Hockey Stick Thinking

In the late 70’s, the oil industry used an optimistic oil price forecast when calculating the economics of a new oil development. They assumed the price of oil, then a little over $10 per barrel, would show a slight increase for several years, but after that, the price would increase dramatically, maybe 4 or 5 times. This pricing scenario was to become known as “The Hockey Stick” because the shape of the curve over time looked like that particular sporting implement. The hockey stick price projection, which everyone thought was the absolute truth, made even dog projects look good.

Of course, we now know that the price of oil did not increase dramatically in the 80’s. There was a period in the early 80’s where the price seemed to follow the prediction (there was that little problem with Iran), but by the mid 80’s, there was an oil glut and the price had fallen. The result was that oil companies became less and less profitable as their predictions of riches failed to come true. This resulted in a severe contraction of the industry. Lay offs and “early retirement packages” followed as companies downsized. Small service companies went out of business. Young people saw their parents out of work and did not follow them into the oil industry. Enrollments in reservoir engineering and geology curriculums dwindled to almost nothing at some universities.

Oil companies adjusted and revised their oil price predictions to be more of a flat line. In other words, they no longer assumed that the price of oil was predestined to increase every year. This made their economic evaluations much more conservative. The result was that only a worthy few projects made it through to the annual budget. But these projects made money and lived up to their economic predictions. Oil company profits increased. And it was a good thing because the industry was beginning to venture out into deeper water and the technology for that deeper water was not going to be cheap. The development costs were going to be much higher and mistakes made during project economic evaluation could have disastrous effects. Conservatism was the best way to proceed unless you wanted to break the company.

Even with today’s oil price over $100 per barrel, I doubt that you can find an oil company executive that would use those figures in his economic evaluation. He knows from past history that the price will not hold at those levels.

It looks as if the housing and mortgage industry got caught in their own version of Hockey Stick thinking. They assumed that housing would always increase in price. No one, it seems, took a step back and considered “What if?” Had they done so, or had they taken a lesson from the oil industry, we might not be in this situation today.