Oil prices: understanding the past, predicting the future

A year ago I predicted that “oil prices will not end 2008 materially higher than they are today, and that they will be at least a third lower in 5-10 years.”

The first prediction was right, in spades – I will write again in 5 and 10 years time about the second.

The prediction provoked a short but high quality exchange in the comment column. Not everyone agreed: Nick Rouse wrote of a “primitive economist’s models that bear no resemblance to reality” while in May, Mary Matthews wrote that “Boy, did you get it so wrong”, before adding “Economists cannot predict the future and trying is a waste of time.” (NB: I respect the fact that neither of you hid behind Anonymous in your commenting).

Economists’ predictions will always have large error bounds because we are trying to predict the aggregate results of individuals’ idiosyncratic decisions. But oil producers and users need to think about likely price trends when making investment decisions. Forecasting is necessary.

Predicting that a price will fall when it is more expensive than usual, and demand and supply are elastic, is likely to be right. As petrol prices rose in the forecourts, people cut back. The number of miles driven fell a little, sales of fuel inefficient cars fell (particularly in the US, where the price rise was highest in percentage terms), and people slowed down on the motorway, quite dramatically. In addition, the prospect of getting more than $100 a barrel for stuff that had been worth much less only a year before led oil producing nations to increase supply.

Demand fell, supply rose, and today Bloomberg report that West Texas Intermediate is $48.58 and Brent is $49.23. These are lower than long term prices, since at these levels deep water exploration, and Canadian and Venezualan oil shales will not be profitable. But oil prices may not rise this year, for three reasons.

First, stocks are high. Last year stocks were low, so bad news led to spikes in prices, as people worried that we would run out of oil (which Nashville did, by the way). This time we could get some short term very low prices, if oil needs to be moved and storage is not easy to come by. Oil is expensive to store, particularly on ships.

Second, demand is low. People remember how much high oil prices hurt, and may well continue to buy cars that do not expose themselves to that risk, even though prices have fallen. And there is a recession in many places.

Third, populist regimes such as Iran and Venezuela need oil revenues. When the price falls, they may be tempted to increase output to try to make up for the lower revenues per barrel. Otherwise they risk losing political support. That in turn, however, will lower the global price.

The prediction: the oil price will not reach even half its 2008 peak in 2009.

* Tim Leunig teaches at the London School of Economics and is an occasional contributor to Lib Dem Voice.

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  • David Heigham 7th Jan '09 - 7:13pm

    I have always been glad that I have no need to make short or medium term predictions for crude oil prices.

    Over the longer, climate change, horizon it is reasonable to suppose that crude oil will not stay above $(2008)70-100 a barrel. Above that level, it will probably pay to turn coal into oil by ‘clean’ processes.

    Refined oil fuels are a different matter. Carbon, gasoline or other taxes; or pollution permits seem bound to force up their price a good deal more.

  • The reality is, you got lucky, oil fell for a bunch of reasons not present in your model, at least as you described your model at the time.

    That rather indicates you still have plenty to learn and should consider being a little less smug.

  • Mark Inskip 7th Jan '09 - 11:18pm

    Tim’s being economical with the truth as well as being smug. His prediction was “that oil prices will not end 2008 materially higher” but they’ve in fact collapsed to less just over $42 a barrel today (biggest one day fall since 2001). And the biggest cause the global recession that Tim failed to notice was on its way.

    Go back to the original article and there’s a link to an FT piece from 1st Jan 2008 with some more of Tim’s predictions, e.g.

    Risk to economic stability in 2008 – none!

    House prices – Tim predicted “Not more than 10% average (fall) across the nation”

    Global Economic Growth – 3%+ (definitely not below 2%)

  • Mark:

    I made predictions for the FT, and am happy to revisit them

    1) No risk of economic stability. As I said, there was no risk that Britain would return to the economic instability of the 1970s, in which we had a 3 day week, widespread strikes, or the collapse of the banking system. Correct: the power is still on, strikes are uncommon, and no customer has lost a penny in any bank.

    Globally I predicted 3.3% growth, and the IMF’s current best guess of growth in 2008 is 3.75%. So that was a correct prediction.

    I predicted no East Asian style currency/financial crisis: right on the currency, wrong on the finance.

    I predicted a danger that some UK mortgage payers would get into trouble, but that declining interest rates would lead banks to be lenient so that relatively few were repossessed: correct.

    I noted that recent price rises meant that negative equity would be rare, and as far as I know that has been true so far.

    I added that the effect of mortgage rates and tougher credit on consumer spending was hard to predict, and that too was correct.

    I predicted a danger that if inflationary expectations rose, then the Bank of E would raise interest rates. Since commodity prices fell, this prediction was not tested, although I would be happy to make it again.

    And I was honest enough to admit that we should be worried about the unexpected, and in that I as more right than I expected.

    I definitely underpredicted the severity of the banking crisis, although the prediction that some shareholders would lose money was true.

    I would tell you about the rest of my predictions, but the FT will charge me £150 to read them! 🙁

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