Group think and conventional wisdom…

“It will be convenient to have a name for the ideas which are esteemed at any time for their acceptability, and it should be a term that emphasizes this predictability. I shall refer to these ideas henceforth as the conventional wisdom.”

J.K. Galbraith, The Affluent Society

 

“All that we imagine to be factual is already theory: what “we know” of our surroundings is our interpretation of them”

Friedrich Hayek

 

We find broad- based and significant evidence for the anchoring hypothesis; consensus forecasts are biased towards the values of previous months’ data releases, which in some cases results in sizable predictable forecast errors.

Sean D. Campbell and Steven A. Sharpe, Anchoring Bias in Consensus Forecasts and its Effect on Market Prices

Great quote in the $FT yesterday that reveals how hard it has been in the oil and gas industry for professional analysts to read the single biggest influencing factor that is reshaping the supply chain: rising CapEx productivity and its ongoing continued pressure. Money quote:

Mr Malek said that with the notable exception of ExxonMobil, most energy majors had shown they were capable of growing output quickly even when investing less than it used to.

“We all thought production was going to fall off a cliff from Big Oil when they started slashing spending in 2014,” said Mr Malek. “But it hasn’t. The majority of them are coming out on the front foot in terms of production.” [Emphasis added].

#groupthink 

An outlook where E&P companies can substantially reduce CapEx and maintain output is not one in a lot of forecast models. Forecasts are rooted in a liner input/out paradigm that leads to a new peak oil doomsday scenario. But the data is coming in: E&P companies are serious about reducing CapEx long term and especially relative to output, and collectively the analyst community didn’t realise it. The meme was all “when the rebound comes…” as night follows day…

The BP example I showed was not an aberration. For a whole host of practical and institutional reasons it is hard to model something like 40% increase in productivity in capital expenditure. But the productivity of E&P CapEx, along with the marginal investment dollar spend,  has enormous explanatory power and implications for the offshore and onshore supply chain.

Aside from behavioural constraints (partly an availability heuristc and partly an anchoring bias) the core reason analysts are out though is because their models are grounded in history. Analysts have used either a basic regression model, which over time would have shown a very high correlation between Capex and Output Production, or they simply divided production output by CapEx spend historically and rolled it forward. When they built a financial model they assumed these historic relationships, strong up until 2014, worked in the future… But these are linear models: y if the world hasn’t changed. The problem is when x doesn’t = anymore and really we have a multivariate world and that becomes a very different modelling proposition (both because the world has changed and a more challenging modelling assignment). We are in a period of a  structural break with previous eras in offshore oil and gas.

These regressions don’t explain the future so cannot be used for forecasting. No matter how many times you cut it and reshape the data the historical relationship won’t produce a relationship that validly predicts the future. At a operational level at E&P companies this is easier to see: e.g. aggressive tendering, projects bid but not taken forward if they haven’t reached a threshold, the procurement guys wants another 10k a day off the rig. There is a lag delay before it shows up in the models or is accepted as the conventional wisdom.

SLB Forecast.png

Source: Schlumberger

Over the last 10 years, but with an acceleration in the last five, an industrial and energy revolution (and I do not use the term lightly) has taken place in America. To model it would actually be an exponential equation (a really complicated one at that), and even then subject to such output errors that wouldn’t achieve what (most) analysts needed in terms of useful ranges and outputs. But the errors, in statitics the epsilon, is actually where all the good information, the guide to the future, is buried.

But when the past isn’t a good guide to the future, as is clearly the case in the oil and gas market at the moment, understanding what drives forecasts and what they are set up to achieve is ever more important. How predictive are the models really?

A lot of investment has gone into offshore as the market has declined. A lot of it not because people really believe in the industry but because they believe they will make money when the industry reverts to previous price and utilisation levels, a mean reversion investment thesis often driven on the production rationale cited in the quote. Investors such as these have really being buying a derivative to expose themselves, often in a very leveraged way, to a rising oil price, assuming or hoping, frankly at times in the face of overhwelming contrary evidence, that the historic relationship between the oil price and these assets would return.

These investors are exposed to basis risk: when the underlying on which the derivative is based changes its relationship in its interaction with the derivative. These investors thought they were buying assets exposed in a linear fashion to a rising oil price, but actually the structure of the industry has changed and now they just own exposure to an underutilised asset that is imperfectly hedged (and often with a very high cost of carry). Shale has changed the marginal supply curve of the oil industry and the demand curves for oil field services fundamentally. Models utilising prior relationships simply cannot conceptually or logically explain this and certainly offer zero predictive power.

The future I would argue is about the narrative. Linking what people say and actions taken and mapping out how this might affect the future. To create the future and be a part of it you cannot rely on past hisotrical drivers you need to understand the forces driving it. Less certain statistically but paradoxically more likely to be right.

The oil price meme…

As the oil price passes USD 80 there is a really interesting post (lengthy, but great) here from Epsilon Theory on memes:

If you get nothing else from Epsilon Theory, get this: we are ALL hard-wired — literally hard-wired through millions of years of neurological evolution — to respond positively to effective meme introduction. We are ALL programmed — literally programmed through tens of thousands of years of cultural evolution — to respond positively to effective meme introduction. It’s no exaggeration to say that our biological and cultural symbiosis with memes defines the modern human species. This is a feature, not a bug.

Eusocial animals (the “pure” form of what it means to be a social animal) swim in an ocean of constant intra-species communications. It’s why these species — the ant, the termite, the bee, and the human — are the most successful multicellular animal species on the planet. Eusocial animals have the ability to store, retrieve and broadcast information (yes, eusocial insects communally “remember” incredibly complex informational structures) in a way that non-eusocial animals simply can’t, and it allows the eusocial animal not only to survive its environment, but to master its environment. Any environment. Humans are essentially giant termites with opposable thumbs and fire, and that combination is particularly unstoppable. But it’s the termite-ness … it’s the swimming in an ocean of constant intra-species communication … that’s the most important of these qualities.

Right on cue this week the FT carried a piece from the research firm Energy Aspects:

While there has been breathless attention paid to prompt Brent prices climbing to $80 a barrel for the first time since 2014, what has received less attention is that the entire Brent forward curve is now trading above $60, including contracts for delivery as far out as December 2024.

This development is an important psychological milestone for the oil market. The market is, in effect, saying that “lower for longer” is dead. (Emphasis added).

Narratives and memes are getting a lot of focus in economics for the right reasons as the above authors realise.

The Bank for International Settlements this week came out with some research that suggested 30-35% of the movement in oil prices was down to demand and supply and the rest of the movement down to potentially financialisation, speculation and other factors.

Another of the big (related) reasons for the procyclicality of the oil price (which the BIS touch on) is the structutral nature of the trading firms in the oil market. When the price is going up CFOs/Risk Officers feel good because they are buying at 70 and selling at 75. So bid/ask spreads narrow, inventory goes up, leverage goes up, and risk is on… whereas on the way down the value of inventory is declining, leverage does down, the bid ask spreak widens, volumes drop… we’ve been here before. Where we haven’t been before is in an oil market where a marginal producer has potentially such a powerful impact on the market.

Overdiscounting… the future of offshore…

The qualities most useful to ourselves are, first of all, superior reasons and understanding, by which we are capable of discerning the remote consequences of all our actions; and, secondly, self-command, by which we are enabled to abstain from present pleasure or to endure present pain in order to obtain a greater pleasure in some future time.

Adam Smith, 1759

 

For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

John Maynard Keynes, 1936

 

The slide above taken from Transocean highlights how competitve offshore has become on a per barrel recovered basis. I’ll ignore the fact that the cost estimates for shale appear high because it isn’t my point: the real point is that to compete in the modern environment offshore oil production will have to be significantly more profitable on a per barrel recoverable basis because there is significant evidence managers underestimate (“overdiscount“) future financial returns the further away they are. Shale returns, while lower, are produced in a much shorter time period than offshore and behavioral finance shows strong evidence that managers prefer these sorts of returns at lower levels when compared to higher returns further away.

In  2011 Andrew Haldane, Executive Director, Financial Stability at the Bank of England, and Richard Davis, and Economist at the Bank of England spoke at a Bank for International Settlements conference and noted:

[r]ecently, in 2011 PriceWaterhouseCoopers conducted a survey of FTSE-100 and 250 executives, the majority of which chose a low return option sooner (£250,000 tomorrow) rather than a high return later (£450,000 in 3 years). This suggested annual discount rates of over 20%. Recently, Matthew Rose, CEO of Burlington Northern Santa Fe (America’s second biggest rail company), expressed frustration at the focus on quarterly earnings when locomotives lasted for 20 years and tracks for 30 to 40 years. Echoes, here, of “quarterly capitalism”.

In 2013 McKinsey & Co and CPPIB surveyed 1000 Board members and found:

  • 63% of respondents said the pressure to generate strong short-term results had increased over the previous five years.
  • 79% felt especially pressured to demonstrate strong financial performance over a period of just two years or less.
  • 44% said they use a time horizon of less than three years in setting strategy.
  • 73% said they should use a time horizon of more than three years.
  • 86% declared that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation.
  • 46% of respondents said that the pressure to deliver strong short-term financial performance stemmed from their boards—they expected their companies to generate greater earnings in the near term.

The implications for offshore investment (decision tree here) versus the certainty of a short payoff from shale investment are obvious. It has been well known in economics for years that managers overdiscount future returns: in behavioural economics it falls under time preference problems. Humans are neurologically wired with a preference for immediacy that affects economic behaviour. As Haldane and Davis make clear:

This evidence – anecdotal, survey, quantitative – is broadly consistent with popular perceptions. Capital market myopia is real.

As early as 1972 Mervyn King, who would later become Governor of the Bank of England, noted that managers in the UK overdiscounted returns from long term investments. This stream of literature dried up as the Efficient Market Hypothesis took over as the vogue theory but it doesn’t change an actual reality.

The fact is that in competition for marginal oil investment dollars there are institutional and behavioural factors pushing for short-term solutions. This article in the Financial Times notes that Shell is under pressure as the CFO hasn’t outlined when the promised $25bn share buyback will start. Do you think the CFO at Shell is pushing for a new Appomattox because it has lower economic costs (but high CapEx) or will she simply seek to favour short pay-off, lower margin, projects?

Managers pushing offshore projects in E&P companies are running into senior managers who represent exactly those type of Board members surveyed by McKinsey and CPPIB. These managers aren’t wilfully myopic, the shareholders are pushing them to be, but they are more focused on immediate payoffs and overdiscounting the costs of the offshore projects. Again this quote from Haldane and Davis seems apposite:

Graham, Harvey and Rajgopal (2005) surveyed 401 executives. They found three striking results. First, managers would reject a positive-NPV project if that lowered earnings below quarterly consensus expectations. Second, over 75% of the sample would give up economic value in order to smooth earnings. Third, managers said that this was driven by the desire to satisfy investors.

When there was no shale this wasn’t an option as the question was “Do you want oil or not?”. The question is a whole lot more complex now and involves and assessment of certainty, risk, payoff potential and timing, and the pricing uncertainty of a volatile commodity over the long run. All this points to the fact the the financial and institutional barriers to new offshore projects are much higher than simple “rational” expectation models of future payoffs would suggest.

 

Investment banking analysts, groupthink, and the space shuttle disaster….

“a mode of thinking that people engage in when they are deeply involved in a cohesive in-group, when the members striving for unanimity override their motivation to realistically appraise alternative courses of action”

Janis, Victims of Groupthink, 1972

The quotes in the graphic above come from an MMA Australia equity placing last year. As a follow on to an earlier post I made regarding equity analysts at investment banks I read this article in the Financial Times Alphaville blog this week which makes essentially the same point:

The problem is that equity research has a famous bias towards positivity. Investment banks seek to do business with companies, which tend to dislike sell ratings. Stock markets spend most of their time rising. Fund managers don’t love to be told their decisions to invest in something is wrong…

So, it is very rare to see more than a quarter of analysts recommend their clients sell a stock

The distribution of ratings bears this out. Goldman Sachs aims to have 10 per cent to 15 per cents of stocks it covers rated as a sell. Morgan Stanley discloses 18 per cent of 3,200 stocks covered are rated underweight/sell. For UBS the global figure is 16 per cent. Investec has just 9 per cent of European and Hong Kong stocks on a sell rating.

How could the offshore analysts of some of the major maritime banks have been so positive when managers in the industry are saying things are very different? And in fact MMA’s latest financial results offer no hope of a market recovery?

Part of the answer I think lies in the psychology of groupthink (a classic article on it is here which applies this logic to the Challenger disaster). Another part of the answer lies in behavioural economics where analysts exhibit a positive confirmation bias, in which they look, and notice, information that accords with their preconceived ideas. This bias comes about understandably because analysts are employed by firms seeking to do business with companies they write reports about (and to be clear analysts who a nicer to managers get preferential treatment). People who want unbiased advice should probably pay for it from someone who owes them a duty of care is my takeaway… but hey I’m biased…