Forecasting

the Price of Brent

Crude Oil
COMM 350
Peter Sephton

Table of Contents
Introduction ............................................................................................................................................... 3
The Theory ................................................................................................................................................. 5
West Texas Intermediate (WTI) ........................................................................................................................................................................ 5
10-year US Bond Yield ........................................................................................................................................................................................... 6
Dow Jones Industrial Average ............................................................................................................................................................................ 7
Exxon Mobil Share Price ....................................................................................................................................................................................... 8
GBP/USD Exchange Rate ...................................................................................................................................................................................... 9
US Unemployment Rate ..................................................................................................................................................................................... 10
Data Methodology .................................................................................................................................... 11
Empirical results ........................................................................................................................................ 12
Testing for Stationarity Levels ..................................................................................................................................................................... 12
Unit root tests ......................................................................................................................................................................................................... 13
Testing for Stationarity First Difference ................................................................................................................................................. 15
Unit root tests ......................................................................................................................................................................................................... 16
ARIMA Model ........................................................................................................................................... 17
ARIMA Forecast ..................................................................................................................................................................................................... 19
Cointegration Model ................................................................................................................................. 21
Engle-Granger Test .............................................................................................................................................................................................. 21
Johansen Test .......................................................................................................................................................................................................... 22
VAR Lag Selection .................................................................................................................................................................................................. 22
Vector Error Correction Model ....................................................................................................................................................................... 24
VECM Output ............................................................................................................................................................................................................ 25
VECM Holdout Period Forecast ........................................................................................................................................................................ 27
Comparison of ARIMA Model and VECM ................................................................................................... 28
Out of Sample Forecasts ............................................................................................................................ 30
Conclusion ................................................................................................................................................ 32
Appendix .................................................................................................................................................. 34
Appendix 1 ............................................................................................................................................................................................................... 34
Appendix 2 ............................................................................................................................................................................................................... 35
ADF Brent Levels .................................................................................................................................................................................................... 35
ADF-GLS Brent Levels ........................................................................................................................................................................................... 35
KPSS Brent Levels ................................................................................................................................................................................................... 35
Fractional Integration Brent Levels .............................................................................................................................................................. 35
ADF US 10 Year Bond Levels ............................................................................................................................................................................. 36
ADF-GLS US 10 Year Levels ................................................................................................................................................................................ 36
KPSS US 10 Year Levels ........................................................................................................................................................................................ 36
Appendix 3 ............................................................................................................................................................................................................... 37
ADF DJIA First Differences .................................................................................................................................................................................. 37
ADF-GLS DJIA First Differences ........................................................................................................................................................................ 37
KPSS DJIA First Differences ................................................................................................................................................................................ 37
Fractional Integration DJIA First Differences ............................................................................................................................................ 37
ADF WTI First Differences .................................................................................................................................................................................. 38
ADF-GLS WTI First Differences ........................................................................................................................................................................ 38
KPSS WTI First Differences ................................................................................................................................................................................ 38
Appendix 4 ............................................................................................................................................................................................................... 39
ARIMA (0,1,0) Output ........................................................................................................................................................................................... 39
ARIMA (1,1,0) Output ........................................................................................................................................................................................... 39
Bibliography .............................................................................................................................................. 40

Introduction
For our research project, we chose to try to develop a model to forecast the price of Brent
crude oil. Oil is a commodity that is vital for all economies for growth, prosperity and
convenience. For centuries before the first oil well, people around the world gathered oil
around "seeps," places where oil naturally rose to the surface and came out of the ground
(Yergin 1991). Collecting oil in that manner meant that even productive areas did not yield
large amounts of oil. Oil was heavily demanded in those days for lighting as whale oil had
become too expensive. This meant that the person who could somehow extract the oil could
capture the huge kerosene market (the refined product of crude oil used in lamps). In 1859 the
first known oil well was drilled, using similar techniques as those used in salt exploration. This
was (eventually) a success, beginning the start of a new age the oil age.

In the present day, the world is dependent on oil for power generation and for use in many
products. This makes oil an extremely useful and powerful commodity in the past we have
seen many wars over it (Yergin 1991). Our interest in predicting the price of Brent crude oil
stems from this desire around the world to find and extract oil in order to use it for
development and increasing standard of living.

Figure 1 - Global Oil Demand (Rising Oil Demand 2011)

Crude oil is a vital commodity and is used in many goods, for example its by-products after
refining are lubricating oils, diesel, kerosene, naphtha (for use in plastics, medicines, de-icers,
perfume, fertilisers), gasoline/petrol, butane and propane. This makes crude oil a vital global
commodity. This is evident in the market, as over two million barrels of Brent crude are traded
per day (Smith 2012). Also from Figure 1 it can be seen that global demand will increase, as
non-OECD countries develop. Figure 2 gives us a clear visual representation of this huge
growth in demand over only the past three years. This makes a forecasting model to predict
future price movements very interesting to construct and, if accurate, extremely useful.








Figure 2 - Global Oil Demand 2010-2013 Map (Nelder 2012)

In order to produce a forecast for the price of Brent, we aim to use two modelling techniques.
We will firstly try to use ARIMA forecasting followed by a more sophisticated modelling
technique such as cointegration, vector autoregression or OLS regression modelling1. We
selected numerous variables in order to help us build our model which are described below in
the theory section. The overall aim of this project is to determine which of the variables we test
are important in the relationship to Brent crude and to better understand the statistical
relationships between the variables and Brent crude prices.

1 Model choice will be dependent upon characteristics of the dataset.

The Theory
There are multiple factors that affect the price of Brent crude oil. We decided to look at the
theoretical relationship between the price of Brent and six other variables in order to compare
theory with our future model, to ensure that the model agrees with theory:
1. West Texas Intermediate (WTI) Crude Oil
2. 10-year US Bond Yield
3. Dow Jones Industrial Average
4. Exxon Mobil Share Price
5. GBP/USD Exchange Rate
6. US Unemployment Rate

West Texas Intermediate (WTI)

WTI, also known as Texas light sweet, is a grade of crude oil that is relatively light (low
density) and sweet (due to a low sulphur content) when compared to Brent crude. The two
are major benchmarks of pricing world crude oil, with Brent being more actively traded than
WTI (Nguyen, London Overtakes New York as Brent Oil Beats WTI 2012), hence why we chose
to forecast Brent and use WTI as an independent variable. The two prices move in tandem with
each other with a fairly constant spread (see Figure 3), however the spread has recently been
widening especially of recent times, due to the issues in Iran and Libya (Nguyen, Brent-WTI
Spread Expands to Seven-Month High on Libya 2013).

Figure 3 - Brent and WTI Crude Oil Prices

10-year US Bond Yield

Over short-term periods the US 10-year bond yields (not prices, prices move inversely to yield)
should move in tandem with Brent crude. The theory behind this is that Treasury yields
depress when there is a lot of demand for Treasury products, which are considered ultra-safe
investments. When the global economy is doing badly, people look for a flight to quality and US
government bonds are often demanded, as well as other instruments (for example Gold) to
maintain a return. The reason that the 10-year bond was chosen as opposed to other US
instruments (also perceived as risk-free) is because it is the benchmark rate that guides almost
all other interest rates (Durden 2013). Brent crude should also reduce in price during
downturns in the economy as there will be less demand due to less demand for consumer
goods. This can be seen in Figure 4; where in 2007/08 the financial crisis hit, and Brent crude
prices collapsed and US 10-year bond yields dropped.

Over the long-term Brent shows a positive trend, whereas US 10-year bond yields have a
negative trend. This doesnt follow the theory above for the short-term, however due to excess
demand with limited supply oil prices have generally increased, whilst at the same time the US
has been strengthening and this is reflected in depressed yields over time.

Figure 4 - Brent and US 10-Year Bond Yield

Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA), The Dow, is a price-weighted average of 30
significant stocks traded on the New York Stock Exchange and the NASDAQ. This means that
when companies are doing well, the DJIA should increase, and this should increase the demand
for oil as factories produce and the cycle goes on. This can be seen in Figure 5 as the DJIA
increases from 2003-2007, then the DJIA crashes and Brent crude prices collapse too. This
pattern tends to hold over the long-term as the two increase and decrease together and seem
to be quite correlated.

The reason the DJIA was chosen over its competitors is because it has stood the test of time
and is not considered to be volatile or risky something we felt was important due to the
increase in volatility in the stock markets over the financial crisis.

Figure 5 - Brent and DJIA

Exxon Mobil Share Price

Exxon Mobil is a multinational oil and gas company. It is the world's third largest company by
revenue (DeCarlo 2013), and also the second largest publicly traded company by market
capitalisation (Associated Press 2013). The company was ranked No. 5 globally in Forbes
Global 2000 list in 2013 (DeCarlo 2013). With reserves of 72 billion barrels of oil equivalent at
the end of 2007 and being the largest refiner in the world (Exxon Mobil Annual Statements),
we felt that this would be a suitable company to use in our model. The link between Exxon
Mobils share price and the price of Brent crude should move in tandem as their business is
based on the commodity. This can be seen in Figure 6, as the two tend to track each other, with
Brent crude being more volatile than Exxon Mobils share price.

Figure 6 - Brent and Exxon Mobil

GBP/USD Exchange Rate

This exchange rate is commonly referred to as Cable due to the fact that in the 1800s, the
dollar/pound sterling exchange rate was transmitted via transatlantic cable. This is the
number of dollars per pound sterling. This is used as a variable to help forecast oil prices as
oil, priced in dollars, tends to move higher as the U.S. dollar falls, and vice-versa. Its a result of
oil traders trying to maintain their purchasing power in the event of a weaker dollar (Lazzaro
2013). This means that when the dollar value falls (so that GBP/USD increases), the oil prices
should increase. This is seen in general over Figure 7; however the financial crisis distorts this
relationship due to the flight to quality previously discussed.

We wanted to use a highly traded currency such as the Yen, Euro, Sterling or the US dollar. Due
to the Japanese QE programmes, as well as the Eurozone Crisis, we decided to use Sterling as
the US dollar counterpart. Furthermore, due to our national interests and as users of the pound
we were interested in analysing the GBP/USD exchange rate.

Figure 7 - Brent and GBP/USD

US Unemployment Rate

The US unemployment rate is a key indicator used to measure the state of the US economy.
This variable was chosen as during slumps in the economy the unemployment rate should
increase, which then means that fewer goods are demanded, so companies produce less,
leading to a lower demand for Brent crude oil. This relationship can be seen around 2007/08
during the financial crisis as unemployment spikes up, and Brent prices collapse. Also generally
across the time series, the two seem to have an inverse relationship.

Figure 8 - Brent and Unemployment Rate

Overall, we chose our variables individually because of the reasons outlined above.
Additionally, as you may have noticed, all of our variables were related to the US, as Brent
crude oil is traded in US dollars. However, it is nave to think that these are the only related
variables, as our variables are dependent on multiple factors and are not simply impacted by
one another. For example the Dow will be impacted by each of the variables above as well as
many more, such as inflation and tapering not just Brent prices.

10

Data Methodology
We retrieved our historical data for the price of Brent Crude oil from the US Energy
Information Administration (www.eia.gov n.d.); a reliable resource for this commodity. For the
additional explanatory variables we ensured that each historical dataset was equally from a
credible source, to allow our model to be as representative as possible (See Appendix 1 for full
list of sources).

Due to our intention to forecast using time series modelling, monthly data was to be used. Our
time period covered January 2000 to August 2013; giving us 164 data points. A holdout period
was included over the last 12 points of the data, one year, in our sample to enable us to
compare the accuracy of the forecast models. We chose to select this time period because we
wanted there to be enough recovery from the financial crisis to be present in our historical
data, to avoid any unnecessarily obscure results. We felt that 13 years of data should provide a
long enough sample to capture trends and would provide a balanced data set either side of the
financial crisis of 2007/08 (The Economist 2013).

Throughout this report we will build two models and compare their accuracy within the
holdout period chosen. Having assessed each models ability to forecast over the holdout
period, testing out of sample is where our discussion will then lead. Following this we will
discuss the implications of each model and its suitability in the real word by comparing the
results to theory.

11

Empirical results
Testing for Stationarity Levels

The first step in any forecasting data analysis is to plot the data so visual analysis can be done
to estimate which modelling technique could be used and to check for any anomalies. In this
case we need to check the individual data plots for any visual signs of stationarity. This would
be shown by a constant mean and variance that is independent of time.

Figure 9 - Data Plots of the Levels of the Series

From these plots (Figure 9) it looks as though each of the variables is non-stationary with each
showing signs of a trend (maybe GBP/USD does not show a trend) and a non-constant
variance. However, this is only a visual analysis. To be sure we need to undertake statistical
tests to confirm our preliminary thoughts.

12

Unit root tests

Statistical testing for stationarity needs to be done before being able to build any of our
forecasting models through unit root and stationarity tests, as we cannot simply rely on our
visual analysis.

ADF and ADF-GLS unit root tests examine the null hypothesis that the data set contains a unit
root. The ADF test does not hold much power if there are shifts in either the constant or trend
in the data; which is why we further test with the ADF-GLS test. This latter test deals with the
deterministics in a more sophisticated manner, resulting in a more reliable inference.
Following on from conducting the unit root tests we can use the complementary KPSS test to
directly see if the series are stationary around a constant or trend. The null hypothesis for the
KPSS test is that the data series is stationary.

In order for the data series to be used within our forecasting models they need to hold certain
characteristics in their levels. The null from the ADF and ADF-GLS would need to not be
rejected, as we need the series to be I(1) and to contain a unit root. Whilst the KPSS null
hypothesis should be rejected to further suggest that the series is non-stationary. Additionally,
if there are any discrepancies in the inference drawn from the unit root and stationarity tests,
we will need to use fractional integration to decipher the true inference. Fractional integration
would need to be used on variables where its series may be stationary; however it takes a long
time to revert to its mean, therefore the correct inference may not be picked up in the earlier
ADF/ADF-GLS and KPSS tests. This contains two tests; the Whittle estimator and the GPH
estimator, which provide estimates for the d. Further, the null hypotheses are that d=0,
therefore if we reject this, the series are non-stationary, I(1).

13

We used a lag of 6 in both the ADF and ADF-GLS2 tests, but a lag of 4 in the KPSS test3 and then
let GRETL set it for us in the test for fractional integration.

The 5% level of significance was used to decide whether the null hypotheses in the ADF test
should be rejected or not; in our case we did not reject the null for any level of the variable.
With the ADF-GLS test at the 5% level of significance its critical value was -2.93, therefore we
do not reject the null for all variables which have t-statistics larger than -2.93. The KPSS test
has a critical value of 0.148 at the 5% level of significance; therefore all variables with t-
statistics larger than this value should be rejected, indicating a non-stationary series. After
completing fractional integration for Brent and WTI, we can say all series are non-stationary,
I(1), and will need to be differenced to be made stationary (see Figure 10) (see Appendix 2 for
a sample of our test results).

Variable
Brent
US/10/year/Bond/Yield
Dow/Jones/Industrial/Average
Exxon/Mobil
GBP/USD/FX/Rate
US/Unemployment/Rate
WTI

ADF?5%?significance?level
P)value
Stationary?
with/constant/
0.6095
NO
0.7328
NO
0.3352
NO
0.8922
NO
0.4177
NO
0.4056
NO
0.7302
NO

ADF(GLS?5%?critical?value?=?(2.93
T)stats/with/constant/
Stationary?
and/trend/
(3.47632
YES
(2.44434
NO
(2.07014
NO
(1.97456
NO
(1.71309
NO
(2.40142
NO
(4.22819
YES

KPSS?5%?critical?value?=?0.148
T)stats
Stationary?
with/trend/
0.0958324
YES
0.277376
NO
0.141104
NO
0.238685
NO
0.563796
NO
0.379412
NO
0.111855
YES

Overall/
stationary?

Conflict
NO
NO
NO
NO
NO
Conflict

Figure 10 - Unit Root and Stationarity Tests of the Levels

2 The cube root of our sample size, 152.

3 The fourth root of our sample size, 152.

14

Testing for Stationarity First Difference

To be used in an ARIMA model, the variables have to be stationary, I(0), in the first difference.
So again, here we need to plot the data, but this time in its first difference. When looking at the
differenced series they all appear to have stationary characteristics - constant mean and
variance whilst being independent of time.

Figure 11 - Data Plots of the First Differences of the Series

15

Unit root tests

We followed the same method as with the levels of series and have found that all series are
stationary in their first difference as shown in the table below (Figure 12).

Variable
Brent
US0100year0Bond0Yield
Dow0Jones0Industrial0Average
Exxon0Mobil
GBP/USD0FX0Rate
US0Unemployment0Rate
WTI

ADF=5%=significance=level
P)value
Stationary?
without0constant0
1.80E&08
YES
5.12E&10
YES
2.83E&06
YES
7.28E&137
YES
9.49E&29
YES
0.00713
YES
3.80E&10
YES

ADF&GLS=5%=significance=level
P)value0with0
Stationary?
constant
2.94E&13
YES
8.94E&18
YES
0.18440
NO
0.06439
NO
0.00479
YES
0.01218
YES
7.98E&09
YES

KPSS=5%=critical=value===0.464
T)stats
Stationary?
no0trend
0.03541
YES
0.07187
YES
0.12026
YES
0.08878
YES
0.10722
YES
0.17270
YES
0.02564
YES

Overall0
stationary?
YES
YES

Conflict
Conflict
YES
YES
YES

Figure 12 - Unit Root and Stationarity Tests of the First Differences

These initial tests have enabled us to decide on the relevant forecasting models that we could
create to enable us to gain the most accurate forecast of the price of Brent Crude oil. Our
results imply that our variables are integrated of the same order, 1, and can therefore be used
for a cointegration analysis, as well as an ARIMA forecast as they are stationary in their first
difference (see Appendix 3 for a sample of our test results).

16

ARIMA Model
From completing our unit root and stationarity tests we now know that the level of Brent has
to be differenced once to be made stationary4 therefore we can use it in an ARIMA forecasting
model. In this ARIMA model the price of Brent Crude oil will be forecasted based upon its
historical values. The accuracy of the model will be dependent upon our use of AR and MA
terms in its structure. As we are trying to model the price of a volatile commodity, we may find
that the best model will follow a random walk.

Before testing what combinations of AR and MA terms provide us with the most accurate
model, we first need to analyse the correlogram of the first difference of Brent when it is in its
stationary state; d_Brent.










Figure 13 - Correlogram for the Differenced Series of Brent, d_Brent

4 To forecast using an ARIMA model the variable needs to be stationary.

17

When visually inspecting the correlograms, we are looking to see if there is any pattern in
either of the ACF or PACF, in addition to observing if there are any spikes at lags which are
significantly different from zero at the 5% level of significance5.

From our correlogram we can see that there is potentially a slight pattern in the ACF and a
significant spike at lag 1 of the PACF at the 5% significance level, suggesting that there may be
a possible AR term in the ARIMA model. Following this visual analysis we begin to test our
models, starting by setting our p term to 1, to capture the AR, and the d to 1 as we need to
work with the differenced series. There is no visual evidence of an MA term as there is no
pattern in the PACF, so the q term is set to zero.

When analysing the statistical output for the ARIMA (1,1,0) model we can see that the phi term
is significantly different from zero at the 5% level of significance as 5.27e-07 is less than 0.05
(see Appendix 4) leading us to reject the null hypothesis that it is equal to zero. This implies
that there is some AR relationship in the data. Following finding this significant AR term we
decided to test to see if there was a second, however this second phi term appeared to be
insignificantly different from zero at the 5% level and we were able to conclude that we only
wanted to include the 1 AR term in our ARIMA model.

Using our intuition and belief that the forecasting of Brent Crude oil could be represented by a
random walk ARIMA model we decided to create the ARIMA (0,1,0) model. In this case we are
saying that there is no AR or MA relationship and that the best forecast of its price in the next
period, is its price in the last period plus an error term. In order to compare these two models
capability of forecasting we looked at the Akaike criterion (AIC) and their forecast evaluation
statistics.

5 These will show as they will be outside of the confidence intervals.

18

ARIMA Forecast

Figure 14 - ARIMA (0,1,0) Forecast

Figure 15 - ARIMA (0,1,0) Forecast

Forecast&Evalution&Statistics

ARIMA&(1,1,0)

ARIMA&(0,1,0)

Akaike&criterion&(AIC)

945.6751

964.887

Mean&Error&&&&&&&&&&&&&&&&&&&&&&&
Mean&Squared&Error&&&&&&&&&&&&&&&&
Root&Mean&Squared&Error&&&&&&&&&&
Mean&Absolute&Error&&&&&&&&&&&&&&
Mean&Percentage&Error&&&&&&&&&
Mean&Absolute&Percentage&Error&&&
Theil's&U&&&&&&&&&&&&&&&&&&&&&&&&&
Bias&proportion,&UM&&&&&&&&&&&&
Regression&proportion,&UR&&&&&&
Disturbance&proportion,&UD&&&&&&

:14.371
242.71
15.579
14.371
:13.412

:8.18
97.333
9.8657
8.18
:7.7096
7.7096
2.8027
0.68745
0.16811
0.14444

13.412

4.3741
0.85095
0.091117
0.057933

Figure 16 ARIMA Forecast Evaluation Statistics

When comparing the AIC from both models we can see that as the ARIMA (1,1,0) AIC is lower
at 964.887, we would expect it to be a better model as it contains an AR term. However, when
considering the statistical output from the forecasting models, we can see that the random
walk ARIMA (0,1,0) creates more accurate forecasts because of the lower Theils U, and
forecasting error statistics (Figure 16). As we are testing two models on their ability to
forecast, we will choose the random walk model of ARIMA (0,1,0) to compare to our other

19

model6. The forecasts from the ARIMA (0,1,0) are shown in Figure 14. This shows that the
forecast predicts a steady increase in the price of Brent crude over the holdout period. Each
observation is within the 95% confidence intervals from the forecasts, and the forecasts do not
visually appear to be too far away from the actual observations (when compared with the
ARIMA (1,1,0) model). However, this is a random walk model which is not particularly useful
as there is just an error term in the model which does not give us any intuition behind the
model.

6 We tested other models including more AR terms, MA terms and combinations of both to ensure we could not
build a model with better forecast evaluation statistics.

20

Cointegration Model
To be able to create a Vector Error Correction Model (VECM), all series need to have the same
level of integration; in our case, all be I(1). From our initial unit root tests we showed that all
the variables are I(1) as they are stationary in their first difference, therefore we can use them
to create a VECM as long as they show a cointegrating relationship. When creating a VECM we
are looking to see if there are any variables which restore the model to the long run
equilibrium, if there is cointegration then at least one variable needs to respond to this long
run equilibrium. To check for cointegrating relationships we performed two tests; the Engle-
Granger Test and the Johansen Test. As the Engle-Granger Test doesnt test for more than one
cointegrating vector it will not be as powerful as the Johansen Test7.

Engle-Granger Test

The null hypothesis for the Engle-Granger Test is that the series is not cointegrated; therefore
testing that the residuals from the model have a unit root. To be able to say that there is a
cointegrating relationship between two variables, in addition to stating that they are all I(1),
we would need to reject this null hypothesis of non-cointegration.

Figure 17 Engle-Granger Results

7 As we have 7 variables we could theoretically have 6 cointegrating relationships.

21

When testing for a unit root in the residual we obtain a p-value of 0.02372, which is lower than
0.05, therefore at the 5% level of significance we can reject the null of non-cointegration
(Figure 17). This result indicates that there is a cointegrating relationship. As the Engle-
Granger Test is not as reliable as the Johansen Test when there are more than 2 variables, we
conducted the Johansen to ensure our result holds.

Johansen Test

This is a more credible test to use, as we have more than two variables that we are testing for a
cointegrating relationship. The outcome from the test will tell us how many cointegrating
vectors we have within our variables. With all other tests conducted in this report so far we
have carefully chosen the lag, either choosing the cube or fourth root of the sample size.
However, for the Johansen Test, we gather this from a different method - the VAR lag selection.

VAR Lag Selection

This selection method calculates the AIC (along with other criterion) at different lag lengths.
Upon entering the first differences of our non-stationary series in to GRETL, the VAR lag
selection technique tests down to find the lag length which should be used. The lag which
minimises the AIC is the lag length which we will take forward and use in the Johansen Test;
which in our case is a lag of 2 as indicated in Figure 18.

Figure 18 VAR Lag Selection Results

22

Having selected the relevant lag, we can now use this in the Johansen Test to discover how
many cointegrating vectors our data set contains. When carrying out our tests we started by
using a restricted trend because of the pattern evident in the time series plots8.

Figure 19 Johansen Test Results

From Figure 19 we are able to see we do not reject the null of one cointegrating vector, as
0.2122 is the lowest rank to be significant at the 5% level, therefore indicating that there is just
the one cointegrating vector in our data set. Additionally the Lmax test, as well as the
alternative Trace test (shown above), also suggest a rank of 1 as their values are larger than
0.05. As it is not clear whether a restricted or unrestricted trend is to be used, we continued to
test with the unrestricted trend to ensure we ended with the same result.9


8 The unrestricted trend was also tested for certainty.

9 To further guarantee that we had discovered all cointegrating vectors, we repeated the Johansen Test twice with
both the restricted and unrestricted deterministics; once with a lag of 3 and then with a lag of 1. Both times we
ended with the same inference therefore confirming our earlier results.

23

Vector Error Correction Model

Now that we have discovered the number of cointegrating vectors in our data set we are able
to go forward and create a VECM.

In this modelling instance, when pertaining how many lags we should include in the model, we
use an iterative process whereby we check for autocorrelation (AR) at 0 lags, continuing until
we have a lag length with no present AR. We were aware that when using GRETL to create a
VECM an extra lag needed to be added to the number entered, as in GRETLs input section a lag
of 1 would in fact mean 0 lags in GRETL. For example when we were testing up from 0 lags to
see if there was any AR, we entered lag 1 and rank 1.

When choosing the deterministics in the creation of this model we used both restricted and
unrestricted trend, our results held the same inference for both. When using 0 lags (therefore 1
lag in GRETL) we found AR(1) in the output therefore continued testing, but now with a higher
lag. At a lag of 1 (therefore 2 in GRETL), we found that there was no AR (1) or AR (2) present in
the data as all Ljung-Box Q p-values are greater than 5% (see Figures 20 and 21).









Figure 20 Evidence of no AR (1)

24

Figure 21 Evidence of no AR (2)

VECM Output

Figure 22 VECM output equation 1 Brent

Figure 23 VECM output equation 2 WTI

Figure 24 VECM output equation 3 Exxon Mobil

Figure 25 VECM output equation 4 DJIA

25

Figure 26 VECM output equation 5 US 10-year b ond

Figure 27 VECM output equation 6 US unemployment rate

Figure 28 VECM output equation 7 GBP/USD

When building this VECM model with 7 variables, we find that the speed of adjustment
coefficient (EC1) for the Exxon Mobil and US unemployment rate variables are positive with a
coefficient of 0.0752823 (Figure 24) and negative with a coefficient of 0.0101341 (Figure 27)
respectively. This follows our original theoretical predictions regarding the positive and
inverse relationship. Both of the variables are significant at the 5% level with a p-value of
0.0101 and 2.08e-11. So in a situation out of the equilibrium Exxon Mobil and the US
unemployment rate will help restore the long run equilibrium. All the other variables (Brent,
WTI, DJIA, US 10-year bond, GBP/USD) are weakly exogenous10.

Since we were able to conclude that the series are cointegrated, we cannot use a regression
equation in the differences because the OLS will omit the error correcting mechanism.
Therefore we will forecast using this VECM11.


10 If the variable does not respond to the disequilibrium, it is weakly exogenous.

11 We tried to improve this model by adding in additional variables to better capture the cointegrating
relationship. We added the VIX index and the reciprocal of the existing US unemployment rate as variables.
However, neither of these improved the model significantly, so they are excluded from the model.

26

VECM Holdout Period Forecast

From our Johansen test we know that we need to use a rank of 1 and from the iterative analysis
performed in GRETL we know to use lag 1 (2 in GRETL). The graphical forecast is shown below
in Figure 29 and the numerical output in Figure 30.

Figure 29 VECM forecast

Period

Actual

Prediction

VECM
Standard/Error

2012:09
2012:10
2012:11
2012:12
2013:01
2013:02
2013:03
2013:04
2013:05
2013:06
2013:07
2013:08

112.86
111.71
109.06
109.49
112.96
116.05
108.47
102.25
102.56
102.92
107.93
111.28

118.18
119.82
120.74
121.62
122.49
123.36
124.19
125.01
125.81
126.59
127.36
128.11

5.217
9.084
12.264
14.894
17.161
19.188
21.043
22.767
24.388
25.922
27.383
28.782

95%/Interval
Lower/Bound Upper/Bound
107.95
128.4
102.02
137.63
96.7
144.78
92.42
150.81
88.86
156.13
85.75
160.96
82.95
165.44
80.39
169.63
78.01
173.61
75.78
177.39
73.69
181.03
71.7
184.52

Figure 30 VECM model hold out period forecasts

27

Comparison of ARIMA Model and VECM

ARIMA
Period
2012:09
2012:10
2012:11
2012:12
2013:01
2013:02
2013:03
2013:04
2013:05
2013:06
2013:07
2013:08

Actual

Prediction

112.86
111.71
109.06
109.49
112.96
116.05
108.47
102.25
102.56
102.92
107.93
111.28

113.94
114.52
115.11
115.69
116.27
116.85
117.43
118.01
118.6
119.18
119.76
120.34

VECM

95%0Interval
Lower0Bound Upper0Bound
102.4
125.48
98.21
130.84
95.12
135.09
92.61
138.76
90.47
142.07
88.59
145.11
86.9
147.96
85.38
150.65
83.98
153.21
82.69
155.67
81.49
158.03
80.37
160.31

Actual

Prediction

112.86
111.71
109.06
109.49
112.96
116.05
108.47
102.25
102.56
102.92
107.93
111.28

118.18
119.82
120.74
121.62
122.49
123.36
124.19
125.01
125.81
126.59
127.36
128.11

95%0Interval
Lower0Bound Upper0Bound
107.95
128.4
102.02
137.63
96.7
144.78
92.42
150.81
88.86
156.13
85.75
160.96
82.95
165.44
80.39
169.63
78.01
173.61
75.78
177.39
73.69
181.03
71.7
184.52

Figure 31 Comparison of both ARIMA and VECM forecasts

As can be seen in Figure 31 the spread between the ARIMA and VECM forecast widens the
further you move away from August 2012 our last actual data point not held for the holdout
period. This can clearly be seen by the prediction for August 2013 where the actual was
$111.28, and the ARIMA forecasted a value of $120.34 and the VECM forecasted $128.11. The
comparison of the two forecasts evaluation statistics is shown below in Figure 32.

Forecast%Evalution%Statistics
Mean%Error%%%%%%%%%%%%%%%%%%%%%%%
Mean%Squared%Error%%%%%%%%%%%%%%%%
Root%Mean%Squared%Error%%%%%%%%%%
Mean%Absolute%Error%%%%%%%%%%%%%%
Mean%Percentage%Error%%%%%%%%%
Mean%Absolute%Percentage%Error%%%
Theil's%U%%%%%%%%%%%%%%%%%%%%%%%%%
Bias%proportion,%UM%%%%%%%%%%%%
Regression%proportion,%UR%%%%%%
Disturbance%proportion,%UD%%%%%%

ARIMA%(0,1,0)
)8.18
97.333
9.8657
8.18
)7.7096
7.7096
2.8027
0.68745
0.16811
0.14444

VECM
)14.644
254.02
15.938
14.644
)13.669
13.669
4.4773
0.84422
0.10096
0.054823

Figure 32 Comparison of both ARIMA and VECM forecast evaluation statistics

As previously observed in the comparison of the forecasts to the holdout period in Figure 31,
this is backed up by the above forecast evaluation statistics. This can be seen as the ARIMA has

28

a lower Theils U statistic as well as lower other error statistics. From this data we would
choose to use the ARIMA (0,1,0) as our forecasting model, as it has shown to be a more
accurate forecasting model over the holdout period. However, we are dubious about using this
model, as aforementioned, it is a random walk and this is not a very good forecasting model.

29

Out of Sample Forecasts

Because we found that the ARIMA (0,1,0) forecasted the best over our holdout period we use
the same model for our out of sample forecast12. After retesting the data to be certain of the
cointegration model, we arrived at the same conclusion that we should use a lag of 1 (2 in
GRETL) and a rank of 1. The two out of sample forecasts are shown below in Figures 33 and 34.








Figure 33 Out of sample forecasts for ARIMA (0,1,0) Model

Figure 34 Out of sample forecasts for VECM

12 We re-tested for unit roots and stationarity on the complete data set (including the hold out period) and found
that all results were the same. The levels were I(1) and the first differences were stationary.

30

Figure 35 Out of sample forecasts showing both ARIMA (0,1,0) a nd VECM

Period
2013:09
2013:10
2013:11
2013:12
2014:01
2014:02
2014:03
2014:04
2014:05
2014:06
2014:07
2014:08
2014:09
2014:10
2014:11
2014:12
2015:01
2015:02
2015:03
2015:04
2015:05
2015:06
2015:07
2015:08

Prediction
111.806
112.332
112.859
113.385
113.911
114.437
114.963
115.49
116.016
116.542
117.068
117.594
118.121
118.647
119.173
119.699
120.225
120.752
121.278
121.804
122.33
122.856
123.383
123.909

ARIMA
95% Interval
Lower Bound Upper Bound
100.524
123.088
96.3774
128.287
93.3178
132.399
90.8211
135.949
88.684
139.138
86.8024
142.072
85.1144
144.812
83.5796
147.4
82.1702
149.861
80.8656
152.218
79.6504
154.486
78.5128
156.676
77.4432
158.798
76.4339
160.86
75.4785
162.867
74.5717
164.827
73.709
166.742
72.8866
168.616
72.1012
170.454
71.3499
172.258
70.6301
174.03
69.9397
175.773
69.2766
177.488
68.6391
179.178

Prediction
109.511
109.046
109.565
110.278
110.992
111.694
112.382
113.055
113.716
114.364
115.001
115.628
116.245
116.854
117.455
118.049
118.636
119.218
119.794
120.366
120.933
121.495
122.055
122.611

VECM
95% Interval
Lower Bound Upper Bound
99.4176
119.604
91.6159
126.477
86.1234
133.008
81.8308
138.725
78.2108
143.774
75.0371
148.35
72.1841
152.579
69.5733
156.538
67.1534
160.279
64.8893
163.839
62.7555
167.247
60.7332
170.523
58.8076
173.683
56.9674
176.74
55.2033
179.707
53.5077
182.59
51.8743
185.398
50.2978
188.138
48.7738
190.815
47.2984
193.433
45.8682
195.997
44.4802
198.511
43.1318
200.978
41.8207
203.4

Figure 36 Comparison of both the out of sample ARIMA (0,1,0) and VECM forecasts

31

The out of sample forecasts both expect the price of Brent to increase over the next two years.
The ARIMA model has less of a slope than the VECM, however starts at a higher level. The
ARIMA and VECM models both forecast an increasing price, with values of $123.90 and
$122.60 per barrel in August 2015, respectively.

Conclusion
In conclusion, we have created an ARIMA and a VECM model in order to forecast the price of
Brent crude oil. Through comparing these models over our holdout period from August 2012
to August 2013 we found that the ARIMA (0,1,0) was a more accurate model based on forecast
evaluation statistics (see figure 32).

Firstly, due to the volatile nature of the variables selected, the ARIMA model in hindsight may
not have been the best option to use as its characteristics lend it to best fit a linear mean
trending data series. Also, ARIMA models tend to be good at forecasting short-term changes,
rather than long-term. From the outset, we were mindful that our ARIMA forecast would
potentially not be too accurate as we planned to forecast two years out of sample. Further,
since our model was structured as an ARIMA (0,1,0), this shows that the price of Brent crude
oil follows a random walk pattern. After reaching the conclusion of no AR or MA terms it made
it clear that an ARIMA model was possibly not the model to use, as ARIMA (0,1,0) models are
basically impossible to forecast; since they are dependent on the price of the previous period
and an error term.

Secondly, as aforementioned our variables are all focused upon the US. If we were to widen our
scope and take into account additional variables from outside of the US then we could have
captured more than just purely one economys demand. If we had access to supply figures from
the Middle East, Norway and other major producers then we feel we would have been more

32

able to produce an accurate forecast. Furthermore, we may not have selected the most
significant variables that are best related to the price of Brent crude. For instance we could
have included other variables such as inflation, indicators of Eastern economies (especially
China) and measures of supply disruption. For example when OPEC was formed or during the
Iraq war there were a spikes in oil prices.

Thirdly, our data sample ranges from January 2000 to August 2013 which includes economic
downturns including the burst of the dotcom bubble in the early 2000s, the events of
September 11th and the financial crisis of 2007/08. The inclusion of dummy variables could
have benefited our model through reducing the impact of the aforementioned, therefore
potentially increasing its forecasting ability.

From the outlook we were sceptical as to whether we were going to be able to produce an
accurate and practical model, as if this was possible people in the financial industry would
currently use such models and make significant profits.

33

Appendix
Appendix 1
1. WTI Crude oil prices (USD): http://www.eia.gov/dnav/pet/pet_pri_spt_s1_d.htm
2. Exxon Mobil Corporation (XOM): http://finance.yahoo.com/
3. Dow Jones (USD): http://finance.yahoo.com/
4. 10-year US bond yield (%): http://www.ecb.europa.eu/home/html/index.en.html
5. US unemployment rate (% of population): http://data.bls.gov/pdq/SurveyOutputServlet
6. USD/GBP exchange rate: http://research.stlouisfed.org/fred2/graph/?s[1][id]=EXUSUK

34


Appendix 2
Sample of the data output for unit root and stationarity tests performed on the levels.
ADF Brent Levels

ADF-GLS Brent Levels

KPSS Brent Levels

Fractional Integration Brent Levels

35

ADF US 10 Year Bond Levels

ADF-GLS US 10 Year Levels

KPSS US 10 Year Levels

36

Appendix 3

Sample of the data output for unit root and stationarity tests performed on the first differences.
ADF DJIA First Differences

ADF-GLS DJIA First Differences

KPSS DJIA First Differences

Fractional Integration DJIA First Differences

37

ADF WTI First Differences

ADF-GLS WTI First Differences

KPSS WTI First Differences

38

Appendix 4

ARIMA (0,1,0) Output

ARIMA (1,1,0) Output

39

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