Oil price outlook

(December 3, 2018)

The last few months have been tumultuous when it comes to oil prices. Brent prices have been on the rise for about a year, passing the 80 USD per barrel level a few weeks ago. The latest and sharpest increase was due to supply concerns as the U.S. sanctions on Iran were about to be implemented.

Now this concern is behind us because the sanctions were implemented with exceptions for some of the largest buyers of Iranian oil. Other large producers of oil, most notably Saudi Arabia, seem committed to ramp up production if needed and U.S. producers have increased their output, making the U.S. the biggest producer of crude oil. On the demand side, there are concerns over the health of the global economy due to the risks of trade war between the U.S. and China, political problems in Europe, and currency crashes in some emerging markets including Turkey and Argentina. A possible slowdown of the global economy will lead to a decline in the demand for oil.

All of those factors brought down the price of oil and are likely to keep it down for some time. Despite occasional disruptions, oil supply seems abundant and, on balance, there is more downside than upside risk to the global economy.

The futures prices at the New York Mercantile Exchange, depicted in the chart, suggest that market participants do not expect a rebound any time soon. The chart shows the prices of crude oil (Brent and WTI) at which buyers and sellers on the New York Mercantile Exchange have agreed to buy/sell oil at some point in the future. These are the so-called futures contracts and reflect the expectations of market participants. The buyers and sellers have agreed now at what price to trade oil in the future. Therefore, with some caveats outlined below the chart, we can assume that the futures prices reflect to a large extent their expectations of the future oil prices.
These expectations may not come true but they are probably the best available forecast numbers. They aggregate the knowledge of buyers and sellers who try really hard to stay informed about oil prices. Other forecasting methods based on survey data or macroeconomic analysis do not seem to perform better.

Some caveats on the futures prices as predictors

In addition to the expected price of oil, futures prices also contain the risk premium and the so-called convenience yield:

Futures price of oil = Expected price of oil + Risk Premium + Convenience Yield

The risk premium reflects the desire of buyers and sellers to avoid uncertainty about the price at which they can buy or sell oil in the future. To reduce the uncertainty, buyers may be willing to pay a premium over what they think the future price of oil would actually be. Similarly, to assure a market for their oil, sellers may be willing to accept less than the expected future oil price. Depending on which side of the market feels a greater need for insurance, the risk premium could be positive or negative. It could also vary over time as market conditions change.

The convenience yield reflects oil refiners’ desire to have stocks of oil in order to ensure a smooth production process. Maintaining an optimal stock of oil requires a decision to buy oil now and to plan to buy oil in the future. The slightly is affected by the current demand and supply for oil as well as the expected future demand and supply. Therefore, as market conditions change, the convenience yield also changes.

We cannot directly observe the risk premium or the convenience yield and, also, they probably change over time. Therefore, the futures price of oil is not exactly equal to the expected price of oil. However, despite these caveats, the futures price of oil seems to be as good (or as bad) of a predictor of oil prices as the alternatives: surveys of expert forecasters and fundamentals models based on macroeconomic data. The advantage of the futures price data is that they are transparent and continuously updated as the market incorporates new information about the oil market and the global economy overall. Nonetheless, the best course of action is to look at the futures data but also to stay informed of the fundamentals moving the supply and demand for oil. For that you can look at our news digest of selected media pieces on oil and fuel prices.

Long-term oil price outlook

Looking longer-term, we don’t see much scope for significantly higher prices. There is growing demand for petroleum products from emerging markets but the demand in developed countries is declining as environmental standards get tougher and electric vehicles spread. Also, demand in the emerging markets would probably taper off as cleaner technologies become cheaper and more accessible. Hence, the World Energy Council expects oil consumption to peak in 2030. Moreover, the U.S. Energy Information Administration estimates that current proven oil reserves would last until 2050 with new deposits being continuously identified. In other words, there seems to be ample amount of oil for many years after its consumption starts to decline. Of course, it matters whether the low-cost reserves dry up first but, overall, these dynamics do not suggest a steep increase in prices.

These factors may not be enough to press crude oil prices much lower than their current levels because on a global level incomes are growing and, so far, this generates additional demand for oil. However, they put an upward limit on crude oil prices. There may be occasional spikes due to supply disruptions but they would be temporary. As economic growth around the world picks up, crude oil prices may drift up on a more sustained basis but probably not much above a 60-80 USD per barrel level in the next few years.

You may also like to see what the oil price forecast implies about the future retail fuel prices.


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