What went wrong with oil? You listened to the street

March 22, 2016 09:00 AM

In January, Modern Trader released “The Issue with Forecasting.” The central thesis argued that the much-revered experts are not very good at predicting the future. At the time, we analyzed market calls from more than a dozen prominent analysts at some of Wall Street’s top firms and determined the probability of their market calls coming to fruition later this year.
But before the ink had even dried, several of the same analysts had already slashed their earnings forecasts and started downward revisions. 

The excuses piled up quickly.

The bigger question isn’t so much about what experts have forecasted. Instead, the focus should be on what they missed. And no bigger misread in the global markets has been more evident over the last seven years than the almost futile exercise of predicting oil prices. 

A breakdown of oil forecasts from the top banks last year (see “Breakout,” page 77), and the forecasting performance is pretty terrible. Last April, Standard Chartered put 2016 oil price north of $90 per barrel. Bank of America Merrill Lynch and Barclays are the closest to where prices are today – and they’re well above $50 per barrel. 

The one bank that can take some credit is Goldman Sachs, which predicted $20 per barrel back in September. But keep in mind that they also made a market call in mid-2008 that projected $200 per barrel. That’s a dramatic turnaround. So how did so many high-paid Wall Street analysts miss this massive commodity downturn – and miss it so badly?

Some argue the miss largely begins with a misunderstanding of a technological boom and the surge of production fueled by shale development in the United States. Before 2008, it was hard to find someone who argued that U.S. production was heading anywhere but down. Chatter of peak oil dominated headlines. The experts missed the shale boom, then failed to understand that the same production techniques for natural gas could be applied on a wide scale here in the U.S. They didn’t believe that U.S. production could reverse its decline. They believed – somehow – that more than 10 million barrels a day in the U.S. wasn’t going to affect global supply prices. 

Then, everyone missed China’s slowdown and the fact that a massive glut was forming.

Everyone was convinced that Saudi Arabia would cut production to offset price weakness, but no one foresaw a political battle between their leaders and Iran. The experts cited production costs – oil prices couldn’t fall below $80 a barrel, because that was the level that was cited as the breakeven level around the globe. As if oil wells magically shut off when traders react to what’s happening at the Nymex. 

Thing is, these factors are well less than half the story. 

At the heart of it is the incapability of the human mind to wrap itself around the sheer size and factors that go into this global market. When something is this large with this many moving parts, we try valiantly to find shortcuts or justify one specific variable. Each day, a headline says that oil prices fell because of whatever factor an energy journalist can point to that day. 

It’s over-simplification at best, and malpractice at worst. This is a thorny industry – the mainline of the global economy. The politics are messy. The financing of drilling operations is incredibly complex. And it’s clear that no one has a clue what oil prices will hit by the end of the year because of so many factors beyond our grasp. No one is suggesting that forecasting should be abolished, but history has shown that when it comes to accurately predicting oil prices, all bets are off. Are we willing to admit we’re just not good at this?

It’s a fair question that warrants the same rigorous academic study as the missed signs of the mortgage crisis. Right now, oil prices are hovering below $30 per barrel, a level that was deemed impossible just a few years ago. I remember sitting in a lecture with a prominent economics professor not long ago. He told the room that we wouldn’t see oil under $100 per barrel in our lifetime again. He somehow still has tenure. 

In the end, I still argue the real problem is that there is no accountability. People are allowed to make any prediction they want, and it is quickly lost in the 24-hour news cycle. When the prediction doesn’t come true, the blame falls on some unforeseen variable. 

But why was this variable so hard to predict?

Perhaps that accountability will generate a more complete picture of the factors. Perhaps we can assign probabilities based on all of the geopolitical and financial inputs, at the worst which could generate a conversation. That’s a lot better than everyone standing around with their hands in the air wondering what went wrong – when the reasons have been sitting before their eyes.

About the Author

Garrett Baldwin is the Managing Editor of the Alpha Pages and the Features Editor of Modern Trader. An author and Baltimore native, he earned a BS in journalism from the Medill School at Northwestern University, an MA in Economic Policy (Security Studies) from The Johns Hopkins University, an MS in Agricultural Economics from Purdue University.