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Oil price forecasts based on myths, not proper analysis

Oil markets
By Paul Hodges on 11-Nov-2015

US rig count Nov15Did your company or investment manager use $50/bbl as a forecast Scenario price for oil this year?  If not, why not?  And has this question even been asked, as you finalise forecasts for 2016?

In recent months, many readers have told me despairingly of their efforts to suggest alternative Scenarios to last year’s “consensus” view that prices would always be $100/bbl.  They are even more despairing today, when they see the forecast for the next few years – which almost always suggests prices will now rise steadily.

My suggestion is that you ask your company to evaluate the success of its forecasts over the past 5 – 10 years:

  • Did it simply adopt the consensus view of $70/bbl in 2007, when budgeting for 2008?
  • Did it include a Scenario based on the potential for a major financial crisis in 2008 and a price collapse?
  • More recently, did it forecast last year’s collapse from $100/bbl?
  • And did it foresee the potential for a major slowdown in China to impact the global economy?

If not, why not?  And, even more importantly, what is it doing to improve the track record for the future?

The problem is that very few companies do this type of routine evaluation.  Yet engineers routinely monitor whether projects are “on time, on budget”; manufacturing teams monitor product quality and safety records; customer services monitor whether deliveries are “on time, in full”.  They know there can be no improvement without measurement.

Obviously, I do have a stake in this debate.  As readers will know, I routinely post a review of the previous year’s Budget Outlook before issuing the new one.  I also routinely publish the full record of Budget Outlooks since 2007, and the full record of my New Year Outlooks since 2008.

This should be basic practice for everyone.  Past performance may not ensure success in the future, but it is the best guide that we have.  This discipline was certainly one reason why I was able to successfully forecast here, in the blog:

  • 2007-8’s final upward rush and subsequent collapse in oil prices, as well as the potential for a major financial crisis  – as highlighted in ICIS Chemical Business in November 2008
  • Plus, of course, I have argued since August 2014 that a Great Unwinding of policymaker stimulus is underway due to China’s adoption of its New Normal policies, and that oil prices would collapse to $50/bbl

My point is simply that it is nonsense for others to say “nobody could have forecast these developments”.  And the world cannot progress unless we apply the basic principles of measurement to such important areas.

One particular piece of current nonsense is summarised in the above chart.  This is the myth that the decline in the number of drilling rigs will have a major impact on US oil production. As we reported in last month’s pH Report:

“The story has everything that is required in the era of Twitter and sound-bites:  it sounds logical, is easy to grasp, and needs no follow-up.

“The only problem is that it ignores the fact that oil rig productivity, like that of gas rigs, doesn’t stand still, as we discussed back in May.  The number of gas rigs has fallen from 1600 in 2008 to 200 today according to Baker Hughes (BH) data, yet US Energy Information Administration’s (EIA) data shows total US gas output has risen by a third from 1.8Tcf to 2.5Tcf over the period.  Gas rig productivity has thus risen 11-fold, and still seems to be on an upward path.  Oil rig productivity appears to be following the same pattern.

“As the chart shows (using BH oil rig count data and EIA oil output data), oil rig productivity has already risen 4-fold over the past 4 years, with no doubt more to come.

The key is the adoption of new drilling techniques, imported from deep water operations.  It would be horrendously expensive to keep drilling new wells in 1000 metres of water.  Instead, companies developed the new technique of horizontal drilling which can increase production by up to 20x compared to traditional horizontal drilling.  Three quarters of US rigs now drill horizontally, compared to only one quarter in 2007.” 

This type of analysis is not rocket science.  It only needs access to the internet and a calculator. Yet last Wednesday, a leading hedge fund told Reuters they were mystified by the rise in oil rig production:

“The part of the report that continues to amaze is the domestic production number, which showed a small rise, despite the ever-plunging rig count” .

Please, send a copy of this post to your CEO and senior management, and ask them to review its argument.  It is, after all, your salary and career prospects that are affected when myths and opinion are mistaken for analysis.