The Coming Copper Crisis and Price Forecasting - Is There a Better Way?

David Threlkeld of metals trading advisor Resolved Inc. got some press this week.
That happens when you predict a catastrophe.

Threlkeld was quoted by Bloomberg repeating an ominous prediction he first made in May 2006. The call? That the copper market is heading for a catastrophic collapse. With the LME price falling to below $1 per pound.

Threlkeld has some credentials. He was one of the first to expose rogue copper trader Yasuo Hamanaka in the mid-1990s. And point out that Sumitomo's hoarding of copper was having an undue effect on prices.

His arguments on the coming copper crisis make some sense. Basically, that most of the world's buying today is from speculators. Investors who will dump the inventory back on the market at the drop of a fedora if sentiment shifts.

Threlkeld's call adds to an ever-present tapestry of forecasts on metals prices by thousands of analysts globally.

People watching commodities markets love to make predictions. On where prices will be a year, two years or ten years from now. Every brokerage house turns out a slate of forecast prices for oil, copper, sugar and every other hard asset.

Pulling exact prices from the future is critical for investment advisors. Brokerage house analysts love to build financial models to predict the value of resource companies. But knowing how much oil a company will pump, or how much copper it will mine, is only part of the cash flow equation. You also need the value per barrel or pound of metal. Then it's simple multiplication to derive revenue streams and figure out a net present value.

So analysts pick a number. In gold for example, brokerage house forecasts for the coming year are running between $800 and $1250 per ounce.

The problem with analyst price forecasts is they tend to be lagging indicators. Most observers base their predictions more on what has happened than what will take place down the road.

When spot commodity prices fall, analysts revise their forecasts downward. Predicting doom and gloom. But when prices rise (as they have over the past year), observers reverse course and upgrade their forecasts. The present always colors our view of the future.

The end result being forecasts are almost always wrong. They're too bullish in good times, when things are getting ready to turn bad. And they're too bearish in bad times, just before a recovery. But everyone gets caught "staring at the sun", fixated on a single point that must represent what's ahead for prices.

The forecast system doesn't work. Why then are we so obsessed with jamming the future into a down-to-the-cent prediction?

Probably because we see no other way. If we're investing in commodities we need to have some view on forward prices, right?

But there is at least one alternative to forecasting. Scenario planning.

The use of scenarios to guide investment decision was pioneered by Shell in the 1960s and 1970s. At the time, the company noticed its oil price predictions were almost always wrong. And they set out to find a better way of supporting their business planning.

They came up with scenarios. As with conventional analysis, the company started by gathering all the data they could on the oil market. What factors drove pricing? How were these changing? What wouldn't change in the market? What events were completely impossible?

But here's where Shell departed from conventional forecasting. Instead of cranking out an exact price for the coming year's crude, they used the data to create stories about what the oil market's future might look like.

Shell realized there were certain features of the oil market that couldn't be predicted. A nation might or might not embrace energy efficient technologies, reducing oil demand. OPEC nations might choose to increase or decrease supply, depending on the whims of rulers.

Trying to make a single prediction about how these factors would play out (and derive a resulting price forecast) was ludicrous. There was just no way to nail down these uncertainties.

So Shell split the difference. They constructed one scenario where things went one way. Then another where the opposite happened. Boiling it down, they created two or three "stories" about what the coming oil landscape could look like.

Maybe it would be a "tight supply" world, where energy efficiency is rejected globally while OPEC cuts off supplies, leading to a race for oil and rising prices. Or, alternatively, it might be an "oil glut" world where nations reduce crude consumption even as producers pump out more supply.

These scenarios were closely constrained by data. But they left designers free to imagine different possibilities about how things might play out.

Importantly, no price forecasts were derived from these scenarios. The stories were used as general guidelines for how prices might fair. Giving management ideas on what they should watch for in the market. And how they should deploy their capital in an uncertain world.

How did the exercise work out? Pretty well. Shell was one of the only oil majors to foresee (at least in some form) the oil shock of the 1970s. Enabling them to respond quickly when the crisis hit.

Since then, Shell regularly uses scenarios to envision the future of energy. You can read their current stories on energy futures on the company website.

Commodities markets are big and complex and uncertain. Maybe it's time we stopped trying to "magic eight-ball" an exact price for oil, gold and copper.

Acknowledging uncertainty, we might be oddly more prepared for the future.

Here's to Shell's scenario pioneers,

By. Dave Forest of Notela Resources