“Most people easily grasp the immediate impact of developments, but few understand the ‘second-order’ consequences.”
In his latest note to investors, Oaktree Capital’s Howard Marks writes about what’s on the top of everyone’s mind: oil.
Marks walks through a discussion on the error of forecasts (they often stick too close to the current status) and the failure of most investors to really consider things that seem unlikely (“tail events”).
But looking at the “second-order” — or what some people might call “knock on” — effects of economic events is where Marks thinks investors really ought to do their soul searching.
Here is Marks’ sketch of the self-correcting aspects that are likely to emerge from the recent drop in oil prices:
- A decline in the price of gasoline induces people to drive more, increasing the demand for oil.
- A decline in the price of oil negatively impacts the economics of drilling, reducing additions to supply.
- A decline in the price of oil causes producers to cut production and leave oil in the ground to be sold later at higher prices.
As Marks writes: “In other words, lower oil prices — in and of themselves — eventually make for higher oil prices.”
A Warning About Forecasters
In his note, Marks also talks about the error of forecasting, namely that it sticks too close to consensus.
Recent Wall Street research has repeatedly discussed the idea that we are in a “new era” of oil prices, meaning that the days of $US100 oil are over, and that after prices stabilise oil will be something like $US70 or $US80 a barrel for the foreseeable future.
But for Marks, this consensus means it is almost certainly wrong.
Back in August, Marks notes that investing legend Byron Wien met with “prominent investors” who all agreed that increasing emerging market demand would sent Brent crude prices from then-current levels of around $US110 a barrel to $US120 over the next five years.
A lack of demand has been blamed, in part, on the current decline.
But more than just this “reasonable” bullish forecast for oil, Marks says that with Brent prices at $US110, bulls likely saw oil going to $US120 while bears saw oil falling to $US100. And given the recent move in oil prices, this is a stunning lack of imagination.
Marks starts his note discussing this year’s move in Treasury yields: yields have fallen while basically everyone on Wall Street thought they would rise.
For Marks, the forecasting error from the consensus shows that not only is the thing that “everyone knows” unhelpful at best and wrong at worst, but this call for rising Treasury yields was uniformly inquiring about the wrong thing: it was the decline in oil prices, not the Fed’s interest rate decisions, that proved the definitive investing event of 2014.
In his paper, Marks highlights a classic quote from economist Rudiger Dornbusch, which can’t be repeated enough: “In economics things take longer to happen than you think they will, and then happen faster than you thought they could.”
And so maybe the investors Byron Wien met with this summer and said Brent crude would go to $US120 will be right. But if they are right, which Marks’ feedback loop suggests they are likely to be, it will almost certainly be for the wrong reasons.