During a large part of the summer of 1979, I spent living in the coastal Italian town of Ladispoli, about an hour's drive from the grandness of Rome. I was just entering my teenage years at the time, but somewhere in the back of my mind I already knew that sooner or later I would be burdened with all the responsibilities of an adult. That time came much sooner than I could have ever expect at the time, but that's another day's story...
Today's story is based on a simple phrase that I learned very quickly in Italy and it is the phrase that is still with me almost thirty years later. That phrase is simply "quanto costa?" or "how much does it cost?" Almost every decision I have made ever since I learned these magic words in Italy depends on the answer to this essential question. Ever since then, I compare the "utility," "worth," or "value" of whatever is being bought or sold to its selling price. Of course, over time my ideas of worth got better formed and started including factors way beyond my naive childhood understanding, but the need to evaluate "worth" vs. "price" - that became a part of my core.
So, why am I telling you all this? First and foremost to admit to myself and confirm to others that I am deep in my soul a value investor. The second reason is that it serves as a good introduction to the following value proposition: sell gold, buy oil. OK, all you gold bugs, I am with you on the intermediate term inflationary outlook that will drive the price of gold ever higher, but on a relative valuation, gold is expensive, oil is cheap and food is dirt cheap.
Oil was especially cheap on Friday, when the expiring January contracts were fetching as little as $33.44 a barrel and Bloomberg was reporting a spot price for a barrel of West Texas Intermediate of $33.87, which was $7.83 below their reported spot price for the sourer Brent! All in all there was a major market disruption. Some will, undoubtedly, attribute it entirely to the doings of the triple witching hour of the third Friday in December. To me, however, it is indicative of an oil market bottom.
Now, I understand all your concerns about the bursting energy bubble and demand destruction. But let’s forget all the noise and simply ask the question "quanto costa?"
Bloomberg tells me the latest prices: gold - $837.40 per troy oz, oil - $39.31 per barrel (average of three), wheat - $211.69 per metric ton. Wheat is actually a bit tougher than simply looking it up. All you get from Bloomberg are the Kansas City and the Chicago Boards of Trade settles for #2 wheat per 100 bushels. So, after averaging the two prices you divide by 100, add 3 cents to upgrade to #1 hard red winter wheat and multiply by 36.7437 to convert to the price per metric ton.
For historic prices, I dug up monthly averages for the past 25 years for the three commodities from Austin Gold Information Network, Kitco Inc. and Index Mundi. If you don’t think these are reputable sources, you are welcome to repeat the exercise with numbers pulled directly from the CIA World Factbook, but by the time you find any data on that website, you will probably qualify as a senior intelligence officer! In any case, massaging the data I learned that for an ounce of gold on average over the past 25 years I could buy 2.6 metric tons of #1 wheat or 16.83 barrels of oil.
However, at today’s prices for gold, I could afford a whole 21.3 barrels of oil or 3.96 metric tons of that #1 wheat! As all things in life tend to revert to their long term mean, I figured this means that either food and oil must appreciate substantially, or gold must similarly fall.
Now, before you go off and attack my simplistic analysis, please allow me to add even more simplicity to the crock pot by reminding you that both oil and gold are depleting resources, while food vis-à-vis wheat is a renewable consumable necessity. Also remember that gold, unlike oil, is not really a necessity, that it is reusable and often easily and quickly substitutable.
Why is any of this important? Well, if you think back to your Macro Economics 101, you may recall that market prices are simply a function of supply and demand and that demand for goods that are not necessities and are easily substitutable and/or reusable tends to be more elastic. This again supports my point of view that oil is cheap relative to gold.
This part of the argument is actually weaker for wheat being relatively cheap, since wheat is a renewable resource, the usable worldwide supply of which has greatly expanded over the past 25 years through science of fertilization, more efficient farming methods and better storage. But the size of the anomaly in the relative price of wheat is so huge right now that it is virtually begging for a correction.
Of course, you could take any aspect of this analysis a whole lot further – I didn’t. Instead, I patted myself on the back for buying a whole lot of OIL - IPath S&P GSCI Crude Oil Total Return Index ETN - earlier in the day Friday for $22.79/share. I left the selling of gold and buying of ag. commodities to next week.
That’s almost the entire story, except that I wanted to answer a question that, perhaps, begs itself. Why am I measuring other commodity prices in troy ounces of gold, instead of $US, or constant (inflation adjusted) $US, or some other currency?
The answer to this question is simple. All paper currency is only worth the amount that the government that issues it says it is worth. Inherently, any fiat paper currency is neither stable nor does it have any worth. It is within the power of any government to increase its currency supply overnight and to otherwise diminish paper money's purchasing power – cases in point: Austria, Germany and Russia in the 1920s, China, Greece and Hungary in the 1940s, Argentina in 1980s, Zaire, Yugoslavia, Russia and Ukraine in the 1990s and Zimbabwe today. Ben Bernanke is now eager to inflate and eventually he or his successor will overachieve.
Some people like to use currency adjusted by inflation, as measured by CPI, in their analysis, but there are many well known criticisms of CPI as a measure of inflation and of the methods used for such adjustments. In any case, these adjustments, at best, would introduce an error into the measurement. So, why not just use gold for comparison, a traditional, universally accepted and widely used measure of value? And, please don’t tell me that Central Banks, in coordinated efforts, manipulate the price of gold. That’s an interesting and maybe even viable theory, but counterbalancing it are facts of outright paper currency manipulations by world governments.
Hope this answers all of my critics before they even get started!
Disclosure: Long OIL and GLD.