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Find Predictors of Trend Directions to Profit the Most

Mar 26, 2008
Some businesses are affected by powerful trends and irresistible trends more than others. In this article we'll look at a business that is sensitive to consider how to anticipate shifts in trends and forces.

Rigged to Win

Imagine for a moment that you rent drilling rigs and crews to petroleum companies exploring for oil and gas. You would like to rent your rigs out for the longest period of time at the highest possible price.

To achieve this goal, you have to decide how many rigs to build, staff, and operate. If you have idle rigs, you have to decide if you should take a long-term contract at the current rental price or hold out for an even longer-term contract or a higher price.

Exploration rig demand is heavily influenced by the level and direction of oil prices. The best environment for you is a combination of high and rising oil prices. The oil companies will project a rosy future, and will pay very high prices to get to the oil sooner. The worst environment is having both low and dropping oil prices because oil companies will forecast a great drop in profitability and cash, and drilling will shrink dramatically.

So, the trend in oil prices turns out to be a better indicator of your future business level than is the absolute level in oil price. If you are a rig operator, you watch that oil price trend every day. When you see it start to slow or change direction, you may have to shift your strategy in a heartbeat.

Checking the Barometer

Weather forecasters find that changes in the barometer, a device that measures atmospheric pressure, are valuable leading indicators of weather conditions. The following examples provide ideas for finding the irresistible force barometers that your organization should use and how to interpret them.

The Chicken or the Egg?

This example focuses on anticipating the direction of oil prices to show you how to find the most likely cause for your own irresistible force changes.

If you want to do more than watch the oil price trend as the barometer of your future oil rig business, you can go one step further and find the barometer for changes in oil prices themselves. The benefit of this latter approach is that you'll have more warning than anyone else in your industry, because it is generally believed that oil prices cannot be forecast.

Fortunately, you don't need to forecast the oil prices, only their direction, which is a much easier task. This advance warning on the oil price direction will allow you to hold out for higher prices for your oil rigs and crews when higher demand will follow, and rent out quickly at current prices when prices for renting your rigs are about to fall.

How might you obtain this advance warning? Clearly, this is one of those problems that no one may ever solve in terms of accurately estimating the exact future price of oil on a certain date.

You have an advantage in addressing this issue in that, for your needs, you don't have to be exact. You just have to do better than the results you would get by guessing blindly. Encouraged by the fact that your new insights from this examination can be relatively modest and still provide large benefits over time, let's begin.

You can break the problem down into constituent pieces. Start with the supply side. Experience with the Arab oil embargo in the 1970s should remind us all that the supply of oil has a big impact on the price level. Generally, OPEC (the oil cartel) is trying to pump less oil than it could in order to keep oil prices high.

Non-OPEC countries and some less cooperative OPEC nations may not always go along with that policy. These countries produce surges in supply that are usually associated with economic crises in those nations, where desperate measures are required to raise cash quickly. You can begin your analysis, then, by monitoring what is happening to new supply, what the pumping agreements are, and watching out for countries that may pump extra oil.

Next, you should look at demand for oil. When world economies are growing, oil demand is higher than when those same economies are in recession. You'll want to establish some connection between the leading economic indicators for the world's economies and future demand for oil.

Other factors can complicate the picture that you should consider. For instance, how much oil is already in storage and in transit through pipelines and tankers?

An unusually large or small inventory can accelerate the timing of a changed price direction. And some types of crude oil require special refineries for processing.

Refineries require rebuilding from time to time, sometimes creating spot shortages. Sometimes refineries explode unexpectedly, also affecting supply. Investigate whether there is sufficient refinery capacity to handle the supply of oil that will actually be available.

Consider, too, that a lot of oil goes into home heating. If the weather during the winter will be unusually mild or harsh, that will have a big impact on demand.

You'll have to check your El Nino and La Nina charts for clues. Governments can change the way they tax gasoline, encouraging or discouraging consumption. Further, vehicle styles can change the fuel efficiency for the miles driven. SUVs burn a lot of gasoline while compact cars use much less.

A valuable next step is to assemble all of this information and these potential indicators, and see how well these data series predicted the direction of oil prices in the past. Sometimes you can learn even more by looking for clues only at those past environments that are the most like the current one.

From these data and observations, you can begin to assemble rules about what combinations of circumstances have indicated an above-average likelihood of oil prices rising or falling. Multivariate correlations will help (if you are not sure what these are or how to develop them, find a statistics or math major to help you).

As you begin to apply these rules to make your decisions, you should keep track of how well they work in practice. If they work significantly better or worse than you expected in helping you anticipate oil price increases, you should study further to understand why. What you learn will often help you to establish better decision rules for the future. A streak of better or worse prediction will often help you isolate additional factors to consider.
About the Author
Donald Mitchell is an author of seven books including Adventures of an Optimist, The 2,000 Percent Squared Solution, The 2,000 Percent Solution, The 2,000 Percent Solution Workbook, The Irresistible Growth Enterprise, and The Ultimate Competitive Advantage. Read about creating breakthroughs through 2,000 percent solutions and receive tips by e-mail by registering for free at

http://www.2000percentsolution.com .
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