Gold, Energy, And the Problem of Capital Storage

 |  Includes: GLD, SLV
by: Gregor Macdonald

One of the reasons that gold retains its competitiveness as a capital-storage unit is the rather slow and plodding rate at which supply is brought to market. Since 1900, compound annual growth of world gold production comes in at 1.098%. That is below the increase for a number of other natural resources but in particular it’s well, well below the rate of credit production–the “resource” which now plagues the developed world. Indeed, the over-production of credit the past twenty-five years has once again driven capital back into hard assets such as gold. This brings up an intriguing subject: the conversion of resources into financial capital, and the conversation of financial capital back into resources. First, let’s take a look at the chart: World Gold Production in Metric Tons 1900 – 2008.

The migration of capital, between the world of natural resources and the world of finance, has been addressed by any number of thinkers, one of the more compelling being Harold Hotelling. Writing in the Journal of Political Economy in 1931, Hotelling proposed that a rational producer of resources would only be inclined to extract and sell that resource if the investment opportunities available with the capital proceeds were greater than simply leaving that resource to appreciate in the ground. So, given Hotelling’s theory of resource extraction, what has happened to gold production since the year 2000? Does the chart reflect geological and cost limits to increasing gold production, even as the price rose from $250.00 to $1000.00 per ounce? Or, has there been some moderate yet gathering decision on the part of global gold producers to extract gold more slowly? After all, why extract gold to merely convert gold into paper currency, beyond the need to pay for the cost of production and provide, say, a dividend to shareholders? In other words, at the rate at which the price has been rising, why hurry to extract the gold?

These same questions have long been asked in the world of energy extraction as well. Why did global oil production advance so quickly into late 2003 as price was rising towards the high thirties, only to peak out for the past 6 years as price skyrocketed? Well, we can safely assume that oil production in the West, governed mostly by for-profit enterprise, was doing everything possible to lift production. In short, they couldn’t. But in contrast to BP (NYSE:BP), Shell (NYSE:RDS.A), Exxon (NYSE:XOM), Total (NYSE:TOT), Chevron (NYSE:CVX), and ConocoPhillips (NYSE:COP), what about the NOCs–the National Oil Companies? Is it possible they were inclined to apply some form of scarcity rent, holding back production slightly? Echoing statements made at least twice last decade, King Abdullah of Saudi Arabia repeated himself this Summer when he remarked about future Saudi oil production: “I told them that I have ordered a halt to all oil explorations so part of this wealth is left for our sons and successors God willing.” | see: Global Crude Oil Supply 2002-2010 in kbpd (this is updated with the latest data through July 2010)

As the United States has now embarked on a massive dollar devaluation program, in part to bust the CNY-USD peg, but mostly to mitigate the next leg down in real-estate and debt deflation, we should consider how resource extractors might behave. Clearly, given that both gold and oil production are now either flat or falling, what should a producer of these two commodities do with the proceeds of their sales? Furthermore, is it possible that individuals and institutions may also gain insight with their own capital allocation decisions, by taking a cue from resource producers? Two obvious possibilities are as follows. First, oil producers rather than chasing higher prices in dollars or holding back oil production might start to demand full or partial payment in gold. Meanwhile, gold producers might consider banking some of their capital not in cash, but also in gold. And yes, both oil and gold producers could simply leave more of the stuff in the ground. What may become more clear is that, beyond the need for operational cash, turning excess production of resources into paper currency will increasingly become, per Hotelling, a losing proposition.