John Samuel Raja D: Forecasts based on future spreads

Will commodity prices go up in the next few months or not? That’s an important question for decision makers in India as any further increase in international crude oil prices would mean that the oil subsidy would increase further. A recent report by International Monetary Fund (IMF) has tried to answer this question through a measure called “Success ratios of price forecasts based on future spreads”.

The difference between spot and future prices is called the spread and this system measures how correctly the spread ratio predicted the direction of actual price changes. For example, the ratio correctly predicted the direction of change for Texas Intermediate crude — it is the only crude taken for analysis – 84 per cent of the time in the last 18 years.

Getting it right Success ratios of price forecasts based on futures spreads
12-month futures*
1990:M1-2008:M11		Crude oil#	0.84
1998:M1-2008:M11
Crude oil#	0.81	Aluminum#	0.88
Copper#	0.93	Wheat##	0.65
24-month futures*
1998:M1-2008:M11
Crude oil#	0.87	Aluminum#	0.88
Copper#	0.89	Wheat##	0.68
* Last observation of the month # New York Mercantile Exchange ## Chicago Board of Trade Source: IMF World Economic Outlook

This is significant in the current scenario as futures curve are upward sloping, that is prices 12 or 24 months from now are pegged higher than current levels. Based on this ratio, IMF economists are saying that commodity prices are likely to recover. But the more important question is: will the current situation (where future prices are higher than spot prices) provide an incentive for producers to build inventories since they could get higher returns by holding on to stocks? Interestingly, the study was silent on how well the system predicted the dramatic rise in oil prices last year.