ValueScope’s Oil & Gas Price Outlook: January 5, 2016

Happy New Year!

Oil & Gas Price Outlook January 2016

After enduring a 32% drop in crude oil prices and a 35% drop in natural gas prices in 2015, this next year has to improve… doesn’t it??

While futures markets aren’t a crystal ball, with a little bit of statistical analysis, they can tell us what market participants expect.  All the information needed is available — we can examine where futures and their option prices are today in order to predict where spot prices will be in the future.  This process is useful for estimating future price ranges or “confidence intervals” for crude oil and natural gas, in support of better investment and lending decisions.

Crude Oil Outlook

Take a look at the price distribution below, which shows the crude oil spot price on January 4, 2016 and predicted crude oil prices based on options on oil futures contracts.  The blue lines are within one standard deviation (σ) of the settlement price (green line) and the red lines are within two standard deviations for each month (for a refresher on standard deviations, see “Probability & Statistics 101” below).

Based on the January 4, 2016 prices, the markets indicate that in mid-February, there is about a 68% chance that oil prices will be between $33.50 and $40.00 per barrel. Likewise, there is about a 95% chance that prices will be between $29.00 and $45.00.

For a longer-term view, I have added a six-month outlook which indicates that in mid-July 2016, the +/- 1σ price range is $31.00 to $58.00 per barrel and the 2σ range is $23.00 to $80.00 per barrel.  In other words, there is a 95% probability that the expected price of oil will be between $23.00 and $80.00 per barrel, and a 97.5% probability it will not be above $80.00 per barrel.

Natural Gas Outlook

We can do the same thing for natural gas, which is currently trading at $2.32 per MMBTU on the Henry Hub.  Although more affected by seasonal factors than crude oil, in mid-July 2016, the +/- 1σ price range is $1.95 to $3.20 per MMBTU and the 2σ range is $1.52 to $4.10 per MMBTU.

December 2015 in Review

Crude oil futures ended slightly below the predicted one standard deviation confidence interval at $36.83 per barrel.  Key factors moving prices over the last 30 days were inventories and rig counts.  OPEC failed to agree on a production ceiling for the first time in decades and predicted that oil prices would be (in real terms) around $70 by 2020 and $95 by 2040.  Also driving prices downward was the American Petroleum Institute’s announcement that oil inventories rose by 2.9 million barrels, when analysts surveyed by The Wall Street Journal had forecast a drop in oil inventories of 1.0 million barrels.

Key Takeaways

Remember, these analyses reflect the market’s expected probabilities, not certainty—but that doesn’t make it any less useful.  If someone asks when oil might trade at $60 again, you now can respond with “there is about an 85% probability that oil will be below $60 in July 2016.” I know this is nothing to get excited about, but at least now you have some idea of the market’s expectations.

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.

---

Tags: Oil & Gas Price Outlook January 2016, Crude Oil Price Outlook, Natural Gas Price Outlook