The Oil Investors Who Don’t Even Know It

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The Oil Investors Who Don’t Even Know It by Jason Gilbert, Elliot Turner of RGA Investment Advisors LLC.

Last month we commented on the swift decline in oil prices and its consequences on the economy and your portfolios. This  was by far our most read commentary to date, so
we thank all of you who shared our note with your friends. We have yet to speak of the same topic two months in a row, though given the broad level of interest and immense market impact, we feel this topic is worthy of continuation. Our last commentary left off with the notion that this “new lower [price] level [of oil] is just beginning” and sure enough,
the oil crash of November made October look tame. When all is said and done, this will stand out as one of the most consequential market moves of 2014. The primary US
benchmark for crude oil dropped 17.7% in the month of November alone. In order to fully explain the implications of oil’s move on markets and the economy, we would like to debunk one of the primary myths related to oil’s present drop and further explain what will likely be  the biggest second-­order risk out of the energy route.

We are going to discuss second-­order consequences/risks in the narrative below, but what exactly are we referring to? People (and investors) focus on the immediate result of an action (for example, “My business is running a loss so I decide to cut expenses in order to increase profitability”). Actions, however, often have unintended second-­level consequences beyond the primary scope and intent of the actors (often separated by a duration of time). Consider our first example above about cutting expenses to boost profitability (First order consequence) -­­“Due to staff reductions, my business was unable to adequately serve its clients – we lost 30% of our customers in the 12 months to follow” [Second order consequence]. While our example reflects a favorable intended consequence, it results in an unfavorable second-­order consequence.

This example decision maker failed to consider alternative results from his original decision. Many decision makers in his position fail to consider the gravity of second-­order consequences on their decision-­making in a competitive market. Often (and certainly in the investment realm), successful businesses recognize potential second and third order consequences early and mold their decision-­making around such information. This is part of what we mean when we speak of the investment world as a “complex adaptive system,” whereby relationships between agents and actions are dynamic and impactful upon each other. This also evokes key elements of game theory, where decision-­makers must consider the rationality of their adversaries and the scope of the potential outcomes. The situation in oil markets right now is your classic prisoner’s dilemma and deriving the intent of various actors is important in thinking about future consequences.

The Myth of the Saudi Squeeze:

Things were already looking bleak in oil markets when a Thanksgiving Day OPEC decision to maintain production levels sent prices spiraling downward.1 Since then, conventional wisdom has developed a narrative around how Saudi Arabia is purposely pushing the price of oil lower in an effort to drive US oil producers out of business.2 This narrative is complete bunk on many levels. Understanding why is important for thinking about the second-­order consequences in this context.

Many OPEC members face considerable risk amidst lower prices. Last month we did the back of the envelope explanation for why Russia (a non-­member, but large producer) could not cut its own oil output. This story about budgetary problems is no different for the likes of Venezuela, Iran, Iraq and the United Arab Emirates, all actual members. Two of
these parties—Iran and Iraq—are in the process of ramping production as they are presently under-­producing their quotas. Given this reality, where is there room for production cuts? All cuts would thus fall on Saudi Arabia. In effect, when people speak of OPEC production cuts, they are implying only Saudi Arabian production cuts.

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