I spent a lot of time during the past 12 months working as technical editor on the fourth edition of Managing energy price risk from Risk Books, which is scheduled to be published in December. This work was not an only an opportunity to interact closely with some of the guiding lights of the industry, but also to reflect on the developments of the past 10 years.
We lived in a very different world when the third edition was published in 2004. The mission of stabilising the world economy and creating a more prosperous and secure world had been largely accomplished, or so we were told. Advances in the science of macroeconomics and financial economics, as well as in the theory and practice of risk management, created a more orderly and safer world. At the macroeconomic level, this manifested itself as the 'great moderation' – a pronounced drop in the volatility of gross national product, investments, employment levels and inflation going back to the 1980s.1 This trend was attributed, to a large extent, to changes in the economic structure of developing countries and the enlightened policies of central bankers, orchestrating advanced nations' economic policies like maestros.
At the microeconomic level, advances in risk management allowed financial institutions to identify and measure risks to an extent unprecedented in history. The corollary of this widely accepted thesis was that the financial industry was able to slice and dice risks, distributing them across many different dimensions to reduce or fully neutralise the impact of exogenous shocks.
This rosy picture stood in sharp contrast to many gloomy predictions regarding future energy production and price trends. Forecasts for US natural gas markets anticipated a looming shortfall of North American production and the need for growing liquefied natural gas imports. The most popular energy blog was The Oil Drum, with many postings offering dire predictions of peaking worldwide oil supplies and future liquid fuels shortages. On the demand side, accelerating economic growth in emerging markets, primarily China, would interact with supply constraints to produce ever-climbing prices, suppressing economic growth. Today, energy markets are more worried about the US oil and gas supply glut and reduced rates of economic growth in China, translating into falling prices for many critical commodities.
These examples demonstrate the perils of forecasting in an era of fundamental structural economic transformation and rapid technological change. The Italian poet Dante Alighieri had a point when he placed the diviners, astrologers and others with enough audacity to attempt predictions of the future in the eighth circle of hell, with their heads turned backwards and tears flowing down their backs.2 At the time, if somebody had predicted correctly what would happen over the next 10 years, the person would have been a laughing stock. They might have even been denounced as a heretic or ended up in a room with well-padded walls to repent their sins against established orthodoxy.
Today, we are not only much more humble, but also busy cleaning up the mess created by years of exceptional exuberance
Today, we are not only much more humble, but also busy cleaning up the mess created by years of exceptional exuberance. The first section of the book, The winds of change, contains a review of the external shocks that hit financial and commodity markets and ongoing efforts to steady the ship of the world economy.
Another objective of the book is to help readers to address a great cognitive challenge of our times: an incessant flow of very detailed information, which overwhelms our ability to process and organise it. We operate in a 24-hour news cycle, with access to multiple overlapping data sources, and the media have to compete for our attention and elevate every minor development to the status of an earth-shattering event. In other words, we face the task of separating signal from noise – and once we have done it, we have to avoid the temptation to mechanically project current trends into the future. Unfortunately, a pile of bricks is not a house and sheer accumulation of facts is not knowledge. We hope that the experts who contributed to the new edition will help readers to discern emerging patterns hidden in market data and see the proverbial forest for the trees.
The changes we have witnessed in our lifetimes will undoubtedly result in a fundamental transformation of our industry. To a large extent, the developments I have described represent a leap into the unknown. So it is perhaps fitting that this year marks the hundredth anniversary of the publication of the most beloved poem of American literature:3
I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I –
I took the one less travelled by,
And that has made all the difference.
Yes, we have definitely taken the riskier road. We shall see where it takes us.
1. This term was popularised by Ben Bernanke, the then-chairman of the US Federal Reserve. See: Remarks by Governor Ben S. Bernanke at the meetings of the Eastern Economic Association, Washington, DC, February 20, 2004.
2. This truth is illustrated also by a well-known adage, attributed, among others, to Yogi Berra, Niels Bohr and Mark Twain: “It is difficult to make predictions, especially about the future.”
3. Robert Frost, The road not taken