Michael Lynch: Methods Of Forecasting Long Term Oil Prices

In the early years of the oil industry, prices moved sharply with the discovery of a new, large oil field or the sudden decline of an existing producer. Producers were like farmers, prey to things happening beyond their control and outside of their knowledge. Efforts to control the price (Standard Oil, Texas Railroad Commission, Achnacarry Agreement, and oil import quotas in the U.S.) enabled the industry, or at least the domestic part of it, to take prices as given. Most famously, when the Shultz Commission considered lifting oil import quotas in 1970, it assumed that prices would tend to decline, based on historical experience.

After the shock of the increase in 1973/74, economists tried to predict the price, although early studies usually assumed they would be flat (relative to inflation). But slowly, studies began to examine the impact of price on supply and demand, and estimate the ‘sustainable’ price based on market fundamentals. Obviously, the willingness of OPEC to produce ‘needed’ amounts of oil, increasingly in question in the 1970s, made a huge difference.

Computer modeling of the oil market became more common in the 1970s, and the Energy Modelling Forum at Stanford undertook to compare different types of models, and in 1982, produced a comparison of world oil models (EMF6). Most projected price as a function of OPEC capacity utilization: if OPEC was producing at more than 80% of capacity, prices would rise. Below that, they would fall. Unfortunately, this required predicting OPEC capacity, which was based on political decisions by governments, and was difficult to model. Most thus assumed capacity, and modified the inputs to generate the desired (gradually rising) price forecast.

Subsequently, as it was recognized that this method was imperfect (at best), most groups forecasting oil markets put their efforts into estimating supply and demand under different oil prices. Most specifically describe the prices shown as “scenarios” or assumptions, without the pretense that a particular method is generating these prices. Output related to OPEC is, or should be, the primary driver of prices, with some combination of the trend in demand for OPEC oil, OPEC market share, and/or surplus capacity in OPEC. (The last impossible to predict over the long-term.) And whether or not OPEC is investing in capacity remains crucial, but is a policy decision and thus unpredictable in the long-run. Still, rising demand for OPEC oil is reasonably considered a factor in rising prices, all else being equal.

Most recently, there has been a reliance on marginal costs as indicative of long-term prices, which fits in neatly with economic theory: but. That theory applies to a competitive market, and between John D. Rockefeller, the Texas Railroad Commission and OPEC, among others, such as rarely existed. In a competitive market, Middle Eastern oil would be the marginal barrel, and it is very cheap; other producers would struggle to compete, as in the 1950s (when the U.S. imposed oil import quotas to protect domestic producers).

As an earlier post discussed, the movement of resources into and out of the market changes the supply curve and thus, the cost of the marginal barrel. With Iran, Iraq and Mexico (and possibly soon Venezuela) opening up to upstream investment, the supply curve is expanding in the middle, keeping prices low for some years to come. Also, the reduction in cost for producing oil from shales adds a large amount of medium-cost oil to the supply curve, suggesting that the long-term price will be determined by the cost of the marginal shale oil barrel. The combination of the two form the backbone of my long-term forecast of prices about $50 per barrel.

Oil Price Forecasts from 2004

Most price forecasts reflect the then-consensus among most pundits: so that in 2004, virtually everyone predicted prices below $30 for two decades, a decade later, the same group saw prices above $100 for the next two decades (your humble narrator excluded). The primary difference between the two: short-term price had risen because of supply disruptions in the Middle East, North and West Africa, and Latin America. Yet another case of a bull market being assumed permanent, a ‘new paradigm.’

Oil Price Forecasts from 2014

Not that people won’t argue that “the easy (or cheap) oil is gone” and the industry is having to go into ever harsher environments to find new supplies, but this has been true for most of the history of the industry. Those drilling in Persia in 1908 would probably be aghast to hear that what they were doing was “easy,” and former President George H. W. Bush often remarks on how much easier it is for people in the oil fields today.

And it doesn’t take much analysis to show that the cost increases of the last decade were primarily cyclical. For one thing, the industry obviously didn’t run out of ‘easy’ oil in a few years after nearly a century and a half of relatively constant costs. And the fact that the cost increases occurred when prices were high and investment (and the demand for workers and equipment) was soaring could not have been coincidence

Does this model suggest long-term prices could remain near where they are today ($30)? Yes, they could, but that depends on the willingness of large producers (Iran, Iraq, Saudi Arabia, Russia and others) to add capacity at those levels, and the ultimate economics of shale oil production, which are still uncertain. It does imply very strongly that price levels above $50 do not appear to be sustainable without some kind of political intervention that seems unlikely now.

Forbes