For most people the reflexive answer to the title question is yes. Consider, however, that over various time spans since 1980, the price of oil has dropped 75, 76, 78, and 75 percent, and risen 320, 265, 370, 196, and 254 percent (The Socionomic Theory of Finance, Robert Prechter, page 458). Prices for most goods sold in retail establishments, presumably determined by supply and demand, haven’t swing up and down like that over the years in either nominal or inflation-adjusted terms.
Perhaps oil supply and demand have special characteristics that drive the price in ways such that percentage changes in price are far greater than the underlying percentage changes in production or consumption. If so, does anyone have a model that predicts supply and demand and delineates a relationship between them and the price of oil? Does this model yield testable hypothesis, and what is its predictive record? Has it consistently caught oil’s dramatic price swings?
There is a model that has repeatedly predicted oil’s price swings and the amplitude of the ensuing trend, but explicitly rejects supply and demand as independent variables. At the very least, this model should prompt a critical examination of the supply and demand hypothesis and its applicability to the oil market.
In Robert Prechter’s recently released The Socionomic Theory of Finance (STF), Chapter 22, “Elliott Waves vs. Supply and Demand: The Oil Market,” the author surveys the predictive track record of oil market analysts at his company, Elliott Wave International (EWI). It is superior to any other record of which I am aware.
Stripped to its essentials, here are the basics of the socionomic theory.
The main theoretical principles are that in human, complex systems:
• Shared unconscious impulses to herd in contexts of uncertainty lead to mass psychological dynamics manifested as social mood trends.
• These social mood trends conform to a hierarchal fractal called the Wave Principle (WP) and therefore are probabilistically predictable.
• These patterns of human aggregate behavior are form-determined due to endogenous processes, rather than mechanistically determined by exogenous causes.
• Social mood trends determine the character of social actions and are their underlying cause.
STF, pg. 313
As established by R.N. Elliott empirically and Benoit Mandelbrot mathematically, financial prices fluctuate as a fractal, with a comparable style of movement on all time scales, from seconds to centuries.
STF, pg. 232
A fractal, according to the Merriam-Webster online dictionary, is: “[A]ny of various extremely irregular curves or shapes for which any suitably chosen part is similar in shape to a given larger or smaller part when magnified or reduced to the same size.” Related: Panic In Vienna: OPEC Needs To Bring Down Costs To Compete With U.S. Shale
While Elliott Waves in financial markets are irregular fractals, they take shape according to certain guidelines and mathematical relationships. Social mood trends, regulated by their own internal, or endogenous, dynamics and impervious to external influences (including supply and demand), motivate social actions in contexts of uncertainly, such as financial markets. For any given time period a market can go up or down, but Elliot Wave analysis yields probabilistic predictions about its likely direction and pattern, which means it can be empirically tested.
The heart of Chapter 22 is a history of Prechter and EWI analysts’ calls on the oil market since 1993, when EWI initiated coverage of that market. Contemporaneous charts and excerpts document their calls, which came either just before or just after eight major turning points (the wave after the ninth is in progress so the jury is still out). Plenty of Wall Street seers make good money drawing straight lines, talking about supply and demand, and predicting consolidations, pullbacks, or bounces, but that crowd has invariably been surprised by the oil market’s huge crashes and rallies. Prechter and crew got the turning points right and demonstrated a noteworthy degree of accuracy on the amplitude of the ensuing moves.
The chapter’s comic relief is provided by its references to books, magazine articles, and quotes from “expert” commentators, economists, analysts, and academics whose choruses of supremely confident predictions are repeatedly obliterated by the market (the predictors generally hold on to their jobs). Peak oil theories and to-the-moon price projections are trotted out at market tops, permanent glut theories and gloom-and-doom at market bottoms. The experts are just as caught up in social mood as everybody else. Without knowing a thing about Elliott Waves, speculators who simply kept track of the quantity, tone, and certainty of forecasts and bet the opposite way when they reached extremes would have done quite well.
No forecasting method is perfect. By its own premises the EWT cannot be. Wave labeling on charts is always with the implicit caveat that it is tentative and subject to future revision—the highest probability forecast is not always the correct one. EWI has had its share of “revisions,” aka “whiffs,” across a variety of markets. However, even those who don’t buy into Prechter’s hypotheses, analyses, or methodologies will find his book intellectually valuable. He has shifted the terms of the debate, proposing that financial markets are not black boxes, rationally balancing supply and demand and deriving equilibrium prices; they’re probabilistically predictable exercises in mass psychology. Competing theories must meet the tests of basic science: testable hypothesis and predictive validity greater than that demonstrated by the EWT.
Someone may build a better theoretical and predictive mousetrap. Until then, oil market participants—from second-by-second speculators to industry executives pondering long range strategic decisions—can benefit from Prechter’s unique perspective and theory.
By Robert Gore for Oilprice.com
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