Thoughts on Oil, Gold and Bonds

The economic news has been quiet of late in comparison with the events we witnessed over the Autumn and Winter in 2008. However there are some interesting developments taking place in the markets. No one can know for certain what will happen in the short term, but I have some opinions of what I think will happen in three key assets, Oil, Gold and Bonds.

Oil

We have seen a recent rally in the price of oil for the past couple of months, with it hovering around the $70 mark. This has pushed up the price at the pump here in the UK to around a £1 a litre. Is this the beginning of a new rise to $100? I doubt it. It's just a rally to accompany the green shoot theories we are all been told or the reports stating that emerging markets are set to grow, but the world has serious issues and we are not going to get a new global boom any time soon. All these imbalances that were created over the past have to be addressed. Someone has to take the pain, but that has yet to happen. Investors such as Jim Rogers have stated they don't see anything worth buying, anywhere in the globe.

Over the long term I'm sure oil will hit new highs - in fact it has too. $200, $300, $400 dollars a barrel, I'm sure we will hit all these milestones in the coming decades. But as the globe enters what seems like a global depression demand just won't be strong enough. If people don't have jobs or incomes then people don't travel as much, and buy products that get transported as demand dries up. Over the long term we will get an oil drilling bonanza, as supply will not be able to keep up with the expanding industrialisation of the globe. When America peaked back in 1971, that decade brought about the biggest investment the US had ever spent on oil exploration and extraction, more money than its entire history. My father was one of the people who lived out there for a while as a young Chemical Engineer back during the oil shocks as the US scrambled to produce more oil (if he had stayed I would have been a Texan). We will have the same in the future only on a global scale. As the oil price climbs, green technology or alternatives will also have significant amounts of money poured into it, a possible future bubble, and if you know the sector there may be some good buys in the next couple of years, but not yet in my opinion.

There is only one reason that would cause the oil price to shoot up in the short term and that is war or civil chaos in the nations that produce oil. The west now relies on its energy from unstable regions of the world. There have been disruptions to a pipeline in Nigeria recently. The recent civil unrest in Iran is a further sign of rumblings in a nation that has potential to prosper, but has a regime intent on not allowing its large young population from obtaining wealth. Unemployment has been a hallmark there for years as the nation can not attract foreign expertise and capital to develop further. Iran has a lower per capita income by a third since 1978, which shows the declining living standards the people have had to put up with. Hostilities towards the west still exist, Persia in the past was a strategic location for oil for the UK which led to the downfall of the shah as resentment grew. With the wests support for Saddam in the Iran-Iraq war, diplomacy became even more strained.

Central Asia and Russia are other regions we obtain oil and gas from in order to diverse our supplies from the middle east, but that doesn't mean the region is anymore stable, its just a hedge between the two. Countries surrounding the Caspian sea such as Kazakhstan not only supply oil to Europe but have also made deals to Asia with China, South Korea and Japan picking up any slack that Europe doesn't use. All of Europe's domestic supplies are in decline. North sea oil and gas, be that from Norway, Holland or Britain are all past their peak. Algeria, which is another energy hub for Europe is also in decline. The EU is expanding beyond 'conventional' geographic Europe for this reason, trying to annex strategic nations such as Turkey or Azerbaijan.

Throughout history all great civilisations and societies have been built on increasing their energy inputs. From the Neolithic age where the domestication of animals increased food production, right the way through to the fossil fuel industrial revolution, society always requires energy to sustain and increase its living standards. Its no different to the age we now live in. Remarks about 'Black Gold' may have been made in the past, but for this century it really will be the case.

Over the long term I believe we will see price controls in energy. The media are already demonising the energy companies and oil companies for the price of such commodities. As long as we have prices set by market forces, supply and demand, then we have direction of how to live our lives and no shortages will occur. In a price based system you can never have shortages. It's always a common myth regarding markets, usually used to justify bubbles, that shortages will create rising prices forever. No matter how scarce a good is it will have a price. Only sentimental value can ignore price. For example there may have been a limited production of a certain type of car, but it will have a price, for example if you have to pay £10 million for it there will be a seller who will sell.

The problem is that price controls are always a popular policy, if the price of a common good has risen quickly in a short period of time. The is where the shortage begins. As the government sets a below market price, supply dries up - why bother selling a product for a loss? As the price is now cheaper then people can afford to buy more of it. With falling supply and rising demand you can see how much havoc this causes. During the 1970's oil shocks this happened when Nixon set price controls, and gas stations ran out of petrol. If prices float freely you can never get this situation as prices control supply and demand. If there is a high price it creates incentives to increase supply. It also creates incentives for people to demand less.

In the UK diesel prices were a lot higher than unleaded petrol a year ago, in fact I was paying around 20-25p more per litre, but I wasn't worried as prices existed. Now they are both the same due to the above concept - prices. Now what if the government had implemented price controls at the time to bring down the price of diesel to petrol? First of all there would have been no increase in production, there would be no incentive to build new processing capabilities. Demand would have kept increasing too as people could be careless in their use. Both would lead to shortages. I posted about price controls back in October last year and from what I've seen I think history will repeat at some time in the future. Again, just not yet.

Gold

Gold I feel is also overbought. Its done its job during the collapse in asset prices last year, it held firm in fact increased depending on what currency you base it on. But I now feel it is due for a downtrend. The IMF is trying to sell a lot of its gold, and has had recent approval from US congress. There has been record buying over the past six months and I think this is beginning to fizzle out. Again over the long term, like oil it will no doubt rise in price, but things correct in the short term and this correction may flush out a few investors and scare some people away. Like oil there is a wild card - are you confident with your domestic currency? As Iceland showed, its no good waiting for moves in the price of gold in say Dollars when your currency collapses. As a citizen of the UK this is the only thing that worries me, but in the short term I think the pound should be able to hold out. Over the long term, I'm very bearish on it. For the past Century in particular after the second world war my country has continually debased, lowering the pounds value, once the reserve currency of the world. It was oil and gas that saved its value in recent times, but this is not going to be the case going forward. The US looks to be repeating the same mistakes of history as we did.

There's a great quote by Hugh Hendry, a hedge fund manager, who is occasionally on the various business channels. It goes something like this as I can't find original version;

"I can't get gold coins right now, there is record demand for them. The current events we are going through is like a book, and everyone has jumped to the last chapter where currencies collapse and its the end of fiat money, but everyone has missed the story inbetween. During the seventies gold halved in price from the 1973 credit crunch until 2-3 years later. This is the part of the story we have yet to see and when this happens then you fill your boots with the stuff."

He also has some interesting views on government bonds which is my next asset I wish to discuss.

Government Bonds

So as Governments deficits were rising last year, with stocks and commodities rising in value until the great collapse of September and October what was Hugh Hendry buying? Government Bonds (specifically he recommended German Bonds). Of course it proved to be an excellent move. As the year went on rates dropped to reach a low round in January of this year or so, increasing the value of the ones he was holding (compared with the losses that the stock market and commodities would have provided). However since then we have seen dramatic moves on the upsides in places such as the US. Interest rates on the governments debts have been rising, which has since wiped out any gains. However I still see a fall to come over the next 6-12 months. We are not out the woods in this crisis and we will get another flight into cash again as events unfold. When this occurs then the so called "flight to safety" trade happens, into governments bonds.

There will be more QE to come, which will create the artificial demand needed for bonds, expanding the bubble further. This won't immediately result in inflation as like with any inflationary boom, the market begins to try and undo these credit excesses during the bust. Prior to WW2 this always resulted in falling prices and a healthy deflation. In recent times however it has been stagflation. Inflation or rising prices accompanied by a recession. Due to the excesses of the credit boom there is a lot more deleveraging to come, therefore the free market contracting money. However in the long term this will be countered by the governments printing money, which is why I believe inflation will happen.

There were comments from a reader in a past post regarding how will the government counter these market forces with such strong deflationary pressures. The answer is simple. The Central bank is an institution who can lend an infinite amount of money, and the Government can borrow as much money as it likes. With such an arrangement it becomes easy to combat these market forces. A loss of $500B, no worries wait while I type that number into the computer. It's that simple. They just call it QE and give it more structure.

Coming back to Hugh Hendry's bond comments, why specifically German Bonds? This is where I suspect Hugh was using history as a guide (It amazes me when people tell me how useless history is, when many individuals use it for investing purposes among many other uses). For the past half century Germany has been one of the hardest money countries around. It didn't experience high inflation during the seventies unlike the UK because it realises debasement never works. When there have been discussions regarding QE for the Euro, who has been staunchly opposed? The German Block, the old Bundesbank. Recent political bills have been passed in German Parliament to set limits on government debt over the coming years to balance the budget in a few years time. Angela Merkel has been critical of US policies and deficit spending, with many of the German political establishment demanding government spending restraint. It's this rhetoric that gains it the credit on the market that it will be the most likely nation to honour its debts, rather than default through inflation. We will have to see if history holds up for these extraordinary times we are going through.


Markets move in mysterious ways over the short term, but I am sure we will get bubbles in all of the three above at different points in time. I do not make investment recommendations in this blog however for the short term, I'm still in cash. I think there are still some more great buying opportunities to come.

Riots, Protests and Revolutions

The video above has some interesting comments made by futurist Gerald Celente in the past few years, along with future predictions of what he thinks is to come. I want to expand on some of what he says in this post as there are various topics worthy of discussion.

Inflation Index

The video includes a scathing attack on Americas CPI index and with justification. Statistics are always open to manipulation and to exclude food and energy in peoples living costs is simply not representative of the average persons consumption patterns. The current monetary system we have then uses this index to target what level to set interest rates at, and how expansive monetary policy should be. A centralised monetary planning board, known as central banks, periodically modify this index in an attempt to represent peoples buying habits.

Why do they set targets of 1-2% for these indexes? Why not 5% or 10%? Why not set monetary policy based on population growth? Or on how fast GDP growth is? Why not any random figure. My point is that the current system is no different to Communisms version of centralised quotas, which had no relationship with fundamental market forces, specifically supply and demand.

As I have mentioned in a past post the market should take control of producing money. Karl Marx was right, money was the key, he was just wrong on everything else. Governments monopoly of this product means that people have no choice but to use their national currency. This in turn creates artificial demand, as I can't buy food in Euros or US Dollars here in the UK. Therefore there is no check in the short term on what the government can do, especially if all governments are following the same policies. In a free market of competing currencies they would all compete with one another, based on supply and demand of consumers desires. If people preferred a certain type of money, then the market would increase supply of that currency based on demand. If people chose not to use a currency, then a contraction in the supply would occur in order to match up with consumers needs. If money was oversupplied, as has been the case with the current government monopoly that exists today, then it would cease to exist as there would be no demand.

The above is not experimental either. Before Kings monopolised money (in recent times the government) money was always a spontaneous creation by the free market in order to overcome barter. Money originated from the market, the authorities just mearly copied it's conception. In fact fiat money like the system we use today has only ever existed when it has been enforced on the people by governments.

There are many currencies in danger due to the above supply and demand dynamics. If we take for example the US Dollar the worlds reserve currency, there are currently many overseas holders. The problem over the last couple of decades has been the increasingly amount that has been printed and the existence of deficits. Many major holders have expressed their concern, Brazil, Russia, Japan, China etc. In fact these nations are already moving away from the Dollar for example Brazil and China have discussed conducting trade in RMB, along with Malaysia and various African nations. Indeed China has been shifting its wealth into commodity's, Gold, Oil or companies and nations associated with these assets.

The problem occurs when everyone heads for the exit. This is a situation where all foreigners sell their dollars. Then we come into the supply demand dynamic above, with no buyers but lots of sellers the price of the dollar will obviously decline. With the government in fiscal overstretch it becomes near impossible for them to do anything about it. Over the long term China, Russia or whoever deals with dollars have no interest in the US. They are currently slowly planning their exit strategies exiting first on the trading currencies they use and keeping their reserves for the time being so as not to put too much downward pressure on the dollar.

Latvia is another worthy example of this currency supply and demand dynamic at work. With the recent IMF loan the country has received (fiscal strings attached) the government needs to rapidly cut current spending due to IMF fiscal constraints. With the economy already in a deep depression, this will further hit growth in the short term. This should create strong devaluation conditions as the market has less demand for the currency of an economy that is in a perilous condition compared with other nations (as its prior perceived productivity decreases). The IMF loan is nominated in another currency, and due to the authorities not wishing for the value of the loan to increase if their currency was to devalue along with the further credit rating downgrades which would result from such a devaluation, they have begun trying to defend their currency with their currency reserves by buying up the domestic currency to create artificial demand. Of course the market is placing positions that the authorities attempts will be useless so are putting it under further pressure as the market believes a devaluation has to occur. This is a prime example of how market forces can't be beaten. Latvia will eventually have to devalue and abandon it's peg (they only have so much reserves), it's just the politicians don't want to face the pain. This is what George Soros did when he broke the BoE and made a billion. He was simply getting the government to face reality sooner than they wanted (in the process the UK government wasted billions of taxpayers money for nothing, however it would have been more costly in the long term if the market hadn't forced their hand earlier).

Price Stabilisation

If we come back to the concept of the price index representing a price stabiliser, some economists believe that markets forces can operate better if prices are 'stable', and have chosen a rate between 1-2% as an optimal range to target. We can take two simple items priced in Sterling to illustrate the fallacy behind this 'price stability' concept, houses and DVD players. Ten years ago a DVD would have cost you around £400, now they sell for £20. A house during the boom went up around 200-300% priced in pounds. If you look around there are many other items that either went drastically up in price, or drastically down in the price.

People don't think that if house prices or stock prices rise in price that this is inflation, but it is. It's priced in pounds or whatever the domestic currency is and these new pounds have to be created either from private banks or by the government. Due to the fact that they are usually an asset for many voters this is deemed as good inflation, despite the fact that it is the same as any other type of inflation. You just don't buy these on a daily basis like food and energy, that's the real reason its accepted.

If you look into the data used you have to wonder the reasoning behind what items appear in the CPI/RPI algorithms. If we take the UK index for example, last year they removed Parmesan cheese and put in its place Cheddar cheese (presuming you buy cheese). Why the change? Could it be to do with that we import Parmesan and with the pounds recent devaluation this good has gone up in price? Could it be some Bureaucrat somewhere wishing to look busy so swapped the specific cheese that is used? To take another example they have also substituted DVDs for Blueray discs, "to represent consumers move away to newer technologies". Would this be due to the fact that new technology has greater potential to fall in value, thus creating a lower inflation value for the headline press releases to give the illusion that we have no inflation?

Neither 'price stability' or 'inflation targeting' makes any sense when you start to analyse it and think critically (they have to create inflation in order to combat market forces that increase purchasing power by making goods and services more plentiful). In the years to come I'm sure these statistics will be heavily fudged in order to try and fool members of the public, trying to maintain the illusion of prosperity.

There were a plethora of amusing quotas that Communist Russia used to try and replace the free markets pricing mechanisms, by using measurements of produced materials rather than prices (prices which are determined by supply and demand). An example would be steel production based on measuring tonnage produced per year. The managers aim was to try and produce enough to meet his target (so he didn't get shot or sent to Siberia by under producing) but to not overproduce in case they increased next years quota too much. Due to the fact that it was based on tonnage there was no incentive to produce good quality steel that was of any use to industry.

So then we come onto say the state controlled oil sector, where they would require drilling equipment made from such steel. Due to it's poor quality it would make drilling laborious as the drilling equipment would keep breaking requiring more effort and time to drill into the well (a classic hallmark of state planned economies is where labor intensive techniques are used over productivity improvements). When they eventually got to the oil, there is usually a natural gas cap on the top, as is the case in many oil wells. As they only had a quota for oil production the gas would be burned off, creating huge environmental damage along with the waste of a precious and non-renewable resource.

Can you imagine the above in a capitalist economy? A company burning off millions of pounds worth of natural gas? A company wasting time buying poor quality steel and then continually having to re-drill? Despite the myth that capitalism overuses the planets resources, capitalism actually makes the most effective use of them compared to all other economic systems. Its only that it supplies us with such a luxurious lifestyle that we use more resources. Compare this with a regime such as North Korea where half the population suffer from basic malnutrition, despite the fact that South Korea supplies aid. There we contrast how well free market forces treat us.

Sub Prime

Celentes comments on sub prime are very true, as many people still think this is the cause of the current crisis when it just a symptom of easy monetary policies. There is far more downward pressure than just sub prime to come in housing. The next stage is prime mortgages as people loose their jobs and can't find new incomes. For those in the UK don't feel too smug, we have sub prime too, we are just behind the US curve. In fact UK home delinquencies are now worse than US sub prime. It just takes time for the banks to write these loses off.

In the US there is Alt-A, Option ARM mortgages which will be the next wave of defaults. Mortgages where the person could pay less than the rate of interest on the loan. As more of these deals are worth more than the value of the asset there will be little incentive for these individuals to continue with such arrangements.

What happens when the central banks have to raise interest rates to defend their currencies? Central Banks will be very reluctant to do this which comes to the next issue, the inflation that they will create. When prices of staple goods such as food and energy are rising how will people pay their mortgage. Would you choose to eat or default on your home loan?

Population demographics are another factor, with many looking to retire in the coming decades won't these people be looking to downsize, to supplement their pensions (presuming they have one or that it hasn't closed/collapsed etc).

Still people talk about the next housing boom in the news. The TV and papers are still full of articles. Denial is still all around with many talking about houses as a great long term investment. We will see what these opinions are at the end of this bear market, but we are a long way off.

Tax revolts, Food riots, Crime and Revolution?

California has already experienced a tax revolt as the people chose for state spending to be cut rather than face higher taxes. With inflation down the road, food will always rise in price as money ripples through the economy. It's one of those goods that you can't avoid not to buy. As unemployment rises along with the general disillusionment of people trying to re-enter the workforce, many will resort to crime. Then with the deficits many nations are running up, will there be cuts in crime enforcement? With protests and riots distracting the police will there be enough resources to cope? Ever wonder why the military is returning from Iraq?

We are living in extraordinary times, indeed a revolutionary era. All the conditions are present, government overstretch, money printing, plutocracy as the rich are bailed out, economic instability and so on. Will the traditionally strong liberal democracies such as the US and UK survive? I suspect so, but it will feel like a revolution in the years to come. When the currency and bond bubbles burst, then we will have a real crisis, not the banking crisis last autumn that was just a warm up, as Celente has remarked "The Bailout Bubble". The real crisis is yet to come.

“Every generation needs a new revolution.”
Thomas Jefferson, American 3rd US President

General Motors - another British Leyland?

Already dubbed as "Government Motors", the former giant of car making has finally admitted defeat and been forced into bankruptcy. American taxpayers now own 60% of the company that the market decided couldn't cut the mustard any longer. Despite decades of stagnating wages and cuts to company benefits, GM just couldn't get market share and profit margins back to its former glory days. The event could be seen as a signal for the beginning of the end for American manufacturing but in truth this has been happening for years. Many companies tried to sustain the illusion, wrestling with superior Japanese or Korean productivity.

President Obama, the peoples president, has gone through with government intervention rather than speedy free market liquidation. Maybe he can do a better job of making cars than all previous failed attempts by states such as communist Russia for example, however I doubt it. The measures are supposed to save jobs, when in reality it will do more harm than good. Someone has to pay for uncompetitive companies if they are not immediately liquidated. If left to the market, the companies assets and labor would have been released. Manufactures who know how to make cars could have bought the means of production, and placed it under their stewardship to make better productive use of these resources. The labor could then have been employed by such organisations, with the excess moving into other areas of the economy that are still productive. As painful as that may have been in the short term, over the long term liquidation is a vital and a key component of economics. If there was no change, we would all have falling living standards as stagnation would occur.

Obama had to bail them out for one simple reason, people voted him into the White House to 'help' them. The problem is they expect him to act, when in reality the best course of action would be to do nothing.

America can catch a possible glimpse into their future as Britain experienced a similar situation a few decades back with British Leyland. A company that was mish-mashed together by government as British manufacturing was in turmoil during the turbulent seventies never stood a chance in the global marketplace. Generally it produced cars no one wanted, for high costs that were shabbily built. The end result after years of fighting market forces, were the good parts being sold to the companies that were productive in the industry, and the left overs put to other uses. In the end the UK could have saved all the pain by just letting the company fail in the seventies and letting the market take over just like what happened eventually over the following decades, but then again what would the politicians do if they couldn't meddle with business, to 'help' the people. Just like the UK then, the US taxpayers are having to foot an auto bailout all because the government says it needs to.

It's no surprise Americans have a love affair with Cars. Vast expanses of land, the largest oil reserves in its day and cutting edge production techniques pioneered by entrepreneurs such as Henry Ford destined America to embrace automobiles. Americas iconic rock band 'The Beach Boys' inter-weaved their lyrics and song titles after famous American models. 409 even mentions saving for a car - how times have changed. As the beach boys sung Fun, Fun, Fun those days GM once enjoyed have gone. It's time for America to stop clinging onto the past, move on from industries they can no longer compete in and look to do jobs they are still competitive in to produce new improved products better than the rest of the world.