Tuesday, August 24, 2010

BP and the Black Swan

The Black Swan Theory was developed by Nassim Nicholas Taleb to explain 1) the disproportionate role of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology, 2) the non-computability of the probability of the consequential rare events using scientific methods (owing to their very nature of small probabilities) and 3) the psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs.

Is the BP Macondo well in the Gulf of Mexico a black swan?
An email from a manager at BP said “WHO cares, it’s done, end of story, will probably be fine.” This was in regard to the decision to use only a few centralisers when cementing into place the pipe that ran from an oil reservoir 13,000 feet below the sea floor to Deepwater Horizon, the drilling rig floating 5,000 feet above it. The cement failed four days after the e-mail was sent, on April 20th. Oil and gas rushed up the well, dooming the rig and 11 of her crew.
Is the blowout due to corruption or bad management?
According to BP’s partner in the well, Anadarko Petroleum “The mounting evidence clearly demonstrates that this tragedy was preventable and the direct result of BP’s reckless decisions and actions. Some in the American oil industry think this reflects a poor corporate culture at BP, in which personal advancement has depended more on cutting costs than on technical proficiency. When Mr Hayward, with a background in exploration, replaced John Browne, much more associated with finance, in 2007, he emphasized a commitment to safety, with ambitious company-wide schemes meant to deliver these results. But chief executives cannot renew cultures without years of protracted and increasingly disseminated effort to that end.
Additional spending of $7 million to$12 million on a safer wellhead piping structure might have prevented natural gas from seeping to the surface and blowing up the rig. So, by saving several million, it has cost BP $20 billion and its shareholders initially $87 billion in stock market value.
In 2003, the Interior Department agreed with oil companies that installing a $500,000 acoustic shutoff switch on every offshore rig would be unreasonably expensive (even though such a switch would likely have prevented all that oil from spewing out). Of course, now that BP is staring at billions of dollars in clean-up costs and the prospect of bankruptcy, that $500,000 switch looks like a bargain. A single well out of the thousands drilled and developed by BP across the globe is responsible for wiping out $87 billion in shareholder wealth and causing a cash dividend that was providing a 6% yield to evaporate. Severe damage has been done to the shares of Anadarko and Mitsui, BP's partners and Trans-ocean the rig owner. By comparison, Exxon's market cap fell only less than 6% in 1989 after the spill in Alaskan waters from a single tanker, the Exxon Valdez.
How should black swans be dealt with?

Some argue that the Precautionary Principle should be followed for every decision. The precautionary principle says that if we are embarking on something new, we should not go ahead until we are convinced it is safe. But this means that many innovations will never see the light of day.

Taleb argues that there should be a redundancy to protect against the results of the event. He points out that Mother Nature has created redundancy – two eyes, two kidneys, and so on. This is what risk management should be about. He says that the financial crisis of 2008 was not a Black Swan, only the result of fragility in systems built upon ignorance—and denial—of the notion of Black Swan events. He provides an analogy, “You know with near certainty that a plane flown by an incompetent pilot will eventually crash.” Taleb’s approach takes no account of the costs of redundancy. His view is that when the event happens it will overwhelm any marginal cost of not having a redundant system.

Was this event a Black Swan?
Accidents of this type are unusual but not that rare. During the last decade, there were 72 offshore blowouts which caused significant spills, compared to 15 the previous decade. Naturally, the more wells that are drilled, and the farther underwater that equipment must operate, the more likely an accident is to happen. Despite these facts, BP was so confident that industry risks were overblown that they cancelled their accident insurance three years ago. BP clearly decided to save time and money at the expense of safety precautions.

Is a Black Swan event like any other – it involves tradeoffs and because it is a low probability event the costs of containing its results if it occurs are not worth it. If the odds of an event occurring are .00000000001 and the cost is $100 billion, the expected value is relatively small. In the BP case the odds of a blowout were considerably higher . So why did risk management not take a blowout into account?

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