The Man On The Spot

In March, oil trade flows through the Strait of Hormuz collapsed. Before the disruption, about 20 million barrels a day passed through it, or close to 20% of global oil consumption. Alarmed, the IEA called the disruption the largest in oil-market history.

Scenario models put crude oil at $170 or even $200 per barrel, up from about $70 before the military hostilities. 1973 began to look almost quaint.

But then something truly marvelous happened: the world adapted to the new circumstances.

As detailed in an IEA report published just three months later, global oil inventories were drawn (including most notably in China), emergency stocks were released, bypass routes were stretched, alternative oil suppliers boosted their production, and refiners changed the crude they processed and the products they prioritized with unexpected agility.

Demand responded, too: high prices, logistical disruption, and precautionary measures altered consumption decisions around the world, leading to a fall in global oil demand in the second quarter. Crude prices rose but fell short of the most distressing projections.

It would be easy to lament forecasters’ infinite incompetence. But prices, forecasts and the headlines around them changed the market fundamentals. The forecasts self-destructed.

In ‘The Use of Knowledge in Society’ (1945), Friedrich Hayek explains the underlying mechanism: ‘The price system [is] a mechanism for communicating information. […] In a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people.’

Accordingly, the ‘price system’ in the oil market sent clear instructions to all oil market participants: release a buffer, seek another route, alter a refinery yield, change a crude slate, defer a journey, consume a little less. Each participant only needed to respond locally to the signal in front of them.

As a result, reactions to the crisis shifted and reshaped the global demand and supply curves. Nobody saw the whole oil market picture. Yet a single data point available to anyone – the price of oil – was all any of them needed. The price that had issued the instructions was rewritten by the actions it instructed. The market moved the market.

Hayek described a functioning pricing mechanism as ‘one of the greatest triumphs of the human mind.’ He was writing against central economic planning, arguing that economic decisions must be left to what he called the ‘man on the spot’, i.e., the person with the local knowledge.

This theory of knowledge has implications for corporate organizations. Firms centralize decisions at their peril when they fail to recognize that relevant knowledge is dispersed among employees closest to customers, operations and technology. The task of leadership is not to replace local judgment with a centralized master plan. It is to create the signals, incentives and decision rights which allow those with local knowledge to respond to changes in the market to optimize an economic outcome.

The greatest human triumph is not that anyone can see a whole system. No one can, including the smartest forecasters and top executives. It is that, with the right setup, no one has to.