The Gulf Oil Spill: A New Black Swan?

Almost two full weeks have passed since Hurricane Isaac ravaged the Gulf Coast of the United States. Although the new levees that were constructed as a response to the Hurricane Katrina disaster successfully protected New Orleans against devastation this year, the neighboring Plaquemines Parish and many other communities were devastated by Isaac’s destructive power.

Many meteorologists predicted that the hurricane’s devastating winds and lashing rains would destroy buildings, collapse electrical power lines, and flood entire communities. But few anticipated that the storm would also bring forth an unwelcome reminder of another recent catastrophe.

In the wake of Isaac’s path, massive globs of oil and tar washed up on Gulf Coast beaches and shorelines. And this past weekend, federal government investigators confirmed that the toxic material had been lurking in the water nearby since BP’s Deepwater Horizon oil spill in 2010.

Chemicals and Bacteria

One of most harmful effects of an oil spill is the damage that the spilled product itself inflicts on the natural environment. The 1989 Exxon Valdez oil spill in Alaska’s Prince William Sound, for instance, released 250,000 barrels of oil into the water, leading to the deaths of thousands of sea animals and well over 100,000 birds.

Just as worrisome, though, is the fact that much of the spilled Valdez oil was not recovered during clean-up activities. Instead, significant quantities remain on the floor of the Sound and under the topical sand and soil of the shoreline, where the toxicity of the material continues to damage the environment.

BP’s Deepwater Horizon disaster actually disgorged far more oil into the natural environment than did the Exxon Valdez event. Up to 4.9 million barrels of oil was spewed directly into the Gulf of Mexico in 2010; it entered an eco-system that was already under stress from industrial development and climate change.

Geologists have noted that chemical dispersants successfully dissipated much of the Gulf oil, and at the time, they hoped that warm water bacteria would devour the rest of it. Nevertheless, the sudden emergence of the oil and tar after Hurricane Isaac was a sober reminder that large quantities of BP’s spilled oil still remain in the water.

An Insurance Challenge

In most business sectors, the risk of industrial accidents can be managed through the purchase of property insurance. An automobile manufacturer in the American South, for instance, can purchase a hurricane damage rider on its insurance policy; its annual premium cost would be established by the meteorological probability that a hurricane would hit the factory, as well as by the estimated damage that would occur as a result of the weather event.

In the event of a loss, after the hurricane passes, the insurer would promptly inspect the wreckage and then issue a check to reimburse the automobile manufacturer. But in the case of the BP oil spill, the environmental damage is continuing to occur many years after the primary catastrophic event. And the substance that is causing the damage is not readily observable (and thus is not easily quantifiable) while it lurks on the ocean floor and under the shoreline soil.

Furthermore, there is no consensus about the method that should be utilized to define and then quantify the insurable loss itself. BP, for instance, has already invested billions of dollars in the Gulf Coast region to restore its seafood and tourism industries. If the emergence of additional pollutants sets back progress in these sectors, should BP’s “sunk cost” restoration investments be treated as insurable losses? Or should they simply be regarded as write-offs of failed expenditures?

The Black Swan

In the field of insurance, the phrase “black swan event” refers to a situation where an extremely improbable loss of great magnitude has struck an organization. Because of the improbability of the event, the organization is likely to be uninsured because its insurance company is likely unable to determine an appropriate premium cost for a coverage policy.

However, the oil related environmental damage from the Hurricane Isaac event was, in retrospect, not improbable at all. Small quantities of oil and tar having been washing ashore after every rain storm, and thus large quantities of such pollutants should have been expected to wash ashore after major hurricanes.

Indeed, although actuaries may be challenged to define the extent of the insurable loss of such events, they should not find it difficult to estimate the probabilities of occurrence. The National Weather Service of the United States has been studying the incidence rates of destructive weather events since it was first created in 1870.

Environmentalists may be disheartened by the emergence and increasing prevalence of post-oil spill pollution clauses in the property insurance policies of upstream industrial energy organizations. Nevertheless, such clauses may be appropriate in an era when deep sea drilling, hydro-fracking, and other risky methods of extraction must be utilized to produce energy resources for an increasingly restive world.

Ben Bernanke vs. The Black Swan

Congratulations to Ben Bernanke, the Chairman of the Federal Reserve Bank of the United States, for being named Time’s Person of the Year!

2009 was most certainly a difficult year for the nation in general, and for regulators of the financial markets in particular. Because we began the year on the precipice of what Nobel Prize winning economist Paul Krugman called the Second Great Depression, but then ended it on the threshold of an economic recovery, we heartily agree that this honor is well deserved.

It is somewhat disconcerting, though, that Chairman Bernanke continues to acknowledge that he didn’t anticipate the collapse of our financial and economic systems. That being the case, one cannot help but wonder whether he is responsibly planning for the emergence of the next black swan.

They’re Not All White

Huh? A black swan? Aren’t all swans white?

In reality, black swans do exist, and they played a prominent role in Nassim Nicholas Taleb’s 2007 best selling book The Black Swan: The Impact of the Highly Improbable. That’s because, for many economists and financial strategists, black swans are quintessential examples of faulty presumptions of impossibility.

Okay … so what do we mean by faulty presumptions of impossibility? Well, for centuries, Europeans assumed that all swans are white because the only swans they ever saw were white. But some free thinkers warned that, although highly improbable, it might nevertheless be possible for black swans to exist in some remote corner of the world. And lo and behold, one famous day in 1697, Dutch explorer Willem de Vlamingh discovered a pair of black swans in the New Holland region of coastal Australia.

Ever since then, the black swan has assumed an important meaning in the minds of financial market strategists. Namely, they represent events that have never previously happened, and thus are often falsely assumed to be incapable of happening … until they actually do happen. The simultaneous collapse of all global markets and economies last year, for instance, represented one such black swan event.

Some Say Black, Some Say White

Or was it truly a black swan occurrence? Bernanke would have us believe so; he has repeatedly described the great bank bailout of 2008 as an extraordinarily rare event, one not required since the bank failures that followed the great Wall Street stock market crash of 1929.

One problem with Bernanke’s assertion, though, is that such collapses actually tend to occur distressingly often. After all, the Dow Jones Industrial Average did decline by over 45% between 1973 and 1974; it later declined by over 22% on a single “Black Monday” day in October 1987. It subsequently declined by approximately 27% between 2001 and 2002; considering the frequency of these declines, one might expect such crashes to come along once every decade or so!

In fact, in his 1954 classic The Great Crash of 1929, Harvard University economist John Kenneth Galbraith noted that “the memory of the financial mind lasts about ten years.” Galbraith explained that, in his opinion, it takes ten years for the painful memories of each market crash to fade away in the minds of investors; thus, every decade or so, they can be expected to become irrationally exuberant and to begin to assume reckless levels of risk. In other words, Galbraith believed that we are doomed to experience crashes relatively frequently because human nature leads us to forget our hard-learned lessons during such time spans.

Furthermore, recent developments in the financial markets, in technology, and in society have facilitated the rapid spread of global market panics. The emergence of our 24/7 internet based news media, for instance, has made it possible for terrifying rumors and distressing news to spread across the globe in the blink of an eye.

And the use of computerized trading systems has made it possible for hundreds of billions of dollars to be yanked out of entire industries, nations, and global regions in a matter of minutes. According to Galbraith, then, global market collapses should not necessarily be interpreted as once-in-a-lifetime black swan events; instead, they should be expected to occur as regularly as the American decennial census.

He Still Deserves It!

So do we believe that Chairman Bernanke doesn’t deserve the Person of the Year award? We certainly wouldn’t go that far; in fact, even if one believes that Chairman Bernanke should have been better prepared to anticipate and respond to the collapse of our financial markets, one cannot help but admire the manner in which he ignored our political maelstrom and plowed ahead with his plan to flood our economy with liquidity.

Nevertheless, true economic prosperity will only arrive when investors regain confidence that Bernanke is prepared to manage any unanticipated problems that may occur in the future. Whether these problems are truly black swans, or whether they are foreseeable and are thus amenable to principles of enterprise risk management, our Person of the Year must nevertheless be prepared to manage another challenging year in 2010.