When analyzing oil markets, use your own judgment – experts often know less than you

The general population forms opinions by absorbing the flow of headlines that bombard the senses; for peripheral topics like energy there is little time or inclination for most to dig deeper. The same happens with financial industry media coverage. One forms opinions based on the preponderance of evidence (that is, the headlines) and it often is too intimidating to challenge predominant themes, or too much of a pain to try. The logical assumption, arrived at in lieu of a lot of digging, is that a general consensus of the world’s (loudest) commentators is bound to be right.

But that notion is demonstrably incorrect, as was proven beyond a shadow of a doubt in 2008 when housing markets collapsed. Thousands of experts were wrong, even Federal Reserve chairman Alan Greenspan. Some examples are more illuminating than others. Here’s a good one in case you missed it (or are under the age of 8). It well demonstrates a fallibility that we often forget is ever-present.

In 2008, the global economy nearly imploded because certain very skilled salesmen convinced us that low borrowing costs and limited housing supply would keep home prices escalating indefinitely. It was a near unanimous viewpoint that house prices would not decline materially, because, well, that just didn’t happen. There is plenty of anecdotal evidence that that was a new truism. One particular statement on the topic sort of set the high water mark though. It comes from a book by a Wall Street egghead named Richard Bookstaber entitled A Demon of Our Own Design. The book is about market crashes and the perils of financial innovation (the author was a pioneer in quantitative analysis and risk management for some of Wall Street’s top banks and hedge funds).

Bookstaber is one of the legendary “quants”, highly educated (PhD) mathematicians and programmers from the best schools (MIT) who developed sophisticated computer models to create trading and investment strategies. Many of these models generated strong initial returns for hedge funds, therefore attracting ever increasing amounts of capital.

What makes Bookstaber’s book so remarkable is that this Wall Street genius at one point in the book walks the reader through a typical modeling example that is so utterly and absolutely wrong that it is hard to believe. Remember, this is not a backwoods rube plotting to rob a gas station. In the book that was published in 2007 (the date is significant, being it was published one year before “mortgages” became a 4 letter word), Bookstaber walks through the complexities of mortgages, and how one must be very careful building a risk-analysis model. Here is his jaw-dropping comment on building an effective model to value the garbage that was being put into mortgage-backed securities: “Mortgages have little in the way of default risk, so if you can get rid of the prepayment risk you have a bond that will feed a huge market.”

Again, remember that this was from one of the “smartest guys in the room”, who lived and breathed this data, and thought he understood the risk better than anyone. The book quoted above is a doctorate level analysis of how financial crises develop and what to do about it, and buried within his very own argument Bookstaber invalidates pretty much every other word he wrote. (I am not holding my breath for an updated version.) In fact, within a year he and his ilk almost blew up the financial world. It’s hard to convey the magnitude of this irony; it’s impossible to even dream up a more perfect example.

What does this have to do with oil markets? Well, it’s a warning flag to those who think that a preponderance of opinions means anything at all. Recently we’ve seen a spate of headlines about how rising oil prices are putting rigs back to work. Oil futures fell on the news. The storyline was laid out so as to be obvious to anyone this side of a donkey: rising oil prices were putting rigs back to work, which will crank up output, fuel the glut, and drive prices down. Any fool could see it. The forward markets agree; oil doesn’t hit $55 on US futures markets until 2020.

But just as with the housing/financial collapse, the contrary evidence is not hard to see. The more-rigs-are-active theory doesn’t even make a whiff of sense, at anything close to these levels. Ten rigs added in the US is a meaningless statistic. In late 2014 there were 1,600 rigs drilling for oil in North America; in early 2016 the total fell to 350. That’s meaningful. When that lowly total jumps by 20, it’s not.

This all-eyes-on-the-data habit loses sight of the fact that oil is a globally traded commodity. Global rig counts are fairly stable (for the last few months) at just under 1,000 active rigs; US totals are moderately stable at about 400 rigs (including 80 gas hunters). Consider that the world produces and consumes 95 million barrels per day. How would a change of 10 or 20 or even 50 active rigs mean anything? It’s not like rig counts went to zero in the downturn; a leap from zero to fifty might have been meaningful or at least noteworthy. But a fluctuation doesn’t mean there is a story. It means there was a fluctuation, which is then fixated on by the media. The variance might be two companies, blowing their brains out to meet a target, who knows? No one asks, they just fit a story to the fluctuation.

When we read those stories, we presume a band of geniuses is behind the scenes ensuring the story is unassailable. Yet remember how wrong a true expert was in the housing blow up. Bookstaber is not an idiot and at the time his book came out it would have sounded highly intelligent and harmonious with the prevailing thought tides. Yet he made the most fundamental error imaginable because he simply accepted conventional wisdom on what turned out to be a rather important point. There is sometimes great danger in accepting that conventional wisdom without question. The current equivalent is the hordes of analysts and commentators that piled on this oil-prices-are-doomed theory; they are no different.

In part, this tendency occurs because local phenomenon are taken as a proxy for the world, again with little thought added. Venezuela and Nigeria are on the brink of losing much of their output (out of a combined total of 4 million b/d) because they can’t pay any bills and are being terrorized, respectively.  Several million b/d could be lost. To boost US production by 2 million b/d would take a thousand rigs drilling for two years, at least. Yet the market reacts more strongly to the miniscule rig count change, because they are lemmings.

But that’s just the way the world works. It’s up to each of us to measure the worth of what we read, and whether it’s useful information, and worth investigating, or just part of the herd mentality. Don’t assume there will ever be retractions if the information is dead wrong. In fact, you can probably expect the opposite: Wikipedia now praises Bookstaber’s book as “being noted for its foreshadowing of the financial crisis of 2007-08.” I presume Mr. Bookstaber’s mother maintains that page.

Don’t accept these headlines without some critical thought; decide for yourself if the trajectory of rig counts heralds the return of meaningful production growth, for example. Look beyond sensational headlines and impressive IR presentations from companies that are incongruously going bankrupt. Look at widely available data to test the headlines for common sense. It’s not a matter of pointing out that someone is wrong, it’s a matter of not letting lazy data analysis shape our view of the world.