How Do Companies Forecast Oil Prices?

Crude oil prices are considered an indicator of the global economy. Governments and businesses try to predict where oil prices are headed, but forecasting is an inexact science.

Standard techniques are based on calculus, but alternatives include structural models and computer-driven analytics. Companies also pay attention to and participate in oil futures markets. Crude oil futures are traded on the New York Mercantile Exchange (NYMEX) and Tokyo Commodity Exchange (TOCOM).

What Influences Oil Prices?

The supply of crude oil is determined by the ability of oil companies to extract reserves and distribute them globally. Supply depends on technological changes, environmental factors, and the oil companies accumulating and replenishing capital. After 2008, hydraulic fracturing and horizontal drilling helped flood world markets with oil.

Crude oil demand comes from individuals, companies, and governments and increases during a good economy but decreases during slower economic times. Oil prices are influenced by non-market forces, including the Organization of the Petroleum Exporting Countries (OPEC). OPEC member nations make joint decisions about how much oil to release to world markets.

Oil is also highly regulated in most countries. The United States, like many nations in Europe, has strict restrictions on where oil can be drilled. Thus, the Environmental Protection Agency (EPA) and companies like Exxon Mobil and British Petroleum influence supply issues.

Futures Market

Companies hire econometricians and other market experts to predict the oil market. These professionals use mathematical models, focusing on financials using spot and future prices or supply and demand considerations. According to the Chartered Alternative Investment Analyst Association, time-series econometric modeling is the most common forecasting method for crude oil prices.

The relationship between futures price fluctuations and spot price fluctuations may point the way to predicting oil prices, according to two academic papers published in 1991 (Bopp and Lady; Serletis). The authors argued future oil prices are not unbiased or completely efficient but are the best indicators. In 1998, an additional study (Zeng and Swanson) looked at crude oil on the NYMEX, the New York Commodity Exchange, the Chicago Board of Trade, and the Chicago Mercantile Exchange between 1990 and 1995 and confirmed similar findings.

However, West Texas Intermediate (WTI) reviewed crude oil futures prices on the NYMEX between 1989 and 2003, finding that forward and futures prices are neither efficient nor unbiased enough to accurately predict future spot prices and suggest that stock price changes cannot be used to predict future movement.

Supply and Demand Models

Supply and demand models focus on macroeconomic variables, such as OPEC production, income elasticity of oil demand, and real gross domestic product (GDP). Because of numerous variables, most companies or analytic services use proprietary calculations and change their formulas frequently.

The goal is to find the most statistically significant variables, then find chart fluctuations in those variables and create rough estimates for future oil price ranges.

Nonlinear Methods

Some statisticians use "nonlinear" approaches and argue that future oil prices are too random and chaotic for traditional calculations. The computations, instead, are based on pattern recognition rather than linear models or econometric regressions.

One popular pattern recognition tool is the artificial neural network (ANN). The ANN model, predicated on the biology of the human brain, lets the simulation learn and generalize experiences based on new data. ANNs are used for analyses in business, science, and investment fields.

The Bottom Line

Businesses and investors employ various ways to make predictions of oil prices. Futures pricing, supply and demand models, and non-linear methods may be used to forecast pricing. The World Bank reports monthly and quarterly on all changes within commodity markets, including the oil market.