Oil Prices: A True Black Swan or the Work of Vultures?
Oil prices are struggling to stabilize in the wake of what some are calling a “black swan” event.
It refers to a theory popularized by Nassim Nicholas Taleb, a well-known risk analyst and statistician.
A black swan is an outlier, a development that fails to follow any normal pattern.
According to Taleb, a black swan event has three characteristics:
1. It is a surprise. Nothing in the past can convincingly point to its possibility.
2. It has a major impact.
3. People contend that they expected the event to take place (in hindsight).
To put this theory into perspective, Taleb considered World War I, the breakup of the Soviet Union, and 9/11 as examples of black swan events, so these are hardly everyday occurrences.
Almost 15 years ago, Taleb applied this approach to the stock market and has been a regular on financial TV ever since, especially when things seem to be taking a turn for the worse.
As a consequence, this has led to the black swan being used as an “explanation” for all kinds of things. It’s the obverse of the mantra “this time is different.”
And that leads us back to the true nature of the 40% drop in oil prices…
Oil Prices: A Fall that’s Hardly “Out of the Blue”
Over the past couple of days, I have seen three separate prognosticators claim that the stunning fall of crude is a black swan event.
It isn’t. But calling it one may be a good way of clouding up what really is happening.
First off, there were always indications on both the supply and demand side that matters were softening. Second, the OPEC non-decision on Thanksgiving to keep production levels unchanged was both predictable (from the Saudi perspective) and telegraphed in advance. Then, the orchestration of the talking heads commentary on the tube made the whole move “legitimate.”
This is hardly something that emerged out of the blue. It’s also not the stuff of a true black swan.
Unless, of course, there is another motive at work and the black swan becomes a convenient cover. Instead, this is what is really happening when it comes to oil prices.
Yes, there are traditional pressures driving down the price of crude. Rapidly increasing supplies and slower demand would have created a correction in oil prices in any event.
But dropping over $40 a barrel has required something else entirely.
Let me explain.
When it comes to oil we are in a new age of massive short plays and swaps. The coordination of these moves is staggering, creating an impact that is immediate. Especially if there is a segue to important policy makers.
For instance, a Kuwaiti official tells the world oil can fall to $60 and… presto, within 48 hours, that’s where oil lands.
Of course, the targets of all of this are well known and have been discussed here at length: Russia, recalcitrant members of OPEC, and U.S. shale producers.
But the vehicle for turning some oil minister’s pronouncement into the “reality” of a futures contract price is found elsewhere.
Working Both Sides of the Pricing Curve
It involves an element I have had my eye on for a while, and was something I was tracking during my recent string of foreign meetings. It’s the positioning of sovereign wealth funds (SWFs).
These funds have been designed to invest the proceeds from national revenues. Usually, the better a country’s balance of payments, the stronger the SWF. This is always a result of a trade surplus – as more is exported out of a country (being paid for by somebody else) than is being imported (requiring payment).
China, for example, is in this category.
But most of the SWFs of consequence involve investing the proceeds of oil sales. In the case of oil producers, that has usually meant the success of an SWF was perceived as dependent on the price of crude. The higher the price, the greater the leverage for an SWF.
Now these funds are almost always conservative, preferring guaranteed or long-term gains over a higher but riskier return. That explains SWF investments in Rockefeller Plaza and hotels on the one hand, or dull but secure 1.5% annualized return from somebody else’s sovereign low-interest bond on the other.
There is also the problem of limiting the financial downside from introducing the proceeds directly into a domestic economy. Given that oil revenues are in U.S. dollars, a direct flow into the economy ends up inflating the local currency rather quickly.
So the proceeds from export sales are largely segregated from domestic trade, kept outside the country, with the profits from investing introduced in ways to minimize the inflationary impact.
All of which has triggered a new development. SWFs have now become a player in the market, shorting the very product responsible for the funds to begin with. In other words, some OPEC members are making money on both sides of the crude pricing curve.
Transacting the deals outside their own borders via SWFs, these countries are hedging the product in both directions. That means they are currently pushing the lower cost of crude forward by pairing shorts to actual oil consignments.
Plain and simple: This is manipulating the market. It’s equivalent to being a poker dealer who is able to read everybody’s hand while taking a seat at the table.
But there is one thing it certainly isn’t. This is no black swan event.
It looks more like vultures to me.