Time To Short Oil

by Dr. Rick Nason
Partner
RSD Solutions Inc.

Is it a good time to short oil?  I do not know, but my interest in shorting has been peaked and I will tell you why.

Normally I am not a fan of predicting markets.  Fundamentally I believe that markets are not predictable.  Over time I believe that the markets are more or less Efficient – in the technical use of the word – and thus you cannot reliably, or profitably make predictions about financial prices.  So why do I think it might be a good time now to short oil?  It is simple – because a major oil company has recently announced that it is removing its puts on oil as it believes that oil prices are going to remain sufficiently high.

This is a major Canadian oil company that is active in getting oil out of the Northern Alberta Tar Sands.  While there is plenty of oil in Northern Alberta, it is very expensive to get at.  Oil producers there need to be assured of a sufficiently high price for oil (generally north of mid 50’s) in order to make a profit. 

While I do not have a fundamental problem with a company deciding to hedge or not to hedge, I do have a problem when the company’s hedging decision seems to be totally predicated on their price predictions for the financial variable in question.  Price prediction is not the function of the company – finding and producing oil is their function, and should be their area of expertise.  If they are so good at price prediction, then they should quit the oil business, and just go into the futures trading business.  It is far easier, cleaner, and quicker to make money in the futures market if you are always going to be right about prices, than it is to try and produce the commodity.

When I was structuring derivatives in the early 1990’s, there was a certain high net worth customer who would regularly place the strangest directional trades using some of the funkiest exotic derivatives available at the time.  Figuring out how to hedge these trades was a real pain.  However the customer was always wrong on their prediction for the market direction.  It got to be so bad, that for one specific trade the trader simply decided to leave the trade unhedged, as the track record indicated that this customer was not going to end up in the money (this was a much simpler time in the markets – oh, the good old days).  True to form, the trade ended up out of the money, and the trader did not have to worry about his unhedged position.  Fortunately the customer was real good at making money in other ways – predicting financial prices was not their expertise.

Companies should be good at making things and / or selling things.  When companies suggest that they are now in the financial prediction market it might be a good time to take a contrary view.  Track records seem to indicate that few mangers of these companies ever successfully set foot in a futures pit.

Hedging, like insurance, is not there solely because you expect something good or bad to happen.  Hedging, like insurance is there because events (both bad and good) will happen.  Unpredictable events will happen.  Hedging, like insurance, should not be solely predicted on predictions.

The Risk Analyst’s Secret Weapon

by Dr. Rick Nason
Partner
RSD Solutions Inc.

Risk analysts have a secret that many managers are totally unaware of.  Let me explain it by telling a little story that is only disguised to protect the innocent (and the guilty).

I was once brought in to a company to act as a risk consultant.  A few days into the assignment I was scheduled to attend a high level executive meeting.  The meeting started as these things tend to do.  The third item on the agenda was a routine risk report.  The risk analyst started the report as usual but used a risk term that I was unfamiliar with.  I politely raised my hand and asked if the analyst would be so kind as to define the term for me.  That was met with looks of shock and dismay around the table.  How could a risk consultant not know this term!  The manager who hired me for the engagement looked visibly shaken and embarrassed.  After an embarrassing silence in the room that acknowledged my ignorance and faux pas, the risk analyst started to explain the measure – and indeed it was a commonly used measure that I was fully aware of – just not with the label that this specific company used for the term.

The meeting continued without further incident and ironically no one asked any more questions.  Needless to say I thought that the assignment was blown and all credibility I might have had was now as good as cremated.  I slinked back to my hotel, wondering how to rebuild credibility.  However much to my surprise there were several messages waiting for me.  Each was from a senior manager at that meeting – and each of them was thanking me profusely for asking the question.  It appears as if no one else knew what the internal term meant either.   A typical response was, “I am so glad that you asked that question today.  I have been going to these monthly meetings for 6 years and never had a clue what they were talking about until you asked that question today!  Thanks again – keep up the good work!”

This got me thinking - now with my much bigger brain seeing as I now knew that this institution had basically renamed many of the common risk management tools.  The question I asked myself is this, “How many risk managers consciously or unconsciously invent language or techniques to confuse their audience?”

Risk management is not hard to conceptually understand (it is hard to implement), but yet it is frequently compared to rocket science and brain surgery.  How much of this is caused by risk managers implementing their secret weapon of terminology confusion?