Saudi Oil: Through the Looking Glass & Other Adventures in Investing

About a month and a half ago I wrote an article on the sudden drop in oil prices, pointing out some basic errors in the media analysis and providing alternative interpretations for what was going on. The media flurry continued, and the errors in reporting and analysis also continued. So I wrote a second article diving in deeper into the analysis. The media storm continues unabated. To understand the insanity, Reuters on 17 November reported that hedge funds where net short oil. On 8 December Reuters announced that hedge funds were net long oil. What gives?

How is an investor or a businessman going to make head or tail of conflicting reports from the same media organisation? Even if both are correct, the second report should have at least explained what appears to be a contradictory statement. But as I will show, there are serious issues in the reporting.

The November report states that in the 20 weeks to 4 November hedge funds sold the equivalent of 244 million barrels of oil. Astounding! To be fair, the report points out “such a turnaround was bound to accelerate and magnify the price drop.” But to be accurate, the report should have put this in context. The 244 million barrel sale over 20 weeks represents the equivalent of production cuts of 1.7 million barrels per day. To understand what this might mean, Iran reportedly proposed cuts of only 1 million barrels per day to counter the price slide.

So what does this mean? I would argue that if we were going to accept that hedge funds cut their positions by 244 million over 20 weeks then they did not accelerate or magnify the price drop, they were the cause of it!

So what gives with the second report apparently contradicting the first report? One possible answer is that hedge funds changed their minds and in 3 weeks reversed their positions again back to their original stance. It’s possible. It may even be probable. But there are competing interpretations. One that needs us to look beyond these fantastic numbers and understand what is the information that Reuters is using to come to their temporally challenged conclusions.

The less gullible reader of the reports might notice that the first one uses the acronyms CFTC, NYMEX and WTI. Hmmm. Let’s not bother trying to understand just now. Let’s simply pattern match. Flip to the second report and, would you believe it, they use ICE, Brent and gasoil. Hmmm indeed. What have we here?

Far too often reading media reports is akin to being a detective. Sherlock’s eye for detail, Columbo’s nose for the inconsistent, and, lord help us, Kojak’s incorruptible tenacity. Why is one Reuters reporter basing his conclusions on WTI crude traded on the NYMEX exchange whilst another one is using Brent, and gasoil(?!), traded on ICE?

Why does one reporter think that a net long position of 90 million barrels of oil on ICE is relevant, when earlier in the year 2.5 times that amount was sold on NYMEX? Even more puzzling, the hedge fund net long position on NYMEX after the massive sale was still nearly 2 times their net long position on ICE after the massive buying.

Sherlock: “Columbo, notice how they keep talking about hedge fund net positions only!”

Columbo:”Good point. Reuters, why wouldn’t you talk about the net oil position of the whole market?”

Kojak:”Stavros! Get me a lollipop and a SWAT team, I’m bringing them in.”

I’m no Agatha Christie, but you get the point. His name is Theodore by the way. Kojak that is. Theo to his friends.

Maybe Reuters is only looking at hedge funds because they are so smart and we should do what they do. Cue maniacal laughter. Or if you are more mentally stable, a simple “pfft!” might do.

So where does this leave us? I’m thoroughly confused and I’m the one writing this article. Let us summarise the issues.

The main problem, and this is not Reuter’s alone, is one of faulty generalisation. The reporters took some data that at first blush looks interesting and rather than put in the work to properly investigate they jumped to a conclusion. Hedge funds sold oil contracts on the NYMEX. Incorrect (printed) conclusion: They reduced their overall position. Correct initial conclusion: This is interesting, let me (1) talk to the hedge funds to see why they did that, (2) see who else is making big moves in the oil market to see what the wider pattern is, (3) check markets other than the NYMEX to see if the aggregate positions have decreased or not, (4) talk to the main OTC players for non exchange traded oil contracts (e.g. swaps) to see what is happening there, (5) check the relevant non derivatives oil securities for trades that might be related, e.g. were the hedge funds massively short the oil companies (Exxon, Shell, BP) and they wanted to hedge out oil price movements by buying oil futures so that they could isolate oil business exposure? (6) etc.

This unproven conclusion is sold to the public via several methods. The first is misleading vividness, or providing a lot of detail (NYMEX, CFTC, ICE, Brent, WTI, hedge fund positions, anything to do with gasoil and lots and lots of numbers) that masquerades as research and analysis. The presence of detail does not mean it is relevant in any way.

Next on our list is post hoc ergo propter hoc which is Latin for “after this therefore because of this.” Hedge funds sold after oil price dropped, therefore the oil price move triggered the sale (see oil company position hedge above). ICE futures positions increased, so hedge funds must have stopped selling and started buying (maybe the funds that were short oil took profits by reversing their positions). The last three times I wore my blue tie to a meeting, the meeting went well, so wearing my blue tie causes good meetings (maybe it’s the red tie that is the magical one).

Then we have the fallacy of equivocation which is the misleading use of a term with different meaning. Oil can mean WTI, Brent or many other things. Exchange can mean NYMEX, ICE or many other exchanges. When talking about budget break even, which budget period are we talking about? Last year, this year or next year?

Finally we have incomplete comparison whereby the short term effect of lower oil prices on oil producers is applied solely by looking at the revenue effect and no analysis of the boost to the global economy and its effect on oil producers’ economies, especially in the long term.

I think we’ve covered enough in terms of logical fallacies. It is important to understand that I am not saying that the conclusion is false, it is just incorrect given the presented facts. I also am certainly not saying that the reporters or Reuters have tried to misrepresent anything. In a fast paced carbon dependent world where does one draw the line in balancing detailed analysis with timely reporting?

So what can we conclude? In the absence of detailed data, here are my views, which are indistinguishable from random guessing:

  1. Oil price effects on global economic revenues are zero sum: Revenue drops by oil exporters match exactly cost savings by importers. By definition.
  2. Oil price declines lead to increases in global economic growth.
  3. Issues relating to the effect on investment in alternative energy sources is a red herring. If oil is cheap, why waste money finding a replacement for oil? Why not use the money to better the world in different ways, say by finding a cure for cancer? When oil price goes back up, then would be a good time to go back to investing in alternative energy.
  4. Oil exporting countries that are reliant on oil revenue do not randomly set a budge and then pray to God that oil remains above that point. They set a budget based on where they think oil will be. They happen to be intelligent that way.
  5. 99.9% of the people in this world will benefit from the lower oil prices, including those in most oil exporting countries.
  6. OPEC can barely influence oil prices to the upside and have next to no ability to influence it to the downside (pumping at capacity, baby!).
  7. Since it is much more sensationalistic if oil price movements up or down are always bad, that economic woes will increase, that evil cartels are manipulating prices and harming alternative energy sources (Climate change! Climate change!), focussing on the rich 0.1% is better than the 99.9% (“Woe is me Felicity, but I can no longer afford the butler!” “But Pippa! Who will serve tea? Surely not you!”) and since sensationalism sells, well there you go.

I hope that I have shed enough light on this issue. I would like to think of myself as the auditor of truth, honesty and the capitalistic way. Yes, I may occasionally indulge in the very fallacies that I rail against. And who knows, my use of Latin phrases every now and again could be snobbish intellectualism masquerading as education and illumination. But if in the end I can help guard against misdirection and unfounded conclusions, watching over information and protecting it from corruption, then I consider my work done.

Just one more thing: Quis custodiet ipsos custodes?

In memory of Peter Falk and Telly Savalas. Who loves ya, baby?

You may also enjoy two related articles on oil: Saudi Oil Price and Saudi Oil Price Redux.