Authors: Thomas Grennes & Andris Strazds  

Forecasting crude oil prices has been difficult. Forecast errors have been large, especially for the end of 2014, when typical forecasts were more than $40 per barrel too high. A panel of Wall Street Journal analysts forecast $94.65 per barrel, but the actual price was $53.27 per barrel. Forecasts implicit in oil futures contracts exhibited similar errors (Kilian and Baumeister). A pragmatist might suggest forecasting a range for future prices based on historical experience over recent decades, but the historical range has been too wide to be of much value. Since 1973 the annual average price (in real March 2015 dollars) for US imports has been between $17.39 in 1998 and $107.13 in 2012. For practical purposes, that is not much better than saying anything is possible.

The steep drop in the price of oil from around $100 in June 2014 to around $50 in December 2014 was dramatic. However, it was not the only steep drop in recent history. An even greater drop occurred from $96.54 in 1980 to $29.84 in 1986, and that decline was especially persistent. The price fell below $40 in 1986 and it did not rise above $40 until 2004. Daniel Yergin used John D. Rockefeller’s term “the Great Sweating” to describe the low prices that persisted for a quarter of a century from their local peak in 1980. Many observers today are asking whether the recent drop will be as persistent as the “Great Sweating” of the 1980s.

The large price decline after 1980 had an especially large adverse effect on Saudi Arabia. Saudi officials tried to use their market power to prevent the price decline. The reduction in Saudi output was not sufficient to prevent the price drop, and real GDP dropped as a result of a decrease in the quantity of oil and a decrease in price. Real GDP per capita dropped from $54,500 in 1980 to $31,000 in 1986. The same large and persistent price decline also had a significant negative effect on the Soviet Union, and some observers have claimed that the oil glut contributed to the disintegration of the USSR to a significant extent (Grennes and Strazds).

DETERMINANTS OF SUPPLY AND DEMAND

Offering one more price forecast would not be very valuable, but it would be informative to analyze the important factors that affect the supply and demand for oil and its price. One factor that influenced the 2014 price drop was the emergence of shale oil that increased US oil production from 5 million barrels per day in 2009 to 9.4 million barrels per day in March 2015. The surplus of oil at a price of $100 per barrel of oil took some time to fall to $50. In the short-run demanders and suppliers are less responsive to price changes than they are in the long-run. Since quantities demanded and supplied contribute less to eliminating a surplus of oil, the price must drop by more in the short-run. Thus, a typical response to an innovation is that a large price drop in the short-run is followed by a smaller price increase toward the initial value in the long-run. Prices in 2015 have risen a bit, and Reuters poll of 34 analysts forecast an average 2015 price of $59.20 for Brent crude and $53.60 for U.S. West Texas crude. The futures market forecasts a similar small increase with March 2016 West Texas crude selling for $57 on March 30, 2015.

Only time will tell whether these forecasts will be wrong again, but there is some evidence that suppliers and demanders are becoming more price responsive. Rig counts of shale producers are down substantially, and spending on oil exploration has decreased. Consumers have already switched their purchases toward larger, less fuel efficient vehicles, and in January American drivers consumed more gasoline than in any month since 2008 (Financial Times).

There is considerable uncertainty about the supplies of several major exporters. Warfare continues in Iraq and Libya. Iran is attempting to negotiate an end to the embargo that began in 2012 and may have cut its oil exports in half (Wall Street Journal, 2015). Peaceful resolution of these disputes would contribute to greater production and lower oil prices.

DIFFERENCES BETWEEN TODAY AND THE PREVIOUS OIL GLUT

What is different about the current world oil glut from the glut of the 1980s? The existence of shale oil production has added to world output and reduced the market power of OPEC producers. The Energy Information Agency is projecting US production will remain at 9.3 million barrels per day for 2015, in spite of lower prices (Wall Street Journal 2015). The increase in  production in 2009 followed decades of falling production in the U.S. Saudi Oil Minister Ali al-Naimi expressed his unwillingness to reduce production and sacrifice market share.  He stated that “Saudi Arabia cut output in the 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake” (Bloomberg). OPEC members as a group have accepted the leadership of Saudi Arabia and refused to reduce output. Ali al- Naimi, announced that OPEC will not reduce production unless non-OPEC producers also agree to reduce output (Reuters). Also, both Saudi Arabia and Russia, as well as many other major oil exporters depend on revenue from oil exports to finance their government social expenditures. Thus, lower prices might even induce them to increase oil exports in an attempt to earn greater revenue. This is particularly true for Russia, which has accumulated much less oil wealth in its sovereign wealth fund than Saudi Arabia. These differences between the 1980s and today point toward prices that could be lower for a longer period than they would otherwise be.

SEPARATION OF THE US CRUDE OIL MARKET

Another difference from the past is that the US market for crude oil has become less integrated with the world market. Prior to the introduction of shale oil, the price of Brent crude oil from the North Sea moved very closely with West Texas crude at Cushing, Oklahoma that is traded on the New York Mercantile Exchange. The Brent price was sometimes above and sometimes below the Cushing price, but the prices were nearly always within $3 of each other. However, since September 2010, the Brent price has been consistently above the Cushing price. The March 30, 2015 Brent premium was $9, but in February it was as high as $12 per barrel. The change in the price spread is the result of the increase in shale production in the US and the prohibition on crude oil exports by the US. The separation of US and world crude oil markets contrasts with the integration of US and world gasoline markets. US policy allows for exports of gasoline and refined products but not crude oil. A proposal to allow exports of crude oil is opposed by US oil refiners who also claim that gasoline will become more expensive if crude exports are allowed. This claim is unlikely to materialize, since US gasoline prices are already linked to world prices through trade. The case in favor of allowing exports of US crude oil is as strong as the case for exports of any product.

If crude oil exports were allowed, traders would face one more anomaly in US policy. The infamous 1920 Jones Act would give shipments of US crude to foreign refiners an advantage over shipments of crude from the Gulf of Mexico to US East coast refiners. The Jones Act increases the cost of shipping from one U.S. port to another by requiring the use of a US flag ship which is more expensive than a foreign flag vessel. It requires the use of a vessel made in the USA, and a crew that follows US work rules and pays US wages. If US policy were based on economic efficiency, exports of crude oil would be legalized and the Jones Act would be repealed. However, these laws have persisted for decades and special interests provide them with strong support.

CONCLUSION     

Oil price forecasts have resulted in large errors. Historical prices have not helped forecasters because they have moved within a very wide range. Supply and demand analysis suggests that prices will move partly back toward their initial values as demanders and suppliers have more time and opportunities to respond to lower prices. However, some differences between today and conditions in the 1980s could contribute to even lower prices in the future. Shale oil is an important new development, and OPEC producers have refused to reduce production in response to lower prices. Saudi Arabia and Russia are important exporters whose reliance on oil revenue to finance government budget expenditures makes it unlikely that they will reduce production in the near future. The rise of US shale production, combined with a prohibition on exports of US crude oil, have contributed to separating the US crude oil market from the world market.

REFERENCES

Bloomberg. 2015. “Saudi’s Naimi Optimistic on Oil with Output Close to Record High”. March 22.

Financial Times. 2015. “U.S. Drivers Hit the Road as Petrol Price Drops”. March 30. http://www.ft.com/intl/cms/s/0/16225076-d6f3-11e4-97c3-

Grennes, Thomas, and Andris Strazds. 2015. “Creative Destruction in Russia and America: the Case of Energy.” EconoMonitor. January 5.

Kilian, Lutz, and Christiane Baumeister. 2014. “What Does the Market Think? A General Approach to Inferring Market Expectations from Futures  Prices”. VoxEU. November.

Reuters. 2015. “Reuters Poll: Oil Prices to Stabilize as Demand Rises”. March 30.

U. S. Energy Information Agency. http://www.eia.gov/forecasts/steo/realprices/

Wall Street Journal. 2014. “Oil Firms Pull Back on Rigs as Prices Fall”. December 30.

Wall Street Journal 2015. “Turning the Screws”. March 17.

Yergin, Daniel. 1992. The Prize. New York: Simon and Schuster.

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