The worst except for the others

Amidst the carnage that is the oil market post COVID-19 outbreak / OPEC+ breakdown forecasters from the major banks have been quick to outline their thesis for why oil prices will remain low or drop even further.

According to Goldman Sachs the demand shock from the spread of the coronavirus was equivalent to that seen in 1Q 2009 amid the financial crisis, while the production surge was likely to be much like that seen in the 2Q 2015 setting the stage for “a likely 1Q16 price outcome.”

“As a result, we are cutting our 2Q and 3Q20 Brent price forecasts to $30/bbl with possible dips in prices to operational stress levels and well-head cash costs near $20/bbl,” they wrote.

History suggests that investor attention will soon seek guidance as to whether now is the right time to dip a toe back in the energy market. The chart below shows global search activity for ‘oil prices from 2004. The financial crisis and the surge in shale output / OPEC restraint post 2014 captured peoples attention. Despite the surge in volatility oil prices have failed to ignite the Google algorithms. Not yet anyway.

Google Trend – ‘oil prices’

But before you base your investment decisions on the word of Goldman Sachs its worth recalling why they might not be worth paying too much attention to. For a forecast to be useful for a commodity investor it has to have three qualities: it has to be correct, it has to anticipate change ahead of the market and it has to have led to a better overall result than taking the consensus.

What follows is an extract from my book, “Crude Forecasts: Predictions, Pundits & Profits In The Commodity Casino” on the poor oil price forecasting record of investment banks and other financial institutions.

Hint: Not great, and Goldman Sachs are worse than most. Skip to last few sentences to see exactly how poor.

The Wall Street Journal (WSJ) polls institutions every month on a range of economic variables including inflation, unemployment and West Texas Intermediate (WTI) crude oil prices. Each month, the survey asks for predictions for the forthcoming June and December. For the sake of consistency, I have reviewed the accuracy of forecasts made both six and 12 months prior to June and December each year. I reviewed surveys from mid-2007 to the end of 2016 and so this covered booms and busts, financial crises and quantitative easing, the Arab Spring and the shale revolution.

By means of a disclaimer, this is not an exhaustive study. By definition, it only covered a ten year period, and there is no guarantee that forecasters that were correct during this boom and bust period will be any more or less successful in future periods. It also says nothing about how well those same institutions did trying to predict other commodity prices including metal and agricultural prices. Finally, it only covers those forecasters that the WSJ surveyed – there may have been others who were more or less accurate in their predictions.

First, were the forecasts right? The answer was clearly no. The average consensus forecast (ie, the average of the commodity price predictions) for WTI crude oil was off by 27% when forecasting six months out. Oil price forecasts looking twelve months out were only slightly worse, off by an average of 30%. Another way of looking at it is that only in three of the nineteen periods reviewed was the consensus six month forecast within 5% of the actual result.

As noted earlier, producers, manufacturers, investors and traders are making billions of worth of investment based on the outlook for commodity prices. If these forecasts are awry on as short term a time period as twelve months then how can they have confidence making decisions over much longer time periods?

Second, did any of the forecasts spot the major changes in the direction of the oil price over the past decade? In June 2008, WTI crude was trading at approximately $135 per barrel. The consensus prediction for December 2008 was just under $112 per barrel and $101 per barrel twelve months ahead. The reality was somewhat different. The financial crisis hit and with it the oil price was hit too. WTI crude prices fell to $41 per barrel in late December 2008, only rebounding to $70 per barrel in mid-2009. Almost all forecasters polled in mid-2008 saw prices falling over the next twelve months, but no one saw the scale of the collapse. The closest six month forecast, although over 50% higher than the outcome, came from Parsec Financial Management!

It was a similar story in trying to call the rebound in prices. Remember that oil and other commodities rebounded in 2009 as quantitative easing helped support prices. Back in December 2008, however, the consensus prediction for June 2009 was for prices to stay low, only nudging up from the current levels of the time. This time the consensus was over 30% too low. Only three forecasts called the market within 5%: Societe Generale, Barclays and the Economic and Revenue Forecast Council.

Over the next few years, oil prices traded in a gradually narrowing range between $70 and $110 per barrel. Sure enough, the consensus and individual forecasts, increasingly anchored against recent prices, turned out to be broadly correct – well at least within a range of 5–15%. Like many forecasters, these economists were driving with their eyes fixed on the rear view mirror, enabling them to tell us where things were but not where they were going. This bears out the old adage that “it’s difficult to make accurate predictions, especially with regard to the future.” The corollary is also true: predicting the past is a snap.

If we fast forward to June 2014, oil prices were trading at approximately $105 per barrel, having peaked at just over $112 per barrel ten months earlier. The consensus forecast was for oil prices to fall from those levels to below $99 per barrel in December 2014. In reality, the consensus proved too optimistic by 85%. All of the forecasters were over 65% too optimistic, apart from one – Parsec Financial Management had predicted oil prices to be in the late $60s per barrel range in December 2014, only 24% too high.

Does that mean that Parsec Financial Management have superior insight? Well, not quite. A look back through earlier forecasts reveals that they were consistently bearish all the way back to early 2010, calling for oil prices to stay around $50–70 per barrel, even though oil prices kept on rising. This is what’s known as the “stopped watch” method of prediction. If you keep on saying something extreme will happen and it eventually does then you are feted as a guru when, in reality, you were lucky (eventually) with the timing.

Predictions are most useful when they anticipate change. If you predict that something will stay the same and it doesn’t change, that prediction is unlikely to earn you much money or wow clients with your predictive abilities. However, predicting change can be very profitable for investors, while timing hedging strategies can be a welcome boost to both producers and manufacturers.

Third, was there a forecaster that you could have followed that would have led to a better overall result than taking the consensus? Of those 26 institutions that contributed prices for at least 14 of the 19 forecast periods and during the key turning points in the market identified above, three forecasters achieved a better than average result than the consensus when looking over a period of six months. These were: JP Morgan (26% forecast error, 4 correct calls); Comerica Bank (25%, 2) and The Conference Board (25%, 3). The most accurate institution achieved a two-percentage point improvement on the consensus, but still had an average six-month forecasting error of well over 20%. The research sample also includes Goldman Sachs, often famed for its supposed commodity prediction ability. How did they do? They were an average of 36% off with one correct call.

Related article: Why do economists have an abysmally poor prediction record?

Related article: The futures curve is not a price forecast

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