Finding a trout in your milk jug

In?the 1800s?people would get canisters filled with milk from the farmer. If the milk tasted off, people would suspect the farmer watered the milk down by dipping the canister in a stream. Henry David Thoreau coined the headline phrase to mean, if there is a trout swimming in your milk, then there is likely water added to it. Let's extend this metaphor to the concept of optionality in the physical energy commodities supply chains and how choosing technology that over simplifies (or outright ignores) relative value between nodes in a network, will deliver trouts in the milk jug of earnings & profitability.

We start with framing the context as follows.

Risk exists when potential future states and their probabilities are known.

Uncertainty exists when future states are known, but the probabilities are not.

Ignorance exists when future states aren't known and therefore probability isn't computable.

There are ways to frame a mental model to deal with these states of the future.

"Uncertainty, not risk, is the difficulty regularly before us. Many phenomena often defined as involving risk actually involve uncertainty. Ignorance is an important phenomenon, I would argue, ranking alongside uncertainty and above risk. Ignorance achieves its importance, not only by being widespread, but also by involving outcomes of great consequence." - Richard Zeckhauser

"Most aspects and decisions in life are uncertain rather than risky. It is rare that what you do is similar to the action on a roulette wheel, which is risk. In addition, the events that often have the biggest impact on what you do are often part of the domain of ignorance." Tren Griffin

Optionality is defined as "...where the payoff function has significant asymmetry between the gains (which are large) and the errors or cost of the bet (which are small or harmless). The general mathematical property of this asymmetry is convexity (which is explained in the figure below); functions with larger gains than losses are nonlinear-convex and resemble financial options. Critically, convex payoffs benefit from uncertainty and disorder. The nonlinear properties of the payoff function, that is, convexity, allow us to formulate rational and rigorous research policies, and ones that allow the harvesting of randomness." Nassim Taleb

Leading to the following conclusion: Underpriced optionality is most often found in the domains of uncertainty and ignorance, rather than risk.

Further, observations of technology (data) enabled businesses "indicate that this time is different in one very important way: highly non-normal processes have become fundamentally more common due to digitization and the proliferation of interconnected networks and services (with demand) directed by algorithms running over those networks.?Changes in the structure of the world created by technology and networks mean that assuming that outcomes will be normally distributed is increasingly problematic (at least) and potentially dangerous (at worst). In short, there are more Black Swans than ever and fewer bell-curves."

Finally, Taleb postulates a tactical model based on Zeckhauser's matrix to benefit from harvesting randomness, and typical to his personality, in a blunt manner. "A rigid business plan gets one locked into a preset invariant policy, like a highway without exits —hence devoid of optionality. One needs the ability to change opportunistically and "reset" the option for a new option, by ratcheting up, and getting locked up in a higher state. To translate into practical terms, plans need to 1) stay flexible with frequent ways out, and, counter to intuition 2) be very short term, in order to properly capture the long term. Mathematically, five sequential one-year options are vastly more valuable than a single five-year option. This explains why matters such as strategic planning have never born fruit in empirical reality: planning has a side effect to restrict optionality. It also explains why top-down centralized decisions tend to fail."

To paraphrase, business plans tend to studiously ignore the unknown and thus result in significant value lost or missed. Evolving these plans to becoming more agile requires understanding the cost of alternative plans. Enabling such incumbent planning with technology that cannot represent all the dimensions of the network that provide alternatives, is doubling down on a structural weakness.

To bring this into the supply chain domain, specifically physical crude oil and refined products.? Physical oil markets are complex systems made up of a network of geographical locations around the world where inventory accumulates and then is transported to another location or consumed on site.? Each one of these locations has its own unique supply, demand and pricing structures. In this network, the combination price, time, best available volume and quality at every location matters. Immensely. Call this the four horsemen of value.

While most barrels of oil or refined products are destined to be delivered to meet an obligation (delivery to a refinery or a fuel station), there also exists uncommitted barrels in the system.? These are barrels warehoused for purposes of meeting future obligations, as safety stock or to benefit from near term price increases.? Committed barrels can be converted into uncommitted barrels if the opportunity to profit elsewhere (as indicated by the relative difference between the four horse men combinations at each location) is greater than the penalty imposed for not meeting the original commitment. These barrels represent the basis for optionality. Contractual flexibility on timing, location, volume & quality provide the specific triggers.??

In times of extreme volatility or network disruption, this translates to significant value give away.? Coincidentally the very physical assets that make up the network; Storage terminals, transportation rights on pipelines, etc. provide the exposure to convex optionality.? Access to physical infrastructure is not a zero sum game and represent the mechanism to quantify optionality.

We have seen many supply chain software solutions attempting to fake their way into this problem set, by using grand concepts like "Control Tower" and buzzwords like "Digital Demand Forecasting". Truth is, like the unscrupulous dairymen from Thoreau's time, this is just adding water to boost volume while diluting value. For the customer, using technology that cannot create a digitized twin of network dimensionality for planning, and simplifying the network as though it were a closed loop, discrete system results in, amongst other things, a culture that only considers a narrow spectrum of opportunities.? The result? Lots of trouts in the milk jug,

We only need to look back at 2019/2020 to see examples of extreme relative value differentials between locations in the network.? Demand destruction led to inventory impairments in the billions, negative WTI crude prices (which incidentally represented massive optionality gain for those with storage contracts at Cushing, OK), the hacking of Colonial Pipelines, Hurricane Ida, etc.? The four horsemen have been apocalyptic in the last 24 months. This is a feature in this network, not a bug. As should it be in the software you use.