Can oil prices be used to predict anything?

Rafael Sandrea, PhD
 
I recently read in the Oil & Gas Financial Journal, June 2010, an article: “Oil price increases may be indicators of economic recession”, which goes on to conclude that all recessions since 1973, including the most recent one, are associated with and preceded by crude oil price increases. This made me wonder since the topic of relationships between crude oil prices and fluctuations in economic activity has penetrated a large literature among economists, sometimes ‘contradictory and acrimonious’ to use the phrase of a distinguished economist friend of mine. Granted the theme is sophisticated but for us non-economists at least some simple, basic relationships must hold. 

Real US Wellhead Oil PricesThe graph shows the trend of global oil supply/demand over the last 15 years. It is gentle – growth is only 0.8% per year over the last 10 years – before, during and after the last recession while oil prices moved enormously from 2004 to 2008. The average WTI price of oil rose from $34/bbl in January 2004 to $145/bbl in July 2008, subsequently plunging to $30/bbl by December 2008! Currently WTI crude oil is trading at $74/bbl. 

One would expect some conspicuous degree of supply/demand imbalance preceding the extreme, unanticipated run-up/run-down in oil prices in 2008. On the contrary, EIA data shows that US oil inventories followed their normal seasonal pattern during 2008. Worldwide, both land and sea inventories were brimming at the end of spring 2008 as is usual; even in-the-ground inventories or spare capacity as it is normally referred to, were also at acceptable levels, around 1.5 million b/d at the time of the oil spike. So in effect all basic markers except oil prices point towards normality. 

The consensus seems to be that given the new market mechanics of storing oil and selling it in the future, coupled with electronic speed trading, even small volumes can rattle the system. The bigger issue is that established oil industry patterns used for long term forecasting of oil prices to determine hurdle rates for new E&P projects are no longer valid or simple. How can this be a rule-of-thumb for forecasting a recession?

 

For more of Dr Rafael Sandrea’s work on global oil and gas resources see: An In-Depth View of Future World Oil & Gas Supply - A Quantitative Model which is available online through PennEnergy.com.


Click here for Dr. Sandrea's full bio.



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