Oil market uncertainty

March 15, 2010
Incomplete information is a big problem for oil market forecasters. Couple the lack of complete data with a market that responds to factors other than supply and demand, and what are forecasters to do?

Incomplete information is a big problem for oil market forecasters. Couple the lack of complete data with a market that responds to factors other than supply and demand, and what are forecasters to do?

If oil futures prices fail to behave according to fundamental triggers, such as increasing inventory levels or declining demand, then how can one predict prices to a certain degree of precision?

This is the conundrum recently addressed by London-based Centre for Global Energy Studies (CGES).

"It is our task as analysts to understand a complex reality, to simplify a confusing picture, to deconstruct the oil market into its constituent parts and reassemble them in such a way as to be able to form a coherent narrative," CGES wrote in the January edition of its Global Oil Insight monthly comment. The analysts continued to look at this problem in the February edition.

They say that it would be satisfying to be able to make sense of a mass of often-contradictory data and statistics. Some data sets are simply not available, such as China's oil consumption. Also, there is no oil-inventory data for most of the developing world.

Further, CGES says the available data sets are inadequate, the uncertainties are many and diverse, and the interplay of politics, economics, and technology are often baffling.

The curse of economics is its inability to perform experiments, since practitioners can't perform live tests of theories of oil price formation, or of how oil demand responds to the rising price of oil, or how long it takes for oil supplies to react to higher oil prices, CGES writes.

With these obstacles it is easy to see why the question of whether oil prices are determined by fundamentals or by speculation remains unanswered, the analysts say.

Some see clarity

CGES has spent some years trying to understand the roles that the physical oil markets and the paper oil markets play in oil price formation. They have found that spot oil prices seem to be driven by inventory disequilibrium, in which cash-and-carry hedging plays a large part, but spare production capacity within the Organization of Petroleum Exporting Countries does not.

"The spot price of oil becomes predictable given futures prices, but futures prices are notoriously difficult to determine," CGES says.

Despite the problems that CGES finds with data, other analysts have no trouble predicting exactly where oil prices will go and dare to make bold predictions of the price of oil, citing bullish views of demand in China and India as well as declining oil output in non-OPEC countries.

But uncertainties exist regarding the growth of the economy and of oil demand in China, as well as growth of production capacity in OPEC countries, which will affect oil prices.

China, OPEC

Chinese economic growth is unlikely to continue at its recent pace, especially if oil prices climb too high and if inflation there leads to economic policies that inhibit growth. CGES says that China seems to have about 5 years left before its ageing population starts to be a drag on its long-run rate of strong economic growth.

Meanwhile, Iraq's plan to expand its oil production capacity would bring online an additional 7.5 million b/d by 2020. Other OPEC members plan to add another 4.6 million b/d to their production capacity. Counting current spare capacity in OPEC, which CGES pegs at 7 million b/d, the organization by 2020 would have 19 million b/d of production capacity exceeding current output levels.

But will incremental demand soak up all of this additional oil? CGES forecasts that worldwide oil demand is likely to grow by 10.3 million b/d by 2020. This is about the same amount of oil that the world will need from OPEC, given a decline in non-OPEC output and an increase in OPEC natural gas liquids and biofuels, the analysts figure.

Given these fundamental elements of the oil market, CGES wonders how some analysts could call for oil prices to skyrocket between now and 2020. On the other hand, though, they say that prices might reach exalted levels if Iran's drive to acquire nuclear weapons leads to serious conflict in the Middle East, with dire consequences for oil supplies.

One thing is certain, CGES concludes: there can be no certainty in the oil market.

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