Oil Prices, Powerball, Adventures in Prospect Theory
What do oil prices have to do with Powerball?
Quite a bit, actually.
Three Powerball winners beat the 1-in-300 million odds by picking 4, 8, 19, 27, 34 and Powerball 10. They, and more than 100 million other people purchased a total of about 1.6 Billion tickets costing about $2.
All of the payouts will average about $1.32 per ticket (perhaps less), but of course only about 1 out of 25 tickets won anything. The odds of winning anything really life changing is over 1 in 10 million.
And, most winners will pay 20% – 40% of their winnings in taxes. In round numbers, the citizens give governments $2 for every dollar they get back. And most folks are playing with money they paid taxes on in the first place, so it’s more like earning $3 to get $1 back.
None of that is aimed at killing the joy of the game for people who have fun doing it. But, the frenzy illustrates how bad we are at uncertainty.
Big payouts that won’t happen very often motivate us about the same whether the odds are 1 in a million or 1 in 100 million. This of course is the heart of Prospect Theory, perhaps the most important behavioral economic achievement of our time. Daniel Kahneman won a Nobel for it, and it was well deserved.
In the same way people celebrate the chance to buy a Powerball ticket, people are panicking (or celebrating) over low energy prices. It makes little sense to rush out and buy a gas guzzling car because you think gas will stay cheap. And, on the corporate level, it makes little sense for investors to push firms into Chapter 11 as an act of desperation.
Talk of $1 gas, or $10 oil is probably just talk. It could happen, but you didn’t win the Powerball, did you?
The EIA’s forecast (their good one, not the bad one people bash) is here: go.usa.gov/cQT3m They say there is a 95% probability oil will stay above $20. Now that’s a low price, and it would destroy a many companies, but it’s double the $10 price some folks are suggesting, The EIA (and energy futures prices) suggest there is a 50-50 chance oil will recover to $40.
Again – $40 is not good for firms with $60 cost of production, but it’s enough for most operators to at least cover cash flow. Paper losses and running out of cash are not the same thing.
And, $40 is four times bigger than $10.
Why are we so bad, and so irrational? Prospect Theory explains it. You can read more about that, and how to do math with it at the Glossary on our web site http://www.lone-star.com/Glossary
The image is the city limit sign from Uncertain, Texas. It’s a good place to think about when you consider oil prices and Powerball.
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