Thursday, July 24, 2008

The Dangers of Extrapolation

With oil dropping down below $125 per barrel, we get a lesson on the dangers of extrapolating from recent history to predict the future. No trend continues forever.

We’ve heard many predictions about oil prices over the last several months. Commentators have told us when they think a barrel of oil will reach $200, $250, and higher prices. However, these predictions are often based on little more than blindly extrapolating from recent price movements.

Just because oil may have gone up $20 per barrel one month doesn’t mean that it will go up by $20 in each of the next 12 months. Such a prediction has to be justified by some sound reasoning to be worth anything.

Oil prices may yet climb sharply again, but you can’t tell this by studying an oil price chart. If oil rises from $120 per barrel to $140 over the course of a month, it may be reasonable to guess that the price was close to $130 mid-month, but it isn’t reasonable to guess that it will be $160 at the end of next month. This is the difference between interpolation and extrapolation.

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