Biases, Pressures, and Problems in Energy Price Forecasting

Abstract

Guest editorial Price matters. It is the arbitrator that balances wishes and physical reality. However, stating the obvious, oil and gas prices are volatile. If they were not, there would be little need for price forecasts or forecasters. Based on the latter's track record, some may think that is not a bad idea. Whatever their reputation, this group at least follows the first law of forecasting, which is to forecast often, either a value or timing, but not both. Needless to say, such arbitration of price is also an issue that many find quite annoying. One of the best surveys showing this was the initial (1983) issue of Arthur Andersen/Cambridge Energy Research Associates’ World Oil Trends under the title, "The Perils of Prophecy." In that report, several industry executives were asked their opinions of price forecasts. Here is what two said.Since you don't know, or at best can't be sure, the safest place to be is halfway between Exxon and Shell.Oil price forecasters make a flock of sheep look like independent thinkers. Accountability in price forecasts requires the admission of how wrong the forecast could be. Therefore, the only forecast that I offer is in the form of a probability distribution. After all, the recognition of uncertainty is intellectually honest, maximizes information, and minimizes unwarranted detail. Indeed, as the industry moves forward on such issues as probabilistic reserves analysis, it is only consistent to have the economic and operating conditions also expressed in a probabilistic manner. A better term than forecast would be hypothesis, which by definition is to be questioned and tested. Forecasts, hopefully, are not made in a vacuum. They are based on underlying assumptions that themselves should be forecasted and therefore tested for consistency, on the impacts of unintended consequences, and on the need for reconciliation with macro global realities. One example of such consequences often overlooked is the relationship between price and the cost of capital investment and operations. Price and cost are not independent variables. Regardless of this questionable record in forecasting, accountants and regulators live on the belief that precision is attainable. They see value in a single point, or snapshot, view of a project or firm's worth. Using such assessments for comparison may have value at that point in time. However, decision makers and investors need to see a range of possibilities to make informed, well-reasoned decisions about the future. This culture of blindly assuming accuracy that cannot be justified has even seeped into the engineer's mentality. And he should know better. The Anchoring Phenomenon George Santayana wrote, "Those who do not study history are doomed to repeat it." A corollary to this observation may very well be that those who do study history will be so confused that they will give up and only watch history go by. At the risk of such confusion, let us look at some actual forecasts from a former major oil company long since merged into another firm. Fig. 1 is a plot of forecasts (the thin lines) starting in 1974 from that major oil company, expressed in 1987 dollars. The actual oil price in 1987 dollars is shown in the heavy line. Inflation has been taken out so that these forecasts can be shown on a realistic scale.