Good Oil Forecast, Bad Oil Forecast

Here's the good oil forecast:  back in the fall of 2005, I predicted oil prices going back down to $35.

Here's the bad forecast: I said it would happen by the end of 2006.

Right price target, wrong time span.  So what went wrong?


The process behind the forecast is still sound, I think.  World demand for oil can change quickly as the economy grows.  World oil supply cannot change quickly, because of time lags in exploration and development (which means putting in the production wells, laying pipeline, building terminals and docks).  So oil price rises in the face of growing demand and slow supply response.  And oil prices have to rise a lot, because in the short-run demand is not very sensitive to price.  Changing oil demand because of price requires changes in equipment and usage patterns, which does not happen quickly.  So it takes a big oil price change to bring demand down to current supply.  But so far we're in the short run.

In the long run, supply increases.  It takes a few years, but supply increases.  Demand relative to output slows down.  Again, this response takes a few years.  That by itself would be enough to bring prices down.  My mistake: I expected this process to occur over the course of two to three years.

How was I wrong?  Two possibilities:  1) I was mistaken about how long the supply response to price would take, and how long the demand response to price would take; or 2) I misjudged the additional increase in demand from the strong world economy.

I don't know the relative importance of these two errors, but I suspect they are both major contributors to my (and others') forecast errors.

So what's the outlook?  I don't know.  We're much closer to an equilibrium in which the price at which new supplies can be brought to market matches the price that people are willing to pay.  But the market is tremendously volatile.

Business strategy for dealing with oil prices:  don't bet your business on a forecast.  Not mine, not anybody else's.  I don't know of anyone who predicted both the rise to $140 and the drop back to $35, and made the predictions publicly with dates attached.  (It's easy for me to say oil will go back over $100 if I don't have to commit to a time period.  Maybe 2045?)

If energy costs are critical to your business, look for ways to hedge.  Certainly continue to look for cheap ways to become more energy efficient, but keep in mind that a large capital expenditure to lower energy costs is a big, big bet.  If betting on energy is not your core competency, don't do it.

What will the next forecast error be?  Someone will ask, so let me say now, that's a stupid question.  It's asking for a self-defeating prophecy.  If I knew what my next mistake would be, I wouldn't make it.