This time series model is being built in order to predict future electrical usage for a power plant. In this example, the power plant management have collected quarterly data starting with the first quarter of 1980 and ending with the second quarter of 1996. In total, we have a sample size of 66, i.e., one observation is taken per quarter.
First, the regression model has to be built. Then, four forecasts will be made, i.e., for times 67, 68, 69, and 70; in words, the forecasts will be made for the 3rd Quarter of 1996, the 4th Quarter of 1996, the 1st Quarter of 1997, and the 2nd Quarter of 1997. Keep in mind that the "current time period" is the 2nd quarter of 1996; consequently, we can view these as future forecasts.
2. The Response Variable:
The variable that we want to predict is labeled "Hours" and stands for electrical usage measured in millions of kilowatt hours per quarter. Basically, we are looking to forecast the demand for electricity at this power plant for the next four quarters in the future.
3. The Predictor Variables:
- "Time": This variable is meant to capture the positive or upward trend in the data. The coding procedure is fairly straightforward. The first observation occurs in the first Quarter of 1980 and is coded as "time 1." The second observation occurs in the second Quarter of 1980 and is coded as "time 2." The third observation occurs in the third Quarter of 1980 and is coded as "time 3." This pattern continues, so that the for example, the fifth observation occurs in the first Quarter of 1981 and is coded as "time 5."
- "2nd Qt": This dummy variable takes on the value 1 if the observation takes place during the second quarter of the year. It takes on the value 0 if the observation takes place during any other quarter of the year.
- "3rd Qt": This dummy variable takes on the value 1 if the observation takes place during the third quarter of the year. It takes on the value 0 if the observation takes place during any other quarter of the year.
- "4th Qt": This dummy variable takes on the value 1 if the observation takes place during the fourth quarter of the year. It takes on the value 0 if the observation takes place during any other quarter of the year.
- (Implied variable): To capture the situation when the observation takes place during the first quarter of the year, we simply do nothing. This has already been captured. This occurs when "2nd Qt" = 0 and "3rd Qt" = 0 and "4th Qt" = 0. We are saying, that the observation does not happen in the 2nd Quarter, the observation does not happen in the 3rd Quarter, and the observation does not happen in the 4th Quarter. Therefore, since there are only 4 quarters in the year, the only option left is for it to be in the 1st Quarter.
4. Graphical Inspection of the Data:
The simplest way to analyze time series data is to plot the response variable of "Hours" against time to see what it looks like. This simple time series plot appears first below. The second picture is the autocorrelation function for this "Hours" variable. The idea behind an autocorrelation function is to lag data and run a correlation analysis between the actual data and the time lagged data. The purpose for doing so is to help spot whether the data has a trend and/or a seasonal pattern in it.
The autocorrelation function produces these black bars that indicate the different autocorrelations at various time lags. When the bar breaks through the red line (the confidence interval) then this indicates we have something statistically significant (it implies a correlation that is significantly different from zero).
What exactly is an autocorrelation? What exactly does it mean? A simple example using a lag of 4. Since this is quarterly data, a lag of 4 means that we are comparing data for a correlation analysis as follows: Quarter 1 of 1980 will be compared with Quarter 1 of 1981; Quarter 2 of 1980 will be compared with Quarter 2 of 1981 and so on. Basically, we are seeing whether or not a pattern exists in the data so that Quarter 1's across time are similar, Quarter 2's across time are similar and so on. We are looking for the seasonal pattern.
In this example, the lag 4 correlation is 0.87. This means that Quarter 1 of 1980 is very similar to Quarter 1 of 1981; Quarter 2 of 1980 is very similar to Quarter 2 of 1981 and so on. For example, we can say that Quarter 1 of 1985 is similar to Quarter 1 of 1986 and so on. We are picking up on the fact that the data has a repeating pattern every year probably driven by the fact that weather influences electricity demand and weather follows fairly predicable seasons year after year.
The easiest way to see the upward trend would be to do a simple linear regression of "Hours" against time and have Minitab (the program used for this analysis) fit a trend line. The results are presented next. Visually, you can see the positive upward slope of the blue trend line. The equation confirms this because the slope of the trend line is positive.
5. The Regression Model Conceptually:
The above analysis suggests that we have to model a trend and seasonal data. This is why it makes sense to include the trend and season variables.
The general estimation equation that Minitab will estimate takes the following form:
Estimated Hours = b0 + b1 "Time" + b2 "2nd Qt" + b3 "3rd Qt" + b4 "4th Qt"
b0 is the constant term or intercept term
b1 is the slope term or coefficient on the "Time" variable
b2 is the coefficient on the "2nd Qt" variable
b3 is the coefficient on the "3rd Qt" variable
b4 is the coefficient on the "4th Qt" variable
We can easily derive from this equation the estimation equations for each quarter. This is done simply by substituting in the appropriate 1's and 0's into this general estimation equation for each case.
The estimation equation for the First Quarter:
The first quarter is captured when "2nd Qt" = 0; "3rd Qt" = 0; and "4th Qt" = 0.
Estimated Hours for the First Quarter = b0 + b1 "Time"
The estimation equation for the Second Quarter:
The second quarter is captured when "2nd Qt" = 1; "3rd Qt" = 0; and "4th Qt" = 0.
Estimated Hours for the Second Quarter = b0 + b2 + b1 "Time"
The estimation equation for the Third Quarter:
The third quarter is captured when "2nd Qt" = 0; "3rd Qt" = 1; and "4th Qt" = 0.
Estimated Hours for the Third Quarter = b0 + b3 + b1 "Time"
The estimation equation for the Fourth Quarter:
The fourth quarter is captured when "2nd Qt" = 0; "3rd Qt" = 0; and "4th Qt" = 1.
Estimated Hours for the Fourth Quarter = b0 + b4 + b1 "Time"
In other words, we have four estimation equations, all with the same slope (b1) but with different constant terms or intercepts.
6. The Regression Output and Interpretation:
Here are the regression results. I have included four forecasts for times 67, 68, 69, and 70, i.e., forecasts of "Hours" for 3rd Quarter 1996, 4th Quarter 1996, 1st Quarter 1997, and 2nd Quarter 1997.
The regression equation is
Hours = 968 + 0.938 Time - 342 2nd Qt - 472 3rd Qt - 230 4th Qt
Predictor Coef SE Coef T P
Constant 968.39 16.88 57.38 0.000
Time 0.9383 0.3377 2.78 0.007
2nd Qt -341.94 17.92 -19.08 0.000
3rd Qt -471.60 18.20 -25.91 0.000
4th Qt -230.23 18.20 -12.65 0.000
S = 52.25 R-Sq = 92.4% R-Sq(adj) = 91.9%
Analysis of Variance
Source DF SS MS F P
Regression 4 2012975 503244 184.34 0.000
Residual Error 61 166526 2730
Total 65 2179502
Durbin-Watson statistic = 1.48
Predicted Values for New Observations
New Obs Fit SE Fit 95.0% CI 95.0% PI
1 559.65 17.39 ( 524.87, 594.43) ( 449.54, 669.76)
2 801.96 17.39 ( 767.19, 836.74) ( 691.85, 912.08)
3 1033.13 17.56 ( 998.01, 1068.25) ( 922.91, 1143.35)
4 692.13 17.56 ( 657.01, 727.25) ( 581.91, 802.35)
Values of Predictors for New Observations
New Obs Time 2nd Qt 3rd Qt 4th Qt
1 67.0 0.00 1.00 0.00
2 68.0 0.00 0.00 1.00
3 69.0 0.00 0.00 0.004 70.0 1.00 0.00 0.00
The Minitab output begins with the regression equation. Instead of using b0, b1, b2, b3, b4 as generic coefficients, the program has substituted in the regression estimates for these values. The coefficient value of 0.9383 is positive. This positive value makes sense; it tells us that if we increase "Time" then the Estimated Hours will go up. To see this, take a look at the First Quarter Estimation equation.
Estimated Hours for the First Quarter = b0 + b1 "Time"
Or, if we substitute in the values for b0 and b1 from the regression equation we get:
Estimated Hours for the First Quarter = 968.39 + 0.9383 "Time"
The t-tests and p-values are meant to determine whether or not the coefficients are significantly different from zero. We want them to be different from zero. The fact that all the p-values are much less than 0.05 is very good news. In fact, all the p-values are below 0.01. This tells us that we can reject the null hypotheses that each population coefficient is 0.
The R-sq or R-squared statistic is a measure of the ratio of sum of squares regression divided by sum of squares total. (These numbers come from the Analysis of Variance chart immediately below this statistic in the chart above.) In this case, the 92.4% means that 92.4% of the variation in "Hours" is explained by the predictor variables. This means that most of the variation that we want to explain has been explained.
The analysis of variance table also reports the F statistic with the associated p-value. The F-Test tests the null hypothesis that ALL the slope coefficients are zero. In this case, the null hypothesis is that b1 = b2 = b3 = b4 = 0. With the p-value virtually zero and the F-value so large, we can conclude that at least one of the four regression slope coefficients is different from zero. This again is a good sign. We want this result since we want to find values different from zero.
The Durbin-Watson statistic is important for model checking. It is meant to check to see whether positive first-order autocorrelation exists in the residuals or error terms of the regression model. The error terms are supposed to be independent and normally distributed with a mean of zero and a constant variance. With time series data, we can easily run into the problem where the error term in one period is related to the error term in the preceding time period. This is the issue that the Durbin-Watson test is addressing.
I ran the Durbin-Watson test manually (I had to look up the values in a table). I used n = 65 for the sample size (even though the real sample size is 66) since 65 is the closest entry in my chart. I used k = 4 since there are four independent variables in this model (i.e., "Time", and the three dummy variables). I used the significance level of alpha = 0.05. From the chart we get upper and lower bounds for the Durbin-Watson test.
dL = 1.47 (lower bound)
dU = 1.73 (upper bound)
DW = 1.48 (the Durbin-Watson statistic from the regression results above)
Unfortunately, we have situation where lower bound < DW < upper bound (specifically we have the situation where 1.47 < 1.48 <1.73. Therefore, the test is inconclusive.
A deeper analysis would continue with the residuals or error terms of the model. We would investigate the autocorrelation functions to see whether any of the lagged residuals display significant correlations. When I did this, I found that most of the lagged correlations are fairly small. The largest value was 0.24. Also, none of the black bars penetrated through the red-line or confidence interval. This implies that none of the lagged correlations are significantly different from zero. This is a good sign. We want the errors to be random; hence, we do not want to find patterns in the error terms over time.
Then, I did some predictions using Minitab to forecast four future observations on "Hours." The program first estimates the fitted value. This is simply done by sticking in the appropriate values of the predictor variables into the appropriate estimation equations. Then, the program calculates 95% CI (confidence intervals) and 95% PI (prediction intervals). What is going on here is that the fitted values are guesses and so they have to be interpreted with care. The intervals are trying to capture certain aspects of uncertainty in calculating these fitted values. For example, we have to take into account the fact that data points do not fall perfectly on our estimated regression line. Moreover, we have to also take into account the fact that we are estimating a sample regression line and not the population regression line. Maybe this company has additional years of data before 1980--maybe going back to the 1920s. We have not used all of this data and so we cannot know for sure whether our sample regression line is similar to the population regression line. Because of these uncertainty issues, Minitab gives up these ranges of values--ideally we want the range of possible values for the forecast value to be as small as possible.