Cold fusion comes back

Are oil prices heading south for good?

In the past two weeks, news has proliferated of a supposed collapse in “the” global price of crude oil.  Since early this summer, the price has fallen from $100 per barrel to $80.  Since Kazakhstan prospers only when the oil industry does, the price decline signals an impending recession.  The solution is for the government to splurge, presumably to cover the anticipated shortfall in private consumption.  Or so go the news accounts.

Like most urban legends, this one has a kernel of truth.  Simple statistical models of data from 1999 through 2013 indicate that a 1% change in the spot price of Brent oil relates to a change in the same direction of Kazakhstani total output per capita of roughly one-half of a percent on average, expressed in annual terms.  (The annual prices are relevant because daily prices, for example, are too volatile to use when we’re planning how much to consume and produce over a year.) The problem with many news reports is that they compare a daily oil price on the futures market to a weekly, monthly, quarterly or annual oil price that is sometimes on the futures market and sometimes on the spot market, sometimes for Brent oil and sometimes for West Texas Intermediate oil, depending on the reporter’s druthers.  The reports compare apples to oranges.  Common sense should tell us that the fact that an oil price has fallen to $80 for a few days does not mean that all of them, or any of them, will stay that low for a year.

So, for the record, here are the latest annual spot prices for Brent oil:  For October 2012 through September 2013, $108.86; for the same period in the following year, $107.23, or a decline of 1.5%, according to data from the US Energy Information Administration (EIA).  I estimated the annual prices by averaging monthly prices. 

Do these data mean that Kazakhstan has nothing to worry about?  No.  It is perfectly possible that the spot Brent price will fall to $80 and remain in the basement for a year.  In fact, the Energy Information Administration this week lowered its 2015 mean forecast for that price to $83.42 (amid great uncertainty, and that is not a weasel phrase.  Unfortunately, in its forecast summaries, EIA does not favor the public with a confidence interval).  

Producers and investors expect price declines.  Saudi Arabia, which dominates the cartel called the Organization of Petroleum-Exporting Countries, recently cut its crude price modestly, and other OPEC members may follow suit.  On the futures market (for delivery in 30 days or so) for West Texas Intermediate oil, the daily price on the New York Mercantile Exchange fell from a 2014 peak of about $108 to below $80.  But those are only expectations, which are historically volatile: That daily price also fell to $80 in 2011 and 2012.  A more reliable indicator is the monthly spot price.  This fell to $87 in October for Brent oil, the lowest since November 2010, reported the EIA.

In general, annual prices will fall by a fifth only if market conditions have changed substantially.  Prices fall because producers want to sell more oil than people want to buy, and the rate of price decline depends on the rate of increase in excess supply.  The annual spot price of crude may suddenly fall sharply if the annual supply suddenly increases more rapidly than annual demand.  Under which conditions would that occur?  

Well, maybe the Europeans aren't buying, note news reports.  But their economy has been weak ever since the financial crisis of 2008.  Why should this weakness suddenly affect oil prices this summer? 

What about supply?  Consider US production of “tight” oil – i.e., crude extracted from shale, sandstone or carbonate rock, as defined by the EIA.  Since 2010, that production has increased about fivefold, from half a million barrels per day to 2.4 million in 2013, said Adam Sieminsky, head of EIA. 

Today, total US production of crude is as high as it has ever been.  But the rate of increase, which is almost entirely due to tight oil, has fallen for about a year.  So why should annual spot oil prices suddenly fall now?

The most obvious new determinants of oil prices are the sanctions against Russia.  Whatever their political merits, they reduce global economic activity and consequently oil demand.  But what are the chances that the sanctions will remain in force long enough to affect annual oil prices?

The vital point – and the one that the media, including the New York Times, rarely mention – is that oil-price forecasts are iffy.  The mean forecast may look precise, until you compare it to the range of other likely values.  For example, for the weekly futures price on NYMEX for West Texas Intermediate oil in January 2015, the mean price was $80 – but the 95% confidence interval ranged from about $60 to $100, reported the EIA.  Futures prices for Brent and West Texas Intermediate oil are more volatile now than they have been for more than a year.

In short, we don’t yet have enough data to conclude that a collapse in oil prices is imminent.  Since 1999, the only time that the annual Brent spot price has fallen sharply (by 40%) was in the Great Recession of 2009.  At that time, annual total output per capita in Kazakhstan fell 1.4%, according to World Bank data.  That was the only decline in real gross domestic product to occur here since 1999.  In light of these trends, it would make sense to prepare now for a price drop -- but to keep one’s options open, in hopes of better information later     

    

By all means, reporters should discuss such improbable but risky events as a depression in Kazakhstan.  But overstatements of its likelihood will eventually turn off intelligent readers.  No one wants to read about cold fusion anymore.  –Leon Taylor tayloralmaty@gmail.com

Notes

The “95% confidence interval” is a range of likely forecasts.  The idea is this:  Any forecast is based on available data, but these vary with circumstances.  I may forecast the 2015 grade of KIMEP students by sampling 50 undergraduates; but if I sample 50 other students, I will get a different dataset and forecast.  If I take 100 samples, then the 95% confidence interval will give the range of forecasts that I am likely to get in at least 95 of the samples.  

Of course, in reality, I probably will take one sample, not 100.  But the dispersion of data in that sample gives us an idea of how scattered the data may be over all samples.  The amount of scatter in the present sample generates the confidence interval.       

Good reading

Clifford Krauss.  U.S. oil prices fall below $80 a barrel.  New York Times.  November 3, 2014.  With specifics about the price declines.

United States Energy Information Administration.  Short-term energy outlook, November 2014.  Online.  www.eia.gov. This Web site also offers copious oil data.    

Adam Sieminski.  Outlook for US shale oil and gas.  United States Energy Information Administration.  2014.  Online at http://www.eia.gov/pressroom/presentations/sieminski_01042014.pdf

World Bank.  World Development Indicators.  www.worldbank.org  Income time series for most countries.