Crude Oil vs. Gold, Silver and Copper

by: EconMatters

Crude oil was being pulled up by gold and silver traders the latter part of last week based upon sentiment that governments are printing more money. So, the only defense against these monetary policies is to buy hard assets in terms of commodities. However, there are a couple of differences worth noting between the commodities, which will ultimately cause certain commodities to diverge more aggressively in the future.

Storage Spectrum - Yellow, silver, Red and Black

Gold and silver are on one end of the spectrum with crude oil on the other end, and copper residing somewhere in the middle. gold and silver storage is much cheaper and easier because it takes up so little space. There are security costs, but relative to the volume of supply coming out of mines each year it is much more manageable from an investment standpoint to buy the physical and store it in a vault.

However, crude oil is an entirely different commodity in that the costs involved in storage are so enormous because oil takes up so much physical space; there is limited storage capacity available all relative to the enormous supply that is being pumped onto the market each day. This makes it a very poor long term hedging instrument for those investors worried about currency devaluation on behalf of governments.

Copper is somewhere in the middle because there is more of it coming out of mines each year compared with gold and silver. So although storage is cheaper than oil, if China stops buying because of high prices, then the storage costs go up more than the expected inflation window, which adds to copper prices before central banks start tightening in an aggressive manner. I am mainly referring to Britain, Europe and the United States.

China Effect on copper

This is the reason copper has run into headwinds after being at the forefront of the inflation trade at the beginning of the year. copper was $4.65 a pound heading for $6 a pound, but stalled as China basically quit buying, compared with what silver has done since taking the baton from copper as the inflation breakout trade leader. China said "hold on" to copper, and traders need China's buying each month to bolster the demand side of the equation relative to the amount of new supply coming out of copper mines each month.

After all, China has been stockpiling copper from a very low base price since the financial crisis provided them with an excellent buying opportunity. So with such high prices relative to their existing supply, it makes sense to cut back on buying. The effect on copper prices served to stall the right angle trajectory climb for a couple of months with prices hovering around the $4.30 a pound area.

So, any news that China is raising rates or implementing additional tightening policies which would lead to slower growth in the future really puts a damper on copper prices, and makes the commodity vulnerable to supply versus storage costs dynamics that gold and silver can largely avoid as investment vehicles.

Copper & Crude – Industrial Commodities

The industrial demand for copper and especially oil are affected much more by price, which leads to demand destruction as prices rise (in comparison to gold and silver), which currently are fueled much more by speculative investor dynamics as opposed to strong industrial demand.

In other words, as prices in gold and silver rise, India may reduce their consumer buying of gold, but this isn't going to be the dominant driver of price if speculative investors really think central banks will print money Zimbabwe style.

Demand Destruction Manifesting in Crude

The problem is that crude oil is being artificially priced higher due to being caught in a trading updraft from the gold & silver momentum trade. This is actually creating more demand destruction for the oil market than would otherwise be taking place due to the fundamentals of supply and demand, which ultimately are the final driver for oil prices given the high storage costs relative to the enormous amount of physical supply that hits the market every day.

The year on year gasoline demand number is now negative in the U.S., at minus 1.6%, and distillate demand year over year is at its weakest point since the economic recovery began. This is starting to show up in the inventory numbers as Cushing is at record highs, and setting new records each week (See Chart).

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The total U.S. oil inventory picture is well above the five year averages, and only 29 million barrels from setting a new modern day record for U.S. inventories established in June 1990 at 388,172 million barrels, as we currently have crossed the 359 million barrel threshold (See Chart).

(Click to enlarge)

We have had builds for 13 out of the last 14 weeks, and this is during the seasonally strong part of the petroleum cycle. At this pace, with such high prices relative to market demand, the U.S. is literally going to be swimming in oil. When the weaker part of the seasonal demand cycle hits with storage capacity filled to the gills, and without major production cuts by OPEC members, prices are set to plunge in the second half of the year.

6 Degrees of Separation - Crude vs. Gold & Silver

This is what separates crude oil from gold and silver, and although copper has some characteristics similar to crude from an industrial demand standpoint, it is really not even close.

Once the industrial and consumer demand slows more than the available supply that is hitting the oil Market each day, the surpluses start to build, and storage capacity starts to fill rather rapidly. After six months time, the fundamentals can no longer be ignored. If supply is still more than demand each day, and existing storage capacity is reached, then it doesn't matter how much the dollar is being devalued due to loose monetary policies of the Federal Reserve, the fact remains prices have to come down.

Crude Oil – An Economic Commodity

This is why long term crude oil doesn't make for a consistent currency hedge like gold and silver. It eventually breaks down due to market fundamentals -- the same speculative demand that can overcome sluggish consumer and industrial demand for gold and silver, cannot adequately compensate for sluggish consumer and industrial demand in crude oil when high prices take their toll.

Crude oil in the end is an economic commodity and subject to basic economic principles of supply, demand and price due to enormous storage costs relative to the amount of available supply that comes to market each day. So speculative demand can drive the oil price for a while, but ultimately the higher prices set the stage for further demand destruction, which ultimately leads to sharper corrections in price due to the fact that in the long term fundamentals carry the day in the oil market.

Investment Takeaway

The investment takeaways from this are the following: When the price of oil corrects due to the fundamentals of supply and demand, it could set off a rather substantial sell off in all those oil related investments that benefited from the upsurge and spike in oil.

These are all good companies that have exceptional long term prospects, but their stocks will most likely go down with the price of oil as it corrects. Investors can a) stay invested, or b) take some considerable profits, and wait for the inevitable correction, then come back in and buy these same excellent companies at a much cheaper price, at least around their 200 day moving averages.

So, I would look to be taking profits in oil related investments that have benefitted considerably from this run-up in oil prices, and if prices correct in oil, I will not be lamenting the fact that I didn't lock in these gains.

The following are a list of companies whose stock prices could be hit with a correction in crude oil markets:

1) Exxon Mobil Corporation (NYSE:XOM)

2) Chevron Corporation (NYSE:CVX)

3) Conoco Phillips (NYSE:COP)

4) Occidental Petroleum Corporation (NYSE:OXY)

5) Apache Corporation (NYSE:APA)

6) Devon Energy Corporation (NYSE:DVN)

7) Sand Ridge Energy (NYSE:SD)

8) Schlumberger (NYSE:SLB)

9) Transocean (NYSE:RIG)

10) Halliburton (NYSE:HAL)

11) Baker Hughes (BHI)

12) Chesapeake Energy (NYSE:CHK)

13) National oilwell Varco (NYSE:NOV)

14) Noble Corporation (NYSE:NE)

15) Total SA (NYSE:TOT)

To Be or Not To Be

I am always reminded of the last time oil ran up in 2008 and Exxon Mobil traded above 95, and my mother, being a long term investor, wouldn't take profits when I advised her that prices would correct in XOM when oil markets corrected as the consumer and the economy couldn't flourish with gasoline prices at $4 a gallon.

Well, if she would have sold her shares before the big institutions started selling, she could have bought back into XOM at $60 a share, that's a $35 a share difference in less than six months. Now, I cannot predict where stock prices of energy related companies like XOM will be in six months, but a majority of them have come a long way in a very short amount of time. In the case of XOM, it was $58 a share as recently as last July during that summer's downturn in the markets.

So, the moral of the story -- don't be afraid to take some profits after a nice run in a sector. What's that old Wall Street line? "Bulls make money, Bears make money, but Pigs get slaughtered."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.