Too clever by two standard deviations

From Stephen Bartholomeusz’s column in this weekend’s Oz:

The BHP board will have done a lot of head-scratching to understand how they could have ended up in the bind the group finds itself in. Its [earnings?] model was supposed to ensure that this situation could never arise.

The BHP model came out of a risk-management strategy developed by former chief financial officer (and subsequently CEO) Chip Goodyear just ahead of the BHP merger with Billiton in 2001, when his team began analysing the group’s hedging strategies.

Out of that work came BHP’s unique “Cash Flow @ Risk” model, which was essentially a set of probability distributions that modelled all the risks – commodity prices, interest rates, currencies, operational risks, balance sheet and jurisdictions – to produce a baseline level of cashflows in all circumstances with a 95 per cent level of confidence.

BHP’s modelling showed that the diversity of its portfolio lowered risk and generated more return for risk.

The model was designed to help the group manage risk rather than to drive strategy but inevitably informed the decisions it took. The Billiton merger and the WMC acquisition pushed up the base level of cashflows the model said would be available in worst-case scenarios.

In essence, the model produced an obvious conclusion. The portfolios of big investment funds are constructed on the same theory that diversification reduces risk and enhances risk-adjusted returns. The model provided BHP with confidence that there would always be a base level of cashflows to underpin the progressive dividend policy.

The plunge in oil price, from above $US100 a barrel in 2014 to about $US30 today, coming as all other commodity prices tumbled, was outside the 95 per cent confidence level within the model. Oil prices had never been so closely correlated with the other commodities.

There was another change within BHP’s portfolio that also impacted the model. For 40 years, until 2010, iron ore prices were set in annual talks between the three big seaborne producers – Rio, BHP and Brazil’s Vale – with the Japanese steel mills. The first deal struck each year became the benchmark for all the contracts …

One of the early conclusions of the analysis Goodyear’s team had done was that the balance between exchange-traded and contract-priced commodities was one of the diversifying elements of the portfolio, because the contracts introduced leads and lags to the price movements in commodities. The shift to market prices for iron ore shifted the portfolio balance to market pricing.

So unforeseen correlations and changes in underlying reality caused the model to fail. Well, bugger me. Who’da thunk it??

But that’s par for the course, when people get blinded by science. What is genuinely puzzling is that the creators of the model didn’t think that a model of cashflows, used to underpin decisions about dividend payments, wouldn’t be used to inform strategy and capital allocation. How could anyone be so obtuse? Even I know that would be an obvious consequence, and I am nowhere near being allowed into the plush, knife-filled executive suite of Encorpera Global Ltd.


About Stebbing Heuer

A person interested in exploring human perception, reasoning, judgement and deciding, and in promoting clear, effective thinking and the making of good decisions.
This entry was posted in Epistemic Rationality, Instrumental Rationality, Poor reasoning, Strat. Assumptions v. Tac. Indicators. Bookmark the permalink.

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