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Müller, Ullrich: Black Gold, Black Swans: The importance of the unexpected for the
future of energy. Hamburg, Anchor Academic Publishing 2013
Original title of the thesis: Oil, electricity and Taleb's ,Black Swan`
Buch-ISBN: 978-3-95489-085-9
PDF-eBook-ISBN: 978-3-95489-585-4
Druck/Herstellung: Anchor Academic Publishing, Hamburg, 2013
Additionally: Corvinus School of Management Ungarn. Master Thesis, 2012
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List of Contents
1. Introduction ... 1
2. Methodological framework and definitions ... 3
2.1 The `Black Swan' a concept and its application... 3
2.2. How to measure `Black Swan' impact energy prices as an indicator ... 8
2.3. A critique of Energy outlooks predictions in the light of `Black Swans' ... 12
3. Analysis The `Black Swan' in the history of oil and electricity .. 17
3.1. Oil a global commodity in turbulent times... 17
3.1.1 1945 1970 A phase of stability ... 17
3.1.2. The oil shock and how it changed the world... 18
3.1.3. The Iran crisis... 21
3.1.4. The 1986 oil price collapse ... 24
3.1.5. The late 80s, the demise of Communism and the first Gulf Crisis ... 25
3.1.6. 9/11 and its aftermath ... 29
3.2. Electricity a versatile necessity in times of crisis... 32
3.2.1. The role of electricity prices ... 32
3.2.2. The California Energy Crisis ... 33
3.2.3. The 2008 Central Asia Energy crisis... 37
3.2.4. The 2011 Tsunami ... 38
4. Is protection possible? Discussion and outline of risk mitigation
measures ... 42
5. Summary and Conclusion ... 47
6. Bibliography ... 49
7. Appendix... 54
1
1. Introduction
"[...] there are known knowns; there are things we know we know. We also know there are known
unknowns; that is to say we know there are some things we do not know. But there are also unknown
unknowns the ones we don't know we don't know." (Donald Henry Rumsfeld)
1
The world is hungry for energy. While old powers seek for untapped sources, newcomers are
prepared to play the great game with new vigor, changing the global landscape of energy
forever. With the words of Daniel Yergin, one of the foremost experts on the matter, energy
has become `The Quest' of the 21
st
century.
2
Enormous amounts of capital and human effort
are invested into resource exploration, energy generation and transmission, reflecting the
insatiable thirst of our growing civilizations. The energy industry and the whole socio
economic system that depends on it are of immense size and importance today and most
likely will be even more so in the future. Hence, a stable and reliable flow of cheap and easily
accessible energy is an important precondition for further human and economic develop
ment and the increased individual and political safety and stability that comes with it. And
yet, history shows that the development of the modern energy fueled global economy was
full of unpredictable turns and surprises, often resulting in great human and financial losses.
Thus, this paper does not deal too much with the new world of energy, but rather with some
of the risks that come with it. To be more precise, it is about a phenomenon called the `Black
Swan' and its impact on the energy related business. While we shall define later in more
detail what a `Black Swan' actually is, for now, suffice it to say, that in its negative form it is a
rare event that hits unexpectedly and causes great damage to everything affected. Its impact
is, therefore, enormous and yet it is almost impossible to predict: The `Black Swan' is the
intellectual incarnation of the rare, the unforeseen and the inexplicable. While the ancients
called it fate or fortune, in modern times, we often perceive it as bad luck or a lack of
knowledge and preparation. We refuse to give it much of a thought. And yet, if we are to
1
Original quote of Donald Rumsfeld, taken from the transcript of a press conference in 2002: DoD News
Briefing Secretary Rumsfeld and Gen. Myers, 12.02.2002,
http://www.defense.gov/transcripts/transcript.aspx?transcriptid=2636, as of 29.07.2012, 02:31.
2
Yergin used that term as the title of his well received account on the status quo and the future of energy:
Yergin, Daniel: The Quest Energy, Security, and the Remaking of the Modern World, Allen Lane, London,
2011.
2
secure the protection needed to keep our energy based society stable, we have to make
some sense out of the phenomenon, even though it might not fit into theoretic models or
mathematical formulas. Therefore, the aim of this paper is to provide a basic problem
analysis. The findings, by the nature of the subject, will not be specific, but should translate
into some broad insights and recommendations that could be of interest to many different
actors in the energy business, be they companies, regulators or private persons alike.
Hence, based on the work of Nassim Nicholas Taleb, we shall first define the concept of the
`Black Swan'. Subsequently, after a critical examination of the strategic prediction models
used in the energy business today, the paper will focus on historic data and experiences in
order to review to what extent the `Black Swan' influenced the development of the energy
world in the past. In order to apply the necessary methodological rigor, `Black Swans' and
their impact will be measured according to predefined criteria and indicators, which will be
elaborated in the first part of the paper. Finally, we shall investigate whether it is possible to
draw any practical conclusions for the future, ultimately looking for methods, which could
render us capable of taming the `Black Swan'.
3
2. Methodological framework and definitions
2.1 The `Black Swan' a concept and its application
The concept of the `Black Swan' has been made popular by Nassim Nicholas Taleb, who in
2007 published a book by that same name.
3
The term itself goes back to the historic fact,
that biologists were convinced that there was no such thing as a black swan, until they were
taught otherwise by finding one in newly discovered Australia. Taleb uses the metaphor to
give a common name to what he defines as high impact events that are deemed so unlikely
that they are not considered to be possible, just until they actually happen. In a broader
sense, a `Black Swan' is a phenomenon that hits completely unexpectedly but has a game
changing effect. This effect can be positive or negative, but it will definitely put an end to the
status quo. However, Taleb's point is not just that unexpected things do happen. Instead he
argues that we are actually ignoring them to the point of denial, due to the way our minds
are formed. According to Taleb, whenever we make plans for the future, we tend to focus on
the foreseeable and base our assumptions on experiences from the past. Thereby we tunnel
our thinking by limiting our imagination to history, again neglecting the fundamental role of
`Black Swans' for our lives. At the same time, Taleb elaborates, we are constantly underesti
mating the power of randomness. Instead of random events, our mind identifies `anomalies'
or `irregularities'.
4
Even when confronted with the logically inexplicable, we still try to
include it into a consistent narrative, which puts the unexpected into a seemingly reasonable
context, enabling us to ignore it again. Differently put, our predictions about the future are
based on bell curve type probability models and historic narratives. According to Taleb's
argumentation, the problem with that is not only that it makes us blind for randomness, but
also that the unexpected can shape our fortune just as much as the expected and predicta
ble. To give an easy example: When we observe a skillful football player, for instance, we
assume that his career must be based on talent and hard training. We completely ignore
that it was just as important for his professional development, that he never experienced
any bad injuries, which might have disabled him to play football ever again. At the same
time, there might be dozens of even harder working and more talented players, who just
3
Taleb, Nassim Nicholas: The Black Swan: The Impact of the Highly Improbable, Penguin Books, New York,
2008. The first publication was issued in 2007 in the USA by Random House.
4
Taleb came to this conclusion already in his earlier work: Taleb, Nassim Nicholas: Fooled by Randomness
The Hidden Role of Chance in Life and in the Markets, Penguin Books, New York, 2007, page xli (prologue). The
first edition of the book was published by Random House in the USA in 2005.
4
happened to get injured and now have to follow a career as accountants or journalists.
Hence, their possible impact on the world of sports will never be part of the equation. This is
what Taleb calls `silent evidence'
5
and he argues that we constantly ignore it, due to the so
called `survivor bias'
6
. This bias makes us incur conclusions about success by only looking at
the small sample of `winners', instead of seeing the whole picture of all the promising young
boys, who ever dreamed about being professional football players.
But why are we so strongly biased in favor of the seemingly predictable? In order to explain
this, Taleb categorizes events into two different types. In his view, they either belong to the
realms of what he calls `Mediocristan' or `Extremistan'. Whereas in `Mediocristan' the
probability of a certain event or phenomenon indeed follows the normal distribution of the
Gaussian bell curve, in `Extremistan' "wild randomness"
7
is the rule. Since in `Mediocristan'
variability is limited, one has to cope only with mild randomness. In effect, within certain
limits, things become predictable. To use one of Taleb's examples: On the one hand, a baker
selling his bread can expect profits only within certain limits, related to the number of
breads he can produce and sell. Writers and singers, on the other hand, might either starve
or become multi millionaires like Joan K. Rowling or Madonna. Since the human mind is used
to process `Mediocristan' style events, it blurs the distinction between the two realms and
consequently applies the wrong rules. Therefore, we assume things to be predictable within
given limits, even when they are not. This leads time and again to gross miscalculations.
The historic literature is full of examples: From IBM's Thomas Watson, who in 1943 famously
predicted a computer world market size of about five pieces
8
, over Neville Chamberlain, who
proclaimed `Peace for our time' after signing the Munich Accord just one year before the
start of the Second World War
9
, to the famous economist Irving Fisher, who on the verge of
5
Taleb: The Black Swan, p. 50.
6
The best explanation for this concept is delivered in: Taleb: Fooled by randomness, p. 93 and following.
7
Taleb: The Black Swan, pp. 215 228.
8
It is, however, controversial, whether Watson ever really made that statement. There is no recorded evidence
and many deem it unlikely altogether. IBM itself thinks that the story about it is based on a misunderstanding;
see http://www 03.ibm.com/ibm/history/documents/pdf/faq.pdf, page 26, as of 24.03.2012, 13:03. Neverthe
less, it makes sense to mention the statement, as it represents many similar claims that have been made about
technological progress during history and which seem to be absurd in retrospect.
9
The BBC published the text of the original press announcement, made after signing the Munich accord on
September 30
th
1938 under the following link:
http://news.bbc.co.uk/onthisday/hi/dates/stories/september/30/newsid_3115000/3115476.stm, as of
13.03.2012, 13:12.
5
the great depression predicted bullish stock markets.
10
What all these cases have in com
mon, is that the oracle was blinded by past experience and the therefrom derived probabili
ties. Ignoring the possibility of random or, at least, ostensive random events, a historic
narrative often becomes the basis for predictive analysis.
Therefore, Taleb argues that the very mistake is to try to predict anything specific at all.
Since it is impossible to attach a numeric probability to `Extremistan' events, it is beyond our
power to decide on and weight the factors to be put into the equation of any predictive
analysis. Furthermore, the possibility of random events strongly inhibits any attempt to get
clear predictions of the inductive type, since there is always the possibility that they will be
falsified in the future. But if it is impossible to come up with a couple of likely scenarios, how
could anybody cope with the risk of taking decisions at all? After all, according to recent
research, in everyday life human emotions are an effective decision making mechanism.
With our limited knowledge about complex realities it is impossible to make sophisticated
calculations about all kinds of daily decisions. Actually, such calculations would be rather
counterproductive. Consequently, habits and emotions become effective short cuts. Howev
er, when confronted with more abstract matters, using the human intuition can become
rather dangerous, leading to fatal errors.
11
Rather than trying to prepare for specific situations and conditions, Taleb concludes, we
should instead create risk protection through redundancies. He mentions the example of
nature, where there are plenty of redundancies, for instance in the human body or in any
other biological system.
12
Furthermore, when talking about risk, one should eschew the
inductive type of risk measurement and rather apply a Popper inspired falsifying approach.
One should refrain from trying to calculate the probability of risky events, based on historical
experiences. Rather one should develop hypothesis about every possible kind of extreme, if
unlikely, risk exposure and then try to minimize it.
13
But what is important for now is the
question, whether we can find empirical evidence for the `Black Swan' at work also in the
development of the energy business.
10
He even kept sticking to that believe, after the events following the Black Friday had wept out most of his
personal capital. For more details: Nasar, Sylvia: Grand Pursuit The Story of Economic Genius, Si
mon&Schuster, New York, 2011, p. 312.
11
Taleb: Fooled by Randomness, p. 182 and following.
12
Taleb: The Black Swan, p. 312.
13
Taleb: Fooled by Randomness, p. 120 and following.
6
But before taking further up on that thought, we still have to consider some important
details. First of all, not every high impact event also is a `Black Swan'. Would, for instance,
Israel execute a preemptive air strike against Iran tomorrow, this would certainly have a
powerful impact on world politics and economics. However, it would lack the element of
random surprise, which is inherent to what we commonly call `chance' or `fortune' and
which constitutes the `Black Swan'. Because such an airstrike is a currently discussed
possibility, no foreign policy maker would completely rule it out. Consequently, Taleb argues
that not even the financial crisis from 2007 should count as a `Black Swan', since many of its
causes and effects were indeed foreseeable and certainly were expected by many in the
financial sector.
14
On the other hand, events like the Tsunami in South East Asia in 2004 or
the one of 2011, which hit alongside earthquakes and a nuclear accident, were certainly
impossible to anticipate in their concrete form and magnitude. Therefore, `Black Swans' are
events that not only have a high impact on the most important subsystems of any systemic
structure but also run counter scientifically or intuitively perceived probabilities. They might
be part of scenario analysis, science fiction movies or described by obscure experts before
hand, however, they will be deemed to be extremely unlikely or even absurd until they
happen. Just like with the lottery, particularly rational observers will argue that the probabil
ity of hitting the jackpot is so low, that participation is of no use. However, the extremely
high impact of actually winning makes participating still attractive. Once successful, winners
will easily accept narratives, explaining why they were bound to be the lucky ones.
15
This
explains why often after some high impact event took place, one will find `historic' lost
opportunities for possible in advance discovery. For instance, in the case of the events of
9/11, the authorities had to face critique for not sharing and ignoring known facts about the
to be terrorists.
16
However, since by the time things actually happened an event loses its a
priori unlikeliness, former obscure hints will by then fit into the story as well established
facts, like the foolishness of building a nuclear power plant just next to the sea or letting
14
Although of course, nobody was able to exactly foresee what would happen, many actors in the financial
markets were aware, that a financial breakdown would be eventually unavoidable. A good account on how the
main actors in the financial industry perceived the prelude of the crisis can be found in: Sorkin, Andrew Ross:
Too Big To Fail, Penguin Books, New York, 2009. Furthermore, Taleb himself describes the dynamic of market
crisis and investor behavior in his book ,,Fooled by Randomness", which he published already in 2004.
15
For example, always sticking to the same numbers, never losing hope or just being inspired by a mystical
appearance.
16
A major example for this is of course `The 9/11 Commission Report', which sharply criticized several
government agencies for their failure to cooperate and read the evidence. A freely accessible version of the
report is available under: http://www.gpo.gov/fdsys/pkg/GPO 911REPORT/pdf/GPO 911REPORT.pdf, as of
24.03.2012, 13:48.
7
strangely behaving Arab men learn how to fly an airplane. But this is ex post facto thinking.
Even though an event could theoretically have been anticipated, its perceived extreme
unlikeliness held it out of the focus and rendered it pure randomness from the point of view
of the failed anticipator. Hence, although 9/11 was of course highly predictably from the
terrorist's point of view, for the rest of the world its concrete materialization was purely
random in terms of predictability. This is what Taleb describes with the turkey model: The
turkey, bred to feed a hungry family, is unaware of his planned sudden death, although his
butcher is fully aware of the exact date of his slaughtering.
17
Illustrating his findings with examples portfolio theory, Taleb argues that in order to achieve
extraordinary returns investors should focus on many parallel high risk venture type of
investments, instead of trying to balance risk by building a portfolio of already proven
businesses. The idea behind this is easily expressed in numerical terms. An investment that
yields 5 % return in 90% of the cases and loses 10% in remaining 10% of the cases, is on
average less attractive than an investment that yields 500% in 10% of the cases and loses 5%
9 out of 10 times. The small losses made in nine of ten occasions are offset by the rain of
cash during the 10
th
occasion. This idea gains even more momentum when considering that,
on the other hand, investments perceived as not very risky can turn into all out losses when
exposed to a `Black Swan'.
18
The point is, that in this paper only events which were suffi
ciently perceived to be unlikely before the fact and thus hit the system from its inherent
standpoint completely randomly, will be considered to be `Black Swans'. Furthermore, by
definition, in order to qualify as `Black Swan', the event has to have had an extremely high
impact on the system under examination. Therefore, the criteria which constitute a `Black
Swan' are highly relative with regard to the respective party or system under scrutiny.
It is evident at this point, that the proposed criteria for the identification of `Black Swans' are
hardly quantifiable in precise numbers, which makes them hard to measure against any kind
of quantitative scale. Fortunately though, Taleb listed them in a summarizing article in the
New York Times. A `Black Swan', according to that definition is an event that fulfills the
following criteria:
17
Taleb: The Black Swan, p. 40.
18
That is valid, provided that there is a strong exposure with a high level of leverage, which can immediately
wipe out an investor's equity.
8
"First, it is an outlier, as it lies outside the realm of regular expectations, because
nothing in the past can convincingly point to its possibility. Second, it carries an ex
treme impact. Third, in spite of its outlier status, human nature makes us concoct ex
planations for its occurrence after the fact, making it explainable and predictable."
19
These qualitative criteria shall henceforth be the basis for our analysis. They cannot be
measured precisely; however, there are signals that can be used instead. While ex ante
improbability has to be proven for each single case according to the historic evidence
available, the power of impact can be gauged by some robust indicators that are inter
subjectively verifiable. Since the subject of this paper is energy, oil and electricity prices
seem to be suitable for that role. In the next paragraph we shall further discuss this possibil
ity.
2.2. How to measure `Black Swan' impact - energy prices as an indicator
By energy we henceforth mean oil and electricity and the scope of our examination will be
limited to roughly the period starting from the aftermath of WWII. This makes sense in so
far, as the current framework of world affairs and economics was largely fixed by the results
of that war and has not been changed fundamentally ever since. The boom in the western
world following the war was fueled by oil and electricity and the global economy became
largely depended on them. Patterns of trade and reliable markets emerged, resulting in
global commodity prices. We ought to use this to the advantage of our investigation.
After all, if we are going to search for the `Black Swan', a common variable regarding the
examined system is needed. Let us recall: Taleb proposed three elements that constitute the
`Black Swan': "[...] rarity, extreme impact, and retrospective (though not prospective)
predictability [...]".
20
As a counter balance to the historic narrative, which we remember
is usually quite misleading but delivers a retrospective explanation, we need an empirical
indicator that allows us to identify sudden shocks to the system. These shocks would
indicate an extreme impact and at the same time allow us to separate the usual from the
rare. Consequently, the best indictor in the given field of interest of this paper seem to be
the market prices for crude oil and electricity, which shall be used as a proxy, helping to
19
http://www.nytimes.com/2007/04/22/books/chapters/0422 1st tale.html?_r=1, as of 10.04.2012, 22:10.
20
Talib, Nassim Nicholas: The Black Swan: The Impact of the highly Improbable, The New York Times,
22.04.2007, http://www.nytimes.com/2007/04/22/books/chapters/0422 1st
tale.html?ex=1178769600&en=bdae1078f2b4a98c&ei=5070, as of 10.04.2012, 22:35.
9
identify `Black Swans', alongside the qualitative analysis. Changes, be they gradually or
abrupt, are reflected by the prices, which mirror the relevant market developments and
reflect external shocks. Finally, it is relatively easy to retrieve the widely available price data
and to put it into a common framework. This makes energy prices a reliable and robust
indicator that allows us to make comparisons and will underpin the qualitative examination.
Now, if we are going to use energy prices as an empirical `Black Swans' indicator, it is
important to first understand how they arise and were they apply. In contrast to electricity,
which is a highly perishable and hardly storable good, there has been a world market for
crude oil and it's derivatives already for a long time. Because oil is usually produced far from
the place of its usage, by definition the market for oil is an international one, involving
different regions through all the steps of the value chain. The US Energy Information Admin
istration consequently defines the oil price as the sum of costs and market conditions.
21
This
means, that the price accounts for the production, processing and transportation costs.
Depending on the circumstances, they can slightly vary, but are nevertheless the fixed part
of the price. Secondly, depending on the market environment, there is a varying premium on
the price, which is basically determined by the real or perceived balance between supply and
demand. Theoretically, if demand is high, prices should be high too, whereas excessive
supply should result in lower prices. Although this is generally true, the vital role of oil for
the global economy makes its perceived future supply and demand a matter of much
speculation, heavily depending on many indirect factors. Political crisis, natural disasters or
economic turmoil can all influence the anticipated future development of the oil market and
have a strong influence on the price, sometimes ignoring the real developments. Not least,
interventions by the OPEC cartel
mainly through production quotas
have a decisive
influence on the oil price, often limiting the role of the free market in price making. Certain
ly, it is the OPEC's intention to keep prices on a stable high level. However, it has also shown
in the past, that it can play an important in price shock mitigation by providing additional
supply in times of crisis. After all, most of its members today have a big stake in the global
economy and its general well being.
21
Office of Oil and Gas, Energy Information Administration: Oil Market Basics, chapter: Prices,
http://www.eia.gov/pub/oil_gas/petroleum/analysis_publications/oil_market_basics/price_text.htm, as of
01.04.2012, 13:53.
10
Finally, since the price development comprises such complex calculations and is bound to
vary strongly over time, there is a lot of room for financial speculation. This further aggra
vates the need for many market players to acquire volatility protection via complicated
market instruments. As a result, transactions happen in many different forms, from long
term contracts over future trades to the local spot markets. These spot markets are usually
the most sensitive indicators of price development because of the immediacy of transac
tions. In addition, each country charges a different amount of taxes on petrol products,
which many times even exceeds the actual market price. This makes taxes one of the single
largest determinants of the price. However, for this analysis neither the imposed taxes nor
the actual, long term planning based production costs are of any particular interest, since
they are relatively fixed and largely predictable. Instead, it is the market condition premium
which ought to be in the center of the examination. Here lies the focal point of speculation
and here is where the `Black Swan' can hit the hardest, immediately translating into different
prices on the spot market.
Electricity prices on the other hand, depend to a much larger degree on local market
conditions. Since electricity cannot be stored or transported effectively over very long
distances, markets are necessarily confined to the region of its production. Therefore, prices
can strongly vary in different markets. Whereas, for instance, one Kilowatt hour of electricity
in Hungary in 2008 cost on average 0.224 USD, the same Kilowatt hour in the United States
cost in the same year on average 0.113 USD and 0.171 USD in Brazil.
22
To what extent local
conditions can determine the price, was exemplified by the California energy crisis at the
beginning of the last decade: An ill conceived liberalization attempt lead to extreme price
volatility on the wholesale market, resulting in excessive state debt and finally also high
consumer prices. One of the major problems was that partly due to speculation, partly due
to a lack of investment
the supply side did not deliver as expected. Finally even blackouts
were the result. Ultimately the ruling Democrats were removed from power and the world
marveled at the rise of `Governator' Arnold Schwarzenegger.
23
In contrast to the oil market,
where suppliers can be chosen on a more international level, the local electricity buyers
were not able to quickly switch to alternative sources of supply and therefore prices rose
22
According to data published by the EIA in 2010, http://www.eia.gov/emeu/international/elecprih.html, as of
01.04.2012, 21:31. The price for the USA still excludes tax, since it is charged regionally.
23
A good overview about the course of the crisis can be found in: Yergin, Daniel: The Quest, pp. 379 395. More
specialized accounts will be cited later on.