What Iron Ore Futures Tell Us About Oil Prices

Recent Commodity Prices Dynamics

With commodity prices falling precipitously during the last 2 years it has been a hard time for both commodity market analysts and commodity exporting countries' finance ministers. Expectations of prices moving even lower are still elevated especially for oil and other energy resources. Nevertheless, there was a bright spot recently: a range of metals prices have rebounded from near all-time lows. Iron ore took most headlines with an almost 40 percent jump since January 2016 for the 62 percent ferrous content shipments delivered to Qingdao China.

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Basic Model

Does it mean anything for other commodities - and for oil in particular? The answer seems "yes". Iron ore futures taken with a 7 months lag are having surprising success in modeling future oil price scenarios. Regression of monthly data for 2010-16 explains 76 percent of Brent oil price dynamics. If we take 2013-16 data period we get an increased 91 percent R-squared. Related: Eni Hopes To Develop Supergiant Gas Field By 2017

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What Is in This Connection?

This connection makes sense if the price of iron ore is considered as relating to approved investment projects with certain amounts of steel and other construction materials needed. Oil at the same time is much more flexible in its use and can be consumed right away. In other words, iron ore consumers plan and forecast their supplies more in advance than oil - statistically 6 months seems the planning gap.

This gives a great possibility for forecasting oil prices taking recent data for metals and calculating the oil price for the next half-year period. Of course, the results of this approach are only supplementary to full supply-demand models and should be taken with great caution as oil depends on many other factors. Nevertheless, this simple approach may provide some guidance for future developments in the oil market. Related: Oil Majors Lose Faith In The North Sea - 100 Shut Downs Looming

Recent Oil Price Movements

What is interesting is the seeming undervaluation of Brent crude in recent months. Starting from September 2015 the Brent oil price stubbornly stayed below the regression line. About 5-10 dollars is sliced from Brent because of a number of factors such as global market volatility, geopolitical and other disturbances. It seemingly explains the difference between the forecast made using this simple calculations and our full-scale oil price model based on supply and demand.

  Related: Why Are Bankrupt Oil Companies Still Pumping?

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Summary

While results of this naïve model are based only on a single factor and should be taken with a high degree of caution, it nevertheless provides useful insight into where oil prices could go in the near future.
It is likely that we will see a rebound in oil prices, but they will still be lower than their potential.

By Sergey Narkevich for Oilprice.com

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