Oil Prices: A True Black Swan or the Work of Vultures?

by | published December 18th, 2014

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.

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  1. Carla Dancey
    December 18th, 2014 at 13:06 | #1

    How long can the oil prices stay down, with so many countries depending on higher prices to stay afloat?

  2. Ella
    December 18th, 2014 at 21:04 | #2

    I second that question!! How long can the oil prices stay down, with so many countries depending on higher prices to stay afloat?

  3. December 18th, 2014 at 21:08 | #3

    Great article!! Was this driven by the us expanding shail oil production? A $40 drop im oil price could not have been produce by the us increasing its production. Refining capacity is still the same.

  4. Cheryl Whiteley
    December 19th, 2014 at 01:33 | #4

    When do you expect the play to end and why?

  5. Steve Rison
    December 19th, 2014 at 09:49 | #5

    One thing about SWFs is not clear to me. You say that SWFs are created from national revenue generated by trade surpluses, and you give China as an example. But isn’t the bulk of the trade between China and the US conducted between businesses, and not between the governments? If business “A” in China manufactures widgets and sells them to company “B” in the US, or vice versa, how does that result in any direct revenue to a government? It seems to me that SWFs will only exist in countries where the governments actually own the natural resources that are sold or traded, or where the governments impose fees and taxes on the exploitation and export of those commodities. But I don’t see any connection between business-to-business trade and SWFs. Am I missing something here?

  6. December 21st, 2014 at 11:13 | #6

    @Steve Rison

    Regarding the question on what is the source of China’s SWF accumulation, it might work like this:
    a) US company buys and imports from Chinese company; and
    b) Remits in U.S. dollars to Chinese company.
    c) Chinese company exchanges U.S. Dollars to Chinese government for local currency (renminbe) equivalent;
    d) Chinese government assigns U.S. dollars to Chinese SWF and prints up (out of thin air) renminbe equivalent to offset payment made to Chinese company.

  7. Albert Bignell
    December 28th, 2014 at 17:21 | #7

    Could the drop in price have anything to do with ISis taking over oil fields in the middle east? i.e reducing their sell-on profits!!?

  8. Dave Hughes
    January 31st, 2015 at 11:12 | #8

    So if I am reading this right the OPEC members likely shorted oil when it was between $80 to $100 and are now delivering on those short contracts . So they are still getting more that $80 a barrel for the oil that is selling now for $45. Well that’s pretty sneaky . So how far out into the future can one sell futures contracts on oil . ? . I would assume that that will tell us when oil is likely to rebound . Once all the $80plus shorts have been filled the game is up .

  9. Dave Hughes
    January 31st, 2015 at 11:18 | #9

    Obviously whoever is on the other side of those short trades lost a lot of money . Was it institutions or individuals . We do not seem to be hearing to much about who is on the loosing side of those trades ,,,,,,,,,yet .

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