Here’s Why Oil Could Be Headed to $0

Feb 24, 2016

You don't need to be an economist to know that the oil market is bonkers these days.

The price of oil has fallen roughly 70% over the past 18 months to a recent $32 a barrel, with many analysts believing the all-important commodity has further to fall. But could oil prices fall all the way to zero? Yup, at least according to one analysis.

Economists at the Federal Reserve Bank of St. Louis recently took a look at the interplay between inflation expectations and oil prices, and built a model around that. What they found is that if the market's current inflation expectations are correct, then oil prices are likely to fall all the way to $0 per barrel by mid-2019.

Now, it's highly unlikely that you'll be able to trade your pocket lint for a barrel of oil in three years. So why did these economists come to the conclusion that oil will soon be free? They used a model that has in the past predicted the future rate of inflation given an assumed path of oil prices. They backtested this model from July 2014 through December 2015, and the model predicted future inflation almost perfectly:


So the authors decided to insert the market's future inflation expectations, using the premium paid for Treasury inflation-protected securities (TIPS) to figure out where future oil prices will go.


As you can see from the above chart, the Fed model's implied oil price by mid-2019, given the market's inflation expectations, is zero. That's far different than what the futures market says will happen to the price of oil, which expects a rebound to around $50 in three years. Of course, oil traders have been consistently wrong about the future price of oil too. Just last year, they were predicting that a barrel of WTI would cost around $60, whereas its actually selling for around $30.

To be clear, the St. Louis Fed economists are not predicting that oil will be free in three years. That just makes no sense given the importance of oil to nearly every economic activity one can think of. But it does underscore how contradictory economic data is today, and how much financial markets are out of whack. The markets expectations for future oil prices and future inflation just don't make a lot of sense when you put them together.

This dynamic has posed a problem particularly for the Federal Reserve. When Fed governors meet next, which will be in mid-March, to decide what to do with interest rates, they're going to have to discount one or another of these variables. Either the market is overestimating inflation, or underestimating the future price of oil. It's Janet Yellen's job to decide which is which.

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