Why We Forecast Crude Oil Prices

Includes: CRUD, OIL
by: Valuentum

As subscribers of Valuentum know, every company's fair value estimate is corroborated by a comprehensive and robust three-stage discounted cash-flow valuation model. Within these cash flow models are hundreds of assumptions, ranging from future forecasts of revenue to a firm's cost structure to fading returns on invested capital to a company's cost of capital over time (competition will eat away at returns over time causing economic profit creation to cease).

The significant implications of the price of crude oil and natural gas on our fair value estimates cannot be underestimated - and not just within the energy sector -- for firms like Exxon (NYSE:XOM) and Chevron (NYSE:CVX). The transportation industry, from airlines such as Delta (NYSE:DAL) and United (NASDAQ:UAL) to air freight/logistics firms like FedEx (NYSE:FDX) and UPS (NYSE:UPS), includes energy as its single-largest input expense. The profitability of companies that make chemicals, rubber and plastics are all influenced by petrochemical feedstock prices. Even the best-selling cars at some of the automakers such as GM (NYSE:GM), Ford (NYSE:F), Tesla (NASDAQ:TSLA) can be influenced by the price of gasoline at the pump. The list goes on and on.

Valuentum uses its internal crude oil and natural gas price deck to inform the future revenue and input cost forecasts for relevant companies across its entire coverage universe. Though the dynamics of the crude oil and natural gas markets are inherently difficult to predict, we think informed upside, base, and downside cases as it relates to crude oil and natural gas prices are critical to the underlying forecasts of our valuation models (and the fair value estimate ranges of firms in our coverage universe). Such a range of probable fair value outcomes is consistent with our use of a margin of safety within the Valuentum methodology.

We're Expecting Lower Crude Oil Prices in the Near Team…

Our base case near-term (5-year) crude oil price assumptions are derived from the CME Brent Crude Oil futures curve. Though there are myriad factors that can drive wild fluctuations in the price of crude oil relative to the futures curve (not the least of which is the relationship between non-OPEC production and demand growth), the futures curve-in the most simplistic sense-reflects the average view among all market participants, which in many cases, is the best forecast.

At times, our near-term base-case crude oil price assumption will vary from the futures curve if, for example, our views regarding current geo-political (socio-economic) events, global gross domestic product growth, and supply-demand assumptions differ greatly from this "embedded consensus" pricing assumption. However, the goal of this simplistic method is to set the baseline for the revenue-generating capacity of firms we cover in the energy sector and to provide the foundation for cost-structure changes of firms who rely heavily on crude oil and its derivatives as inputs.

To arrive at our near-term (5-year) upside and downside cases, respectively, we apply a standard $30 premium to the futures curve (base case) and a standard $30 discount to the futures curve (base case), both in year 5. The size of this particular margin of safety band (in units as opposed to percentage) is substantiated via the historical annual standard deviation of crude oil prices (Europe Brent Spot Price FOB), unadjusted for inflation, from May 1987 through the present date (raw data), which approximates such a figure ($31).

Our base-case forecast for the price of crude oil is roughly $90 per barrel by the end of 2018. Our upside case is approximately $120 per barrel, while our downside case is approximately $60 per barrel. The EIA projects the Brent crude oil spot price will fall to annual averages of $106 per barrel and $101 per barrel in 2013 and 2014, respectively, relatively consistent with Valuentum's forecasts. OPEC is targeting a nominal price of $100 per barrel (OPEC Reference Basket) over the medium term.

We estimate that production costs of oil shale, which is advancing aggressively in the U.S., are between $60 to $120 per barrel, further substantiating this pricing range. Heavy oil bitumen (Canadian tar sands) will likely require $75 per barrel to be economical (also within the range), and all of the major independent oil companies currently boast significant tar sands reserves. We don't expect ethanol and biodiesel to be significant sources of supply in the near future, given estimated costs for incremental supply that could top $130-$150. However, these estimates may come down in coming years as technology advances.

5-Year Range of Probable Outcomes for Crude Oil Prices (Europe Brent) - $/barrel

(Click to enlarge)

Source: EIA, Valuentum

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Some of the firms mentioned in this article are included in our actively-managed portfolios.