More from this series:

Takeaway

• There's no way to really know the real risk premium to use for projecting.
• Adding a 3-5% risk premium to the futures price seems reasonable.

In this post, I will address an issue that I know almost nothing about – the future price of oil. Interestingly, this is an issue that generates considerable discussion, but as far as I know, almost no serious analysis. What I have read on various blogs is fairly detailed discussions of the decline rates of existing oil fields as well as discussions, by peak oil advocates, of the fact that new oil discoveries do not seem to be offsetting these declines. There is also some discussion of the ability of the Iraqis to very quickly ramp up production.

Futures Price vs. Forecast of Futures Price
Although tracking supply is challenging, predicting incentives and the ability of suppliers to increase production, and the future growth in demand, is even more challenging. This is probably why we see very little in the way of long-term predictions about future oil prices. As a financial economist I have a tendency to look to the futures market to gauge the market’s “forecast” of future oil prices. However, forecast must be put in quotations, since the futures price cannot really be viewed as a forecast of the future price. Indeed, the relation between futures prices and expected spot prices are given by the following formula:Expected Price = Futures Price x (1 + risk premium)

What this means, is that one must gross up the Futures price by a risk premium to get the market’s expectation of the price in the future. So, for example, if the Futures price for oil in 5 years is $80, and we think the appropriate risk premium is 3% per year, then we would want to gross up the $80 price by a bit more than 15%, (since the growth rate compounds), suggesting that the market expects the price in three years to be a bit more than $92 per barrel.

Unfortunately, there is no way to really know what the appropriate risk premium on oil. For example, some people think that there is no risk premium on oil, and others think it is as high as 5%, which means that an $80 5-year futures price can imply expected oil prices in 5 years could be as low as $80 but could also be greater than $100. Basically, what this means is that the long-dated futures contracts offers guidance about expected prices in the future, but it’s not very precise. In the table that follows, I have futures prices taken from early March 2010 along with the implied expected price with a 3% and 5% risk premium. Although these futures prices offer an imprecise estimate of expected oil prices in the future, the disconnect between these prices and the statements of various prognosticators who suggest that oil prices will be in the $150/barrel to $200/barrel range within the next 5 years is quite striking. Oil Futures Prices as of April 2010 and Implied Expected Price With a 3%, 5% Risk Premium

Oil Production Fundamentals to Get Worse?
Despite my efficient markets leanings, I find the arguments of the oil price bulls reasonably compelling, at least for the short-run. The oil bulls argue that the fundamentals of oil supply will be considerably worse in 2015 than it was in 2008, when oil prices were approaching $150 barrel. Existing oil fields are depleting faster than new oil fields are coming on line, suggesting that the supply crunch of 2008 will reappear when the global economy recovers. I also agree that consumption patterns in developed countries won’t change a lot within the next 5 years (in the absence of a price spike) and demand in developing countries like China and India are likely to grow. Although I think oil prices in the $150 to $200/barrel range in 2015 are quite possible, the idea that oil prices will peak out at say $300 or $500 per barrel, as some peak oil enthusiasts have suggested, seems completely implausible and impossible to reconcile with the futures market. If oil prices were to hit the $200 per barrel range, consumption patterns would change in meaningful ways, and we would see a much quicker ramp up in the production of oil from tar sands and other heavy oil. Because of these likely demand and supply responses, I think that it is likely that oil prices could actually fall between 2015 and 2018. Indeed, the price range given by the longer dated futures prices seems pretty reasonable. When we polled our online panel of energy experts, we found:

• 40% of survey participants expected oil to be priced about $125/barrel in 2015, with equal numbers expecting oil prices to be above or below that amount.
• Panelists were much more evenly divided on the price of oil in 2020, though most people felt it was going to be somewhere in the range of $100-$175/barrel.
• Most panelists expected heavy oil production in Canada, Venezuela, and Iraq to increase from the current 8 million barrels per day to around 10-15 million barrels per day in 2020.