Herding in Texas29.03.2017
Herding is an important topic. I just read the ‚Schumpeter’ column of The Economist, March 25th, 2017, about current conditions of America’s shale industry, which is “testament to Texan grit”. The industry is deeply mired in debt, and struggles to regain profitability at the prevailing low prices of oil. In 34 of recent 40 quarters, it “burned up cash”. It even faces a paradox: Many industry insiders seem to hope that further expansion of production will eventually push the firms back into the range of profitability, but that would almost certainly contribute to keeping oil prices low, thus suppressing future profitability.
Is fracking an example of herding? I think, yes. But if so, we can also see that standard economic models of herding do not seem to grasp the dynamics here. They mainly rely on the distinction between private and public information, and that individuals who join the herd ignore their private information in favour of public information, thus potentially falling into the trap of following wrong public information, while private information might in fact be reliable. This is the case of a negative information externality. But in the shale industry, it seems that the information is on the table for everybody, and that there is no contradiction between private and public information. What prevails is general uncertainty. That is why Schumpeter refers to “grit”: Texans simply take the risk, and they do it collectively. There is indeed a high risk that the industry implodes at some time, thus creating another fatal ‘bubble’ story.
One explanation offered is the role of incentives in oil companies where managers face pay schemes that do not seem to focus on returns on capital. But that would less apply on smaller firms that are also very active in shale. So, I think that our research on herding will help to sort out the conditions under which the economy produces such troubling developments, and might suggest ways of designing precautionary measures.
Obviously, our second case methodological case study on behaviour towards risk and uncertainty will be also relevant, since the shale industry, as mentioned previously, is an example of collective risk taking. But there is no central planner, so what drives the development? One possible explanation may point to the role of status competition in the struggle for profit: High risk is a predictor of high profitability, by necessity, though, alas, with low probability. Once you have entered the race, it is difficult to retreat, because this means to lose out with high probability in the direct comparison with your competitors: actually, you may think that your leaving will enhance their chances of success. So, everybody feels committed to stay in the race, a classical Prisoner’s dilemma, it seems. This behaviour would certainly be reinforced by imitative strategy development, strongly fostered in the business communities. And finally, yes, there is ‘grit’, perhaps the impact of neurophysiological mechanisms of risk taking on what is a predominantly male business culture.