Oil & Gas Price Outlook December 2015
Don’t rely upon Wall Street soothsayers — if you want to predict the future of oil & gas prices, rely on probabilities and not a crystal ball. For instance, Goldman Sachs recently made headlines when an analyst noted that $20 oil was possible next year. Analysts can run large macroeconomic models to predict such values, but they are all predicated on numerous assumptions. Is there a better source of insight for future oil & gas prices?
While futures markets today can’t determine the future for sure, with a little bit of straightforward statistical analysis, they can tell us what market participants expect. All the information needed is available—we can examine where futures prices are today in order to predict where spot prices will be in a few weeks or months. This process is useful for estimating the future price range of any traded commodity, but it’s very helpful as a barometer for the energy market as a whole.
Crude Oil Outlook
Take a look at the price distribution below, which shows the crude oil spot price on November 30, 2015 and predicted crude oil prices based on option and futures markets. The blue lines are within one standard deviation (σ) of the mean and the red lines are within two standard deviations (for a refresher on standard deviations, see “Probability & Statistics 101” below).
Based on the November 30, 2015 prices, the markets indicate that at year-end there is about a 68% chance that oil prices will be between $37.50 and $46.00 per barrel. Likewise, there is about a 95% chance that prices will be between $32.50 and $52.50. At the end of February 2016, the +/- 1σ price range is $34.50 to $52.50 per barrel and the 2σ range is $25.00 to $66.00 per barrel. In other words, there is a 95% probability that the expected price of oil will be between $25 and $66 per barrel, and a 97.5% probability it will not be above $66 per barrel.
Natural Gas Outlook
We can do the same thing for natural gas, which is currently trading at $2.25 per MMBTU on the Henry Hub. Although more affected by seasonal factors than crude oil, at the end of February 2016, the +/- 1σ price range is $1.95–$2.80 per barrel (68% probability) and the +/- 2σ range is $1.30 to $3.70 per MMBTU (95% probability).
Remember, these analyses deal in expected probabilities, not certainty—but that doesn’t make it any less useful. If someone asks you longingly if oil will be at $75 again soon, you now can respond with “there is about a 97.5% probability that oil prices aren’t expected to get above $66 before the end of February 2016, so I wouldn’t count on it.” Likewise, if you’re a banker whose borrower needs at least $3.50 natural gas prices in order to meet their debt service obligations in early 2016, the fact that there’s about a 95% chance that gas prices will be lower than this number should help you make a more informed decision— no black magic required.
Probability & Statistics 101
Remember the normal curve from your first statistics class? We can use it to determine the probability that future prices will be within a certain range. In a normal distribution, there’s about a 68% chance that a data point lies within one standard deviation of the mean, and about a 95% chance that it lies within two standard deviations.
Analysts and traders use metrics known as option Greeks in order to decode the sensitivities of futures and options to price changes. Using option Greeks, we can determine the prices and probabilities that market participants as a whole are expecting. How can we determine the likely behavior of such a large and often unpredictable group? Because investors are already telling us what they expect by voting with their dollars, not just their intuition.
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