FRBSF Economic Letter
2005-38; December 30, 2005
Do Oil Futures Prices Help Predict Future Oil Prices?
The
price of oil has risen by about 60% since mid-2004 and
by more than 40% since the beginning of 2005. Though
the U.S. economy has apparently absorbed this supply
shock well so far, the path of future oil prices remains
a concern
for monetary policymakers. Higher oil prices can damp
demand, as consumers and firms spend more of their budgets
on oil-related
products and less on other goods and services. Furthermore,
if higher oil prices are passed through to a significant
extent to other goods and services and ultimately wages,
inflationary pressures can build.
Is the price of oil
likely to rise further, or will it decline gradually, as it
did in the mid-1980s? A natural
place to look for an answer is in the markets, where
oil traders are knowledgeable about the industry and
where their profits ride on making sound investments. This Economic
Letter discusses how to forecast future oil price
movements based on information from both the oil futures
market
and the spot market. In particular, we conduct a series
of
forecasting exercises and compare the performance of
models that use oil futures and spot prices in an attempt
to find
the one that performs best.
Oil futures prices and spot oil prices
Oil futures prices reflect the price that both
the buyer and the seller agree will be the price of oil
upon delivery.
Therefore, these prices provide direct information about
investor's expectations about the future price of oil.
 Like the prices of every other risky asset, however, oil
futures prices include risk premiums, to reflect the
possibility that spot prices at the time of delivery may
be higher
or lower than the contracted price. Figure 1 plots a
measure of the risk premium for oil futures prices, defined
as
the difference between the oil futures price and the
expected future spot price from the Consensus Forecast's
survey.
The difference is expressed as a percentage of the current
spot price. As the figure reveals, although the oil price
risk premiums are close to zero on average, they are
quite large and volatile over time. This suggests that
oil futures
prices are not necessarily the best predictor of future
oil prices.
The current, or spot, oil price may also help
predict future oil price movements. As Hotelling (1931)
states, given
certain simplifying assumptions, the opportunity cost
of storing oil is the foregone interest rate. Therefore,
in
theory, the expected rate of return to holding oil should
be identical to the interest rate; in other words, the
price of oil is expected to appreciate at the interest
rate. In practice, however, holding oil stocks often
provides some advantages or flexibilities for manufacturers
in managing
their operational risks. Such benefits (net of storage
costs) are called "convenience yields" and should
be reflected as a premium, mostly positive, in the current
oil price. Thus the expected rate of return of oil stocks
may not be identical to the interest rate, and a forecast
based on the current spot price may tend to overpredict
future oil prices.
Forecasting models and methodology
We formulate four models based on oil futures
prices and the spot oil price. The first is a random
walk model, which
predicts that spot oil prices will stay at their current
levels. This is the simplest statistical model and provides
a benchmark to evaluate the forecasting performance of
other models. Second is Hotelling's model, which predicts
that the future oil price will be the current spot price
adjusted for the interest rate. Third is a futures model,
which predicts an oil price level in the future identical
to the current futures price level. Fourth is a futures-spot
spread model, which uses the spread between the current
futures prices and the spot price to predict movements
in the future price of oil.
We evaluated model performance
using two criteria. First, we estimated the model over
the full sample (mid-1980s
to present), calculated its forecasts for horizons that
vary from one to twenty-four months and then compared
the forecasts with the actual oil prices over these months.
The model with the smallest average prediction errors
is
said to have the best "in-sample" fit, since
its parameters are estimated over the full sample.
Second,
we conducted a more realistic "out-of-sample" forecasting
exercise, where we estimate the model using the data up
to a given month, instead of the full sample, and then
make forecasts for future months. The model with the smallest "out-of-sample" forecast
errors has the most forecasting power, because, in practice,
we are only able to observe data up until today (that is,
we are only able to perform "out-of-sample" forecasts).
However, we use both criteria in evaluating the models
to obtain more robust conclusions.
Results
Several conclusions emerge from the forecasting
exercises. Raw futures prices are found to be unbiased
predictors
of future oil prices; that is, for the past two decades,
the raw oil futures prices are as likely to overpredict
as to underpredict future oil prices. However, while
the average of forecasting errors based on raw futures
prices
may be close to zero, such errors are quite large over
time. Indeed, raw oil futures prices provide relatively
less accurate forecasts than models using both the futures
prices and spot price (the "futures-spot spread" model).
Therefore, incorporating information on the relationship
between current futures prices and spot price improves
the forecast.
 The "futures-spot spread" model
has the best "in-sample" fit.
Figure 2 displays the fitted value for three-month and
twelve-month horizons and the actual oil prices. The standard
deviations of the prediction errors range from about 10%
of the spot price at a one-month horizon to about 30% at
a twelve-month horizon. The next best performer is the
Hotelling model (based on the current spot price and interest
rate), with the standard deviations of prediction errors
ranging from about 10% at a one-month horizon to about
35% at a twelve-month horizon.
The "futures-spot spread" model
also does a fairly good job when predicting "out-of-sample." In
particular, it performs better than the others when predicting
oil price movement in the near term, up to the next four
months. For longer horizons, Hotelling's model performs
slightly better. The performance of raw futures prices
is only slightly worse than that of the "futures-spot
spread" model at short horizons but much worse at
longer horizons. We also conducted the forecasting experiment
for different periods and found that, during the past two
decades, relative performance of these models was quite
stable.
The observation that futures prices are more useful
in forecasting near-term oil price movements may reflect
the
fact that the near-term oil futures markets are much
more liquid than longer-term futures markets. For instance,
the average daily trading volume of the "light, sweet
crude oil" futures contracts on the New York Mercantile
Exchange over the past two years is about 72,600 contracts
for a horizon of one month, 22,000 units for two months,
4,800 for four months, and only 1,000 units for the one-year
horizon (one unit represents 1,000 barrels). As the futures
market becomes less liquid at longer horizons, the quoted
futures prices may become a less accurate measure of expected
oil prices, because they are more vulnerable to shocks
that may not be related to the expected oil price movements
in the future.
Predictions
On the basis of the estimated relationship between
the oil futures prices and future changes in spot prices,
forecasts
of crude oil prices for the next two years can be calculated
from the latest spot and futures prices. On December
12, 2005, the spot price for West Texas crude oil was
about
$62. The three-month and twelve-month futures prices
were both around $64.
Based on these data, the "futures-spot
spread" model
projects a slight increase in oil prices, with the spot
price rising to $65 per barrel by March 2006 and $67 per
barrel by December 2006. However, the accuracy of such
forecasts is quite low. For instance, we can only say that,
with 90% certainty, the spot price in March 2006 will be
between $55 and $74 per barrel. Conclusion
Oil futures prices contain important information about
future oil price movements, especially for the near term.
In particular, taking into account the relationship between
current spot and futures prices instead of considering
only the raw futures price can significantly improve
forecasting accuracy. Prediction errors, however, are
still substantial,
and accurately predicting the future price of oil seems
as elusive as ever.
Tao Wu
Economist |
Andrew McCallum
Research Associate |
References
Consensus Forecasts Inc. 2005. "September 2005 Oil
Prices." Consensus Forecasts (September 12)
p. 27.
Hotelling, Harold. 1931. "The Economics of Exhaustible
Resources." The Journal of Political Economy 39(2)
(April) pp. 137-175.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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Questions? Contact
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