Black Swans in the Oil Patch

September 5th, 2013
in contributors

by Robert Rapier, Investing Daily

The petrochemical industry deals with flammable materials that are often hot and under pressure. Keeping those materials controlled and contained is imperative if accidents are to be prevented. One of the most important aspects of my job as an engineer has always been to identify, quantify, and then reduce the risk so that energy is produced and delivered without harm to employees or the general public.


Follow up:

As a result, I have always been interested in low probability, high impact events. These are discussed in detail in Nassim Nicholas Taleb's excellent book The Black Swan: The Impact of the Highly Improbable. As Taleb writes, "A black swan is an event, positive or negative, that is deemed improbable yet causes massive consequences."

The Fukushima nuclear accident in Japan has been called a black swan by some. For others the accident was the result of an engineering design error that failed to properly assess the risk of a large tsunami striking the plant (not exactly a black swan in coastal regions prone to earthquakes). In any case, the accident provides a perfect example of a failure to properly assess risk and consequences.

While this concept is critical to understand when attempting to engineer safety into designs, it is also of vital importance to investors. In fact, Taleb has said that 97 percent of all the money he has ever made was made on Black Monday - Oct. 19, 1987 - when the Dow Jones Industrial Average fell 22.6 percent in the largest one-day drop in US stock market history.

The reason Taleb made so much money is that he had been making bets on out-of-the-money puts, which under most circumstances were consistently losing him small amounts of money. But in the event of a very large drop in the stock market, that payoff could be - and ultimately was - huge.

The potential for these sorts of low-probability, high-impact events has influenced the way I invest. In the history of oil production, there have been a number of events that have caused oil prices to spike suddenly and significantly. Some examples are the 1973 Arab oil embargo, the Iranian Revolution in 1979 and the subsequent Iran/Iraq war, as well as the Gulf War in 1990.

While prices retreated following each of these spikes, history shows that sharp oil price movements are almost always up rather than down. So the Black Swan, at least in theory, ought to be an oil investor's friend.

Another way to think about this is to consider that a million barrels a day of oil production can be disrupted much faster than a million barrels a day of new oil production can be brought online. The former will cause a sudden spike in the price of oil in a tight market, while the latter has the potential to cause a gradual decline in the price of oil (assuming demand growth doesn't consume that extra capacity).

This is one of the reasons that I believe that when oil prices break out of the current trading range - and they have been edging toward the upper end of that range because of recent events in the Middle East - it will be to the upside.

China's expected increase in energy consumption increases those odds.

The Energy Information Administration (EIA) recently released its International Energy Outlook 2013 (IEO2013). The report forecasts that world energy consumption will grow by 56 percent by 2040, with developing countries increasing their consumption by 90 percent.

This growth will be driven largely by China's expected economic growth:

China, US, India energy demand forecast chart

I have many colleagues who don't believe China will see this kind of growth, because they don't believe that much energy will be available. This sets up a potentially intense competition for future energy supplies. If China's growth turns out to be anywhere close to this projection, there will be enormous implications for the global energy markets. I will discuss some of these in upcoming issues of The Energy Letter and The Energy Strategist, but consider for a moment the effect on the oil markets.

It is not a coincidence that, over the past decade, China's sharp rise in oil consumption took place even as oil prices doubled, and then doubled again. Global oil production expanded, and demand contracted in many developed countries, but China's increasing oil demand ensured that there was never enough spare production capacity to significantly moderate oil prices.

If the EIA forecasts are to be believed, consumption growth in China over the next 30 years is going to look very much like it did over the past 10 years. If that is true, then the oil markets will remain tight.

In that case, it is far more likely that a black swan event will cause oil prices to race to $150 rather than drop to $50 a barrel. If oil supplies are tight, a disruption in supplies from any major supplier will have a disproportionate effect on oil prices. Revolution in Saudi Arabia, for example, could take 10 percent of the world's oil supply off the market. In that case, there isn't nearly enough spare capacity to make up for the shortfall, and oil prices will very quickly skyrocket.

A sustained oil price shock would rock portfolios and imperil a wide variety of industries. But owning shares in an oil producer would provide some insurance against this possibility.

Selectivity is important. A refiner or pipeline company, for instance, won't help with a surge in oil prices. But portfolios with a position in a dedicated oil producer or three should get along better with the black swans that may roil the oil markets in the years ahead.


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