A small minority of energy experts forecast a 2014 decline in crude oil prices, but no credible source predicted it would be anywhere near as bad as it was.
Even the short-term outlook for the oil price appears, despite reams of unsuccessful attempts by analysts and strategists worldwide, almost unknowable. But former Goldman Sachs Group Inc. economist Jim O'Neill believes he's found an indicator that cuts through the clutter and can provide investors with an accurate signal for the oil price: Five year West Texas Intermediate futures.
In a recent column for online magazine Project Syndicate, Mr. O'Neill wrote that "the five-year forward price is much less influenced by speculation in the oil market than the spot price, and more representative of true commercial needs. So when the five-year price starts moving in a different direction than the spot price, I take notice."
In other words, Mr. O'Neill believes that hedge funds and other volatile sources of "hot money" are not involved in futures contracts sixty months out. The five year futures price represents the sober and more accurate supply and demand calculations of the oil producers themselves.
The chart below shows how the five-year futures indicator has worked. (Long term data for the futures market was only available on an annual basis, but the current price is quoted at $67.40 U.S.). The most obvious characteristic of the five year futures index is that it is less volatile than the spot price. This was most notable in December 2008 when the spot price had plunged 53 per cent from its recent peak, whereas the futures price had only fallen 13.5 per cent.
SOURCE: Scott Barlow/Bloomberg
Importantly, and to Mr. O'Neill's point, the futures price in December 2008 proved a far better indicator of the spot price for the next two years. The chart implies that the buying in the spot price between 2006 and 2008 was excessively optimistic, and that the subsequent sell-off price represented an overshoot to the downside.
Hindsight is 20/20, but investors who were following the futures price in late 2008 could easily have inferred that the energy sector was underpriced relative to its future prospects. Virtually any energy-related investment made at that time would have generated extraordinary returns.
Current readings provide reasons for optimism in energy markets but not a full recovery to peak levels. If Mr. O' Neill's theory is correct – and as he points out in the piece, before his successful career at Goldman Sachs, he wrote his Ph.D thesis on oil markets – the five year oil future price of $67.40 per barrel is a better indicator of where the crude price will be in the months and years ahead. This estimate is far lower than the heady days of $100-and-above WTI prices, but far better than the current spot price of approximately $46.
Follow Scott Barlow on Twitter @SBarlow_ROB.