Tuesday 30 December 2008

Oil price pricing and previous expectations

Earlier this year I said that the expected world oil price would be around US$140 a barrel. The price is now around $38 per barrel. Did I go wrong and how?

The figure was an expectation, not a prediction for the actual price. It is an average of all possibilities for the price, so the fact that the price is $38 does not necessarily mean that the expectation was wrong. That said, the expectation would have looked more likely to be correct if the year end figure was somewhere between $120 and $160 a barrel, since my expectation implies that $38 would be an extreme value and quite unlikely.

The expectation was presented in the context of market predictions that the price would hit $200 or $300 dollars in the near future. The theory I used showed that price slowing was more likely than continuous acceleration. Acceleration would be the result of oligopolistic supply decisions, rather than changes in oil demand. My expectation appears more realistic than the market anticipation at the time.

The expectation was presented as being based on economic fundamentals, rather than oligopolistic pricing or market overreaction to price stimulii. Given the possibility that the market has presently overshot and is pricing too low relative to economic fundamentals, it is quite possible that a more objective pricing on fundamentals would have a higher oil price. However, we may say that even if the fundamentals-based price is, say $70, the price is still unlikely to have occurred in a price distribution with $140 as the expected value.

In retrospect, the very rapid growth in prices over the last decade looks like a bubble in which actual prices detached from economic fundamentals. I should have evaluated the economic-fundamentals price as lower, by projecting the mid 1990s figure at a growth rate lower than the observed rate. The projection rate should still have been higher than previous trends, by virtue of the emergence of the large developing countries. In retrospect, I should also have assessed that the price bubble presented significant downside risk both from market correction and from damage to aggregate demand. An expectation of $80 or $90 would have been better, and I hope I would have said this even if the price today was $200 or $140.

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