Reflexivity Theory And $60 Oil: Fairy Tales or Great Depression?

``Oil prices are coming down for all the wrong reasons: low economic growth and low demand. What we are not seeing is oil prices coming down because there is new supply coming on to the market or because the world has got more efficient.” Tony Hayward, BP chief executive

Allow me to disinterest you with a prosaic discourse on market psychology. Why? Because psychology drives the markets more than anything else. Said differently, economies and or markets are driven by people’s incentives to act for a particular goal. And present activities seem to reflect emerging signs of inconsistencies enough to make us discern that some prices haven’t been reflecting “reality”, but of “perceptions” of reality.

Since we will dwell much of successful speculator George Soros’ “reflexivity theory”, this also means we will be having a quote-fest from Mr. Soros.

Understanding George Soros’ Reflexivity Theory

Let me begin with Mr. Soros’ fundamental explanation of the Reflexivity theory [The Alchemy of Finance p. 318]

``The structure of events that have no thinking participants is simple: one fact follows another ending in an unending casual chain. The presence of thinking participants complicates the structure of events enormously: the participants thinking affects the course of action and the course of action affects the participants thinking. To make matters worst, participants influence and affect each other. If the participants’ thinking bore some determinate relationship to the facts there would be no problem: the scientific observer could ignore the participants’ thinking and focus on the facts. But the relationship cannot be accurately determined for the simple reason that the participants’ thinking does not relate to facts; it relates to events in which they participate, and these events become facts only after the participants’ thinking has made its impact on them. Thus the causal chain does not lead directly from fact to fact, but from fact to perception and from perception to fact with all kinds of additional connections between participants that are not reflected fully in the facts.

``How does this complex structure affect the ability of an observer to make valid statements about the course of events? His statements must also be more complex. In particular, they must allow for a fundamental difference between past and future: past events are a matter of record, while the future is inherently unpredictable. Explanation becomes easier than prediction.” (all emphasize mine)

Essentially, there are three variables that shape the reflexivity theory: facts, events and perception.

Let me cite a hypothetical situation:

Fact: Falling Prices or bear market

Event: Official Recession is declared

Perceptions:

1) Concerns about recession prompt for falling prices.

2) Falling prices impels the perception of an economic recession.

The dilemma: This becomes a chicken and egg problem of having to ascertain which among the two comes first or which causes which?

In the same plane, we ask “does the causal chain equate to events (recession) reinforcing the facts (falling prices) or has the facts (falling prices) been shaping events (recession)?”

Facts or events are always seen from the privilege of hindsight or ex-post. But since people don’t exactly know the future, it is always easier to explain away as predictions by the convenience of associations, buttressed by additional connections, the past activities. Essentially, such predicament represents as feedback loop transmission which predominate the thinking process operating in the marketplace.

And where such feedback loop gets bolstered-both falling prices and economic weakness are increasingly being felt and validated-the tendency is to draw enough “following” or “crowd” to shape the growing conviction into a major trend or into a socially accepted and popularly entrenched view or belief.

A vivid empirical example, a non-financial or non-market practitioner neighbor whom I recently bumped into at the local “sari-sari” store confidently insisted to me that the Philippines will experience an “economic recession” in 2009! Wow. Obviously his pronouncements had either been influenced by the headlines from the broadsheet or from news broadcasted by the media airwaves.

Now going back to the feed back loop mechanism of falling prices and recession, such chain of linear “cause-and-effect” thinking leads to the point where the denouement extrapolates to our perdition, or said differently, the ultimate outcome from such induction process is that prices will fall to zero and or society will stop functioning-which is nothing but plain balderdash.

If the US is now in the “eye” of the recession storm, it means that many parts of its “complex” or highly structured economy, which has been unduly boosted by tremendous doses of debt driven malinvestments, are presently enduring from a painful but necessary adjustment process which involves the clearing out of such excesses.

But it doesn’t mean that ALL of the US economy is suffering, because people’s lifestyle fine tune under dynamic operating conditions. The fact that the world’s largest publicly listed company (money.con.com) and retail behemoth Walmart reported a 10% rise in profits (Reuters) amidst the third quarter squall suggest of the societal response to income elasticity of demand, where changes of income prompts for a change in consumption pattern. The truism is that people will continue to live or society will continue to exist, even at more financially or economically difficult environment, but some sectors are likely to benefit from such adjustments.

The other obvious point is that the present “prevailing bias” dynamics (of falling prices-deleveraging/recession feedback loop) will eventually outlive its usefulness, whose popular convictions will extend to the extremes and morph into a false premise.

To quote Mr. Soros anew, ``Economic history is a never-ending series of episodes based on falsehoods and lies. The object is to recognize the trend whose premise is false, ride the trend, then step off before the premise is discredited." (highlight mine)

Reflexivity and Oil Prices: Spotting False Premises?

In recognition of a trend whose premises could seemingly false, where prices don’t square with economics, oil prices could be an embodiment.

The fact: Prices for oil as measured by the WTIC (West Texas Intermediate Crude) have been in a bear market. To date, prices have lost some 60% from its peak last July.

The event: Pronouncements from energy authorities that demand growth could become negative.

This excerpt from Wall Street Journal (highlight mine): ``The International Energy Agency warned Thursday that world oil-demand growth this year is on the cusp of falling into negative territory for the first time in 25 years, as global economic problems hammer away at energy consumption.

``In a new twist from past months, the agency also substantially lowered its forecast for oil demand in China and other emerging markets, where much of the growth in energy consumption is coming from. The IEA cut its expectations for demand in 2009 in these nations by 260,000 barrels a day.

``The IEA, in its monthly oil market report, said world oil demand will grow by 0.1% in 2008, down from a previous growth projection of 0.5% and far below the 1.1% growth in 2007. Globally, consumers and businesses will use on average 86.2 million barrels a day, 330,000 barrels lower than IEA's previous report.”

The popular perception: Falling demand have sparked a fall in oil prices. Falling oil prices reflect oil demand deterioration. So a feedback loop between falling demand and falling oil prices have fundamentally been reinforcing each other.

In our latest outlook, Demystifying the US Dollar’s Vitality we noted how OIL prices peaked at the same time the US dollar bottomed. We equally pointed out that the rapid pace of acceleration in the surge of the US dollar (as measured by the US dollar index basket) mirrored the sharp degree of descent by oil prices where we opined that the carry trade of being “short the US dollar- long commodities” have basically been unwinding.

We also posited that the all important driver that has virtually been encompassing the divergent global markets- such as the surge in the US dollar, the downside volatilities in the ex-US dollar currencies (except the Yen), the crash of the oil, commodities, emerging markets, the widening of various credit spreads, the collapse of asset backed markets, commercial paper markets, globally stock markets, surfacing of various crisis in different nations (such as Iceland, Hungary, Pakistan, South Korea etc.) and the disruptions in trade finance-have been the ongoing debt deflation or “deleveraging” dynamics.

The recent seizure of the credit markets and the ensuing gridlock in the US banking system has fundamentally impaired the flow of financing enough to have a substantial spillover impact to the global economy.

Thus, the prevailing bias or perception has been one of decelerating global economic dynamics prompting for the selling pressure in oil prices as indicated by the above by the Wall Street report.

And amidst falling oil prices and empirical evidences of deteriorating global economic growth, the feedback loop transmission of falling prices and falling demand has now been fostered into a conventional theme.

So where does this race to the bottom all stop?

With such linear based thinking, some questions pop into our mind: will oil fall below $50 to $10 per barrel or even to zero? Will people shun traveling? Will commerce stop? Will our lives grind to a complete halt?

The world is evidently so consumed with the Keynesian brand of economics, where almost everything seems centered on demand aggregates such that the mainstream appears to have forgotten the supply side variables.

It’s Not All About Demand, Supply Matters Too

Here is where we part with the consensus.

Figure 1: IEA World Production By Source In The Reference Scenario

As Figure 1 from IEA world energy outlook 2008 shows how conventional oil fields (dark blue) are expected to rapidly deteriorate following a “peak” by 2010.

And even without the popular political rhetoric of “energy independence” (an issue we will discuss in the future), such a gap would need to be filled by new oil fields or non-conventional oil or natural gas liquids.

According to the IEA fact sheet, ``The world’s endowment of oil is large enough to support the projected rise in output, but rising oilfield decline rates will push up investment needs. Proven reserves of close to 1.3 trillion barrels equal more than 40 years of output at current rates; remaining recoverable resources of conventional oil alone are almost twice as big. But there can be no guarantee that those resources will be exploited quickly enough to meet the level of demand projected in our Reference Scenario. Decline rates – the rate at which individual oilfields decline annually – are set to accelerate in the long term in each major world region. The average observed decline rate worldwide is currently 6.7% for fields that have passed their production peak. This rate rises to 8.6% in 2030.” (underscore mine)

This means that massive investments are needed to cover such deficits.

But the question is, how will the investments come about and where will the investments come from when access to credit have been severely limited, or if not, the cost of money have been pricier, or oil prices have not been enough to prompt for a revenue stream required to fund or finance future oil projects?

Windfall Profit Taxes and Fairy Tale Oil Prices

Figure 2: Agorafinancial.com: Estimated Cost of Oil Production

Figure 2 shows that at $57 oil, most of the alternatives to the conventional oil have been rendered unfeasible, as present prices appear to be at below the estimated cost of production. This also means at present prices oil companies, whether state owned or privately owned companies are suffering from losses.

Proof?

From Timesonline.co.uk (highlights mine),

``Leading Russian oil producers, including TNK-BP, BP's Russian affiliate, are grappling with a collapse in profits from the export of Siberian oil.

``Heavy export tariffs have almost wiped out the profit margin from selling crude oil outside Russia, forcing Siberian producers to sell at prices as low as $10 a barrel on Russia's domestic market. Fears are mounting that the profits squeeze may speed the decline in Russian oil output, already down 6 per cent this year.

``The profits crunch, caused by the collapse in the worldwide price of crude, is provoking concern within Russia's oil community that capital expenditure budgets will have to be cut if profits from oil sales do not recover. “The tax burden is very tough,” Valeri Nesterov, an oil analyst at Troika Dialog, the Moscow brokerage, said. “The problem is that the future of the oil sector might be jeopardised if the Government doesn't reduce the tax burden.”

As you can see, high taxes and a sharp drop in oil prices pose as double whammies and threaten to curb the immediate supply in the global oil markets as capex are likely to get excised if losses continue to mount.

Besides, high taxes are products of reactionary government policies aimed at attempting to secure more revenues in anticipation of “eternally” high oil prices.

This should also serve as lesson to windfall profit advocates. What has been missed by governments and their social liberal proponents of taxing windfall profits are that

1) Oil is a cyclical commodity

2) Oil prices are never permanent and subject to the balance of demand and supply

3) High taxes tend to compound the miseries of oil companies when prices become unfavorable.

4) Profits are needed to fund or finance future oil or energy supplies.

5) Speculation or “greed” does not drive oil prices as evidenced by the 60% loss from the top.

To quote Steven Landsburg, ``Most of economics can be summarized in just four words: People respond to incentives. The rest is commentary."

More proof?

Figure 3 ntrs.com: Mexico’s Rapidly Declining Crude Production

Mexico, the third largest oil exporter to the US following Canada and Saudi Arabia (EIA) has been encountering a precipitate decline in oil production as shown in figure 2. The Cantarell oil field which accounts for 60% of Mexico’s oil production has been declining at a rate by nearly 20% and could reach 30% (oil drum).

Remember, about 40% of state revenues come from the oil industry which means unless Mexico’s economy diversifies or expand its oil output, the country runs the risk of declining revenues, which given the present conditions of state spending could lead to a debt default.

Yet for years, Mexico has prohibited foreign companies from exploring on its national geography, which has been controlled by state owned monopoly the PEMEX. But recent events have reinforced the political and economic exigency to expand production by accepting foreign investments. Hence, the Mexican government, despite the unpopularity of the measure, has signaled its willingness to subcontract exploration and drilling to foreign companies (time.com).

To quote James Pressler of Northern Trust, ``The only thing that could make this situation worse for Mexican oil production would be an actual storm. The Mexican government, seeing the same warnings we are, has finally passed a much-contested and watered-down energy reform bill to get the sector back in shape by allowing foreign investment – though some fear that it is too little too late. The concern is that the weak legislation is not nearly enough to reverse the strong, downward trends of the oil sector. The justification: Pemex posted a $1.3 billion loss in Q3 as crude production fell almost 10% from a year ago. Clearly, it’s going to take a lot of foreign investment to turn Pemex around, and a lot of time. The real question is, will any private firm invest now that oil has fallen below $60 pb, the credit markets have all but seized up, and Mexican security conditions have worsened?”

And just how much investments are needed to bring supplies on stream to balance with demand?

Mr. Byron King writing in the Rude Awakening from agorafinancial.com gives us a clue,

``According to the IEA, even with massive levels of investment in the oil patch, the best estimate is that the global oil industry can reduce the rate of depletion to perhaps the 6% range. So the world energy industry will have to run faster just to keep from falling too far behind the demand curves.

``Again, you need to keep in mind that current energy prices are just too low to support the level of energy investment that the world needs going forward. (Meanwhile, the U.S. government is spending trillions of dollars just to bail out the banks and bankers, not one of whom runs pump jacks.)

``The IEA estimates that the oil industry will have to invest over $350 billion per year to counter the steep rates of decline in output. And even that will not be sufficient to maintain levels of output for traditional forms of crude oil. Thus, much of the future investment will have to go toward extracting other kinds of hydrocarbon substances. And these "other kinds" tend to be very expensive to develop.”

In addition, capital cost expected for the energy sector is projected at $26.3 trillion going into 2030 with 52% of the total or $13.2 trillion earmarked for the power sector and the balance for upstream oil and gas industry (IEA). Over the present term some of this are at risk.

So unless the world falls into a great depression (version 2.0), which seems unlikely unless global government start erecting barriers that would restrict trade and finance flows, the likelihood is that oil demand trends will continue to be strong over the medium to long term and will pose as hazardous strain to the demand-supply equation.

From the basis of the continuance of present government policies, the IEA also predicts that the “primary demand for oil (excluding biofuels) rises by 1% per year on average, from 85 million barrels per day in 2007 to 106 mb/d in 2030”, where most of these demand would come from non-OECD countries, see figure 4.

Figure 4: IEA Estimated Change in oil Demand by Region

From the IEA, ``These global trends mask big differences across regions. All of the projected increase in world oil demand comes from non-OECD countries. India sees the fastest growth, averaging 3.9% per year over the projection period (to 2030), followed by China, at 3.5%. High as they are, these growth rates are still significantly lower than in the past. Other emerging Asian economies and the Middle East also see rapid growth. In stark contrast, demand in all three OECD regions (North America, Europe and the Pacific) falls, due to declining non-transport demand. The share of OECD countries in global oil demand drops from 57% in 2007 to 43% in 2030.”

Conclusion: Groping For A Guidepost

As you can see based on the above projections, oil below $60 dollars hasn’t been unambiguously reflective of real world economics. To paraphrase Agora’s Byron King, $60 oil seems priced at “Fairy Tale” levels.

Instead, oil at $60 has been a function of indiscriminate selling, triggered by the massive waves of debt deflation or delevaraging dynamics.

This downside overshoot only aggravates the structural imbalances in the supply demand equation over the medium to long term basis that risks an equivalent fierce overshoot to the upside once the present trends inflects or reverses.

This also means that while oil prices can remain at depressed levels as global financial markets attempt to find its footing, from which George Soros once observed ``“When a long-term trend loses momentum, short-term volatility tends to rise, it is easy to see why that should be so: the trend-following crowd is disoriented”, the brewing imbalances are likely incite a sharp recovery perhaps sooner than expected.

Furthermore, this also demonstrates how market psychology works; the public has been anchoring oil prices on the premise of a deep global recession, if not a great depression from a prospective an OECD deflationary environment. The latter idea is something we don’t share unless governments, as we stated earlier, start erecting firewalls.

As in the case of Zimbabwe, we understand that a government determined to inflate don’t need a functioning private credit system in order to inflate.

All it needs is 24/7 full scale operations by the printing presses and an expanding network of bureaucracy (or helicopters). As we noted in Black Swan Problem: Not All Markets Are Down!, its 231,000,000% (hyper) inflation has prompted for a year-to-date return of 960 QUADRILLION % (!!!) in its stock market as people flee its national currency. Why the refuge in stocks? Perhaps because to quote Mr. Soros, ``stock markets is one of the most important repositories of collateral”.

And as global governments combine to adopt a path to Zero Interest Rate Policy and have been flooding the world with “money from thin air” to rescue entities affected by the bubble bust, this equally reflects another reason why oil at $60 seems like a fantasy.

Finally, Mr. Soros tells us that ``People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

Applied to the oil markets, it simply means that once oil prices begin to reverse, the “expert” rationalizations over “deflation and depression” will likely be replaced with stories of “recoveries” and renewed concerns over inflation.