Why you should never take advice from people who have no "skin in the game."

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The U.S. energy independence story: Will anyone be punished if it turns out to be wrong?

Will anyone who is currently predicting U.S. energy independence be punished if the story turns out to be wrong? I ask because the story--and that's all it is right now--appears to be driving public policy and business planning practically worldwide.

Often implied with that narrative is a corresponding abundance of oil globally. In fact, some are predicating worldwide abundance on a continuous rise in U.S. oil output. This is despite the fact that even many optimistic forecasts make such ideas seem foolish. The actual data for crude plus condensate (which is the definition of oil) show oil production in the rest of world declining almost as much as the United States has increased its production from 2005 onward. Worldwide crude volumes have barely nudged upward in the last eight years, just 2.7 percent versus 10 percent in the previous eight-year period, according to the U.S. Energy Information Administration. This is despite record oil prices and record investment!

"The Evil Spirts of the Modern Day Press". Puck US magazine 1888; Nasty little printer's devils spew forth from the Hoe press in this Puck cartoon of Nov. 21, 1888. http://commons.wikimedia.org/wiki/File:Puck112188c.jpgNow, a lot of people stand to get hurt by the energy independence/abundance story--which is, in effect, a forecast--if the story turns out to be wrong. This is because governments, businesses and households will not have prepared themselves for a negative surprise--all because they were assured that the United States and even the world had nothing to worry about when it comes to oil supplies.

So, the short answer to the above question is that no one will get hurt except those who believe the story and act on it. And, herein lies what author and student of risk Nassim Nicholas Taleb calls the agency problem. His latest book, Antifragile: Things That Gain from Disorder, has much to say about the agency problem and should be mandatory reading for anyone who must manage risk--which means just about everyone.

Let's take the dodgy U.S. energy abundance story and see if the people who are propagating that story will be hurt if it turns out to be wrong. These people are essentially acting as agents for the industry even though they often appear in the media as neutral observers and thus agents for the public in its quest to understand our true energy situation. The most salient fact about these sources is not their hidden ties to the industry--which is bad enough--but rather the fact that they don't have any "skin in the game." That means that while they may have significant upside as a result of their forecasts or as a result of repeating the forecasts of others, they do not share proportionately in the downside if their predictions are wrong. This is a key point. It tells us that people can hype a development to increase their own wealth and/or stature while dumping the risk on others. The actual truth of something becomes immaterial to the prospective gains.

First, let me talk about journalists. Journalists are an obvious case of the agency problem. They are ostensibly acting on behalf of their readers to discover the truth. But, they often repeat uncritically what the oil industry, their paid consultants, and fake think-tank and university academics supported by the industry tell them.

It's difficult for those reporting on energy issues to buck the industry as it might ruffle feathers among longtime sources and shut down the information pipeline. And, that's the problem. Reporters depend on living, breathing sources for their information far more than they do on meticulous documentary research. And, this has become even more the case with the advent of the 24-hour news cycle and the corporatization of news--both which developments have resulted in fewer and fewer dollars going into genuine investigative reporting. (I can tell you from experience that such reporting is time consuming and involves sifting through a lot of tedious documents.)

Some journalists are exploiting the oil hype to sell books and thereby enhance their reputations and their pocketbooks. But, neither the book-writing journalist cited in the link above, nor his compatriots who are just doing their daily job of reporting the energy news will be forced out of their jobs or be forced to return their book profits, as the case may be, if U.S. energy independence turns out to be a mirage.

In saying this, I'm not advocating laws that would force such an outcome. I'm merely pointing out that believing someone's forecast about an important and critical public policy matter, someone who has no skin in the game, that is, who has no downside if they are wrong, is personally dangerous--and malfeasance if applied to public policy or business.

You will also notice that almost without exception such stories and books make scant or no mention of climate change, as if the supposed renewed fossil fuel abundance has no consequences for the unfolding climate nightmare. When I see this omission, I suspect either stupidity on the part of the writer or cupidity for the profits and stature that come from aligning oneself with a powerful and wealthy oil industry.

Industry consultants and fake think-tank academics are already well-paid for their fealty to the industry line. When they speak to reporters, there's no downside if they are wrong. Their consulting fees and think-tank salaries DEPEND on their repeating the industry story. And, no one will take their money back if the story is discredited.

So, now I've covered the broad array of writers and pundits who have been touting U.S. energy independence (and some who've been saying it will solve the world's energy problems as well). How about the industry insiders themselves? Won't they suffer if their forecasts are wrong?

The short answer is that most will suffer very little. And, that's because of the curious system of compensation which most corporate officers today enjoy. The largest part of their pay often consists of stock options--that is, the option to buy the company's stock at a predetermined price for a set period of time. It doesn't sound like it would be that bad. And, their incentive appears to be to manage the company properly to increase the stock price.

But their incentive turns out instead to be to manage the news about the company to increase the stock price as quickly as possible. Investors nowadays can be easily misled and can quickly move their money to the latest speculative craze. In fact, this has always happened wherever people traded company shares through history. But, it has been enhanced by the Internet and all forms of electronic trading.

When the stock price is safely above the option price, the insider buys the deeply discounted shares from the company directly and then dumps the shares on the market almost immediately to secure a large and risk-free profit. The insider gains from short-term hype while avoiding the downside of possible long-term disappointment. And, nobody comes to take back the stock option profits when optimistic projections and pronouncements turn out to be wrong.

Then, there is problem of the board of directors being beholden to the company management rather than the shareholders--yet, another agency problem. And, these directors often approve outrageous bonuses for management which, of course, are not taken back when things go bad.

Perhaps the most visible recent example was the $75 million bonus awarded to Aubrey McClendon in 2008, then CEO of Chesapeake Energy Corp., as the natural gas market collapsed and the excessive borrowing by Chesapeake tanked its stock price and nearly brought the company to bankruptcy. In this case, institutional shareholders actually tried to do something by filing a lawsuit. The result: McClendon got to keep his bonus, but had to buy back a $12 million collection of antique road maps that were purchased from him by Chesapeake at the direction of board to help cushion his horrendous losses on the Chesapeake stock he owned.

To his credit, McClendon had much of his personal fortune invested in Chesapeake. But, as we can see, he did not have the downside of other investors since he was able the manipulate to board into giving him $87 million of the stockholders' money (including the $12 million for his map collection). The downside, as it turned out, would have been an almost complete wipeout of his fortune had it not been for the felicitous cash infusion by order of the board.

What might solve the agency problem in such cases is never to grant stock options. Rather, we should require whoever enters top management to invest a substantial portion of his or her savings in the company and be forced to retain any position for 10 years or more before selling. This would carefully align the management's aims with those of shareholders since management would now have a lot of skin in the game with no chance of a bailout if things go badly.

But, don't hold your breath waiting for this proposal to be adopted. The entire executive compensation system for publicly traded companies is expressly designed to prevent executives from taking a hit for their mistakes while giving them all the upside for the company's success--even if it's temporary, due to factors outside their control, or due to clever manipulation of the news media. Instead, the stockholders get hit. It's the agency problem in spades!

Now, the broader issue is not the greed of corporate insiders at the expense of shareholders though that's an important issue. The broader issue is how public policy is being affected by people who have little or no downside if their public pronouncements and projections are wrong.

Unfortunately, this issue has become endemic in society as so many of us are divorced from the consequences of our actions in a world with highly specialized jobs and worldwide networks capable of wreaking havoc far from the decision and the decision-makers.

All the extractive industries disproportionately place bad consequences on those nearest the site of extraction for the benefit of the rest of us and for their own bottom line. In the case of the fossil fuel companies, they benefit from free disposal of carbon dioxide into the atmosphere which, of course, is moving us toward a climate disaster that will affect us all--just not enough for now to destabilize the fossil fuel companies.

Certain parts of the academic world--usually economics faculties--are laced with influential voices who offer advice on public matters, but, once again, suffer no punishment if their ideas are adopted (often with vigorous assistance from the financial industry) and then result in disastrous consequences. We can see how well that has worked for financial deregulation advocated by so many academic economists. So far as I know none who advocated such changes have been ousted from their tenured seats.

In fact, Harvard academic Lawrence Summers as deputy treasury secretary during the Clinton Administration was instrumental in the repeal of the Glass-Steagall Act--a Depression-era law which had kept the commercial banking system safe for 60 years by keeping it separate from high-risk investment banking. Summers not only didn't get punished for his role in setting the stage for the banking meltdown of 2008, but actually returned to run the National Economic Council under Barak Obama.

But, of course, Summers was not alone. Many academic experts and financial executives had been pushing for financial deregulation for years. And, here is another aspect of the agency problem. When one person makes a costly error, it is much easier to pin the blame and extract consequences. When hundreds or thousands help perpetrate a social, environmental or economic disaster, the blame is diffuse. No one person feels that it was he or she that caused the problem, and the law in the United States and many countries counts bad advice and misguided advocacy as free speech.

I am not suggesting that we end free speech. That would be a solution that is worse than the problem. To use Taleb's words, I am suggesting that we not allow ourselves to be suckers. And, one of the surest signs that we are on the road to being suckers is when we take the advice of someone who has little or no personal downside if he or she is wrong.

Almost always in such cases, there are hidden risks that only appear too late to address. By that time the touts have long absconded with their riches or remain well-protected by their benefactors.

The record of history recommends extraordinary proof in the face of extraordinary claims. Given that oil is finite, given that we are now consuming it at the highest rate in history, given that oil continues to hover at its highest average daily price ever (even after adjusting for inflation), and given that the risks of climate change are so great that they could wipe out our civilization as we know it--the burden of extraordinary proof lies with those who claim that oil abundance for the long run is an actual fact and that that fact won't somehow destroy civilization as we know it.

So far, all they've given us are disjointed, ambitious and deceptive claims about supply that are at odds with independent assessments. And, they've given us absolutely nothing about how this supposed new abundance doesn't bring a climate disaster closer.

But, the promoters of the U.S. energy independence story and the renewed oil abundance meme have managed to do one thing quite well: enrich themselves while being protected from any long-term downside of their forecasts--until, that is, world oil production becomes so constrained or the habitability of the planet so severely affected due to climate change that even their wealth and stature won't protect them from at least some of the consequences.

P.S. For my view on how we should approach the uncertainties of our energy future, see my previous piece "Dueling forecasts: Why our energy future is actually a risk management problem".

Editor: Image is from Wikimedia Commons:  "The Evil Spirts of the Modern Day Press". Puck US magazine 1888; Nasty little printer's devils spew forth from the Hoe press in this Puck cartoon of Nov. 21, 1888.

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