Monday, November 30, 2015

Oil, Defaults and Human Behavior

Economics has been greatly enriched by the spread of behavioral insights.

Until the 1990s, economic analysis was dominated by ideas such as “efficient markets” and “rational expectations.” These doctrines were based on the notion that people were robots and would act to maximize wealth in all aspects of their behavior.

It was assumed that if markets were declining, rational investors would enter the market to scoop up bargains. This behavior would tend to stabilize markets and reduce volatility.

It turns out that human behavior is far from “rational” (as economists define it). As the result of some ingenious social science experiments conducted by Daniel Kahneman and others in the 1970s and 1980s, it has been demonstrated that people act in accordance with all kinds of biases and irrational impulses.

If markets are crashing, most investors will panic and dump stocks rather than look around for so-called bargains. More often than not, human behavior tends to amplify extreme movements rather than calm them down.

These biases come in many forms. There is herding (the tendency to follow the crowd), anchoring (the tendency to give too much weight to a particular event) and confirmation (the tendency to embrace data that we agree with and ignore contrary data).

If the crowd tends to be irrational, is there a way for you to remain focused and exploit the irrationality to your advantage as an investor?

The answer is yes, but only if you can overcome the biases of human nature. You need to look for signals (what we call “indications and warnings”) that show you what is really going on.

There is no better example of the tug of war between human bias and market fundamentals than the oil market.

Remember $100 per barrel oil? It wasn’t that long ago. As recently as July 25, 2014, less than 15 months ago, oil was $102.09 per barrel.

What kind of behavior did this high price produce? Many oil producers assumed the $100 per barrel level was a permanently high plateau. This is a good example of the anchoring bias. Because oil was expensive, people assumed it would remain expensive.

The fracking industry assumed oil would remain in a range of $70-130 per barrel. Over $5 trillion was spent on exploration and development, much of it in Canada and the U.S. This led to a flood of new oil, which reduced the market share of OPEC producers. Saudi Arabia was losing ground both to OPEC competitors and the frackers.

In mid-2014, Saudi Arabia developed a plan to destroy the fracking industry and regain its lost market share. The exact details of the plan have never been acknowledged publicly but were revealed to your editor privately by a trusted source operating at the pinnacle of the global energy industry.

The Saudi plan involved a linear optimization program designed to calculate a price at which frackers would be destroyed. But the Saudi fiscal situation would not be impaired more than necessary to get the job done.

A $30 per barrel price would surely destroy frackers but would also destroy the Saudi budget. An $80 per barrel price would be comfortable from a Saudi budget perspective but would give too much breathing room to the frackers. What was the optimal price to accomplish both goals?

Such optimization programs involve many assumptions and are not an exact science. Yet they do produce useful answers to complex problems and are much more reliable than mere guesswork or gut feel.

It turned out that the optimal solution for the Saudi problem was $60 per barrel. A price in the range of $50-60 per barrel would suit the Saudis just fine. That was a price range that would eliminate frackers over time but would not unduly strain Saudi finances.

What makes Saudi Arabia unique among energy producers is that they actually can dictate the market price to some extent. Saudi Arabia has the world’s largest oil reserves and the world’s lowest average production costs. Saudi Arabia can make money on its oil production at prices as low as $10 per barrel.

This does not mean that the Saudis want a $10 per barrel price. It just means they have enormous flexibility when it comes to setting the price wherever they want. If the Saudis want a higher price, they pump less. If they want a lower price, they pump more. It’s that simple. No other producer can do this without depleting reserves or going broke.

- Source, Jim Rickards via Daily Reckoning