Bushuev V.V. Structural and wave analysis and the forecast of world dynamics of oil prices

BP's Na Kika platform in the Gulf of Mexico at sunrise on June 12, 2013.

Vitaly Vasilievich Bushuev – General Director
Institute of Energy Strategy, Doctor of Technical Sciences, Professor, e-mail: vital@df.ru

Abstract. The global oil market environment is an important factor for macroeconomic, investment and geopolitical decisions. There is a widespread belief that oil prices are almost impossible to be predicted, as they depend on the uncertainty of current and future supply and demand indicators and on a variety of other random factors. The article attempts to show that although the market is difficult to predict, it is quite logical. The Institute of Energy Strategy is successfully working on forecasting oil prices based on the harmonic analysis of price dynamics, its structural representation in the form of Elliott waves and neural modeling. The peaks and troughs of 2008, the price spikes of 2014, the downward trend of 2018-19 were predicted in a timely manner as well as the new oil boom of 2021-22 was forecasted on the basis of the results obtained.

Keywords: oil prices, Elliott waves, forecast, regularity.

World prices for oil constitute an important factor for the formation and implementation of the Russian budget. And their volatility largely determines the variable part of the country’s export earnings. Thus, a decrease in the average annual world price of Brent crude oil by $10 per barrel corresponds to the change in revenues of $30 bln. The desire to insure the budget based on the minimum expected cost of oil on the world market, which often turns out to be $15-20 per barrel less than the real one, is causing an unjustified underestimation of estimated income and reduction in the state’s investment opportunities. Therefore, attempts to make a more accurate forecast of the level of oil prices expected in the mid-term (3-5 years) seem reasonable.
In most cases, numerous forecasts by domestic and foreign experts and organizations are based solely on the physical idea of the expected demand and possibilities to cover it with production volumes and export supplies of oil resources. However, oil price is formed not in the physical commodity market, but in the futures market, where the volume of transactions is 8-10 (or more) times the volume of real deliveries. The futures market is much more volatile.

Fig. 1. Arrangement for forming the expectations of market participants

Thus, the volume of real deliveries in 2014-2018 varied within 3-5%, while the price changed several times. Moreover, if in 2015 the physical surplus of oil in the world market was the dominant factor, and the price fell under its influence, then already from 2016, under the influence of, among other things, the OPEC + transaction, the expected increase in this surplus has decreased. But the main thing is that at the same time, the financial demand caused primarily by inflationary expectations in the USA not only “ate” the excess of physical supply, but also exceeded it by 3-4 times, which in aggregate explains the beginning of rising prices. An important role among new players is played by strategic investors who buy oil futures not for speculation, but to protect against expected inflation, and sell them when this probability decreases. In mid-2017, Trump’s macroeconomic policy gave rise to such expectations, which a year later gave way to a certain skepticism. Psychological expectations of traders in the oil market not only depend on the expected imbalance of resources and the availability of free financial resources that can come to the futures market, but they themselves give signals to the market and its potential players.
However, these explanations for what happened, unfortunately, are not exhaustive and even more they cannot be decisive in predicting further development of the situation in the oil market.

Offshore drilling platform Polar Ligths

Recently, attempts have been made to link price dynamics with other related factors. Difficulties and uncertainties in the forecast of most market analysts are associated with their attempts to take into account the long-term effect of cause-and-effect relations between many resource, financial and geopolitical factors and oil prices. Attempts to analyze these relations were made in the work of the Institute of Energy Strategy [1].
Unfortunately, the main conclusion of this work was that all of these numerous factors have an ambiguous, often multidirectional and inconsistent – in force and time – impact on price dynamics. In addition, prices themselves have an impact on these factors (demand, investment, exchange rates, inflation expectations, geopolitical decisions, etc.). Therefore, multifactor models do not yield a satisfactory result when forecasting global market conditions over the mid-term. This work also showed that the dynamics of prices on the world oil market are determined not so much by physical factors of supply and demand (they mainly bring only fluctuations into the overall harmonic curve), but mainly by financial and economic reasons. Oil on the world market is primarily a financial asset, and its price is formed in the futures market of financial derivatives. Strictly speaking, it is wrong to set one factor against another, and the behavior of players in the “paper” oil market is determined by many factors, both physical and financial, macroeconomic and geopolitical. The price is formed in the futures market through the prism of expectations of its participants in relation to expressed and predicted factors.
Thus, the price level is the result of transactions of oil-market participants driven by expectations regarding the price in the future, adjusted for price volatility. This approach can be shown in the diagram (see Fig. 1).
The key to understanding this arrangement is that changes in the physical oil market, as well as in other economic markets, do not directly affect price, since they do not have a direct impact on the oil market, but have an influence through the main players, their psychology and perception of those or other economic, macroeconomic and political events. It is the psychology of traders who react differently to current, and especially to expected events, that determines their individual and collective behavior in the market. It should be noted that in parallel with the actions of market participants, which lead to price movements in a certain direction, there are also external agents – central banks and government agencies, participants in other financial markets, risk managers of companies that indirectly affect pricing. The channel of this impact is macroeconomic policy, operations in the foreign exchange market and other actions that affect not only oil price, but also the availability of capital for market participants. The main objective of the actions of these agents is to stabilize the current situation, both in the context of monetary policy and in the context of risk management.

Fig. 2. Feedback loops for multiplicative operations
Source: [2]

Thus, when considering the oil market in a different plane, it is possible to determine both the movement of spinning factors acting through the expectations of market players, and promoting factors acting through monetary-policy instruments and exchange-rate effects, as well as the market participants’ perception of the current situation (Fig. 2).
Separately, in addition to those elements whose effect can be clearly observed, for example, the influence of monetary policy through a decrease in interest rates or the influence of the changing expectations of market participants against the backdrop of growing demand for energy resources, there is also an unobservable effect of the influence of the system of these factors. In other words, the cumulative effect does not have an additivity property, that is, it cannot be decomposed into the sum of the effects of individual factors. This feature arises as a result of the interdependence between individual components of the system, which cannot be studied using an approach based on cause-and-effect relations. Thus, in order to make a relevant forecast for oil prices, it is necessary to move away from econometric analysis and other approaches based on cause-and-effect relations or multiple regressions, where there is a risk of missing essential variables – the problem of endogeneity. Also, these approaches prevent evaluating the unobservable effect of the result of interactions of individual factors.

Fig. 3. Harmonic analysis of oil prices

At the same time, while the market is difficult to predict, it is quite logical. It is necessary to identify these patterns, which are not of an opportunistic causal nature, but which determine the behavior of the market for a sufficiently long period of time. The main law of the market is the frequency (albeit not time-stable) of the rise and fall of prices, the repeatability of the structure of these fluctuations in the form of corresponding harmonics and fractals (such as Elliott waves, which are true not only for the dynamics of the futures market, but also reflect general socio-natural, financial-economic and technological trends of evolutionary development). A harmonic analysis of the retrospective dynamics of prices (Fig. 3 – in comparable prices) showed that the sum of the four dominant harmonics (with periods of 5 years, 9 years, 13 and 26 years) approximates this process quite well. And the spread of the resulting harmonic model for the future makes it possible to predict further price dynamics (for the period until 2025).

Fig. 4. Basic structure of the cycle
Fig. 5. Elliott Rules

At the same time, harmonic analysis provides a rather crude model by which only the qualitative structure of past and expected price dynamics can be estimated. Remaining captive to cause-and-effect relations, many analysts argue that it is impossible to predict prices on the oil markets, apart from building regression models that give some plausible results within a limited time period, provided that the overall trend of the process’ development dynamics does not change. But practice shows that trends change at certain intervals: uptrends are replaced by downtrends. The alternation of trends has led to the realization that the dynamics of processes in the market (as in most other cases) are wave-like. This pattern makes it possible to look for other ways of forecasting dynamic phenomena. A purely harmonic analysis, however, while allowing for the identification of a dominant frequency of fluctuations, has no standing to argue that price and macroeconomic dynamics have strictly-repeating periods of fluctuation. Therefore, it is necessary to look for some fractal (similar) structures with whose help one could describe the wave-like behaviour of dynamic processes.

Fig. 6. Structural dynamics of world oil prices and their approximation by Elliott waves
Fig. 7. Comparative forecast of current (as of 05/19/19)
and ten-year (as of 11/30/09) forecast values ​​of Brent-brand oil prices
Fig. 8,а. Comparative forecast of average monthly oil prices by 2017 for the last three years over the mid-term
Fig. 8,b. Comparative forecast of average yearly oil prices by 2017 for the last three years over the mid-term
  1. Similar structures in the stock markets were identified by R. Elliott in the 1930s. The charts show a repeating structure in the form of four cycles of eight waves: five of which coincide with the trend, while three go against the trend (see Fig. 4). Fractal rays are called waves in Fig. 4. These waves have come to be known as Elliott waves.
    The description of the standard approximation model for long rows in the form of Elliott waves is given in [3]. At the same time, the selection of the beginning of this wave structure remains pretty much subjective. That said, all market cycles consist of two types of waves: driving and correctional. The first ones are signed with numbers from 1 to 5, and the second are denoted by the Latin letters a, b, c.
    The main task of predicting prices in the market is to find any affordable way to allow it to move forward. That is why in wave theory, the main attention is focused on the moving type of waves, which are called a trend in technical analysis. To determine where the price is, you need to know the construction peculiarities of each wave. For this, the “Elliott Rules” (Fig. 5) were developed, and practiced in most market situations.
  2. Of course, structural analysis makes it possible to record past and future cycles and the trends of world price dynamics. To obtain quantitative estimates, a self-learning neural model [3] was specially created together with IT specialists from Dubna University.
    Using this model for more than 15 years has allowed us to formulate forecasts of world oil prices, which predicted a surge in prices in 2008 and their subsequent collapse, as well as fairly-plausible dynamics for subsequent years on the basis of the forecast made in 2009 (Fig. 7).
    Based on the structural forecast from the harmonic analysis (Fig. 3) and on the basis of the Elliott wave last rays (rays 1-5 from 2016 to 2025 in Fig. 6), quantitative (average monthly and average annual) estimates of expected oil prices were obtained on the neural model. Comparison of the forecasts obtained over the past three years (Fig. 8) confirms that they coincide with fact, and also indicates their proximity to each other in terms of assessing the near future.
    The period 2019-2020 is characterized by a decrease to 50-55 dollars in price after the surge in 2018. That said, during 2021-22, we can expect a return of prices to the level of 65-70 dollars per barrel.
    Despite some deviations in the forecasts for the past year, the graph in Figs. 7 and 8 allows us to state that even with fluctuations in current estimates over the long-term, neutral models have fairly close values of forecasts and actual price dynamics over the long-term.

Sources used

  1. Bushuev V.V., Konoplyanik A.A., Mirkin Y.M. et al. Oil prices: analysis, trends, forecast – M: ID “Energy,” 2013-344pg.
  2. Bouchouev I. Measuring Financial Supply & Demand for Oil Derivatives// Energy Risk Europe Conference/ Koch Supply & Trading – 2017.
  3. Bushuev V.V., Sokotuschenko V.N. Intellectual forecasting – M: ID “Energy,” 2016-164pg.