say future prices are useless as a forecast. If the real forecast was that the oil prices would rise significantly in future, then the current oil price would rise (after allowing for convenience yields, storage costs etc) because speculators would want to buy now to benefit from high prices in future. Since the "futures price" is determined (as you describe) from current prices and the no-arbitrage assumption.

Incidentally, these no arbitrage rules don't always apply to all commodities. Some commodities cannot be stored indefinitely and thus the replicating portfolio of buying the underlying spot and selling foward doesn't work because the underlying cannot be stored for long terms. Depending on the term of the contract, this means that very long-dated futures become interesting!

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DT

Bizarrely, the same is true for weather. Generally, the weather tomorrow will be the same as the weather today. Of course, I'm pretty sure that the weather six months from now will not be at all like the weather today, but it's highly accurate on a day to day basis.

Harold

A weather authority told me that the best predictor of tomorrow's weather is today's weather. This beats the predictions from the monster computers at the National Weather Service in Golden, Colorado, he claimed. I was never able to verify my authority's assertion, but this oil price thing makes me think he was correct.

tim power

futures prices follow a no-arbitrage rule..they are entirely useless in predicting future prices. Indeed, conventional market wisdom says a downward sloping futures curve (future oil cheaper than spot oil) is actually bullish of oil because it indicates a lack of physical supply. A lot of very clever economists get this wrong. Keynes and Ben Bernanke are two that have got it wrong in the past.

Dave

I enjoy hearing non-experts talk about economics matters. Not because I wish to gain insight, but because they generally lack any to begin with.

brian

Microeconomics 101: Price=Marginal Cost in the long run. The highest estimate I have seen for the marginal cost for a barrel is around $75.

I am not saying that it will quickly approach a number close to $75, but I don't have to make that call. All I'm saying is lower, probably much lower over a year or two. I'll take that bet over any over-engineered econometric model any day.

brian

reminds me of the most accurate weather forecast, if it's more then three days out is will not rain...

brian

memills,

I agree with the premise that we are at or near peak oil. However, that observation is disconnected from the price, and could be accurately stated at $10/bbl or $200/bbl. You can turn coal into oil for less than $60/bbl - it's just a question of how long it takes to get the plants built.

So I agree that we have this secular tailwind to prices over the next 10-15 years, but that doesn't mean cycles are obsolete.

memills

Oil isn't like the weather.

Oil is a finite, non-renewable resource, and we may be near Hubbert's peak now. After peak oil, oil production will fall fairly rapidly.

Given this, and increasing demand for oil, and without an breakthru in renewables that can scale up rapidly, here's my bet:

...higher oil prices in the future

The new normal isn't the same as the old normal. Peak oil means a paradigm shift.

Andrew

Carl,

Were the current governments (at large, not single individuals) in power *before* the current spike in prices above $60? Yes. So one can hardly say they are _dependent_ on the high price.

In fact, they are to some degree hurt by it. It also affects (raises) prices at home, which their respective residents are much less able to pay than we are.

PDB

Predictions in anything (finance, politics, sports), whether made with sophisticated algorithms and lots of data or pulled from somebody's ass, tend to do worse than rules-of-thumb. For example, in pro football, picking the team with the better record going into a game, and if have the same record, than picking the home team, has outperformed all the predictions over the last few years, whether made by computer or football commentator.

Phil Birnbaum

I'm surprised that the current price is more accurate than the futures price.

How much money could you have made by betting on the current price when the futures market is significantly different?

Charlie

Many years ago, they ran regressions on things like class rank, SAT scores, etc. to try to predict students' rank list (a number between 1 & 7). They announced that they were able to predict it +/-1 in 60% of the cases. A professor pointed out that 70% of students were in ranks 2-4. By not predicting 3 in all cases, he said as he walked out, they had achieved a net loss of accuracy just by opening the students' folders.

mao

Efficient market hypothesis suggest that prices are martingales (i.e best forecast for tomorrow is today's price or differently said speculative returns equal zero), what could be simpler......

Carl

The huge thing about the oil markets that no one talks about is the moral hazard that is currently taking place with Iran and Russia.

Iran and Russia both have governments that depend on high oil prices to keep them afloat.

Every time the price of oil starts to dip, Iran's government does something crazy to drive the price back up. Iran has a balancing game of keeping the world on edge enough to keep the price of oil high, but not so much that they'll be the recipient of military action. Russia then opposes many sanctions against Iran and supplies them arms so that this can continue and then they both have been benefiting from the high oil prices.

I'm all for a free market and don't think speculation is bad, but in this instance I think it could drag us into World War III.

Hal

Futures markets are not forecasts. They incorporate forecasts of price moves, but also storage, interest, delivery and other constraints. It bugs me when alleged experts point to the futures market as the market's prediction of future prices. No, it's the price today for future delivery, not the future spot price.

Larry

I learned about the superior accuracy of the "no change" forecast over other methods when I first poked my nose into forecasting decades ago.

I learned that its relevance extends to so many areas that the successful use of other techniques is the exception, not the rule.

brian

Dave, please grace us with your wisdom on the topic.

irma

i'm looking the theory of price towards the macroeconomics variables such as exchange rate, and CPI. Could anyone help me?

sagar

what will be the future of oil after 10-15years ?