Forecasting Oil Prices: It’s Easy to Beat the Experts

Most economists are used to being button-holed at parties and asked about some specific feature of the economy. And the more distant the topic is from your research, the more likely it is that you will be asked about it. Right now, I’m getting plenty of questions about what is happening to oil prices.

I recently dug into the recent oil literature and discovered something amazing: It is easy to do better than the experts. At least this is what I learned from a recent working paper, “What Do We Learn From the Price of Crude Oil Futures?” by Michigan economists Ron Alquist and Lutz Kilian.

The authors compare a whole range of different ways of forecasting oil prices: they look up the Consensus Forecast (from a survey of expert economic forecasters), oil futures, the difference between the oil price in futures and spot markets, and also a range of more or less complicated econometric models that take account of recent trends, as well as variables like the interest rate.

And it turns out that they all do worse than one simple forecast: the current oil price. That’s right: the most accurate forecast of oil prices over the next month, year, or quarter is the current oil price. We call this the no-change forecast.

The Alquist-Kilian finding was the subject of my latest commentary for American Public Media’s Marketplace (available here; or here for the audio version). Here’s the highlight:

Amazingly, this simple rule did better than the average of dozens of professional forecasters! In fact, the no-change forecast was 34 percent more accurate at predicting oil prices in 3 months time, and 18 percent more accurate at predicting prices in a year’s time. While professional prognosticators might argue that this difference isn’t statistically significant, it sure is embarrassing.

It turns out that the so-called experts add too much variance to their forecasts, leading them to do worse than the no-change rule.

I was more surprised by the poor performance of the oil futures prices as forecasts. My usual response to being asked about the future of oil simply involved looking up the futures market and calling those prices a forecast. However this isn’t quite right: the spot price embeds in it an option value or “convenience yield” that isn’t factored into futures prices. And if this convenience yield moves about (and it tends to move up and down with economic uncertainty), then this causes the futures price to fluctuate in ways unrelated to the future oil price.

If you are interested in learning more about oil prices, Kilian’s recent papers are a useful starting point. The longer Marketplace story is available here.