Thursday, August 30, 2007

An OPEC Less Opaque

Do oil prices always have to be a matter of surprise?

The price of oil has always been a subject of great debate, analysis, and not least, fascination. And not surprisingly so, given the importance of that simple little number to the world economy. However, oil prices seem to have a remarkable propensity to confound the bravest of predictions. Real oil Prices began an upturn in late 2002, and trebled by mid-2005*, leading to predictions of $100 oil over the next few years. While the nightmare $100-a-barrel predictions have not materialized - and don't appear very likely to do so anytime soon** - the fact remains that a price rise that appeared to be a temporary spike does seem to have led to a more or less permanent plateau.

What's more, as the US DoE's graph shows, the behavior of oil prices over the past 30-some years can hardly be described as monotonic. And each time it lurched up or down, it is not difficult to imagine the wide-ranging impact on the fortunes of nations, governments, industries and individuals.

The benefits of steady oil are thus not far to seek. But can the price of oil be steadied, or at least made to move in more predictable ways over the short- as well as long-term?

Clearly, this is an immensely difficult question to answer. Many factors are at work. The prices of even the staidest of commodities are volatile at the best of times. And oil can hardly be described as a staid commodity. It's price is affected by a heady mix of geopolitical considerations, speculation, regulatory moves, and so forth. Also, as the DoE graph shows, the price trajectory has been punctuated by various events which caused the price to react sharply, most of which were quite unpredictable at the time. And against this backdrop of formidable factors, it appears there isn't really much any single entity, such as one government or one institution, can do to steady the price.

More transparency
But make no mistake- there is an awful lot that one particular organization can do - if it has the will. This organization is, not surprisingly, the Organization of Petroleum Exporting Countries (OPEC). Headquartered in a deceptively unassuming building in central Vienna, OPEC still wields enormous clout in deciding the world's energy future. Of course, it's record of influencing the oil price since the oil price shock has been somewhat less than stellar, particularly after Saudi Arabia abandoned the swing producer role in 1986.

The world oil industry is beset by lack of good data (and probably some obfuscation) on production figures - actual output as well as capacity. Similarly, there is rarely much clarity on oil reserves. OPEC can make a big difference by evolving better mechanisms to govern output and reporting.

This sentiment is not exactly new - a US Joint Economic Committee press release dated 2005 says, "Much more transparency in OPEC oil production is needed, as noted by the International Energy Agency and others".

Price gyrations are clearly not good for anybody. And OPEC suffers almost as much from high prices as consumers do. High prices can severely crimp demand, particularly if measures such as gasoline taxes imposed to control the environmental impact of oil use gain wide traction. Consistently high prices can also encourage research into technologies to produce alternative energy*** (although these are not without concerns of their own.). And so OPEC will do itself a favor by becoming more transparent. And it will greatly help the world economy avoid getting onto a slippery slope.

* the US Dept. of Energy has a nice graph that traces the prices of oil (nominal as well as real) over the period 1970-2006.

** interestingly, $100 oil predictions are still going strong.

*** More on alternative energy technologies in my next post, where I'll also be talking about how we applied our methodology for foreseeing emerging technologies to the problem of guaging the potential of technologies that produce energy from solar, wind and other sources.

Saturday, August 25, 2007

What REALLY Works..umm..well, sort of..!

Is there a secret sauce for corporate success?

The Halo Effect is a cognitive bias whereby the perception of a particular trait (for example, of an individual) is influenced by a general impression (of that individual). This effect was first postulated by Edward L. Thorndike, an American psychologist who conducted research into how World War I soldiers were appraised by their superiors. He found high cross-correlation between all positive and all negative traits - in plainspeak, that means that soldiers who were found to be good on one or two traits were rated as good on all other traits as well, while those who were seen to be bad on one or two traits were rated poorly on all other traits as well.

Lest we think that this is an affliction confined to senior World War I army officers, it isn't. Pretty much all human beings suffer from this bias - apparently it is a mechanism used by the human brain to manage the complexity of the world. This, for example, is why celebrity endorsement of products works, even when it is fairly apparent that the celebrity has no credentials - or credibility - to endorse those products.

Most of us also seem to intuitively realize the existence of this effect - for example, this is why people go to extraordinary lengths to put on their best behavior in the presence of somebody in authority.

Now, a book called The Halo Effect ... and the Eight Other Business Delusions that Deceive Managers, published in February 2007 by Free Press, sets out show how this effect may color our perceptions of company performance. At first glance, this is the book the business world was waiting for, and didn't know it. It's a good, down-to-earth look at the various studies, scholarly and otherwise, that have claimed over the years to uncover the secret sauce that drives great companies. This is a book full of solid horse sense - the most refreshing book in years in a genre notorious for pompous claims and buzzphrases.

It dedicates itself to debunking simplistic "theories" that purport to answer the core question of what really determines corporate performance. The core argument of the Halo Effect is that when a company performs well, we shower glowing ratings on every one of it's management traits such as leadership, culture, strategy, execution, et al. When the company performs poorly, we promptly buckle over to the other extreme, demonizing the very same leadership, culture, etc.*!

Along the way, the book unveils eight other "delusions" that frequently afflict attempts to answer this question. In buttressing its arguments, the book quotes from authorities as varied as George Bernard Shaw and the legendary Nobel Laureate Richard Feynman.

The book comes with cast-iron credentials - the author is Prof. Phil Rozenzweig, who is a PhD from the Wharton School at the University of Pennsylvania, and has taught at Harvard Business School and IMD, Switzerland. His candor is incredibly refreshing, and the fact that most of the authorities on this subject that he takes on are people of his "own" - business school professors - shows admirable boldness.

The other delusions include the old statistician's chestnut - mistaking correlation for causality. Another one relates to the quest for single, over-arching explanations for good performance where in reality there may be multiple factors at work. Yet another delusion deals with the fact that company performance is often seen in absolute terms (reduction of inventory costs, for example) while it should really be seen in relative terms (for example, market share, or change in inventory costs relative to those of the competition).

I thought one delusion, the 'delusion of rigorous research' is rather inaptly named. It holds that it doesn't matter how rigorous our research methodology is if it uses data that isn't of good quality. True enough, but this delusion would probablybe better named so as to direct the focus on the poor data quality.

Personally, perhaps the best takeaway from this book was the exhortation that one should not select a sample for study based on the dependent variable - for example, if you want to study if a new technque for teaching mathematics to children works, you should study how kids who were taught using that technique fared, but you should also look at children who weren't taught that technique! **

One criticism that may be leveled at the book is that it is sometimes too quick to assume that the data used by various studies were "contaminated" by halos; it seems to me that this is too facile, and perhaps unfair, a conclusion. We should probably credit the authors of those studies, the references they consulted, and the subjects they interviewed with a greater degree of discretion and diligence than that. Another thing I found myself wishing the author would refrain from is the extent to which he bases evidence for the delusions on news reports in the business press, such as BusinessWeek, Fortune and The Wall Street Journal. These are written by reporters under stifling deadlines, often under pressure to sensationalize the mundane - a fact that does not escape most discerning readers. There can be a smattering of these, but the author would probably have done better to focus his considerable energies on well-funded studies done over a long period of time, with purport of scholarly rigor, and papers and books*** based on such studies. The readers of such reports, papers and books are typically asked to suspend common sense and prior experience, and submit to scholarly authority derived from apparent academic rigor, and it is these for which the greatest disapprobation should be reserved.

So, what does work, according to the author? Well, he concludes, somewhat disappointingly, that it's the right strategic choice, and good execution!

But this is not to take away from the otherwise excellent content of the book. It's job is not to give us formulas. It's purport is to caution us that business performance is far more complex, and far less amenable to simplistic analysis than we tend to think, and it achieves that goal with admirable panache!
* I have referred to this "binary" thinking as the Extreme Tendency elsewhere, albeit in a somewhat different context - that of foreseeing the prospects of emerging technologies!

** Later in the book Rozenzweig shows that even observing this precept doesn't help much in uncovering what drives corporate success, but it's a very important principle to keep in mind nonetheless.

*** That, without openly claiming anything of the kind, actually intend to expand the fame of their authors as management Gurus, not to say anything of their pockets!

Sunday, August 19, 2007

In Search of Senselessness

Internet search disputes are beginning to veer toward the outlandish

Advertising has always brought out the most competitive side of companies. Which is understandable, given the huge stakes involved. Advertising is a key mechanism for creating and monetizing consumer mindshare, and is thus bound to be an arena where companies fight tooth-and-nail. Sportspersons and organizers of major sports events, for example, have long had to contend with sponsor companies attempting to bar rival companies' advertising, on grounds of conflict of interest.

In internet advertising too, such conflicts have sprung up from time to time. Now, Google is being sued because searches on its engine using keywords that are trademarked return results that are sponsored by the trademark-holders' rivals. Specifically, American Airlines claims that a search such as one using the keyword 'Aadvantage', a word trademarked by it, returns rival airlines' website links under sponsored results, thus allowing those rivals to get a "free ride on American Airlines" (not sure if the pun is intended or not).

American Airlines is a mighty company and is probably better off focusing its considerable energies on higher payoff areas. One hopes wiser counsel will prevail at that admirable company. But it'll be interesting to see how Google can / will respond.

So, what recourse does Google have? It can

- refuse to allow searches using keywords that are trademarked by a company. Clearly not advisable as many users do want to search by such keywords.

- 'sanitize' search results to ensure that the results (sponsored or otherwise) being thrown up do not belong to rival companies. This has a number of operational difficulties - for example, a search string may have several keywords, only one of which is trademarked. In such a case, it leaves the searcher poorer, as s/he is deprived of results that they may really be looking for.

- do as above, but only for sponsored results. This still has problems - for example, it may open Google to accusations of discriminating against those rival companies.

As for Google, it innovates constantly on various aspects of its advertising initiatives. But developments such as these are indicator of how complex something as relatively straightfoward as serving up internet ads can be.

Saturday, August 18, 2007

Welcome Rumblings in the World Economy

Home loan lending excesses of the past are coming home to roost, but there may be a heartening side to these rumblings.

The past few weeks have seen major tremors reverberating through world financial markets. The Dow Jones Industrial Average fell precipitously on July 26th , and again on on August 14th. It continued to fall for the next two days. Merril Lynch said Countrywide Financial, the largest US mortgage lender, could go bankrupt. Hedge funds operated by Bear Stearns were said to be teetering dangerously. BNP Paribas caused a flutter by announcing that it was halting redemptions from 3 securities funds, effectively freezing a total of $2.2 Billion in assets.

All these developments were traceable to the subprime home lending excesses that have been happening for years. The US Federal Reserve, which had maintained that the subprime issue did not need its intervention, cut its discount rate on August 17th, signalling that it was worried and willing to act to contain the damage.

Why are these admittedly bleak developments welcome?
As I wrote here in March, risk is being underpriced in the world economy. These developments may be an indicator of that situation beginning to get corrected. Hank Paulson called the July 26th fall of global markets a "repricing of risk"*. Lenders all over the world are waking up to the fact that there have been excesses in lending, particularly on the home loan front, and these excesses need to be corrected.

Another reason for "cheer" is that the extent of these rumblings are showing just how far-flung the effects of the subprime excesses had spread. Few expected that the first bank to go under would be a German bank (IKB Deutsche Industriebank), and a French bank (BNP Paribas) would be among the first to press the panic button by freezing its funds. This global spread of risk was suspected, but now there is data to confirm it, and that can only be good - at least it will encourage more diligence and discipline in financial matters.

A third reason why these events may be positive is that they may indicate that the subprime excesses have happened worldwide, and are not just a US phenomenon, they are apparently thought to be.

Large risks remain - the subprime mortgage mess in the US is still far from over, the fragility of the Chinese financial system is a cause for concern, and much of the mechanics of the world economy remain poorly understood. So, a widespread appreciation of the extent and magnitude of risk in the world economy can scarcely be anything but welcome.

All this also goes to show that nasty surprises are not always a bad thing. As long as the rumblings are just the sound of risk being more realistically assessed, we should be happy to hear them. They're just the sound of a soft landing.

* he also said subprime was nothing to worry about, a statement which was belied on August 17th when the Fed cut its discount rate.