Why Did No One Predict the Oil-Price Collapse?
We have just had a free fall in one of the most important prices in the world-the price of oil. Looking back, we are keenly aware that it dropped about 60% from its 2014 high to its recent low. Although some people thought the price of oil would go down, nobody (at least nobody that I can find) publicly predicted anything like this big a drop. Why?
Oil prices went from $108 a barrel in June of last year to an intraday low on January 13, 2015 of $44. Among those failing to predict this drop were the government's Financial Stability Oversight Council and its Office of Financial Research. Although they were searching for systemic risk factors, they didn't find this one. Why not? Perhaps they were too busy trying to expand their power over insurance companies to think of it. As for the Federal Reserve, their current adverse case "stress test" has oil prices going up to $110, so they missed the direction of the stress as well as the magnitude.
The Wall Street Journal's 2014 economic forecasting survey found that "The economists surveyed expected oil to end 2014 at about $95 a barrel, up from about $92 at the time of the survey." A big miss to be sure, but they were not alone.
The U.S. Energy Information Administration's 2014 outlook gave itself a very wide margin for error, projecting oil prices between $159 on the high to $70 on the low. Obviously that range wasn't wide enough, with the actual low so far about 35% under their lowest case.
The IMF World Economic Outlook of October, 2014 forecast that the "average price of oil will be $102 a barrel in 2014 and $99 a barrel in 2015."
As Wells Fargo analysts said in December, "Markets anticipated a slight decline in oil prices, but few (if any) expected the rapid 50% decline." Or as the investors on last week's Barron's Roundtable reflected, "None of us predicted the oil price plunge." Or as one financial journalist wrote with candor, "My recounting hasn't yet made mention of the recent dive in oil prices.... That's because I missed it. I console myself with the knowledge that nearly everyone else was clueless, too."
Not quite everyone was entirely clueless. Political economist John Tamny did predict a significant drop in oil prices based on the relationship of gold, oil and the floating fiat dollar, using the guideline that one ounce of gold would buy 15 barrels of oil. But this implied an oil price drop to $75-$80 a barrel, not $45-$50. It was a much better forecast than others had, but was still a long way from the actual magnitude of the price collapse.
Everybody, including all the experts, missed. How is this possible? The uncomfortable reality reflects three essential facts:
1. However valuable a discipline economics may be, it is not a predictive science. (Consider, in addition to the whiff on oil prices, the claim of Marc Faber's Gloom, Boom and Doom Report that "Professional economists have predicted none of the last seven recessions.")
2. Regulatory agencies, central banks and financial stability committees are no better than anybody else at economic foresight or the future path of prices.
3. Prices can change a lot more than you expect or even think possible. We vividly experienced this with house prices eight years ago, tech stock prices 15 years ago, and now with oil prices, in spite of the fact the price of oil has plummeted before-- in 2008-09, the 1990s and the 1980s (when, at least so the story goes, a young Lloyd Blankfein bought a tanker-lot of oil for J. Aron for $8 a barrel.) A senior officer of the Russian central bank recently said, about the corresponding drop in the ruble, "I couldn't imagine even a year ago that such a thing would happen, even in my worst nightmares."
Yes, our imagination is too limited to be a good guide to the possible changes of the future. Economic commentator Martin Wolf confessed that "I lacked the imagination to anticipate" the financial crisis. Former Treasury Secretary Tim Geithner made this into a general proposition: "Our crisis was largely a failure of imagination. Every crisis is." But where is the required imagination to come from? A hard question indeed.
Prices of financial assets reflect the expected prices of other things, discounted by another price, interest rates. But the expectations of future prices, including the expectations of the most informed and intelligent experts, can be wildly wrong. That's why the bad times end up so much worse than your worst case scenario, and why, as an old banker told me years ago, "Risk is the price that you never believed you would have to pay."