Uncertainty, Expectations, and Fundamentals: Whatever Happened to Long-Term Oil Prices?

One of the major features of the oil market during the 1990s was the relative stability of the long-term oil price. While the spot price and the price of near-term futures contracts sometimes exhibited sharp price volatility that volatility was only partially transmitted to the back end of the futures curve which was anchored around the $20-22/barrel range. However as oil prices rose sharply during the boom years the consensus on the oil price that would balance the long term fundamentals of the oil market broke down and the whole futures curve became subject to a series of shifts. Our empirical evidence suggests that in the late 1990s and early 2000s there was limited evidence of adjustment between short-term and long-term oil prices. These dynamics however changed in early 2005 with the long term price making most of the adjustment towards the prompt price. We suggest an interpretation of the long-term behaviour of oil prices based on the insights of two models. The first is based on a signal extraction mechanism and shows that when the private beliefs by investors about the long-run determinants of oil prices become less precise relative to the information contained in the current spot price then the expected future oil price becomes closer to the current spot price. The second model is based on Bayesian updating and shows that if the variability of the spot price increases and/or if the spot price remains higher over a sustained period of time than anticipated by investors then the probability distribution of the parameter capturing the speed of mean reversion will shift and the expected future price will move closer to the current spot price. Our analysis predicts that in the face of increased uncertainty the long-term and short-term prices are bound to exhibit similar movements. These changes had important consequences on the oil price formation process.

By: Bassam Fattouh