WHY DO EXPLORATION and production companies make more
acquisitions, buy back more stock, and invest more in growing and
developing their reserves when the commodity price is high and
these uses of capital are at their most expensive levels? Why do
they lever up at the top of the cycle when there seems to be more
downside than upside? These actions seem at odds with the rational
concept of “buy low and sell high.” Can behavioral finance explain
these seemingly irrational behaviors?
For over half a century, business school students have been
trained in the efficient market hypothesis which asserts that inves-
tors cannot “beat the market” because the stock market is so ef-
ficient that share prices reflect essentially all available information
at all times. In their economics classes, these students have been
taught how investors always make rational decisions that are in
their best self-interest. Given the volatility in the oil and gas industry,
many undoubtedly wonder how efficient the market is and how
rational investors are. How do we explain the apparent market
inefficiency and irrational behaviors?
A few decades ago a new field of “behavioral finance” emerged
with the intent of explaining why markets sometimes deviate
from absolute efficiency and how our innate biases cause irrational behaviors that can influence decisions and drive markets. For example, one of many so-called irrational behaviors
results from “recency bias,” which explains that we often extrapolate recent events into the future. That is, if oil prices have
been low, we act as if they will continue that way, and when
prices are high, we act as if that will continue, too.
In addition to explaining investor actions, behavioral finance
can help explain management behaviors too as executives are
prone to the very same human biases as investors. When developing strategies, thoughtful management teams should
consider how irrational behavior by investors and competitors
can affect the market and create opportunities to capitalize on.
More on this later.
Behavioral finance in oil and gas
REINVESTMENT RATE, LEVERAGE, AND THE COMMODITY CYCLE
GREGORY V. MILANO AND JINBAE KIM, FORTUNA ADVISORS, NEW YORK, NY