Thursday, July 17, 2008

Confirmatory Bias and Oil Investing - Part Two

I recently came across a post on the Victor Niederhoffer Blog about the concept of Confirmatory Bias. I shall reprint the standard quote from Sir Francis Bacon that is used in much of the literature on this subject:

"The human understanding when it has once adopted an opinion (either as being the received opinion or as being agreeable to itself) draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects and despises, or else by some distinction sets aside and rejects; in order that by this great and pernicious predetermination the authority of its former conclusions may remain inviolate..."

After searching further, I came across a paper published in the Review of General Psychology in 1998 authored by Raymond S. Nickerson of Tufts University. I believe that the concepts he discusses have applicability to current beliefs by bullish energy investors in the oil market.

He presents a modern definition of the concept of Confirmatory Bias:

"...the seeking or interpreting of evidence in ways that are partial to existing beliefs, expectations, or a hypothesis in hand."

In his paper he reduces the concept to its component parts. Yesterday, I discussed the first two parts, and today I present my discussion of Parts 3 and 4.

Number 3 - Overweighting positive confirmatory instances.

"Studies of social judgment provide evidence that people tend to overweight positive confirmatory evidence or underweight negative discomfirmatory evidence."

The International Agency Energy (IEA) last week revised its estimates for the supply and demand situation in oil. The part of the report that made the headline was its prediction that the oil market would remain "tight" for the next five years. What was ignored was the negative information that the IEA had cut demand growth from 2.2 to 1.6% per year on average for the next five years. Although this cut in demand came from the mature economies and not the emerging economies, it is the equivalent of 500 thousand barrel a day of demand being taken off the market. This equals all of the growth in China every year for the next five years.

Number 4 - Seeing what one is looking for.

"People sometimes see in data the patterns for which they are looking, regardless of whether the patterns are really there."

This is also very prevalent in oil markets. Every other week there is news about some labor strife in Nigeria, a major oil exporter. This usually results in a couple hundred thousand barrels a day being temporarily removed from the market, and a $4 dollar a barrel rise in price. Yet when Saudi Arabia increases production by 500 thousand barrels a day, the market doesn't care. Investors see a temporary supply disruption as permanent, and ignore a permanent increase.

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