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.