Markets October 2005

Hundred-Dollar Oil

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Where do you think oil prices will be next year? Go ahead, pick a number—any number—and you can probably find an expert somewhere who agrees with you. Andy Xie, the chief Asian economist for Morgan Stanley, says oil prices are about to collapse—recent prices of about $60 a barrel are far too high to last. The oil analyst Matthew Simmons says hogwash—we'll soon be paying $100 a barrel. Other pundits have staked out much of the wide real estate between those predictions.

Talk is cheap. But through two types of contracts—futures and options—traders on the New York Mercantile Exchange do more than talk: they bet daily on whether (and how much) oil's price will rise or fall by certain dates. By putting the information from options and futures together, one can come up with the probabilities that the market is assigning to oil's hitting any given price in June of next year.

So what does the smart money—or at least the money—say? The probabilities appear below. They indicate that right now the future price of oil is virtually impossible to predict, even for experts. That's not unusual: oil prices have often darted up and down unexpectedly, and a variety of factors—including the political instability of the Middle East and the uncertain future of Chinese oil demand—are making prices especially volatile today. Of course, individual investors can take or leave risky bets on future oil prices. The U.S. economy, on the other hand, has no choice but to continue playing a very high-stakes game.

Price in June
of 2006
Probability
Less than $30 2%
$30-$40 10%
$40-$50 19%
$50-$60 21%
$60-$70 17%
$70-$80 12%
$80-$90 8%
$90-$100 5%
Above $100 6%
James Hamilton is a professor of economics at the University of California at San Diego. He writes on current economic conditions at www.econbrowser.com.
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