Herding Behavior

The bandwagon on $100 oil filled up very quickly. I thought we were likely to see $100 oil next year, which is why I have consistently said I wouldn’t make that bet on oil prices for 2008. But, if you look back just a couple of months ago, nobody was calling for $100 oil this year. In early August, WTI was hovering in the low $70’s. That’s when you need your financial advisor to step up and say “$100 oil is coming fast.” That would be a gutsy call. Yet it would be a call supported by pretty much the same fundamentals that are in place now (with the exception of Iraq/Turkey). After all, supply and demand projections are pretty much on target from what they looked like in August. Nothing has dramatically changed. If anything, the supply picture looks a bit better with OPEC cracking the taps a bit.

So why did oil have to go through $85 with a bullet before the chorus for $100 oil became loud? $100 oil by the end of the year is now conventional wisdom. The experts on CNBC are telling us to brace for it. We are given this information as if we can’t deduce for ourselves that the chance of $100 oil this year is much higher after the rapid rise into the high $80’s.

This herding behavior is sort of comical to watch. We saw it on Black Monday. I noticed it when ethanol stocks were riding high in the first half of 2006. I thought most were overvalued. In fact, I wrote my first article on overvalued ethanol stocks in June 2006 in response to an article the previous week that urged investors to embrace ethanol stocks. As ethanol stocks drifted lower and lower, the herd started to defect. But they didn’t defect until the slide was well underway. Why didn’t they defect early, based on the fundamentals? Because that’s not the way a herd behaves. (I grant that there are lots of exceptions). I sometimes wonder about the ratio of people doing fundamental analyses to those just parroting the work of others and getting paid for it.

Finally, ethanol stocks were down 60% and the remainder of the herd awoke from their slumber. Ethanol stocks became a poor investment, and the remaining holdouts finally said “Perhaps we should downgrade ethanol stocks from hold to sell.” It’s the same kind of herding behavior that pushed some tech stocks from $5 to $150 to $2 in the late 90’s.

Back to oil prices, there was a very funny column in yesterday’s Houston Chronicle that explains oil prices are so volatile:

A day in the life of an energy trader

Here are some excerpts (OK, extensive excerpts!) that capture the gist:

It was just another day on the trading desk at Flippum Energy Partners. I decided to drop by and see what the traders thought about crude oil prices, which closed above $89 a barrel Thursday, setting a record.

“The prices have consumers worried. What does it all mean?” I asked Lefty Dollarhyde, the head trader. “It means oil is going to $100 a barrel before Thanksgiving,” Lefty said. He spoke without taking his eyes off of the bank of computer screens in front of him. Their glow bathed him like a tanning bed. He hammered furiously on the keyboard.

“What can we do?” I asked feebly over the clacking.
“Go long oil. That’s what we’re doing. We’ve maxed our position.”
“If oil keeps rising, doesn’t that mean gasoline will soon follow?”
“Nah, we’re short gasoline. Nobody’s driving.”
“OK. If nobody’s driving, then won’t demand for oil eventually fall?”
Lefty’s fingers froze over the keys. He paused for a moment, then leaned back in his chair and called to another trader sitting in the next row.

“Hey, Slick! Check the stockpiles. Whatcha got?” Slick responded with a litany of numbers and place names, but he talked so fast I couldn’t write them down. Lefty returned to the screens. He picked up the phone and punched in a few numbers, cradling the receiver on his shoulder. If I understood his staccato instructions, he was placing an order for January puts, a bet that prices would fall. I was confused.

“Didn’t you just say oil was going to $100?” “Nah,” he said, the phone still against his ear. “Stockpiles are fat. It’s going down. It’s nuclear winter, baby. A major glut. We’re shorting crude big time.”

As Lefty typed furiously, I looked around and saw a group of traders gathered around a television across the room. They appeared to be ogling Maria Bartiromo. Suddenly, one of them turned away and shouted in our direction.

“Lefty! Turkey’s amassing troops at the Iraqi border. It looks like an invasion.”
Geopolitical scares Lefty unleashed a string of profanity so foul it singed the pages of my notebook from 2 feet away. He shook his head. “See? Geopolitical conflict. That’s what it’s all about. We got a new war. No oil’s getting through. Bundle up, baby, we’re all burning trash to stay warm this Christmas.”

He was on the phone again, going long on crude. As he put the receiver down, Herb Flippum, the firm’s founder, walked up. We chatted a few minutes as Lefty continued to stare at his computer screens. Flippum patted Lefty on the shoulder.

“Hey, Lefty, remember my neighbor who bought that huge SUV, the Ford Subdivision? He told me this morning he’s selling it and getting a Yaris.”

Flippum walked off shaking his head and chuckling to himself. Lefty was already on the phone. “That’s what makes us different. I factor anecdotal evidence into my positions. If a guy’s selling his SUV for an econo-bug, that tells me demand is falling off. Prices will hit $75 before they hit $100.”

He leaned back in his chair to catch his breath. He looked at me, as if he just realized I’d been sitting with him all morning. “So, what do you want to know?”
“Well, I was hoping to explain to my readers what’s happening with oil prices.”
“Oh,” he said with a shrug. “You just have to understand the markets.”

Don’t get me wrong. I obviously believe the underlying fundamentals strongly favor higher oil prices going forward. But I know what’s going to happen if the herd now spooks in the other direction. Monday is the last day for trading the November WTI contract. I think you will see a lot more volatility with the December contract, which becomes the front month contract on Tuesday.

13 thoughts on “Herding Behavior”

  1. Call it Thug Oil vs. Peak Demand. Which will prevail?
    In the short run, alway bet on the thugs. And the current thugocracies look strong. It pays to be a thug backed up by oil money. You have guns, money and power.
    Longer run? Bet on man’s brains.
    Check out The Energy Blog today. A battery car with more than 100 mile range will come to market in Norway in 2008. And the city of Ann Arbor is installing LED city street lights.
    Look for radical declines in fossil oil demand if this price regime holds.
    Oil may hit $100. If it does, probably a good time to go out a few years and buy $40 puts. But even $90 may be a good time to do that.
    2009 Dec. $40 puts are selling for $140. Buy 10, be prepared to piss it away. That’s $1,400.
    My guess is that you will triple your money well before Dec. 2009.

  2. At some point, probably before I moved toward S&P 500 Index Funds and CDs, I decided that “prices just are.”

    That was like 10 years before I read Taleb, but after I had read Bogle

    At the same time, I believe that price resistance levels are real, and breaking through them demonstrates … something.

    The “what” they demonstrate though gets a little fuzzy.

    You know, one of the interesting things Shiller did, since he was into this already, was call a group of investors right away, in the middle of Black Monday. He asked them its cause, and basically they had a dozen different reasons. But tricky guy that he was, he sent them all surveys six months later. He asked them what they thought at the time.

    Can you guess? They’d settled into the agreed post-hoc analysis, and remembered that they those concerns (program trading, whatever) at the time.

    This differed from what they said they felt in real-time.

    Funny stuff. Prices are. And human reactions to the vary.

  3. Over at The Oil Drum, they’ve got T. Boone Pickens saying “I don’t know where the world chokes on the price.”

    I’ve seen alot of comments like this in the last few months, particularly in the context of people wondering that we haven’t already choked. This often goes along with speculation that OPEC had, in the past, kept prices under $50/bbl out of fear of crashing the economy, and has now decided (based on recent events) that that isn’t a concern, leaving them free to take profits.

    What I have not seen, but have wondered about, is the potential for a form of “overshoot” in the economic sense. Our economy’s productivity is tied to cheap energy. But our economy is enormous and very complex, so it has alot of inertia. That inertia will tend to increase the response time between a signal (rising energy costs) and feedback (economic slowdown). It is also largely debt-based, which will only serve to increase that delay time.

    It seems to me that, based just on this qualitative, gut level perspective, likely that when we finally do see the economic impacts of expensive energy we may find that we have greatly overextended ourselves in the time between the onset of the signal and the arrival of the first strong feedbacks.


  4. Here’s a thought: From a low of just over $50 a barrel in January, oil prices on the futures market have surged nearly 75 percent. Yet the economy remains relatively healthy, corporate profits are holding up well.
    Even taking inertia into account, it seems that the run on oil prices (up what? 450%+ since December 2001) has apparently had a minimum impact on the global economy. It’s not going to change in one month. Or even six.

    Perhaps our economy’s productivity is not tied to cheap energy. We’ll find out soon enough, but the evidence is building…

  5. Perhaps oil is just like any other commodity: prices go up and two things happen: 1. You cut your consumption. 2. You look for alternatives.

    Granted, alternatives look quite pathetic, even at $85/bbl. But then, even the airlines are surviving $85/bbl.

    Perhaps $85/bbl (or beyond) is what it takes for us to use energy wisely.

    PS. Ben will you shut up about the ghost of Peak Demand until you have some proof that it is happening? $85/bbl should choke demand, but so far the evidence is rare. Your predictions about future oil prices are downright hilarious. BTW, are you actually backing this big talk up with real investments? Just a question.

  6. Greenengineer wrote: “What I have not seen, but have wondered about, is the potential for a form of “overshoot” in the economic sense.”

    Sure, why not?

    But if you are coming at this from my angle you’d think about the concrete probability of any of these futures coming true.

    Most often we say “I think X will happen” and then, sotto voce, make a bet on X (or not).

    The probabilities are not concrete and often not stated explicitly at all. Further, projections are often discarded (“my bet was good, and if it hadn’t been for this Turkish thing …”).

    Taleb reminds us that our odds were supposed to be good, “Turkish thing” included.

    (Robert is a stand-up guy for not taking that easy way out.)

  7. greenengineer, boom / bust cycles are what you see in a system where response seriously lags input, and there is no damping factor.

    Industries where capacity increases take years to accomplish are examples, they typically overbuild capacity in response to high demand, then suffer overcapacity afterwards.

    The economy is complex, but not all parts of it have slow response times. And not all energy uses are inelastic.

    The big problem with most oil alternatives is scale, they don’t scale well.

    Lithium ion batteries have technical issues, and after those are overcome, there is still the scaling issue; just how much lithium is it going to take to outfit even half of the cars on the road, and how do we dispose/recycle those batteries? And at what cost?

    Space Based Solar Power avoids the ground based solar scaling issues, but it requires cheap orbital capacity, which we don’t have yet, and has a huge up front cost.

    Nuclear is the only power technology we have in hand at the moment, and there is promising work being done in IEC fusion (by the way, Dr. Bussard did get the funding to continue)

  8. a study of history, current eco/geo politics, and world population status/trends may be the better choice of data/analysis to use for coosing financial instruments for growth.

    it has long been obvious that the other 4 billion folks on planet saw what was happening; deciding it was their turn at the trough the rest was momentum on their part and obsrvation/selection by the investor[or other possible beneficiary–bin laden ??

    thus the current commodity bull/$$$ growth. the precise timing of detail happenings[oil price levels, e.g. ] is as it occurs.

  9. anonymous, from my “bogle” link above:

    “The statistic that is most often quoted in this regard is that over time, 80% of actively managed funds lag the simple S&P 500 index, with dividends reinvested.”

    I think the thing to think about is: how smart are fund managers? If they are “smart,” why do 80% fail to beat simple index funds? This really reaches out beyond the narrow mutual fund focus of Bogle’s book.

    Certainly mutual fund companies have motivation to hire the very best investment thinkers available, and if that’s the best … how good are the other folks, and the folks in other fields?

    (esp. in fields that may not have decades of reference data like index averages to compare with!)

  10. maybe to your “broad movement” point, sure globalization and growth are driving this … but no one has a predictor for when that will hiccup.

    no one had a predictor for the japanese slump, the dot-com bubble, the housing bubble.


    think worldwide on the subject.

    the japanese experience came to an end.
    the tech bubble ende.

    here we are in worldwide bull growth[those experiences aside]

    there will be periodic crash setback. growth will start again, after each setback.

    that’s been history to date. i’ll bank my remaining years on that premise.

  12. My bet on growth is similar, with S&P 500 index funds. But there have been long periods of bear markets, in living memory. We had 20 years of inflation-adjusted loss from the 1960’s to the 1980’s.

    Now of course we are all shaped by this amazing 25 year bull market. We’d like to think such markets go on forever …

    On commodities, remember the Simon-Erlich wager.

    Are you making the same bet Ehrlich did, only now?

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