Validate Your Assumptions

Posted: April 1, 2007 in Powerful Ideas

I got an inquiry from a journalist the other day. He was looking for insight into the conventional wisdom which states that massive Chinese demand is behind rapidly rising oil and commodity prices in the last few years. On the surface, this “conventional wisdom” appears logical. We all learned in Economics 101 that higher demand leads to higher prices, right?

In actuality, though, prices are the result of the interplay between demand and supply. I suspect that many other factors are also at play, especially in a highly volatile sector like oil. However, most market watchers and commentators simply look at one aspect of the world economy (growing Chinese demand for commodities) and interpret that in a simplistic manner as the cause for rising oil and commodity prices. Is the reality that easy to understand?

I decided to test this assumption for myself because I was curious to find out if the conventional wisdom is right. The relationship between prices and total world consumption (a proxy for total world demand for oil) has historically been quite weak. When you graph oil prices and oil consumption as time series over the period 1965-2005 (using data in the BP Statistical Review of World Energy June 2006), there is no apparent direct relationship between the two factors. Moreover, the correlation for total world oil consumption is weak, and the one for Chinese oil consumption is negligible.

Oil prices and consumption (total world and China) have both been rising since 1999. However, you can take prices and consumption over any arbitrary time period and find correlations that either support the thesis that oil prices are driven by rising demand, or the converse. Between 1965 and 1979, total world consumption and prices were highly positively correlated, but between 1979 and 1998, the correlation was highly negative. During all this time proved reserves grew enormously (essentially doubling between 1980 and 2005), as did production.

Perhaps China’s increasing oil consumption is driving oil prices. If this is the case, though, what drove prices up during the seventies, when China’s consumption barely registered in world markets? What drove prices down during the 1980s and 1990s (as a trend), while consumption kept trending higher? What happens if, next year, oil prices suddenly collapse and yet oil consumption remains strong? How will conventional wisdom explain the relationship then? What about the complex interplay of consumption, exploration, proved reserves, unproven reserves, and production, not to mention political meddling?

I believe that the conventional wisdom is wrong. Many other factors, some of them psychological and others political, play a role in setting oil prices, as well as other commodity prices. There is simply no easy causal relationship between Chinese demand for oil and global oil prices. Anybody who says this is simply repeating “conventional wisdom”, what “they” are saying, and not even bothering to check for themselves.

Now, all of this wouldn’t make much difference if it weren’t for the fact that businesses and governments make decisions every day on the basis of this type of conventional wisdom. If you read about it in the Wall Street Journal, or Business Week, or The Economist, then it must be true, because these are reputable sources. The problem is that these sources are just repeating time-worn litanies and beliefs about apparent patterns. The world is a complex place. It is not amenable to facile generalizations and simplistic models.

Regardless of the causal relation between rising oil prices and rising Chinese demand, oil prices will eventually go down. It may not be a long-term trend, but it may appear as a sudden drop in the market. Conversely, there could be another oil price “shock” which sends prices unexpectedly higher. The reality is that no one knows what will happen tomorrow, next week, or next year. Nor can anyone really explain why oil prices or any other prices go up, down, or sideways for any length of time. All of the explanations are post facto rationalizations. If you bought low and sold high, you’re brilliant. If you bought high and sold low, you’re a victim of unfortunate timing.

In the early 1970s, prior to the first OPEC oil price shock, Royal Dutch Shell decided that everything was just too perfect in the world for oil companies. They explored a variety of possible futures and prepared for what appeared to be the most likely scenarios. One of these scenarios included an oil embargo which would send oil prices through the roof. In 1974, they were prepared and weathered the storm better than most.

Whether it’s oil, other commodities, or anything else, executives and organizations must be prepared to deal with uncertainty. As with Royal Dutch Shell, the best starting point for that is to validate assumptions, conventional wisdom, and whatever “they” are saying. Chances are that there isn’t much to the common sense and conventional wisdom, and that it’s mostly rumor and conjecture.

Accepting uncertainty and seeing for oneself is the first step in preparing to assume risks inherent in any undertaking and to defending against the inevitable threats and dangers that will arise. Continuing to believe whatever “they” are saying might not be the best strategy for thriving over the long term.

Richard Martin is President of Alcera Consulting Inc., a management consulting firm that helps excellent executives become world-class leaders and that assists individuals and organizations to thrive in the face of risks, threats and uncertainty. He is known for his intellectual breadth and has led teams in critical and sometimes life-threatening situations as an infantry officer in the Canadian Army. Areas of expertise include crisis leadership, strategy, risk management, disaster preparedness, coaching, mentoring, speaking, and training.

© 2010 Richard Martin. Reproduction and quotes permitted with proper attribution.

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