Forecasting Crude Oil Price

By - Akash Chandrayan Guide - Prof. Santanu Bandyopadhyay

Department of Energy Science & Engineering IIT Bombay April 2012 / Mumbai

Crude Oil Pricing Mechanism

1960-1970: Major players decided the prices 1980s: Traders in the Spot Oil Market , forward contracts became popular. Mid 1980s to present: Futures and other financial derivatives.

Crude Oil Pricing Mechanism

Benchmark Crude Oil: Serves as reference to the oil which is extracted from similar places and qualities. Major Bechmarks:
West Texas Intermediate (WTI) : Traded in New York Mercantile Exchange (NYMEX) Brent Crude Oil : Traded in International Petroleum Exchange (IPE) at London.

Other Benchmarks are Dubai (Middle East), Tapis (Malaysia), Minas (Indonesia) and Bonny Light (Nigeria).

Crude Oil Pricing Mechanism

Spot Market: Spot oil price is the current Crude Oil price. Spot Oil Markets are Over the Counter (OTC) The major spot markets are
Rotterdam for Europe with benchmark as Brent New York for US with benchmarks as WTI

Crude Oil Pricing Mechanism

Futures Market: Two parties agree to buy or sell oil at a specific price at a specific time in future. Used to reduce the risk associated with the volatile prices of oil. Can be traded up till a certain period before the delivery month of the contract. Less than 5% of the futures contracts result into physical delivery of Oil.

Efficient Market Hypothesis and Forecasting

Proposed by Professor Eugene Fama (1960, University of Chicago) as a theoretical concept for better understanding of Financial Markets. One cannot consistently beat the market for long period of time. Price of any security at a time to reflects all the information available (in some information set I ) at the time to If the hypothesis holds true, the best forecast for a price in future is todays price.

Econometric Forecasting Models

Time Series Models: Extract out trend in the historical data series using statistical analysis.
Auto Regressive (AR), Integrated (I) and Moving Averages (MA). Combinations of these produce ARMA (Auto Regressive Moving Average) and ARIMA (Auto Regressive Integrated Moving Averages) models.

Used as benchmark for other models.

Econometric Forecasting Models

Financial Models F (t, Tm) = S (t) e (r+w-) (Tm -t)
When r+w- > 0, F (t, T) > S (t) and the markets are said to be in contango. When r+w- < 0, F (t, T) < S (t) and the markets are said to be in backwardation.

If it is assumed that F (t) = E (S (t+1)) then,

S (t+1) = o + F (t) 1 + (t+1)

Econometric Forecasting Models

Structural Models: Models utilise the available information regarding oil inventories, political issues, stocks, seasonality Good in-sample forecasting ability Long term forecast useful for Oil companies, Policy makers

Forecast evaluation of Time-Series models

Short term one step ahead forecast Daily WTI spot price data has been used Time frame chosen is May 12, 2011 to Feb. 27, 2012.

Source : Energy Charter Secretariat (2007) - Putting a Price on Energy International Pricing Mechanisms for Oil and Gas, p71

Crude Oil Historical Price Trend

160
140

120
100

80
60 40 20 0 Jan Dec Dec Nov Nov Oct Oct Sep Sep Aug Aug Aug Jul Jul Jul Jul Jun Jun Jun Jun May May May May Apr Apr Apr 02, 22, 10, 23, 06, 19, 04, 17, 09, 29, 18, 08, 29, 21, 13, 05, 25, 18, 11, 04, 27, 19, 14, 02, 23, 14, 01, 198619861987198819891990199119921993199419951996199719981999200020012002200320042005200620072008200920102011

Crude Oil Price ($/bbl) trend

Forecast performance measures

MSSE error: Mean Square Standard Error is defined as:
=1(

())2 /

Success Ratio: Success Ratio measures the ability of forecast to predict the correct direction of price change.

If (Sp (t) S (t-1))*((S (t) S (t-1)))>0 D (t) = 1 else D (t) = 0 SR = () / T =1

Diebold Mariano Test Statistics

Compare two forecasting models:
(model, random walk) 1(t) = Sp1 (t) S (t) 2(t) = Sp2 (t) S (t) Ho: E [1 ()2 ] = E [2 ()2 ] H1: E [1 ()2 ] E [2 ()2 ] d (t) = 1 ()2 =

1 2

2 ()2

1 2

; = asymptotic variance

= + 2

1 =1

; = ,

S is a N(0,1) distribution under null hypothesis and therefore we can reject Ho at 5% level if |S|>1.96

Akaike Information Criteria

2 = ln + 2 is the maximum likelihood estimate of 2 which is variance of (t). l is the order of model 2

Time Series Models and Results

The Random Walk Model : E (S (t+1) |I (t)) = S (t) S (t+1) = S (t) + (t) Model Identification : 2 = ( ())2 / (T-1) =1 2 = 3.4393
MSSE 12.36 1.85 (No Change) SR 44.90% N.A

Time Series Models and Results

Auto Regressive (AR):
S (t) = n S (t-n) + n-1 S (t-n-1) + ..+ 1 S (t-1) + o + (t)
Model AR(0) AR(1) AR(2) AR(3) AR(4) AR(5) AR(6)

AIC

3.8584

1.2388

1.2443

1.2533

1.2622

1.2676

1.2757

AR (1) model
MSSE SR DM test-statistics

1.532

46.94%

-4.9460, 0.3369

Time Series Models and Results

AR (2) model:
MSSE SR DM test-statistics

1.535

48.98%

-4.8978, 0.9580

Moving Averages (MA) S (t) = co + (t) - 1 (t-1) - 2 (t-2) -- n (t-n) MA (1) model:
MSSE
4.924

SR
44.90%

DM test-statistics
1.0333, 7.3172

Time Series Models and Results

Auto Regressive Moving Average (ARMA) S (t) = o +
ARMA(1,1)
MSSE 1.534 SR 48.98% DM test-statistics -4.9011, 0.8747

=1

( ) + (t) -

=1

( )

ARMA(2,1)
MSSE 1.535 SR 48.98% DM test-statistics -4.9003, 0.9640

Time Series Models and Results

ARMA (1,2)
MSSE 3.356 SR 48.98% DM test-statistics -1.0747, 6.1141

ARMA (2,2)
MSSE 1.533 SR 48.98% DM test-statistics -4.9008, 0.9054

Time Series Models and Results

120

100

80

60

Spot Price

Random Walk
AR(1) AR(2) MA(1)

40

20

Time Series Models and Results

120

100

80 Spot Price 60 Random Walk

ARMA(1,1)
ARMA(2,1) 40 ARMA(1,2) ARMA(2,2) 20

References
Energy Charter Secretariat (2007) - Putting a Price on Energy International Pricing Mechanisms for Oil and Gas, Chapter 3. Mileva and Siegfried (2007) - Oil market structure, Network effects and the choice of currency for oil invoicing, Occasional Paper Series, European Central Bank Timmermann,Clive W.J. Granger (2004) - Efficient market hypothesis and forecasting, International Journal of Forecasting Frey, Manera, Markandya, Scarpa (2009) Econometric Models For Oil Price Forecasting: A Critical Survey, CESifo Forum 1/2009 Ruey S. Tsay (2002), Analysis of Financial Time Series Nota di Lovoro (2011) - Oil Price Forecast Evaluation with Flexible Loss Functions, Fondazione Eni enrico Mattei Alquist, Kilian, and J. Vigfusson (2011) - Forecasting the Price of Oil, Board of Governors of the Federal Reserve System, International Finance Discussion Papers EasyReg International Software was used for implementation. It can be downloaded from http://econ.la.psu.edu/~hbierens/EASYREG.HTM DM tests were performed using external file: dmtest.m file which can be downloaded from : http://www.mathworks.com/matlabcentral/fileexchange/33979-diebold-marianotest-statistic/content/dmtest.m

Thank you!