Why oil price projections can be seriously wrong
The other day, oil prices shot up again after a report from the IEA that demand in 2006 would resume a strong upward trend:
World oil prices climbed after the International Energy Agency made a smaller-than-expected downward revision to energy demand growth, analysts said. New York’s main contract, light sweet crude for delivery in November, rose 56 cents to 62.36 usd per barrel in electronic trading. In London, the price of Brent North Sea crude for November delivery advanced 50 cents to 59.28 usd per barrel “The decline in demand as indicated by the IEA is not as big as some people feared,” Investec analyst Bruce Evers said. “Some people thought that the revision downwards would be much bigger than that.”….
However in 2006 demand would grow by 1.75 mln bpd, owing to a rebound from “the largely temporary impact of (hurricanes) Katrina and Rita and a recovery in Chinese demand”. “The IEA says there’s going to be a sharp rebound in demand next year, while supply remains tight,” Evers said. “1.75 million is quite a big increase when OPEC spare capacity is less than 2.0 million (barrels). So by the end of next year the market is going to be very, very tight.”
Who is the IEA, we asked, and how do they make their projections? The IEA is an operation of the OECD. Located in Paris, it collects a lot of oil statistics from governments, oil companies, consultancies, journalists, and public sources around the world. It publishes the Oil Market Report, which may be viewed publicly with a delay of a couple of weeks. Here is how that publication describes the IEA’s forecasting process, at page 48:
From this description of the model, it appears to us quite likely that the IEA has a high probability of being significantly wrong about its 2006 forecast. Going back a year, the IEA seriously underestimated demand for oil, using its model. Now we believe that its model likely does not anticipate a shrinking of demand over the next six months from unprecedented current high prices. To be fair, a “long term oil demand model,” such as that of the IEA, should not be expected to be terribly accurate over the period of a year or two. The IEA’s model appears to be big lumbering thing, loaded to the gills with data such as OECD semi-annual economic growth projections; its description gives no indication that it has effective demand/price adjustment mechanisms for 50% price increases in a year. So in our view, the IEA projections seem to have a good probability of significantly overstating 2006 demand.
In most every business slowdown or recession we have watched over the last thirty years, one factor has been nearly universal: very smart people were caught off guard. Corporate forecasters, whose job it is to see over the horizon, get fooled time after time. And they often had dynamic, short-term, forecasting models at their disposal. Likewise, purchasing managers consistently get caught off-guard. Our perspective is a lot less fancy: when the price of something goes up 50%, demand goes down, a lot, over an intermediate term in which alternatives can be put in place. For the IEA to forecast “a sharp rebound in demand next year” seems to us counter-intuitive. We’ll wait and see who is right.