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Introduction

Earlier explorations of how to predict oil prices led, in 1978, to my being named project director of a contract between USC and the OPEC Secretariat in Vienna to develop a world energy model. OPEC wanted a tool to help devise rational oil production and pricing policies. Late in 1981, we installed the model on OPEC's computers in Vienna. It is unknown how effectively OPEC was able to use the model, but it did foretell the shape of recent events in world oil markets. In Jan. 1981, we gave our sponsors the results of a study of what would happen if OPEC raised its production rate back to 20 million barrels per day, a study they requested after their production rate fell to around 18 million B/D. The model predicted that if OPEC's rate were to be raised as proposed, oil price would fall $20/bbl within a year. Although not spot on, the prediction is certainly indicative of what was to come. (For this study all price elasticities were arbitrarily increased by 10 percent from their base levels, the medians of estimates reported in the literature. In hindsight, this adjustment was conservative. The past decade's price-induced, reduced growth rate in energy consumption, so-called conservation, corresponds to even larger values of price elasticity.) There is no indication that OPEC paid attention to this or other model predictions, they were still whistling their favorite high-price tune when the market forced their first official price cut late in 1982.

This paper presents some rules of thumb that my experience suggests may help to understand the evolution of oil prices. The intent is to identify factors to consider in deciding on the credibility of an oil price forecast (yours or another's), rather than to prophesize future oil price. The presentation is professorial in style; a series of questions penetrating different aspects of the dynamics of oil prices are asked, and answers to these queries are advanced. This interrogatory is targeted to broaden the reader's perspective on what makes the oil market tick. We also examine how individuals have responded in the past to signals from the marketplace. This examination's purpose is to call to attention the impact of emotions on the subjective weightings applied in reaching an economic decision. In the oil patch expectations about highly uncertain outcomes, both economic (mostly prices and taxes) and physical, exert a major influence on investment decisions. Being aware of how emotions can slant these expectations is a key consideration for a decision maker.

DISCUSSION QUESTIONS

To establish a backdrop for our discussions the first question asked is, "What is the consensus, if any, of recently published prognostications of future oil prices?" Sorting through the stream of predictions appearing in recent issues of Petroleum Intelligence Weekly, Oil and Gas Journal, et al., one finds these major themes:

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