One of Charlie Munger (Trades, Portfolio)’s favorite writers, Garrett Hardin, wrote a book called "Filters Against Folly,"Â in which he describes his approach to rational thinking. In three simple words, this approach can be summarized as literacy, numeracy and ecolacy.
Literacy means what is being said. Numeracy means quantifying the problem. And ecolacy goes on an extra step to ask the questions so what and then what?
This is a very simple approach to think. Personally I have found it invaluable in investing because you would ensure that you understand the business model (literacy), the financial information and any other quantifiable evidences (numeracy) and the direct and indirect impacts, or the second, third and fourth order consequences (and then what?).
Of course, this approach is not easy because our brain likes mental shortcuts and numeracy and ecolacy will force our brain to take the high road. The implication – very few people can follow this approach but for those who do, the reward is likely to be substantial – it should be.
Let me again use an example from the latest memos from Howard Marks (Trades, Portfolio) and Jeremy Grantham (Trades, Portfolio) to illustrate this point. In Marks’ memo, he quoted Byron Wien of Blackstone as an example of representative thinking at the time when oil was above $100 per barrel. This is the full quote:
“Most believed that the price of oil would remain around present levels. Several trillion dollars have been invested in drilling over the last few years and yet production is flat because Nigeria, Iraq and Libya are producing less. The U.S. and Europe are reducing consumption, but that is being more than offset by increasing demand from the developing world, particularly China. Five years from now the price of Brent is likely to be closer to $120 because of emerging market demand. “
If you think about it, the above quote is really just the literacy stuff. There are essentially no numeric evidences whatsoever and all the consequences are obviously first level. But, to most people, this statement makes intuitive sense, made possible by how our brain works. I don’t know whether his statement is true or false but I won’t make any decisions just based on literacy-backed intuition.
I believe the simplest case is the right one this time: that it was not unexpectedly weak demand but relentlessly increasing U.S. oil supply that broke the market. There is little that is dramatic about recent GDP growth or oil efficiency. Global GDP growth has been a little disappointing continuously for several years and I believe is likely to continue to be so until official expectations become more realistic. But this disappointment has been slow and steady from the 2009 economic low and many oil experts, I am sure, learned to adjust for it. Increases in the efficiency of oil usage have also been steady but unsurprising. The end result for oil usage in any case was a very boring series of small increases.
In great contrast to the picture for oil usage and efficiency, we now see some drama. Such large increases from one source – U.S. fracking, which accounted for over 100% of the U.S. increase, went from about 0% to 4% of global production in only five years – have not been seen since the early glory days in Texas, Pennsylvania and Baku in the 19th century and in the Middle East in the 1950s and 1960s. In 2013 and 2014 increases in U.S. fracking production equaled 100% of the increase in global oil demand. Worse yet for OPEC, the estimate by June 2014, with the price still around $100, was for U.S. fracking production in 2015 to be even higher than the estimated total increase in global demand this year! More importantly, the increasing surge from U.S. fracking had absolutely not been expected as recently as 2009.
Ecolacy (So what? Then what?). combining literacy, numeracy and ecolacy:
Lower oil prices and much reduced capex will guarantee that oil from fracking will start decreasing this year and that the supply of traditional oil will be less than it would have been. Indeed, at recent prices, very few, if any, new drilling programs will be started, and a mere three years later at current prices, 80% or so of Bakken production would be history. But right now we have a substantial excess of production, and oil demand is notoriously inelastic to price in the short term – people will not be leaping into their cars to celebrate lower gas prices. But with time they may drive an extra 1-2% percent here and elsewhere, and the excess will slowly clear: possibly by mid-year and almost certainly by the end of next year. After supply and demand come into balance, the price initially is likely to rise slowly, held in check by the increasing amounts of U.S. fracking oil that can be profitably produced at each new higher price level. It is this rapid response rate that will make the frackers the key marginal suppliers. This is a sensitive and, I believe, unknowable equation as to precise timing, but this phase will likely end only when fracking production, even at much higher prices, tops out, as it most likely will in the next five years. After that, I believe the equation will revert to the relatively more stable and more knowable one of the 2011 to 2013 era, in which the price of oil will be the full cost of finding and developing incremental traditional oil, which by then is likely to be over $100 a barrel. (In the interest of full disclosure I personally have been and will continue to be a moderate buyer of oil futures six to eight years out, for reason.
You can see the dramatic difference in the level of thinking between two investors. Whose opinion do you value more and why? I think the answer is obvious. Jeremy Grantham (Trades, Portfolio)’s opinion deserves more credit because not only did he go the extra mile to find the data that is not that easy to find, but also he went a step farther to think about the second and third order consequences. It takes much longer for Mr. Grantham to come up with his opinion and to lay out why he thinks that way. It’s a habit, I can guarantee you, that helps him to become a legendary value investor. This is why whenever he writes something, we eagerly read it religiously.
Let me again use one of my favorite Munger quotes to end this discussion.