As of late January 2016, the West Texas Intermediate price of crude oil is approaching $30, down from $106 in June 2014. It is fair to say that few observers expected such a major decline in the price of oil as of June 2014. For example, the IMF in October 2014 predicted that the "average price of oil will be … $99 a barrel in 2015 and will remain unchanged in real terms over the medium term” (IMF 2014). The IMF was not alone in its assessment. This is not the first time either that oil price expectations missed their target spectacularly. The last 40 years of oil price fluctuations are replete with episodes of unexpected changes in the price of oil (see Figure 1). In a recent discussion paper, we explore the question of how economic agents form expectations about the price of oil and of why future realisations of the price of oil often differ from these expectations (Baumeister and Kilian 2016).
Figure 1. The real price of West Texas Intermediate (WTI) crude oil
Not surprisingly, there is a range of different approaches to quantifying oil price expectations. For example, is has been shown that consumers tend to expect the price of oil to grow from its current value at the expected rate of inflation (Anderson et al. 2011). In contrast, many central banks and international organizations simply equate oil price expectations with the prices of oil futures contracts (IMF 2005). More sophisticated measures of the market expectation of the price of crude oil may be obtained by adjusting the futures prices to account for the risk premium in oil futures markets (Hamilton and Wu 2014). Finally, economists often generate oil price expectations based on models of the global market for crude oil that incorporate data on past oil prices, on the global business cycle, on changes in oil inventories and on global oil production (Kilian and Murphy 2014).
Why is there no agreement on the expectation of the price of oil?
These four measures of oil price expectations may differ substantially in practice, especially during episodes of major oil price fluctuations. The reason is that each measure is based on a different set of information. For example, expectations generated based on estimates of oil market models focus on the predictive content of a small number of carefully chosen indicators of the state of the global oil market including variables that are known to contain forward-looking information such as changes in oil inventories.
Financial market expectations take account of these economic determinants of the price of oil, but they also embody other determinants such as the market’s assessment of the political stability of the Middle East, of the prospects for new oil discoveries, or of the profitability of new oil extraction technologies, all of which are difficult to capture by conventional regression-based methods. This does not necessarily mean that financial market expectations are more accurate, however, because financial market participants are also prone to misinterpreting evidence or to overreacting to news.
In contrast, consumer expectations abstract from most of the information considered useful by many financial market participants and economists. Because the interpretation and predictive content of such information often is questionable, this alternative strategy is not without potential merit either.