Most economists are used to being button-holed at parties and asked about some specific feature of the economy. And the more distant the topic is from your research, the more likely it is that you will be asked about it. Right now, I’m getting plenty of questions about what is happening to oil prices.
I recently dug into the recent oil literature and discovered something amazing: It is easy to do better than the experts. At least this is what I learned from a recent working paper, “What Do We Learn From the Price of Crude Oil Futures?” by Michigan economists Ron Alquist and Lutz Kilian.
The authors compare a whole range of different ways of forecasting oil prices: they look up the Consensus Forecast (from a survey of expert economic forecasters), oil futures, the difference between the oil price in futures and spot markets, and also a range of more or less complicated econometric models that take account of recent trends, as well as variables like the interest rate.
And it turns out that they all do worse than one simple forecast: the current oil price. That’s right: the most accurate forecast of oil prices over the next month, year, or quarter is the current oil price. We call this the no-change forecast.
The Alquist-Kilian finding was the subject of my latest commentary for American Public Media’s Marketplace (available here; or here for the audio version). Here’s the highlight:
Amazingly, this simple rule did better than the average of dozens of professional forecasters! In fact, the no-change forecast was 34 percent more accurate at predicting oil prices in 3 months time, and 18 percent more accurate at predicting prices in a year’s time. While professional prognosticators might argue that this difference isn’t statistically significant, it sure is embarrassing.
It turns out that the so-called experts add too much variance to their forecasts, leading them to do worse than the no-change rule.
I was more surprised by the poor performance of the oil futures prices as forecasts. My usual response to being asked about the future of oil simply involved looking up the futures market and calling those prices a forecast. However this isn’t quite right: the spot price embeds in it an option value or “convenience yield” that isn’t factored into futures prices. And if this convenience yield moves about (and it tends to move up and down with economic uncertainty), then this causes the futures price to fluctuate in ways unrelated to the future oil price.
If you are interested in learning more about oil prices, Kilian’s recent papers are a useful starting point. The longer Marketplace story is available here.
and 
. You can also watch it on 
I’m surprised that the current price is more accurate than the futures price.
How much money could you have made by betting on the current price when the futures market is significantly different?
I enjoy hearing non-experts talk about economics matters. Not because I wish to gain insight, but because they generally lack any to begin with.
Dave, please grace us with your wisdom on the topic.
Carl,
Were the current governments (at large, not single individuals) in power *before* the current spike in prices above $60? Yes. So one can hardly say they are _dependent_ on the high price.
In fact, they are to some degree hurt by it. It also affects (raises) prices at home, which their respective residents are much less able to pay than we are.
A weather authority told me that the best predictor of tomorrow’s weather is today’s weather. This beats the predictions from the monster computers at the National Weather Service in Golden, Colorado, he claimed. I was never able to verify my authority’s assertion, but this oil price thing makes me think he was correct.
futures prices follow a no-arbitrage rule..they are entirely useless in predicting future prices. Indeed, conventional market wisdom says a downward sloping futures curve (future oil cheaper than spot oil) is actually bullish of oil because it indicates a lack of physical supply. A lot of very clever economists get this wrong. Keynes and Ben Bernanke are two that have got it wrong in the past.
Bizarrely, the same is true for weather. Generally, the weather tomorrow will be the same as the weather today. Of course, I’m pretty sure that the weather six months from now will not be at all like the weather today, but it’s highly accurate on a day to day basis.
Oil isn’t like the weather.
Oil is a finite, non-renewable resource, and we may be near Hubbert’s peak now. After peak oil, oil production will fall fairly rapidly.
Given this, and increasing demand for oil, and without an breakthru in renewables that can scale up rapidly, here’s my bet:
…higher oil prices in the future
The new normal isn’t the same as the old normal. Peak oil means a paradigm shift.