We're In a Market Where Oil Confirmation Bias Persists
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We’re In a Market Where Oil Confirmation Bias Persists

by | published October 23rd, 2019

Recently, several analysts have been talking (again) about something called confirmation bias.

This is a term used to describe when somebody applies explanation, data, opinions, and, upon occasion, distorted reasoning to justify a conclusion they had made before the whole process began.

We see this approach often in politics, where practitioners skew information so that it conforms to a preordained partisan world view. Sort of like cognitive dissonance on steroids. In fact, entire TV networks are built on it.

But it is hardly limited to election cycles.

For a while now, such bias has been present in how people read the trends in crude oil pricing.

Here, confirmation bias emerges when one is justifying a call on the direction of oil based on elements other than simply what the market may be actually saying. The better part of the process involves attempting to factor into the calculation what broader economic and financial considerations may mean on the demand side.

The less defensible intentions mirror investment moves that have already been made by the pundit. These are more often seen these days in bias-supporting shorts on oil. Moves to profit from a price decline receive a self-justifying confirmation from selective “analysis.”

A short makes money only if the underlying commodity or equity moves down in price. The investor borrows shares or control over material contracts and then immediately sells them, returning later to the market to buy them back for return to the source.

Now, let’s put this into perspective with a simple example I usually use in discussing shorts…

Manipulate the Market or Drive a Truck

Say someone is convinced stock ABC will decline (or believes others can be manipulated into believing that will be the case). Shares are re-borrowed and immediately sold for $10 each. The stock does indeed decline, and the investor then later moves back into the market, buys the borrowed shares back at $8 each, and returns them to the source. The result is a $2 profit per share.

Of course, get this wrong and there is theoretically no limit to how much can be lost, since what has been shorted must still be repurchased at market and returned. If you make money shorting, therefore, the underlying commodity’s price must be declining.

Cherry-picking data to persuade others that the sky is falling fattens the short artist’s bank account. I know some highly leveraged players who have never made a move that is not a short. I periodically send them a brochure I sometimes used with my graduate students who were not faring well. It advertises how to learn truck driving in three weeks.

There are also opportunities to run long plays if the price is rising – essentially, buying at a lower price and selling higher. But shorting is much easier, providing that the market agrees with the player’s view on where oil is going.

There are aspects of the market in which shorts provide a liquidity service to rebalance bids and offers. Unfortunately, when it comes to oil the overweighting to the downside has little to do with balancing and mostly to do with making a profit off an artificially created margin.

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Now, the result may well reflect the direction oil is likely to move anyway.

The problem is that heavy shorting also distorts the movement.

How to Estimate Actual Market Conditions

In response to this, which many Oil & Energy Investor readers know, I developed a series of calculations that I term the Effective Crude Price (ECP). ECP attempts to remove excessive short and long plays to estimate a pricing level more reflective of actual market conditions.

My experience over the past two years has indicated that an ECP in either direction of more than a 3% deviation from market price is statistically significant.

An ECP higher than the prevailing market price indicates outside pressure to reduce the price, while one lower points toward an overheated price. The latter occurred immediately following the September 14 drone/cruise missile attacks on Saudi oil assets.

However, more than 70% of the time since the ECP was introduced almost two years ago, when statistically significant anomalies have taken place, they are to the downside.

Shorts remain alive and well, occasionally moving into more dangerous territory where investors may be overreaching. Anecdotal evidence has emerged from the ECP calculations that a portion of the oil shorts are insufficiently offset or not offset at all.

Such offsets show up as hedges (usually employing options) to protect should a market move against the short emerge. “Naked” shorts carry little or no hedging but are cheaper to run. That exposes the short runner to a higher degree of risk and also reflects a more desperate attempt to generate a profit.

Okay, projecting an environment meant to drive prices down is essential to a successful short.

Enter, once again, the use of confirmation bias.

Confirmation Bias at its Finest

Successful shorts often make profits at the margin; that is, a slight swing in market perception is sufficient.

Notice how the confirmation bias roles out, especially with certain TV talking heads who are there to front short moves. A shorthand is used to signal the expected market response.

Whenever prices begin rising, here is a quick usage of five rejoinders, with used individually or in tandem. Each one is a good example of confirmation bias. To the extent that any data are involved at all, they are not drawn from normal indicators of market performance but from extrapolated “evidence” based on where prices are expected to be.

The five current elements utilized are the following:

  • The slowdown in the Chinese economy,
  • Concerns over a global market decline,
  • Sketches of forward demand projections,
  • U.S. production levels, and
  • How quickly Saudi volume is coming back online.

Each of the above is selectively used to discount a price rise and there are substantive rejoinders to the way each is used. But the formula remains the same: “Oil prices are increasing but are capped by continuing concerns over [take your pick, any or all of the above].”

There are counter pressures arising as well. The main one this week is over the now almost certainty that OPEC will increase production cuts to offer any pricing slide.

That is hardly what the short artists need to hear.

The market we have is never the textbook “perfect” model. Matters are always a bit out of joint. But what we have had given to us is a “balance” with thumbs pressed down on one side.

At least, until these guys figure out some other way to make money off of artificial manipulation.

Sincerely,

Kent

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