Last week Jim O’Neil wrote an article in Project Syndicate discussing the perils of oil price forecasting and his quest to determine an equilibrium oil price. According to the former employee of Goldman Sachs…
My conclusion is that a good indication of this moving equilibrium does exist: the five-year forward oil price, or the amount paid for guaranteed delivery of oil five years from now.
At the time of writing the forward price for Brent crude in January 2020 is just over $74 per barrel – almost $25 per barrel above the near term futures price. When compared to the 50% plus decline in the Brent near term futures price since June the 5-year forward price has barely budged. So whats the relevance of this apparently arbitrary date in the future? Here’s more from O’Neil.
In my ongoing quest to become better at forecasting, I began, a few years ago, to pay attention to the five-year forward oil price as it compares to the Brent crude oil spot price, the price of a barrel of oil today. I suspect that the five-year forward price is much less influenced by speculation in the oil market than the spot price, and more representative of true commercial needs. So when the five-year price starts moving in a different direction than the spot price, I take notice.
GS expand on this in their 2010 paper Commodity Prices and Volatility: Old Answers to New Questions. The cyclical component of price is determined largely by fluctuations in short-term fundamentals as captured by inventory levels. As demand adjusts over short time horizons, demand is the key driver of the cyclical component of price and typically dominates the market on a 1 – 2 year horizon.
Conversely, as supply is generally slower to adjust than demand, given the capital- and time-intensive nature of commodity production investments, these structural supply-side factors typically drive the market on a 2 – 10 year horizon. The structural component of price is usually determined by the long-term supply curve or the cost of bringing the last needed unit of the commodity to the market – referred to as the marginal cost of production.
Historically—throughout the 1980’s and 1990’s long-dated prices rarely moved, reflecting the relatively stable cost of bringing new supply into the market. Things then changed from about 2004. Given the shifting sands involved in the cost of producing a commodity (geology, other commodity prices, geopolitics, resource nationalism and not to mention the main development costs) are in a constant state of flux, so the marginal cost of production is to. It is a moving target. Although the price of a commodity can certainly fall below the marginal cost of production in the short term (the current price is an example of that), in the longer term prices should rise to at least the marginal cost.
The forward price is useful as an indicator of long term pressures in a commodity market it is by no means a forecast. There are many factors which affect the forward curve other than just market expectations of where the price of a commodity will be that far out in the future. First, the ‘cost of carry’, which includes interest rates, storage costs and insurance. Second, the physical characteristics of the commodity (whether it is easy to store, whether there are ample inventories etc). Third, the effect of John Maynard Keynes’ ‘normal backwardation’ theory. Fourth, market liquidity and finally the curve fails to account for the ‘real’ inflation-adjusted value.
So to conclude the 5-year forward price of oil may give some useful insight into long term cost pressures. But use it wisely, as it is not a forecast.