I believe the charts I have in this column contain some powerful insights. You will want to keep them handy when things get rocky. They come courtesy of Barry Bannister, an analyst at Stifel Nicolaus, who delivered an interesting talk in Baltimore recently.

I’ll focus on oil, though a similar story holds true throughout the commodity sector. I don’t put a lot of faith in macro predictions — as no one can predict the future. But you can study track records. You can look at history. History reveals some interesting clues about what the future may hold.

The quick take? It doesn’t look like the party is over just yet. But even if it is, past peaks in oil give us clues. When you dig a little deeper into those relationships, you find a great road map for making money.

If you look at the price of oil, you find something interesting. Since January 2001, you can explain the move in the price of oil largely as a function of increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply, as this next chart shows:

Basically, $100 per barrel oil is what we would expect to see, given this relationship between the oil price and money supply. Given that we are still in the midst of a credit crisis of sorts, it seems unlikely the Fed will tighten money in any way at all. That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms.

The other thing to remember — and people forget this by worrying excessively about a U.S. recession — is that the story of oil is no longer a U.S.-centric story. You’ve surely heard about how the rapid growth in China and other emerging markets drives oil demand. Well, it’s good to keep that in mind. See the chart below:

China and India are only beginning to consume oil at any meaningful level. Right now, they are consuming oil at a rate the U.S. did in the early years of the 20th century. But look, we don’t need China to start guzzling oil like we do. Even if it moves half the distance between it and Hong Kong, that’s a lot of extra demand. The way I look at it is this: What’s more likely, China stays at 1910 oil usage or moves somewhere closer to, say, 1950s U.S. oil usage? I think the latter.

Even if oil has already peaked, that doesn’t mean oil is headed back to $40 per barrel or lower. In fact, if this oil boom follows history at all, we’re looking at years of oil prices right around $100 per barrel.

After studying the history of other recent oil booms, what you learn is that in no prior oil boom did the price of oil retreat rapidly toward where it was before the boom began. In each case, the price of oil stayed up for years after the peak. If you’ve got investments tied to the booming oil prices, that means you’ve got plenty of years to make more money.

So where do you go to make that money?

The one obvious place people will automatically look is to own oil and gas producers. That’s not a bad idea at all. But I’ve got another angle here. If you look at the capital and exploration spending of both Exxon and Chevron from 1928-2007, they show spending bottoms in 1948 and 1974. After each bottom, there was a long run of spending.

Spending peaked nine years after 1948. Spending peaked seven years after 1974. If 2005 proves to be the bottom on capital spending — and it seems so, since Exxon only recently announced it would increase its capital spending to $25-30 billion over the next few years, a 25% increase — we won’t see capital spending peak until 2012 at the earliest.

Now, why is this important? Think about what the oil companies spend money on. Where do they go shopping? They go shopping at the oil field services and equipment companies.

So that is where you want to be. Because even if oil has peaked, we’re still looking at years of strong spending by the oil companies. You want to have some exposure to the receiving end of all that spending. Such companies will mint cash. And they give you a little different payoff than owning a straight producer. As Bannister pointed out, it can sometimes be better to own the picks and shovels. You don’t actually own or produce the oil or gas, but your equipment is vital to those that do.

He used Newmont Mining, the big gold producer, as an example of a producer that has profoundly disappointed investors amid what may be the greatest gold bull market in history. Newmont’s costs rose so fast and so much that it never really enjoyed (at least not so far) the higher price in gold. But if you were in some mining equipment manufacturer, you got paid.

So the key takeaways here are these: The price of oil has room to run yet, in part because of the growth in money supply and in part because of pressing international demand. Secondly, even if we already saw oil peak, history says that prices won’t retreat by much over the next several years. And finally, the capital-spending boom by the big oil companies is just getting started, which is great news for investors in oil field services companies.

Regards,
Chris Mayer
May 20, 2008

Rising Oil Prices was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Gold isn’t the only commodity on a tear. Gold’s little brother silver has surpassed the $20 per ounce level, oil hit $110 per barrel, natural gas is above $10, soybeans traded as high as $16, and wheat surpassed $20 per bushel. The currencies have been on a tear, as well, the most noteworthy being the yen, trading in the 100 handle, and the euro, trading as high as $1.56.

Supply and demand fundamentals, as well as the commodities supercycle, have affected many of these markets, but when you have a move across the board as we have, must look at the other side of the equation. I am, obviously, talking about the falling dollar.

Investing in any one of these commodities is a fine way to hedge the falling dollar, and investing in a broad array of these commodities is even better. But I would like to use this post to discuss the two most common dollar hedges.

I was recently contacted by a friend who is in Germany on an extended stay. He is set to return to the U.S. in a couple of months. The reason he e-mailed me was to inform me that he has been accumulating euros as a hedge against the falling dollar. We opened up a dialogue comparing euros and gold as dollar hedges in the past and going forward.

The obvious reason you would buy euros or gold is because you are short the dollar. I don’t need to state that we agree with that position. As a reader of Whiskey & Gunpowder, you know our view on the systematic destruction of the U.S. dollar by the Federal Reserve.

So let’s start off by looking at the past performances of the euro and gold versus the U.S. dollar, starting in 2001. The reason I chose 2001 is because that is when the most recent bear market for the dollar began. For obvious reasons, this approximately coincides with the bottoming of the euro and gold markets.

In 2001, approximately 95 cents bought you one euro. Today, it will take $1.56 to buy one euro. So if you had bought euros in 2001, you would have had a cumulative return of 64 percent.

How about gold? If you had bought an ounce of gold in 2001, you would have paid approximately $260. With gold hitting $1,000 per ounce, you would have made a cumulative return of 285 percent.

So the question of which dollar hedge has been the most effective thus far is a no-brainer. Gold has significantly outperformed the euro over the past six-plus years. In order to pursue this question further and make some predictions going forward, we need to ask ourselves why gold has outperformed the euro as a dollar hedge.

I believe the reason is very simple. The euro, just like the dollar, is a fiat currency. It is not backed by a gold or silver standard, therefore leaving the value of the currency up to the good, or not-so-good, nature of the monetary authority. If history has shown us one thing, it is that central banks are good at devaluing currencies. The reason the euro has appreciated against the dollar is because the Fed is inflating much faster than the ECB. So more or less, the 64 percent gain is equal to the cumulative inflation of the money supply of the dollar minus the cumulative inflation of the money supply of the euro.

Gold is a different story. Although global monetary authorities, including the IMF and BIS, have attempted manipulation of the gold markets, the real effect in the long run is essentially zero. Simply put, gold is probably the only asset left in the world that is no one else’s liability. There is one thing we can look at. The closest thing in the gold market that compares with the inflation of the euro is gold mined out of the ground. Because of the commodities supercycle and changing financial tendencies, growth in global demand for gold has grossly outstripped newly mined gold and gold sold by central banks. So for lack of a better word, gold supply is deflating.

So the euro has appreciated against the dollar, but it has been inflated in its own right, while at the same time, it is impossible to inflate gold. The best way to sum this up is to look at the price of gold in euros. You will see that gold priced in euros has increased by 133 percent since 2001. The price of gold is as good a judge of inflation as any. So theoretically, the difference in inflation between the euro and the dollar should approximately equal the difference in price increase between gold valued in euros and gold valued in dollars. That difference is actually 153 percent, which doesn’t exactly equal the 64 percent appreciation of the euro against the dollar.

So where does the additional 89 percent come from? It’s hard to say. It could easily be attributed to the fact that the euro was still a very young currency, it could be because of the commodity supercycle, or it could be due to some other reason. This is not a question that I have looked very deeply into. Regardless, it does not affect the analysis of the past, present, or future relationship between the dollar, euro, and gold.

Moving on, the final aspect of this piece is to figure out what the future will bring for the two most popular dollar hedges. The question we have to ask ourselves is will the trend change? Will gold be the best dollar hedge going forward? The simple answer to that question is no, but there never really seems to be a simple answer.

So to restate my answer, over the next couple of years, gold will continue to be the best hedge against a falling dollar. In fact, I expect gold to outperform the euro more significantly in the near future than it has over the past six years. This view doesn’t have any fundamental basis to it. If the end of the precious metals bull market in the early ‘80s is any foretelling of how the current gold bull will end, we have some fireworks to come. What I mean is that as the Johnny-come-latelys enter the precious metals market, it will exceed its true value and balloon into a bubble that will be remembered for some time to come.

It is at this point that the trend of gold outperforming the euro as an inflation hedge will no longer hold true. The new trend will be the transition into the euro as the new reserve currency of the world — and that is a discussion for a future day.

But for the time being, I strongly recommend owning gold over euros as the best inflation hedge against the dollar. It doesn’t really matter exactly how you do it, whether it be with physical metals, mining stocks, ETFs, futures, or option. It all depends on which investment style suits you best. But the more diversified your portfolio, the better. That is why I recommend owning not only gold, but also a broad array of commodities investments, ranging from the energy sector to agricultural commodities and precious metals…and yes, even some foreign currencies aren’t a bad idea.

Regards,
Nick Jones
March 17, 2008

Dollar Hedge was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.