Stock Investing vs. Oil Field Development

As someone who've spent over ten years in the oil industry, I am seeing great similarities between the businesses of oil field development and stock investing. Understanding these similarities - and the differences - may help us better understand the business of stock investing by analyzing it from another perspective and, hopefully, improve our investing performance.

Obviously the similarities of the two businesses start with the fact that both are risky businesses. In the oil industry, which is capital intensive and with high risk, the geologists and engineers (including the reservoir, production and financial engineers) try to evaluate and optimize the value of a portfolio of oil and gas fields by making predictions that are based on scant and indirect information as well as on assumptions that are thought reasonable, say, about the future oil price or the geologic models of the fields. As smart as we are - many of us have a Ph.D. degree - we still have to be aware that these predictions could be very wrong because the data or assumptions we use may be wrong, or simply because some future events are just unpredictable. How to manage the uncertainty and risk thus becomes the most important aspect of any oil field development project, even more so than making the predictions themselves.

In fact I would say the same principle should apply to any risky business, stock investing included, if the optimal outcome is to be expected. [Another example that comes to my mind is the business of medical care/diagnosis of patients.]. In reality however, many individual investors have no knowledge or a mindset of treating stock trading as an investing process that requires researches, i.e., making unbiased predictions that are based on data, assumptions and experiences, and requires managing, i.e., what to do when things do not work out. Trading on hot tips or emotion ("it's so cheap, let's buy more!") will most likely lead to disaster over time, as I painfully lived through several years ago.

The other similarities between the two risky businesses are:

1. Both are about making predictions and assessing uncertainty/risks by integrating all available information. Some information is better ("harder") than the other. More information does not necessarily mean better predictions or lower uncertainty/risk.
2. From the viewpoint of a statistician, many variables in the stock market and in an oil project are all random variables that behave as stochastic processes over time or space. Any individual's prediction of these variables, e.g., the fair value of a stock or an oil field, no matter how smart and experienced the individual is, is just one of many possible estimates in the market place or the workplace. The implication is that you should not bet (all your money) on any one particular outcome. Specifically we should not set or act on a fixed price target.

   [I always get a kick out of analysts who state/raise/lower a price target for a company with the precision after two decimal points, without specifying a time frame].

   [Based on the same analogy, I would go a step further and say: do not trade options, because it involves evaluating the probability of two events happening simultaneously: (a) a fixed price floor/ceiling (strike price), and (b) on a pre-set date - much harder to do than predicting a stock's movement direction (up or down) only.]

3. It seems true that people always under-estimate, thus are unprepared for, the magnitude of volatility in the market or the complexity of geology in an oil field.
   
4. The methodologies for analyzing stocks and oil fields are remarkably similar: most people use a combination of fundamental (valuation or physics-based) and technical(statistics-based) methods. [Here is another view on fundamental and technical analysis, in Chinese].
   
5. Trends: the golden rule of trend-following applies in both stock trading and reservoir modeling ( e.g., in reservoir mapping:

   "Do not go against a trend while it lasts, unless you have information that suggests otherwise, i.e., its reversal".

   In statistics, this is called "unbiasedness". Yet many people lose money simply because they are biased. They stubbornly believe that they are right and the market is wrong.
   
6. Discontinuities: an oil formation may encounter faults or other boundaries, causing abrupt changes in reservoir and/or fluid properties. Similarly a stock can gap up or down, sometimes significantly. Discontinuities cannot be predicted precisely, but there are things that can be done to anticipate or manage them.
7. Each stock or potential candidate for purchasing can be regarded as an equivalent of a unique project in one's entire investment portfolio. Just like in the oil business, a project calls for thorough researches beforehand and, once commissioned, requires frequent monitoring and management.
8. All theories of probability and risk management apply to both businesses. Nobody can guarantee 100% success rate, but the goal should be to win consistently in a probabilistic sense.
   

My experience is that, if you find a winning strategy, technically it is much easier to profit in the stock market than to profit from an oil project. In other words, it carries less risk. The reasons are:

1. Even though there are countless factors that affect stock prices in any given moment, it is still a 1D game - you just need to predict what will happen in another future time. By no means an easy task, it is possible in a probabilistic sense (for a small investor anyway). For the oil field, we need to build models in 4D, i.e., what happens in adjacent wells, blocks or layers and how things will change over time in each of these units. We also need to deploy sophisticated physical models in addition to empirical/statistics-based techniques.
2. The stock market is very liquid - in most situations you can cash out and go away. You can not, however, abandon an oil rig without taking huge loss and dealing with lots of related business and legal troubles.Your decisions are vindicated soon - in days or months, unlike in the oil industry it takes years or decades, if ever at all, to show the impact of the work that you are so proud of.
3. Stock investing can be done by one person. In fact, many very successful investors are loners who otherwise would not prosper in a corporate world such as a integrated oil company.
4. It's your own money and you are motivated. You don't need to beg other people for a budget in order to, say, drill a well. Of course you don't get free donuts either, and all loses are yours!

To be continued.