In the movie Bull Durham, veteran catcher Crash Davis advises rookie Nuke LaLoosh to bean the team’s mascot. This bluffed lack of control convinces the batter to stop crowding the plate.
Last week, the International Energy Association (IEA) announced that it would be releasing 60 million barrels of oil from the world’s strategic oil reserves. On the face of it, it was an odd move. Oil prices were already starting to move down from their spring highs. Although Libya has put less oil in the market, global oil supplies appear adequate to fuel the world’s muting economies. And 60 million barrels is not that sizeable an outflow, equating to less than one day of global demand. Yet oil prices swooned on the news.
Financial talking heads, confounded by the move, came up with the following theses: a) the IEA is stupid as all government and quasi-government agencies are, b) the economy must be in bigger trouble than we know if the IEA had to pull this kind of desperation move, or c) it was an Obama-inspired political move to marginally help the US economy and placate voters.
Someone from work stepped into my office and started spewing the “stupid” theory. I looked up and said,
“You got it wrong. The IEA beaned the mascot. They’re bluffing. And every oil trader either knows it or will figure it out in the next ten minutes.”
“If everyone knows it’s a bluff, it won’t work. They’ll just drive the price back up.”
“You’ve never played poker, apparently,” I replied.
Bluffing Works, Even when it is Obvious
People who don’t play poker have a misconception about bluffing. They assume that a bluff is intended to fool or mislead opponents. They believe that subterfuge and deception are the keys to its success. They are wrong. The reason bluffing works is because it is hard to defend against — even when a player is nearly convinced he is being bluffed. Some of the elements that make a bluff particularly hard to defend against were employed by the IEA.
If you bluff every hand, or bluff from the cut-off every time, it won’t take long for your opponents to realize it and start to mount a defense. It signals that you are bluffing with a wider and weaker range of hands. The first time one of your opponents wakes up with a half-way decent hand, they’re going to snap you off. And they’ll keep doing it until they shut you down.
Less frequent, non-pattern, bluffing signals a stronger hand to your opponents. Even if your opponents suspect you are bluffing, it increases their uncertainty.
The IEA doesn’t have an established record of bluffing - it has called for reserve releases only three times in its history. The US has released oil from its reserves only three times in the last 20 years. Eleven million barrels were released after Hurricane Katrina. During Dessert Storm, 21 million barrels were released. Interestingly enough, non-emergency sales of 28 million barrels occurred during ‘96 and ‘97 to help pay down the deficit.
Bluff into Weakness
It is much easier to bluff someone off a weak hand than to bluff them off a strong one. And out-bluffing a bluffer is perhaps one of the most successful strategies there is.
I’ve heard people suggest that the IEA should have made its move in spring, when oil prices were at their peak. But that would have put the IEA up against a fundamentally stronger hand. Economic indicators were stronger, suggesting better odds of a continuing economic recovery and thus demand for energy. Unrest in North Africa was at a fever pitch with high uncertainty about its spread and effect on oil supplies. Few speculators would fold long positions in the wake of strategic oil releases. In fact, release of strategic reserves might have fueled more speculation.
Economic indicators around the world have since weakened. This, in turn, has weakened the thesis for higher energy demand. Oil prices had begun to drop. Although some speculative positions had come out of the market, there was still a lot of hot money riding Brent oil long. In fact in mid-June, the price spread between WTI and Brent reached a record level of nearly $21 per barrel. This wasn’t a particularly strong hand for Brent and spread speculators going forward. There was arguably much more downside risk and limited upside potential.
It was also probably not a coincidence that the IEA chose to time its announcement just after the US Federal Reserve lowered its economic growth estimates and after Bernanke held a press conference, highlighting the near-term challenges for the US economy.
Threaten Multiple Decisions
Novice poker players often bluff by going all-in. They erroneously believe that forcing their opponent to make a do-or-die decision gives them a position of strength. But by doing this, they are risking their tournament life on a bluff. They also give their opponent the opportunity to have to make only one difficult decision.
By betting less than your stack, you still have a high probability of getting an opponent to fold on the spot. Also, by keeping a big stack in reserve to bet in successive rounds, your opponent has to consider that they will be forced into making additional difficult decisions throughout the hand. The potential threat of future bets — and decisions - is a powerful deterrent.
The IEA bet small and left itself with a big stack. Currently US companies have an inventory of roughly 350 million barrels of oil. The US strategic reserve has approximately 730 million barrels in inventory. Although the US strategic reserve is the largest, all 28 member countries of the IEA have to maintain strategic reserves of no less that 90 days of inventory, based on their prior year’s net imports. This emergency inventory represents roughly 1.6 billion barrels of oil.
Have a Risk versus Reward Edge
The last thing you want to do is risk a lot to reap a little. Every poker player is trained to calculate the size of their raise/bet/call versus the size of the pot. The most effective bluffs are those that give an opponent a poorer risk/reward profile than your own.
Here, the IEA is in good shape. The worst thing that can happen is a quick rebound of oil prices. But even if that is the case, countries that release reserves will reap money from the sale of their oil near the market top, which will help pay down their budget deficits. In the US, the sale of 30 million barrels of oil will give the US a little more wiggle room re: the debt ceiling. Oh and the bonus? It pisses of OPEC.
The best case is that oil prices, especially the price of Brent, falls. This reduces the inflation risk across the world, giving struggling economies more time to maintain loose monetary policies in the wake of tighter fiscal policies. It gives consumers the ability to spend more money on other goods and services. And save oil companies, it will help margins and revenues for the vast majority of businesses.
For leveraged long investors, the risk reward scenario is not so good. The initial price drop triggered margin calls, which may have necessitated the liquidation of more promising hands. Going into a summer with potentially weaker economic data or subsequent reserve releases heightens liquidation risk. Even if some speculators ride it out, others will vacate the trade putting even more downward pressure on prices. With the Brent-WTI spread at a relative high, the upside potential is arguably muted, necessitating faster-than-expected economic growth or a significant disruption in oil supplies.
To the IEA: “Nice hand.”