A Short-Run Crude Oil Price Forecast Model with Ratchet Effect
Ye, Michael, Zyren, John, Blumberg, Carol Joyce, Shore, Joanne, Atlantic Economic Journal
Crude oil markets have been heavily influenced by OPEC's behavior for almost 30 years. In the 1980s, OPEC changed its pricing policies to allow the marketplace to have a larger impact on price. Prices became more transparent with the accompanying evolution of spot and futures markets. The availability of international supply and demand data has also improved. This has afforded analysts more opportunity to analyze and forecast crude oil prices.
During much of the 1990s, crude oil prices fluctuated around $20 per barrel. Towards the end of the 1990s, the world supply-demand balance shifted significantly. A combination of supply increases from OPEC, including the return of Iraq's crude oil volumes to the marketplace following the first Gulf War, and diminished demand as the Asian financial crisis occurred, produced excess supply in petroleum markets that resulted in crude oil prices, as represented by West Texas Intermediate (WTI) crude oil, plunging to almost $10 per barrel. Because of this price collapse, in March 1999, OPEC changed its market behavior and reduced oil production. With less supply and the subsequent recovery of demand, petroleum markets tightened. Prices rose and settled at around $30 per barrel, well above the prior average of $20 per barrel. Then in 2004, prices began their second ascent, and by the middle of 2008, were well over $130 per barrel.
From the early 1990's until early in the current decade, crude oil prices could be explained and forecasted using only OECD inventory data (see, for example, Ye et al. 2005). During that time, OPEC had excess production capacity that could be used to meet unexpected demand increases. However, as world demand grew, this excess capacity diminished, reducing the perceived ability of producers to meet demand increases in the short term. Improvements in forecasting capabilities were seen when an excess production capacity variable was added as an additional predictor in the forecast model (see, for example, Ye et al. 2006). However, since early 2004, estimated inventories and excess production capacity significantly under-predict WTI prices, even with shift factors added to the model to reflect possible structural changes.
The objective of this study is to develop a short-run forecast model that can provide improved monthly forecasts for crude oil prices. An additional variable, the cumulative excess capacity, is derived and incorporated into the forecast model to capture the so-called Duesenberry Ratchet Effect observed in the crude oil market in recent years, reflecting the changing behaviors on both the demand and supply sides. This new model provides significantly improved forecasts for the entire post-Gulf War 1 time period over previous models.
The three predictor variables, inventory, excess production capacity, and cumulative excess capacity are supported by the economic literature both theoretically and empirically. First, the relationship between commodity inventory levels and short-run price has been studied for nearly a century. (1) Inventory balances supply (2) and demand; it captures expected seasonality and general trends in production and demand, as well as unexpected supply or demand shifts. It is the immediate "supply" when needed and can also become a demand to cushion fears of shortages.
[FIGURE 1 OMITTED]
Second, the economic literature has recognized the impact of excess production capacity, or capacity utilization rate, on commodity markets in general (e.g., Dixit and Pindyck 1998) (3), and on petroleum markets in particular (e.g., Dahl and Yucel 1991, and Powell 1990). Recently Kaufman et al. (2004) tested quarterly models of OPEC behavior and found capacity utilization to be an important explanatory variable. Thus, both theoretical and empirical studies indicate that excess production capacity must be considered when analyzing the petroleum industry, which has nearly costless short-run production quantity adjustments, but which exhibits a large capital investment cost to develop new reserves. …