Uncertainty

How difficult is it to forecast oil prices? Compare the prediction of Philip Verleger, as reported in Bloomberg today, with the forecasts I talked about yesterday in my post on speculation:

Crude oil will collapse to $20 a barrel this year as the recession takes a deeper toll on fuel demand, according to academic and former U.S. government adviser Philip Verleger.

“The economic situation is not getting better,” Verleger, 64, a professor at the University of Calgary and head of consultant PKVerleger LLC, said in a telephone interview yesterday. “Global refinery runs are going to be much lower in the fall. If the recession continues and it’s a warm winter, it’s going to be devastating.”

But as I noted yesterday, these are not the only predictions for oil prices. Many forecast higher prices in the future. As the Bloomberg reporter notes:

At the other end of the spectrum from Verleger, Goldman Sachs Group Inc. predicted in a report yesterday oil will rally to $85 a barrel by the end of the year, and recommended that clients buy futures contracts for delivery in December 2011.

Why is it so hard to predict oil prices? These two quotes demonstrate that there are deep differences on fundamentals. That is, it is very hard to predict what will happen to fundamental factors like demand and supply in one year. Then it should not surprise that prices are hard to predict.

So oil prices are pretty surely to be either $20 a barrel or $85 per barrel. That is what I call uncertainty in forecasts.

Shoot the Speculators

Lenin could just order that speculators be shot. Today we have to have an investigation by the CFTC. So we learn in the Washington Post:

"Here we go again," Bart Chilton, a commissioner at the Commodity Futures Trading Commission, said late last month. "Crude oil prices are up 60 percent on the year. Supplies are at a 10-year high, and demand is at a 10-year low. You do the math. Why should prices be over $70?"

Last week, the CFTC said it would consider new measures to curb speculation and increase transparency in energy markets, where the agency's data suggest that a substantial amount of oil trading was concentrated in the hands of just a few investment banks and trading firms. Also last week, the leaders of Britain and France urged measures to counter "damaging speculation."

The argument seems to be that with oil demand lagging and inventories very high, that oil prices should be falling. Current prices of $60 per barrel must thus reflect the role of speculators. Worse, financial speculators!

It is always hard to understand how people can make money by moving a price away from its fundamental value. And what is most important about oil is how difficult it is to predict its future price. Oil prices are volatile, they tend to resemble a random walk, although for most of the period since 1859 (when oil was discovered in Pennsylvania) real oil prices have rarely exceeded $25 per barrel in current prices (see here, for example, for excellent charts).

Another reason why investors are looking to oil is because of fear of inflation. Oil can be a hedge against inflation:

Many of these investors are seeking to diversify their holdings or protect themselves against inflation that governments and central banks might foment while jolting the global economy. "It's like a barbecue that is not catching fire," said Jan Loeys, J.P. Morgan Chase's London-based head of market strategy. "You put all kinds of lighter fluid on it, and it's not taking. Then at some point, it takes, and then you don't have a lot of time before it blows up in your face."

So the actions of governments are leading to speculation that oil prices will increase. Either because they will head off recession and thus spur oil demand, or because they increase debt so much that there will be inflation. And, if the dollar declines in value oil prices will rise simply due to the fact that the price is denominated in dollars.

The fundamental point, of course, is that oil prices are just very hard to forecast. Each day, the price moves up or down, and there is some clever commentator who can explain why it moved. But it is very hard to forecast oil prices over longer periods. That does not mean it is not a good investment, however. It could help diversify risk for many investors.

Now suppose you are an investor and you read that oil prices are likely to rise to $85 by 2010, as in this report from Bloomberg:

Commodities will rise as investors’ appetite for risk revives along with the global economy, Morgan Stanley analysts, led by Hussein Allidina, said in a report yesterday. At the same time, oil production will drop as much as 6.3 percent a year among suppliers outside the Organization of Petroleum Exporting Countries and by 3.5 percent within the group, the bank said.

Oil demand is expected to rise 1.4 million barrels a day, or 1.7 percent, in 2010, led by emerging markets outside the Organization for Economic Cooperation and Development, the International Energy Agency said on July 10. Crude prices have climbed 35 percent this year on optimism that government stimulus will overcome the worst recession in six decades.

Under such circumstances I think investing in oil might not be a bad idea when the current price is $60. And if producers read these articles they have less incentive to produce now. So it is hard for me to believe that it is just evil speculators who push the price up.

Let us suppose that without the speculators the price would fall today to $50. But in 2010 it will be $85 as the stories say. Then absence of speculation means a much larger price jump in the future. Won't that be more disruptive? If prices are lower today, then there will be less exploration so that when demand recovers the price increase will be even more severe.

So, by all means, lets shoot some speculators. Good entertainment. But I will bet that shooting regulators and even government officials would get higher TV ratings.

Beware what you say

Perhaps I should be more careful about what I say about the financial crisis. In Latvia, economist Dmitrijs Smirnovs was arrested for "for bad-mouthing the stability of Latvia's banks and the national currency, the lat. Investigators suspect him of spreading 'untruthful information,'" according to this article in the Wall Street Journal. In October Smirnovs "took part in a discussion organized by a small local newspaper, Ventas Balss. Predicting serious trouble ahead for Latvia, he said: "'All I can advise is this: First, don't keep money in banks. Second, don't keep money in lats.'"

The problem, of course, was the Smirnovs was correct:

After insisting its banking sector was healthy, Latvia last month took over the largest locally owned bank, Parex, to save it from collapse. After denying it needed aid from the International Monetary Fund, the government is now in talks with the IMF.

Finance Ministry officials acknowledge that secret police won't save the country from economic crises. But they do believe Security Police vigilance makes the public think twice before spreading uninformed gossip about banks.

"It is a form of deterrence," says Martins Bicevskis, Finance Ministry state secretary.

Arresting people for spreading rumors, or the truth, about the economy is an old Soviet practice. The Latvian officials are afraid of the effect of rumors on speculative flows of capital. But it is not clear that such policies are anything but counterproductive. The less information people have about the economy the more subject they are to rumors and fears.