“In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.”
As 2017 draws to a close geopolitics and technological innovation appear (at least on the surface) to be the main drivers of greed and fear in commodity and other financial markets. The problem for investors is that the risk underpinning both geopolitics and technological development cannot be priced up neatly.
A fragile peace?
The recent arrest of more than 200 princes, businessmen and other high ranking officials in Saudi Arabia would have been unthinkable only a month ago. Now, the inherent fragility of the Saudi political and economic system may mean that the country now implodes; or indeed the cracks may by papered over for years into the future. But how do you put a price on that risk? Just because things go quiet now does not mean that the risk has gone away.
Ruptures in the price trend for many commodities are often the result of geopolitical developments. Political scientists Ian Bremmer and Preston Keat defined geopolitics as: “The study of how geography, politics, strategy, and history combine to generate the rise and fall of great powers and wars among states.” Given its importance to the running of the modern global economy, nowhere is this more vividly observed than in the battle for energy resources and, in particular, oil.
If geopolitics plays such a big role in seismic moves in the oil market and many other commodities, then if geopolitical shifts can be forecasted with any accuracy this must give forecasters an edge, right? The Good Judgment Project, set up by Phillip Tetlock, set out to answer the first part of this question. They explored the profile of the best out of hundreds of forecasters who made over 150,000 predictions on roughly 200 events during a two year period. Forecasters were asked a multitude of questions, such as: Will the United Nations General Assembly recognise a Palestinian state by September 30th 2011? Will Bashar al-Assad remain president of Syria through to January 31st 2012? The researchers found that forecasters can be good at spotting changes, but only over long timescales.
The problem with geopolitical events is that they tend to be binary outcomes (although clearly not always). They either happen in the future or they don’t. This contrasts with what we might term “market” or “economic” risks which are more dynamic. There are three main problems with binary outcomes: first, they offer little information advantage for investors to play with; second, they are hard to predict and, third, they offer few easily identifiable markets that might benefit from a particular outcome.
Even if you have fantastic foresight about how a geopolitical event is likely to develop, the next problem is decoding what the impact is likely to be on a range of different markets. All too often pundits focus on the immediate effect; for example, based on whichever candidate wins an election. However, they forget to draw the dots as to how the “narrative” could change once the geopolitical uncertainty of the political event falls away.
Even if you could correctly forecast that the regime of a particular oil producing nation would be toppled within a given year, you wouldn’t be able to know the exact path that oil prices would go as a result. You could at least add a risk premium to your forecast, but even that might not be correct. It is after all the risk of a sharp spike in prices that gets people’s attention.
Batteries now included?
Take technology. How do you price up the likelihood of further innovations in shale extraction technology both in the US and elsewhere in the world? Or how do you price up the likelihood that the recently launched Tesla truck will usurp conventional combustion engine powered vehicles and so put a dent in transport demand for oil?
Implicit in any forecast of commodity prices is an assumption of how technology could evolve and how its adoption will affect commodity prices. Commodity prices provide the incentive for new technology, yet also influence commodity production and consumption. Innovations, once introduced, may lead to higher yields from agriculture, more oil being extracted from offshore wells and deeper mines to extract more metals and minerals – all of which could eventually lead to rising commodity supplies.
High commodity prices may also lead to innovation on the demand side too. High energy prices, for example, may discourage consumers from using a particular energy inefficient product. This acts as an incentive for companies to redesign their products to become more energy efficient and less resource intensive. However, just because a technology might appear to be negative for demand doesn’t mean it has to be bad for prices, at least not in the short to medium term. For example, if oil producers are worried about the growth in electric vehicles they may decide to postpone large scale, multi-decade, multi-billion dollar investments. If they get it wrong and electric vehicles don’t take off as fast as they expect, then oil prices may rise sharply if there isn’t enough supply to meet demand.
And remember, don’t forget about rebound effects. If an innovation results in an energy intensive product (transportation for example) becoming cheaper or more accessible consumers are likely to want to consume more of it. Every improvement in technology has a rebound effect.
It’s the uncertainty over how current technology can be utilised and how technology could evolve that makes forecasting so difficult. Technological developments of all sorts involve a large dose of serendipity. The philosopher Karl Popper perhaps best describes the struggle to anticipate future innovations: “The course of human history is strongly influenced by the growth of human knowledge.” Popper also wrote:
But it’s impossible to “predict”, by rational or scientific methods, the future growth of our scientific knowledge because doing so would require us to know that future knowledge and, if we did, it would be present knowledge, not future knowledge.
Yet to forecast the price of oil, lead or cobalt into the next decade we need to make some assumption about how technology will make it easier to extract these commodities and how technology will change the demand for these commodities. Note that no one predicted the invention of pig iron or imagined how it would affect the nickel market, neither did anyone anticipate the introduction of hydraulic fracking and how it would turn the market for oil on its head.
Yet, a question is whether it has it always been such? Times are always uncertain and is now really any different? As can be heard almost any time someone frets about the future, there is the issue of hindsight bias. Someone says, “Things are uncertain, not like it was in the past.” The first part of that statement is accurate; the second is not. The future is always uncertain, whether it is the future we face right now or the future that people faced a century ago.
The answer for investors then may be to unplug from the noise and just ask themselves two questions: first, where are we in the cycle?; and second, what lessons from history can we draw for what might come next?
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