The steep decline in oil prices since mid-2014 and current volatility fuel intense speculation about future prices. Although desirable, is it possible to predict oil prices?

Slavisa Tasic, PhD | Author & Associate Professor of Economics, University of Mary

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“But gentlemen, it is all so infinitely complicated.” This favorite phrase of Gustav Schmoller, a 19th-century German economist, applies to many economic situations—especially predictions. While I would be the first to admit that physicists are smarter than economists, I would also say that economics is more difficult. In the natural sciences, there are constants, measurable variables and experiments to confirm or falsify theories. None of this is true for economics. Some causal connections are known while others remain mysterious. Many variables are only vaguely defined, immeasurable or unknown altogether, and even the known and measurable ones continuously change.

The collapse of the price of oil, which began in June 2014, has been the most important story for the energy sector, not only in North Dakota but across the nation and worldwide. We know the obvious: that the price is determined by supply and demand. Just how supply and demand behave is controlled by countless volatile and unpredictable factors, including everything from engineering solutions in the Bakken to the monetary theories held by governors of the U.S. Federal Reserve. Accordingly, the complexity of influences behind prices means that economists are—regardless of what TV pundits in search of attention say—fundamentally unable to forecast prices. The daily price of oil is a dynamic distillation of all possible information about current and future oil production and uses available to humans around the globe. Claiming predictive powers is tantamount to claiming superior insight into the cumulative knowledge assembled by global markets.

Reality Check and Signal

Oil prices result from filtering information from around the world and these prices also tell us something about the world. The recent fall in oil prices reveals, for example, that there is a lot of oil floating around. To a significant extent, this is due to the shale revolution, which started in the Bakken in 2008. Oil production increased dramatically in North Dakota, passing a million barrels per day in April 2014. Despite low prices, American oil production is still expected to grow in 2015, averaging 1.1 million barrels per day (bpd).
High oil prices crested in 2008 at over $140 per barrel, declined rapidly and then rose steadily to more than $100 per barrel in 2010, which persisted until mid-2014. Because of such high prices, many previously unprofitable oil fields became attractive and production increased further.

The U.S. ranks third in crude oil production behind Saudi Arabia and Russia and, since 2012, has ranked first in the production of petroleum and other liquid hydrocarbons, including natural gas liquid and biofuels.

The falling price of oil acts as a reality check and a signal in the opposite direction. Producers are already reacting, and in North Dakota applications for new permits have more than halved since last year.

Locally, it is important to know what kind of projects will be abandoned. Estimates for North Dakota’s breakeven price average in the mid-$30s per barrel, with large variations for different areas and producers. Some outlying areas of the Bakken break even at $85, where drilling has been suspended. Currently (September 28) the price of WTI crude oil is $44.74 per barrel. Oil production requires significant fixed investment including equipment, personnel and other rig costs. Then when the well is drilled, pumping continues even below the breakeven price. In the short term, price drops will not drastically impact quantity. Bakken production hit a record 1.22 million bpd in December and 1.2 million in May. What matters are overall trends and expectations.

Expectation of Abundance

Judging from current prices, it seems the shale revolution has created the expectation of abundance. For most American consumers, and for most of the world, cheaper oil is good news. We save money at gas stations and falling transportation costs drive the prices of almost everything else down. Not only do consumers save, but cheaper oil—provided that prices are driven down by improving production and not by falling demand—is often associated with higher overall economic growth. One popular estimate is that for every $10 drop in the price of oil, the world economic output grows by half a percentage point. Economic growth is good in itself and also acts as a self-correcting mechanism for the price of oil in the long run. A stronger economy means higher total demand for goods and services and, in turn, higher demand for oil. This pushes oil prices back up.

Naturally, world economic growth is swayed by factors more important than the price of oil, and it will take more than this feedback loop to lift oil prices significantly. Prognoses for long-term economic growth nowadays are as extreme as swings in oil prices. Several influential commentators, such as Larry Summers (former Secretary of the Treasury, economic advisor for the Obama administration and President of Harvard University), see a gloomy picture. Technological progress, their argument goes, is likely to slow down because technological low-hanging fruits were harvested in previous decades, and there is not much left to be invented. If true, a period of prolonged stagnation and stalling global demand might be in front of us.

Other commentators, in contrast, see endless possibilities ahead. Technological progress will not slow down but instead continue to advance and, combined with other innovations and inventions, accelerate future growth sometimes in directions unfathomable to us today.

Central Banks

Short-and medium-term economic growth prospects are more intelligible for economists. Save for wars and catastrophes, the strongest determinants of such economic growth are the actions of central banks around the world. This has been especially true in the aftermath of the recent Great Recession. The U.S. Federal Reserve’s decision to end the third round of quantitative easing, announced in October 2014, has contributed to the stronger dollar and therefore to cheaper oil in dollar terms. The traditionally conservative European Central Bank (ECB) has been, even by its standards, overly restrictive in the past several years, unwittingly slowing down economic growth in the eurozone. This year, ECB changed course and started a quantitative easing program, which has already been effective in boosting aggregate demand, growth and prices in Europe. This monetary intervention contributed to the partial oil price recovery in the first half of 2015. Still, with the sluggish Japanese economy and intensifying warnings of a coming slowdown in China, world consumer and investment demand has not been at its strongest. The very healthy supply of oil in combination with rather lukewarm demand makes for low oil prices.

This is merely a peek into the entire scenario but with impacts as diverse as the ones mentioned, it becomes clear why making sense of the oil market is, to borrow from Schmoller again, “so infinitely complicated.” Those adversely affected cannot do much about oil prices, but they are not entirely toothless. Producers reacted with improvements in efficiency that continuously increased drilling accuracy and lowered the cost of fracking. The silver lining of another negative price shock is the pressure it puts on producers to keep seeking technological innovations and organizational advancements.

Dutch Disease

Policymakers can do more. All across America, warning signs of previous economic declines remain: abandoned mining towns, rotting barns, rusting factories. Detroit, for example, was one of the most prosperous industrial hubs in the world and then declined all the way to bankruptcy. North Dakota has seen oil booms and busts. The Economist coined the term, “Dutch disease,” in 1977 “to describe the woes of the Dutch economy,” the magazine reported. “Large gas reserves had been discovered in 1959. Dutch exports soared. But, we noticed, there was a contrast between ‘external health and internal ailments.’ From 1970 to 1977 unemployment increased from 1.1% to 5.1%. Corporate investment was tumbling. We explained the puzzle by pointing to the high value of the guilder, then the Dutch currency. Gas exports had led to an influx of foreign currency, which increased demand for the guilder and thus made it stronger. That made other parts of the economy less competitive in international markets… . Since that article, economists have proposed other Dutch-disease effects.”

When oil booms happen, it is normal and desirable that resources are diverted to the most profitable use. But the inevitable adverse effect is that other economic sectors suffer. As noted above, after the Netherlands found large reserves of gas and started exploiting them in the 1960s, its currency appreciated rendering the nation’s economy uncompetitive internationally and hindering the development of other business sectors. In North Dakota, this effect has manifested in high wages, rents and prices in general. It is wonderful that local workers are paid some of the highest wages in the nation. But that is not attractive for prospective investors in sectors other than oil, which have to compete for workers.

Welcoming Other Businesses

To offset the discouraging effects of high wages and other business costs, policymakers in North Dakota might consider what other successful states have done: Create a welcoming business environment for sectors other than oil and oil-related services. Although North Dakota is wisely building a rainy day fund with surplus oil revenue, it would be better to ameliorate the impact of downturns in one sector by diversifying the state’s economy.

After the oil bust in the 1980s, Texas launched development programs to stimulate business and encourage economic diversification. As a result, the state’s GDP grew from 6.5 percent of the nation’s total in 1995 to 9 percent in 2014. At the same time, between 1982 and last year, the proportion of tax revenue generated from oil and gas declined from 18 to 5.5 percent.

Delaware has permissive corporate laws and no sales tax. South Dakota has low unemployment rates comparable to North Dakota without the oil boom. Instead, South Dakota relies on zero individual income and corporate tax policies to stimulate business growth. South Dakota ranks second and Wyoming ranks first on the 2015 State Business Tax Climate Index, published by the Tax Foundation, a non-partisan research think tank based in Washington, D.C. In comparison, North Dakota ranks a distant 25th.

Business friendly policies are not always affordable in the short term and that is why states shy away from them. But in the long run they pay off. New businesses and their workers increase commercial activity, population density and establish networks. These stimulate communication, business exchange and idea sharing, which become sources of creativity and additional growth. The economy, as a result, becomes dynamic and versatile, which renders oil-price uncertainties much less worrisome.