Behavioral Explanations Make Sense of Oil's Plunge

"The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism," Benjamin Graham and David Dodd wrote in their landmark work on "Security Analysis" in 1934.

"The market is a voting machine, whereon countless individuals register choices, which are the product partly of reason and partly of emotion."

Graham and Dodd became the founding fathers of fundamental analysis and had a huge influence on generations of fundamentally focused investors such as Warren Buffett as well as the Institute of Chartered Financial Analysts.

So there is a certain irony that their work contains one of the most explicit and famous statements about the effect of sentiment, emotion, herding and other non-rational factors on pricing, which are central to modern theories of behavioural finance.

Fundamental analysis and behavioural finance are often set up in opposition to one another. Each has fierce defenders, especially among the fundamentalist school, with many adherents attached to the ideology of the market as an exquisite and infallible measuring instrument.

But fundamentals-only explanations are never terribly convincing. They generally have to torture the data to relate causes and consequences of different magnitudes and time scales.

The best theories about how markets work blend the two. The greatest minds in finance - from economists John Maynard Keynes, Frank Knight and Hyman Minsky to successful investors Buffett and George Soros and top theorists Robert Shiller, Benoit Mandelbrot and Didier Sornette - have all mixed fundamental and behavioural approaches.

A mixed approach is the only way to make sense of a plunge of more than 40 percent in benchmark Brent prices in just over five months (http://link.reuters.com/bes53w).

CATCHING UP WITH SHALE

Fundamentals-only approaches cannot explain such an enormous turnaround in such a short space of time, while there has been only a small shift in underlying supply and demand.

"Notice how it all happened at once," Harold Hamm, the chief executive of shale driller Continental Resources (CLR), told Forbes magazine in an interview published in October ("Why Harold Hamm isn't worried about plunging oil prices," Oct 20)

"It is not supply-demand related," he complained. "The market is not in glut." Instructed by Hamm, who also owns most of the company's shares, Continental monetised its hedges for 2015 in the expectation prices would bounce back.

Instead prices have fallen further. On Friday, Continental's share price fell 20 percent in a single day after OPEC decided to leave output unchanged and Saudi Oil Minister Ali Naimi reportedly declared a price war on U.S. shale drillers at the organisation's meeting in Vienna last week.

Hamm is right there have been no developments over the last five months sufficient to explain such a large price swing. Libya's resumption of war-ravaged exports appears to have been the immediate trigger, but a tenuous increase in output of less than 1 million barrels per day is not sufficient to explain the magnitude of the fall.

Instead, the market is finally catching up with a fundamental shift that has been playing out for at least the past three years but is only now being reflected in prices.

For three years, the transformative potential of shale oil production in the United States has been evident to anyone who looked at the monthly production statistics published by North Dakota's Department of Mineral Resources, the Railroad Commission of Texas and the U.S. Energy Information Administration.

But for most of that time, the sustainability and implications of the shale revolution were downplayed by the majority of oil experts, as well as by investors and OPEC itself. (http://link.reuters.com/byq53w)

For almost the same period, the slowdown in oil demand growth has been similarly evident, with oil consumption in the advanced economies having peaked between 2005 and 2007 and now stagnating.

The data has all been there in plain sight in the EIA's consumption statistics and the quarterly filings of the airlines, railroads and trucking firms.

But it was rejected or interpreted away, because it did not fit the dominant narrative and was not incorporated into prices.

NEW NARRATIVE DAWNS

Markets can sustain a dominant narrative for a long period, even when it is no longer consistent with the evidence, as group-think and herding behaviour cause inconsistent data to be rejected.

But fundamentals do reassert themselves eventually. The dominant narrative begins to break down and a new interpretation breaks through.

Behavioural finance is the medium through which fundamentals are transformed into prices by means of telling stories about the world.

The big fall in oil prices has arisen because the market has suddenly started to incorporate three years or more of fundamental data to form a new narrative.

It is not the fundamentals that have suddenly changed; in truth they have been shifting since at least 2011. It is the market's interpretation of them.

Fundamental approaches can explain the slide in prices needed to rebalance the market, but only behavioural approaches can explain why the adjustment has been concentrated in such a short period.

Mixed fundamental-behavioural explanations can explain why Hamm was wrong to dismiss the price fall as "a case of the emperor has no clothes".

Mixed explanations can explain the sudden surge in volatility after a period of prolonged and abnormally low volatility.

And mixed explanations strongly suggest the market is likely to overreact, with prices overshooting on the downside, before establishing a new trading range.

Just as the oil market became locked in a bubble in the first half of 2008, with prices rising exponentially towards the peak in July and becoming increasingly volatile as liquidity evaporated, the same processes are now at work on the way down.

By John Kemp