Price Forecasting and Project Evaluation in the 1980's (includes associated papers 13347 and 13675 )
Authors: Campbell John M. , Hubbard Robert A. 
Published: December 2007

Forecasts of prices-including oil, natural gas, equipment and drilling costs, and money-affect thee valuation of all projects. The adoption of detailed forecasting procedures in the 1970's was intended to improve project evaluations in the pre-OPEC years. The practice of changing price forecasts every few months as the result of continuing price instability is costly and defeats the advantages of the forecasting process in improving project evaluation. Past price forecasts of oil, inflation, drilling, and cost of capital have been collected from public and private sources. The accuracy of forecasts since 1976are compared with actual prices. The causes of the errors are identified, and the implications for forecasting in the 1980's assessed. The costs associated with the time of professional staffs involved in changing or redoing valuations are also estimated.

Introduction

The ingredient necessary for sound project evaluation prior to the OPEC cartel was accurate assessment of reserves and drilling and completion costs. This comparatively simple approach was successful because of stability of prices oil, natural gas, drilling costs, completion costs, and the price of money. Price stability was lost in the 1970's when general economic inflation combined with OPEC activities made paces more unstable and therefore more important in project evaluation. The result was the development of detailed forecasting models that attempted to provide reasonable estimates of future prices. Accurate estimates of future prices areas important, if not more important, today than reservoir analysis in producing sound evaluation of projects. The original intent of the forecasting effort wasthe development of various price profiles. The price predictions, it was hoped, would reflect long-run, secular changes. The price forecasts were not expected to coincide exactly with the prices that would eventually result, nor should it ever be expected. The gap between predicted and actual price forecasts should be as small as possible, but this is not always feasible. Oil price forecasts in the 1970's were made more difficult, for instance, because of the new and old oil categories in the U.S. that were used in addition to OPEC categories. Other examples include the early failures in estimating completion and drilling prices. Tying drilling and completion prices only to general inflation ignores the supply/demand conditions in the oil patch, which differ significantly from the general economy. Linking oil prices to general prices becomes even worse when one realizes that inflation forecasts are typically less accurate than most reserve estimates. Forecasts were initially developed at the corporate level and remained constant for the entire year. The stability in the forecasts was essential for comparison of alternative projects. It also minimized the effort of the engineers performing the evaluations, allowing them to concentrate on the engineering variables that they could control. In the late 1970's the situation changed dramatically. The oil crisis during 1979–80, along with phased decontrol of U.S. oil, produced changes in prices that shattered the forecasts in place at that time. Forecasts have changed consistently within most companies since then, first, by increasing significantly to reflect recent changes in prices and incorporating faster growth rates, and second, by dropping by as much as 100% to capture the depression-like conditions in the oil patch. The shift from extreme optimism to the current depression state occurred with a lot of changes in between. Price forecasts changed monthly-more often in some cases. The consequences of price changes designed to be representative of current price conditions have minimized, in some cases, the benefits of the more detailed forecasting effort. First, the principle that forecasts used in project evaluation are long-run, secular values that will by necessity contain errors has been rejected. Second, changing prices constantly has generated a feeling that good engineering analysis is not very important to project evaluation. "Pricesdominate engineering variables" has become a prevalent opinion; therefore, many engineers have said: "Why should we worry about doing a good engineering job?" Third, and perhaps most important, the constant revision of prices has imposed a significant cost on the companies. These costs are indirect and difficult to measure, but are nevertheless a major drain on company resources. The fundamental issue is whether the benefits of changing secular forecasts to match short-run price conditions exceed the costs of constantly rerunning evaluations already approved and the opportunities lost because of the time spent on revising existing projects. Discussion of these points identifies the strengths of current forecasting procedures that must be retained in the 1980's. The current deficiencies or weaknesses of the application of price forecasting to project evaluation must be acknowledged and corrected if the industry is to avoid the situation in which it currently finds itself.

JPT

P. 817^