Gold and Oil: A Long Term Play on the Economy

If Samuel Taylor Coleridge were still around today, perhaps as an economist or a banker, he would have probably been caught saying, “Money, money, everywhere, but no one wants to lend.” Yes, this has been the theme ever since the Fed began cutting rates and using alternative methods to thaw out the credit markets. America is literally printing money and handing it out, yet no one is happy with what they have and are refusing to lend. Banks are unwilling to issue credit and investors are scared to buy corporate paper, leaving only the government to step in to facilitate the smooth operations of both the American and global financial system.

The credit crunch has left banks stingy and unwilling to lend, unsure whether to offer credit to populations not only across America but also across the world. Central banks across the world have simultaneously worked to pump billions of dollars into the world financial system to heat up the cold credit conditions.

Unfortunately, the numerous days without sleep and the hours of painstaking negotiations have not yielded any immediate results. Many feel the problem is that banks are being told two different things: lend on one side but build up tier 1 reserves on the other. During this time period, oil plummeted from highs of $147/barrel to below $100, leaving Russia on the verge of defaulting on the ruble; Venezuela struggling to operate with low oil, and many of the OPEC nations adjusting to a shortage of oil income. Gold also saw a massive rundown from highs around $1000 to present day prices of $868. This was after gold had retreated to the low $700 levels. Combine this sudden lack of cash inflows from oil with large scale government spending to prop up key sectors in the economy, and you have yourself a bunch of bad news.

The type of government spending witnessed today may help solve our problems in the short term, however in the long run the excess money supply will only stoke inflation. We are currently in a deflationary environment as commodity prices have pulled back, allowing the Federal Reserve and the ECB (European Central Bank) to slash rates to help offer liquidity to their respective regions.

Now that we have established that money supply is ridiculously high to fix our credit problems, what can investors seek to battle this? How about gold and oil? Yes, I said gold and oil. Since the beginning of the year through December 22nd, gold is up 2.59%, unlike the broad commodity index, the iPath DJ AIG Commodities Index (DJP), that is down almost 42% during the same time period. Ignoring the underlying factors that make gold move (a topic for another discussion), this shows the resilience gold has for any economic environment, whether it be during inflationary times or present day deflationary times. Several critics may bring up the point that TIPS would be more effective, and I will not disagree, but the idea behind investing in gold is two fold: one being that it simply diversifies one’s portfolio further, the second being that gold holds value worldwide, serving as a global inflationary hedge. Gold has returned over 180% in the last 5 years as gold bullion has had a return of over 100% in the last 25 years paired with significant tax advantages, further showing the difference between TIPS and gold.

Oil has been hammered thus far, reached highs of $147 and at one recent point trading a tad above $35. I believe this to be a GREAT time to invest in oil with such ETNs at great lows relative to the mid 2008 prices. Unlike gold, investors will have to use derivative instruments to harness the long term potential of oil. I like the U.S. Oil Trust (USO) that has been beaten down this year. The fund invests primarily in West Texas Intermediary, sweet crude oil with small exposure to natural gas and heating oil. In an inflationary environment, I believe that investors will rush to the safety of oil once emerging market demand returns. In order to understand the complexity of crude oil pricing, visit the Fundamentals of Crude Oil Pricing. Black gold will eventually face supply bottlenecks and will see price appreciation as demand skyrockets and the world realizes the true necessity of researching and developing alternative energy sources.

Before we part, it is necessary for me to reinforce the seriousness of long term inflation fears. It is extremely hard to quantify the relationship between the recent government spending binges and long term inflation. Let’s look at inflation this past summer as commodity prices rose due to the disparity between supply and demand (although many blame speculation solely). The PCE rate (less food and energy) came in at 2.5% while the CPI (including food and energy) was up a record 5.0% YOY. Imagine the long term inflationary pressures in the next 5 to 10 years once we overcome the current deflationary environment partially attributed to drastic declines in commodities and the “sudden” disappearance of wealth brought on by the credit crunch once the excess money supply rears its ugly head.

Money supply? The government has spent billions on the TARP, bailing out the nation’s financial institutions and the incoming Obama regime has plans of expenditures north of $850B to build up the aging U.S. infrastructure. Plans of even another stimulus are also brewing. There is a glut of cash out there and it is going to be extremely hard for Bernanke and his lieutenants to lap it back up as Obama pumps out more through government expenditures. In my opinion, the government must stop spending while loans should not be made to corporations outside of the financial services industry. Take my word for it, look for gold (if you can get your hands on it) and invest in oil. Speaking to a high end jeweler in Chicago, gold bars are extremely hard to come by unless you are a large gold house due to high demand. Take my thoughts and perhaps gauge for yourself where to position your portfolio as we move towards a long period of high inflation where we will all be swimming in worthless money.

- Santosh Sankar

Disclosure: The author has interests in buying gold in the near future.

Comments

[Shannon Melton:]

Some more thoughts on the dollar, gold, and oil:

experienceiseverything...

Jan 06 04:29 PM

[bricki:]

Yes, huge inflation coming, except we are deflating now. Not to mention that in the '80s when Japan went through the same thing we are going through now they didn't have any meaningful inflation at all.

Jan 06 05:00 PM

[patio:]

Exactly. These authors miss the second part of the equation every time on this topic. Yes, the banks (and credit card companies, etc. )aren't lending, and the standards to get a loan ( or credit of any type )have gotten back to where they should have been all along.
But the second part of the equation: the demand for loans has dried up, ist kaput-ski. Who needs to expand their business now? Who wants to buy that new car, that second home, all that discretionary stuff now?
Or for the long forseeable future.


On Jan 06 05:00 PM bricki wrote:

> Yes, huge inflation coming, except we are deflating now. Not to mention
> that in the '80s when Japan went through the same thing we are going
> through now they didn't have any meaningful inflation at all.
>

Jan 06 06:01 PM

[User 265729:]

If the banking system was insolvent in Q3 2008 and Paulson was just bailing out his buds with the TARP, don't expect inflation anytime soon. He was just using his position to CYA his friends.

This is why you still see deflation and this is why there is no lending -- Paulson was just proping ip their sheets for the FDIC. If the banks HAD MONEY at the start of this, then you would have seen some evidence of increased lending or inflation. Nothing.

No inflation and no lending are the smoking guns that the banking system was (still is) insolvent.

Jan 06 08:22 PM

[gabe borens...:]

Inflation was not an issue for quite some time.The phenomenal price spike in commodities ,including gold and the crude was the result of the massive leveraged speculation by the hedge funds not the function of the excessive demand(demand pull inflation).In fact as the demand for the crude and the other commodities imploded ,deflation and a massive contraction are dominating the current cycle with the vegeance .
The recent hike in the energy sector is driven by the events in the Middle East and Russian emargo on the gas exportd to the Ukraine.In the period ahead these prices should once again resume the downward trend.
The programs in place and the new aid package discussed by the President elect should "ignite" the non-inflationary economic recovery and the stock market rally(U.S).
One financial sectors of the market continues to be vulnearable to a major setback.
Gold ?it is a shiny piece of metal that was utilized as the means of the "standard ". exchange since some primitive societies became aware of the gold. Now ? who cares .Are you going to purchase a house ? a car ?with the kilobars.
When the inflation becomes a threat -not in the period ahead-the sophisticated investors will committ to inflation indexed bonds

Jan 06 09:09 PM

[Greg Pinelli:]

Inflation indexed bonds!? Maybe the tooth fairy will guarantee them! The author is spot on..gold can easily be translated into ANY coin of the realm..in 12-18 mos the word "Inflation" will be on everyones lips..and contributors on Alpha who are now telling us to beware of deflation will...change their spots!! Your website should be shunned or burned down! 2000 years ago people much smarter than you (which must have been almost anyone) knew gold was the standard of value......


On Jan 06 09:09 PM gabe borenstein wrote:

> Inflation was not an issue for quite some time.The phenomenal price
> spike in commodities ,including gold and the crude was the result
> of the massive leveraged speculation by the hedge funds not the function
> of the excessive demand(demand pull inflation).In fact as the demand
> for the crude and the other commodities imploded ,deflation and a
> massive contraction are dominating the current cycle with the vegeance
> .
> The recent hike in the energy sector is driven by the events in
> the Middle East and Russian emargo on the gas exportd to the Ukraine.In
> the period ahead these prices should once again resume the downward
> trend.
> The programs in place and the new aid package discussed by the President
> elect should "ignite" the non-inflationary economic recovery and
> the stock market rally(U.S).
> One financial sectors of the market continues to be vulnearable
> to a major setback.
> Gold ?it is a shiny piece of metal that was utilized as the means
> of the "standard ". exchange since some primitive societies became
> aware of the gold. Now ? who cares .Are you going to purchase a house
> ? a car ?with the kilobars.
> When the inflation becomes a threat -not in the period ahead-the
> sophisticated investors will committ to inflation indexed bonds
>
>

Jan 06 09:49 PM

[Alex Filonov:]

Everybody's getting ready for inflation... We'd be lucky to have one soon. We are in deflation, Fed is worrying about inflation getting too low.

Jan 06 10:51 PM

[iyamwutiam:]

The deflation story is being over-sold for one reason. Japan did not have the unique position of being a 'reserve currency'- so their stimulus basically was financed by their savings surplus which means what ? It means you have a hole and you had extra dirt -so filled the hole and back to level ground. No movement in ten years.

The 'goal' of all central banks is inflation. First -since banks are first out of the gate with the cash -they benefit the most. Then it trickles down and spreads-and soon it loses value. In short -the goal of all central banks is inflation -which is why -the most developed countries in the world are the most indebted. (With the exception of Germany-ahh the Fatherland). Also ironically socialist countries like Finland/Sweden etc-ironic isn't it!

The US dollar is the reserve currency -and let's face it - deflation would destroy the entire US economy with in two years. Why? Simple because all those holding excess US dollars (Japan/China/Germany/E... -since they can't 'buy' US assets would have that much more to dump. Especially if they don't have to hold onto a huge chunk to finance energy/commodity demands which are regulated via 'reserve currency'.

Why would I hold onto an excess of 500 billion/100 billion US dollars if oil became 30 dollars a barrel. The answer- I wouldn't - I would dump that sucker so fast - that a blink of an eye would seem like a year.

The 'powers' that be know this. So they uniformly inflated the market -England/France/Italy/... all the 'broke' countries dump tons of currency into the system.

Only inflation -will keep their dominance and hegemony on life support. Deflation will wipe out all debtors -with the biggest ones-falling the hardest.

Hence-Gold and Oil.

Jan 06 10:59 PM

[Crocodilian:]

Robert Frost, the banker? That's a fine image . . .

More to the point of your piece, I'll reiterate this perplexity: If inflation is in the cards, why is it that we see deflation? Let me pose a hypothetical: Perhaps the vast sums of money being poured into the system have to some extent already been offset ("pre-sterilized") by the massive losses incurred by households and businesses this year.

Demand has fallen off a cliff, as have household assets. Whatever amounts of money are entering the system through the actions of the Treasury and the Federal Reserve, they are unseen by consumers and businesses. What they see is that their incomes are falling, their assets are falling and whatever rivers of cheap money are coming . . . ain't here yet.

The market is not presently discounting _any_ inflation. Why not?

Jan 07 12:40 AM

[Ricard:]

Not knowing why gold moves does not make it a more attractive investment. The reasoning is rather crucial, I think. Perhaps it has something to do with US foreign currency reserves. Or maybe individuals hoarding it awaiting the next Coming. Or maybe China is playing ball. Or, maybe gold is about to plummet. Well, what is it?

Oil I am more certain of, but in the other direction. We just had 8 years where two oilmen locked up the White House, held secret meetings with oil execs, and then subsequently waged war against one of the largest producers of oil in the world. The supply/demand argument is not that strong otherwise...oil can be replaced by something else, and all producers know that. Once that replacement cost becomes lower than the various tar sands around the world, people will rethink their oil addiction. We now have a pivotal political swing in the opposite direction. XOM is still priced very close to where it was at peak oil. Can Goliath fall?

Jan 07 03:05 AM

[auto44:]

If gold has no value, what about paper?????????????/


On Jan 06 09:09 PM gabe borenstein wrote:

> Inflation was not an issue for quite some time.The phenomenal price
> spike in commodities ,including gold and the crude was the result
> of the massive leveraged speculation by the hedge funds not the function
> of the excessive demand(demand pull inflation).In fact as the demand
> for the crude and the other commodities imploded ,deflation and a
> massive contraction are dominating the current cycle with the vegeance
> .
> The recent hike in the energy sector is driven by the events in the
> Middle East and Russian emargo on the gas exportd to the Ukraine.In
> the period ahead these prices should once again resume the downward
> trend.
> The programs in place and the new aid package discussed by the President
> elect should "ignite" the non-inflationary economic recovery and
> the stock market rally(U.S).
> One financial sectors of the market continues to be vulnearable to
> a major setback.
> Gold ?it is a shiny piece of metal that was utilized as the means
> of the "standard ". exchange since some primitive societies became
> aware of the gold. Now ? who cares .Are you going to purchase a house
> ? a car ?with the kilobars.
> When the inflation becomes a threat -not in the period ahead-the
> sophisticated investors will committ to inflation indexed bonds
>
>

Jan 07 12:53 PM

[deuxsous:]

Thanks for your calm and well-reasoned long term view which I share.

Jan 07 03:41 PM

[Gold Barron:]

Since 1869 US crude oil prices adjusted for inflation have averaged $21.05 per barrel in 2006 dollars compared to $21.66 for world oil prices.

Fifty percent of the time prices U.S. and world prices were below the median oil price of $16.71 per barrel.

If long term history is a guide, those in the upstream segment of the crude oil industry should structure their business to be able to operate with a profit, below $16.71 per barrel half of the time. The very long term data and the post World War II data suggest a "normal" price far below the current price.

The results are dramatically different if only post-1970 data are used. In that case U.S. crude oil prices average $29.06 per barrel and the more relevant world oil price averages $32.23 per barrel. The median oil price for that time period is $26.50 per barrel.

Jan 07 05:43 PM

[deuxsous:]

Gold Barron,

That's a very interesting oil price history which I've not seen that far back before. When February NYMEX NY Harbor crude oil futures got as low as $36.15 per bbl recently and the NY cash was at $32.15 on December 24th and 26th it was virtually on your post-1970 average world price. Since then the NY cash price bounced as high at $48.81 earlier this week . With your data it's easier to consider the possibility that the long term average price is good support for the time being.

screencast.com/t/rUcJi...

Jan 07 07:26 PM

[iyamwutiam:]

I understand that most of the posters are from the US of A. And suffer from the seeing the trees and not the forest syndrome. Face facts -Oil is a natural resource and so is not and will not be annexed into the false paradigm of scale of economies. I won;t say that it wasn't seduced into it -but I will say that Russia/GCC/ etc are waking up.

The point - the bubble has burst. No one is buying that the 'dollar'/'Euro'/'Pound... is ctually worth anything. Its like talking to a broke -ass friend who has lived beyond his means for years -and you know it/knew it.

Come on -- its not that hard. The so-ca;;ed richest countries in the world -have FINALLY been exposed as charlatans -as they shpuld have been -centuries ago. The stoopid train -can only go on for so long.

The train is no longer -a mystique -the Orient Express went from being a 'premier' experience to being an anachronism that people with culture were too polite to say it is a relic. Face it - the West has ben exposed as a fraud - a charlatan - and indebted vampire- that can never repay the blood bank.

Truss me bro-- the west is at most two decades away - from having their 'indebtedness' being serviced by the rest of the world.

be afraid -very afraud. Because at the end of the day -- tecnology has a price - it is called debt. And guess what -very soon - people are going to call in the debt.

If technology -is not given up - then there is only one option - the same option India/China faced with a cash rich/productive society when meeting the debt ridden empires of India/China/Indonesia/... etc.

If I were the US -I would seriously be worried -because - people are starting to realize-in under a century- that the country is a poser.

Jan 08 12:23 AM

[iyamwutiam:]

A bit carried away - I guess. The point is - the perception that Federal Reserve assets (debt) /Euro Assets (debt) means somethings - well is being realized as not being to concrete.

God bless Amrica -ecause its greatness stems truly -TRULY-stems from the eternal truth of meritocracy-- ut that is being shown as the Emperor's new clothes-even in Asia.

Jan 08 12:28 AM

[auto44:]

Three Billion Asians were not in the market during those times,not to mention South Americans and easy to find new sources. New sources are much more costly to recover. The rear view mirror is useful, but not as useful as the windshield. This is not a put down of your work and ideas, just a supplement to your thoughts. keep on contributing...


On Jan 07 05:43 PM Gold Barron wrote:

> Since 1869 US crude oil prices adjusted for inflation have averaged
> $21.05 per barrel in 2006 dollars compared to $21.66 for world oil
> prices.
>
> Fifty percent of the time prices U.S. and world prices were below
> the median oil price of $16.71 per barrel.
>
> If long term history is a guide, those in the upstream segment of
> the crude oil industry should structure their business to be able
> to operate with a profit, below $16.71 per barrel half of the time.
> The very long term data and the post World War II data suggest a
> "normal" price far below the current price.
>
> The results are dramatically different if only post-1970 data are
> used. In that case U.S. crude oil prices average $29.06 per barrel
> and the more relevant world oil price averages $32.23 per barrel.
> The median oil price for that time period is $26.50 per barrel.
>

Jan 08 10:21 AM