“He who foretells the future lies, even if he tells the truth.” (Chinese proverb)
Hi! And thank you for your interest! I hope I manage to retain it.
My name is Andrew. I have spent most of my working life as a consultant in the energy sector. I want to reflect on this life and see what can be learned from it. I want to start with the business of forecasting.
I have been employed by developers of large projects such as power stations, HVDC power cables, gas pipeline consortia, storage facilities; by prospective lenders of money including banks, private equity funds, pension providers and public bodies; and by governments and regulators interested in their commercial viability and possible consequences for energy consumers, the enviroment and the economy. Most of the time, these clients have been interested in my forecasts: forecasts of energy prices, power station output, energy flows between nations and atmospheric pollution; forecasts for the next 15-20 years usually and sometimes up to 50 years into the future.
Based on evidence to date, my forecasts have always been wrong. Of course, with long range forecasts one can hope they turn out right in the end; but it would be fair to say they have not got off to a very good start.
In this series of blogs, I want to explore why it is that forecasters like me are so much in demand. I will consider how and why we are cajoled, usually against our better judgement, into making forecasts in the first place; and the distinction between what we can genuinely offer and what we are asked to do. This will involve making conjectures about business psychology as well as energy economics. Such conjectures are based on personal experience; I hope they are more illuminating than the forecasts.
The price of oil will, er, always stay the same
In July 2008, the price of oil (Brent crude, to be specific, but it doesn’t really matter) was 145 $/bbl (dollars per barrel). The market’s view of future oil prices (ICE Brent monthly, again the details don’t matter) was 140 $/bbl extending out over the following 9 years, i.e. to summer 2017.
Roll forward six months to January 2009. The price of oil had collapsed to 45 $/bbl, less than a third of its level in the previous summer. The market’s new view was a slow recovery from 45 to 70 $/bbl in 2012. (Of course, the market was unashamed at having slashed its forecast by more than 50% from the previous July.) As things turned out, the spot price rose above 125 $/bbl in 2011 and again in 2012, suggesting that it would have been better to stick with the original forecast.
More recently, in early 2015, the spot price was 115 $/bbl and the market foresaw a gradual decline to 100 $/bbl by 2020. Six months later, the spot price collapsed to 48 $/bbl. Has the market learned from its mistakes? Well it is predicting a slow rise to 70 $/bbl by 2018 …
Essentially, the market assumes the current price will be extended into the future, perhaps with a slow rise or slow decline. It has proven incapable of predicting the sudden rises and falls (what posh people call “volatility”).
Perhaps others have done better? In the near term, this is meant to be impossible according to most economists: the market takes account of all the information that is available and represents the combined wisdom of all of its participants. In a ‘liquid’ market such as crude oil, this should be unbeatable, not that that stops others from trying.
The best known and one of the most reputable of these ‘others’ is the International Energy Agency, or IEA. The IEA annually produces its World Energy Outlook or WEO, a weighty 600 page pdf that is almost unreadable but certainly very learned. It contains highly researched and methodically produced analyses for the world economy and the future of energy prices over the next 20-30 years. And how has it performed? Well, a wide range of academic investigations have been done on this question and the general consensus is the WEO’s performance to date has been slightly better than flipping a coin and guessing the outcome.
In his excellent book “Thinking, Fast and Slow” Daniel Kahneman explains why we should not expect much from pundits who make long range predictions. Most surveys into the perfomance of long range forecasts by experts show that dart-throwing monkeys would have achieved a similar level of success.
And yet we still do it
So why do we make forecasts? I guess one answer is a tendency to conflate luck with skill. The Chinese proverb at the start of this blog is not generally appreciated, at least in my experience. If someone succeeds – in this context, meaning they make a prediction that turns out to be accurate – they ascribe it to skill rather than good fortune, wilfully overlooking the fact that if blind apes throw darts at a dartboard then eventually one of them will hit the bulls-eye. (You might be familiar with Alan Sugar of The Apprentice, and his widely disseminated motto: “there is no such thing as luck in business”.)
And yet, we think that forecasting is necessary, that someone has to do it. That has always been my top excuse. And we believe in data, increasingly so in this age of ‘big data’: the more facts we have about what happened yesterday, the more confident we are in our ability to predict what will happen tomorrow. In general we believe in progress – technological and scientific progress – so that past failures are rationalized as being the results of inferior past techniques and knowledge: we are better now, we think, and will not repeat the same mistakes. With such a positive mindset, no track record of failure, however stark, deters us from trying again.
None of this quite gets to the heart of the psychological motivation for foretelling the future. In my next blog, I will describe my own reflections on this, accumulated over the last thirty years of unsuccessful predicting.