Tuesday, December 2, 2014

The two-edged sword of Black Swans - the case of oil


Oil prices have declined by over 35% since the beginning of the year. No one really expected this kind of move and there have not been good explanations for the decline. Our understanding of the oil market may be subject to some major rethinking. This type of surprise from our underlying assumptions is a perfect example of a black swan. Forecasters did not have this drop on their radar.

The supply story explains the decline only if a small change in production will have a major impact on price. The increase in total global production  has been growing at a lower rate than global growth over the last five years even with the impressive increases in US oil shale. There has not been a supply shock in the normal sense.

The demand driven story is suspect unless you believe a small decline in demand will cause a massive price adjustment. Global growth has been revised down in 2014, but the numbers do not suggest a recession. Most of the oil demand increase has come from emerging markets. These economies have slowed but are still growing at much higher rates than the G10 and represent a greater portion of overall demand. 

Regardless of the cause, this oil decline has all of the hallmarks of a black swan. However, investors need to appreciate that all black swans are not bad. For consumers this price decline has become a windfall gain. For oil importing countries, it will improve trade balances. For exporters, the impact is very negative with a significant change in the terms of trade and a reduction in balance of trade surpluses. This decline is a major negative credit event. Companies will fail. Investments and loans will go bad.  Credit risk has increased. None of this was expected.

Black swans will always lead to winner and losers. Investor have to look beyond a one-sided view of market events.

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