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(originally published by Booz & Company)


Taking a Chance on Oil


We live in uncertain times. The war in Iraq and on terrorism, diplomatic struggles with nascent nuclear powers, and a crisis in global finance have combined to make the world a very unsettled place to do business. Consider the plight of an executive in charge of strategic planning at a major international oil company. Faced with the decision of whether to make significant investments in exploration and production, he or she needs to take into account expectations about the future price of oil. It is, of course, nearly impossible to predict that price. But insight into the elements that contribute to price fluctuations may help companies improve their planning and better manage their risk.

On the surface, the price of oil appears to be subject to the laws of supply and demand. Oil is not reusable, and supplies are tied to a variety of factors, including exploration, geopolitical issues, and, ultimately, just how much oil the world has left. Meanwhile, global demand is on the rise as the developed world maintains its seemingly insatiable appetite for hydrocarbons and countries such as China and India look to fuel their fast-growing economies.

Like any market, however, something less cut and dried is also influencing the cost of oil: the changing expectations of participating buyers and sellers. In the past, every time the price of oil has gone up, naysayers around the world have claimed that reserves are running dry — and have yet to be proven correct. Given this long history of mistaken predictions, it is clear that most people have had little idea whether supply and demand or market expectations is the predominant influence on price.

But if it were possible to calculate just how much of the price of oil at any given time is due to fundamentals and how much is the result of uncertainty, companies could make better decisions about investments whose performance depends on what oil will cost in the future. That calculation requires a third factor, what economists call an “instrumental variable,” closely correlated to one of the primary factors — in this instance, the degree of uncertainty — that can help produce a consistent estimate. In the case of crude oil, an excellent variable is readily at hand: the price of gold.

Gold is currently selling at nearly US$1,000 an ounce, up from about $350 just three years ago. The price has jumped not because the world’s gold supplies are fast being depleted or because demand for gold from jewelry makers and high-end audio cable manufacturers has suddenly increased. Although the amount of gold in the world is essentially finite, all of it is reusable, and industrial demand for the precious element has remained relatively constant for years. Rather, the price of gold has long been a function, and a leading indicator, of global uncertainty. Stock markets may plummet, entire empires may crumble, but gold will always retain some value as a medium of exchange. Thus, when uncertainty is high, the price of gold rises. When the situation calms down, the price declines.

Therefore, we can use the correlation between oil and gold prices to understand how geopolitical uncertainty affects the former, and to distinguish uncertainty’s influence from that of underlying supply and demand. It turns out that the price of gold has tracked the price of oil very closely over the past decade or so. And because the amount people are willing to spend on gold is an excellent indicator of uncertainty, gold provides a near-perfect variable for determining the degree to which perceived instability is influencing the price of oil. Our analysis shows that there was a 90 percent correlation between gold and oil prices between 1999 and 2007; however, the correlation dropped below 10 percent during the relatively stable period from 1992 to 1999, after the Gulf War. This suggests that a large proportion of price changes in the past several years could be attributed to the impact of uncertainty, and only a small proportion to changes in the supply–demand balance. (Inflation induced by oil prices might also explain the correlation between oil and gold, because gold itself is a common hedge against inflation. However, that link explains only a small portion of the correlation between the two commodities’ prices.)

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  1. Michael M. Hutchison, “Aggregate Demand, Uncertainty and Oil Prices: The 1990 Oil Shock in Comparative Perspective”  (PDF), Bank for International Settlements, Economic Paper No. 31, August 1991: A traditional analysis of the role of uncertainty in the price of oil.
  2. Oil Market Uncertainty Hampers Investment,” Pipeline magazine, August 20, 2007: An oil industry view of how uncertainty affects the future demand for oil.
  3. Crude Oil: Uncertainty about Future Oil Supply Makes It Important to Develop a Strategy for Addressing a Peak and Decline in Oil Production” (PDF), United States Government Accountability Office, Report No. GAO-07-283, February 2007: An effort by the federal government to predict when oil production will peak, given a wholly uncertain supply-and-demand future.
