Stay the Course: The commodity bull market still fundamentally sound
By Tony Allison, February 4, 2008
At the risk of sounding like a Dana Carvey parody of the first President Bush, I believe the concept of “staying the course” in commodity-related stocks is still the place to be in 2008. I promise not to refer to “a thousand points of light.” Wall Street is always looking for new flavors of the month to push, but that is not a reason to abandon the commodities sector, especially energy and precious metals.
We are likely to see great volatility in 2008. We may see a recession. We may see hedge funds pushing the panic button and selling everything with a bid, including energy and precious metals. But for patient investors, the tangible asset sectors will continue to be fundamentally attractive. Energy and other commodities are in a long term secular bull market, but will be subject to volatility and downdrafts, especially with the ongoing credit crisis roiling the markets.
Money Supply Expanding Globally
oney supply growth continues globally. Inflation is embedded in the system globally, not just in the US. We have managed to export our inflation internationally, as other central banks print to protect their currency and export markets. One can also see why the US conveniently discontinued its M3 money supply data. Most experts who follow global money supplies put the US M3 number at 15% and growing.
Source: Bloomberg (January 29, 2008)
The end result of this is likely to be higher energy prices, higher gold prices, higher food prices and higher interest rates. The inflation train has left the station. The massaging of government inflation statistics won’t hold off the inflation, as the train will soon arrive in every city and town bearing bad tidings for consumers.
Oil prices are down slightly on the theory that the US economy is slowing and there will be demand destruction. Recent trade statistics show we are importing more of it and paying a higher price for it. People will not stop driving to work. The point to remember about oil is that it is priced in a global market. A barrel of oil in Australia or Japan is the same price as a barrel of oil in the US. The US has not contributed to incremental global oil consumption in over two years, as the market price has surged from the $60 range to around $90. So if the US falls into recession, how much demand destruction will actually take place, and will it really have an affect on the global price of oil?
The incremental demand is coming from Asia, and from the producing countries; the Middle East, Russia, Venezuela, Mexico etc. due to domestic growth and subsidized prices. Growing domestic demand in these areas will likely cut into export growth.
The other side of the coin is supply. The US is now highly energy dependent, unlike the days of yore. The US now imports approximately 70% of its energy (oil, natural gas and refined products). According to the SERA report, world oil depletion is running at 4 million barrels per day. Matt Simmons believes that figure is very conservative. In Mexico for instance, as the Cantarell oil field depletes rapidly over the next 10 years, and domestic demand grows as well, where will the US get the lost supply? Canada’s tar sands are a likely area, but the extremely high cost of production and long time frames to grow significant production would seem a perfect recipe for three digit oil prices. Oil will be available in future years, but the days of cheap energy are likely a part of history.
Major Producers Admit Concern
Even the major oil producers are starting to change their tune. “Up until about 6 months ago, the major oil company CEO’s were in lockstep that Peak Oil wasn’t an issue we should take seriously,” said Simmons in a Financial Sense Online interview last weekend. “Companies would refer to Peak Oil in print as ‘junk science.’ The companies would never refer to flow rates and decline curves. But out of the blue at a conference in October in London, Christophe de Margerie, the new CEO of Total admitted that he couldn’t see how the industry would supply beyond the low 90 million barrels per day range in future years. And James Mulva, the CEO of ConocoPhillips recently said adding the numbers up, it would be difficult for global production to supply more than 90-92 million barrels per day.” Current world demand is approximately 88 million barrels per day.
Energy Independence- Realistic Goal or Pipedream?
Politicians in this election year speak of the US becoming “energy independent” within a decade. How is this even in the realm of possibility? It might take 10 years to get one nuclear reactor built. How are we going to replace 70% of our energy needs in a decade? This is not happening. Over the last half century, the US has squandered its legacy of cheap, high quality oil, without a thought or a plan on how to replace it. Now we must pay the global rate just like other oil-dependent countries, and the price isn’t going back to $20 a barrel because we would like it to.
As the rapidly industrializing areas of Asia seek energy wherever they can find it, expect coal and uranium prices to go higher based on demand alone. In addition, Canada will be using much more natural gas in its oil production in the tar sands fields. That means less natural gas will be piped into the US, and ultimately higher prices will be the result.
Precious Metals Fundamentals
The reality is that the current bull market in gold has been very steady. The price of gold has risen every year since 2001 in US dollars. Since 2005, gold has been moving up in all major currencies, unlike the 1970’s, where gold didn’t rise much in German marks or Swiss francs. In many ways it’s been a “stealth” bull market, as the mainstream investor has not been involved to this point. One of the issues is the size of the precious metals market is so small. The market cap of the entire HUI index is only a little over $150 billion. The market cap of Exxon is nearly $470 billion by itself.
The metals sector is so small that volatility can be magnified, and scare off potential investors. When hedge funds dive in or out of the market, the market can move up or down rapidly.
On the other hand, the limited size of the gold market is part of its attraction. In a fiat currency world run amok, gold is the only globally-accepted money that cannot be created at will. There are approximately $187 trillion in global financial assets and only $600 billion in privately held gold at today’s prices.
Institutional Sea Change in Gold
The institutional money is now starting to buy bullion and gold shares. According to a recent front page Wall Street Journal article, gold is now getting the attention of big money. The Bessemer Trust, a New York institution managing over $52 billion for wealthy families held no gold three years ago. Now they have $300 million in gold bullion and are looking to buy more. According to Marc Stern, chief investment officer of Bessemer, “Gold doesn’t have a policy, gold doesn’t have a central banker, gold doesn’t have a printing press. It is a form of insurance.”
Brett Gallagher, who oversees $63 billion in investments for Julius Baer Investment Management agrees. “We don’t feel the dollar is a good store of value” he said in the WSJ January 31st article. His fund holds gold-related stocks as well as other commodities-related shares that he believes will benefit from a weak dollar.
Continuing the institutional sea change, a recent Barron’s interview featured Joseph McNay, who manages more than $3 billion at Essex Investment Management in Boston.
“Increasing the money supply kept the situation from getting worse faster than it would have otherwise,” said McNay. “From one point of view, that's good. But there is a point of view from which it is not good, and that is it decreases the value of our currency on a consistent basis and sometimes at an accelerated rate. In the past four or five years, the euro has gone from 82 cents to the dollar to $1.48. That is all lost purchasing power in our currency. We are in a lose-lose situation. The decline in the value of our currency is directly inflationary. Lost purchasing power is inflation. The bigger risk is that, at some point, the large holders of U.S. dollars may decide they want a lot less of them, if any. This is a very challenging set of conditions for us.”
A Currency Alternative
McNay continued as to the implications for the market. “We are going to have an even more narrowed and focused market than we had last year. Something the world is going to want now is a currency alternative. An investment I have felt positive about but now feel dramatically more positive about is gold. Gold is probably the single most important investment that most of us can have a representation in.”
If the smart money institutional crowd is beginning to move into the market, chances are the bull has a ways to run. In 1980, investors would line up outside banks to buy gold. Today the average investor is much more interested in Google or Apple. If the dollar continues to deflate as the Fed pumps unlimited liquidity into the credit markets, the average investor may begin to realize dollar-denominated assets are not the safe harbor they once were.
Public Not Significantly Involved in Gold
The metals bull market will likely not end until there is wide public acceptance, which is not yet on the radar screen. Before that happens other factors are likely to push the market forward. Those would be 1) continued de-hedging by larger gold hedgers such as Barrick, 2) new demand from China, Russia and Middle Eastern Sovereign Wealth Funds, and 3) much greater institutional participation around the globe. As in all bull markets, the public jumps in at the end, creating a final top.
Rogers Still Long Commodities
From a broader commodity perspective, legendary investor Jim Rogers recently gave an interview to Fortune Magazine from his new home in Singapore. Rogers believes the US will suffer a significant recession, but the commodity secular bull is far from over.
“The pullback in commodity prices on recession fears hasn't dampened his enthusiasm for resources investments, either. More like a cyclical correction in the middle of a long-term bull market. "Certainly some commodities are going to be affected,’ says Rogers. 'But it's not as if the markets haven't figured this out. Remember the old expression: 'Dr. Copper is the best economist in the world.' Well, Dr. Nickel and Dr. Zinc figured out a few months ago what I thought I had figured out, that we were going to have a recession. Nickel is already down 50%. Other commodities may fall more. But I don't see the economics of agriculture being much affected at all. Maybe there will be a few less cotton shirts bought. Maybe there will be a few less tires bought. But the supply is under more duress than the demand."
Once again Rogers draws on the 1970s in his analysis. "Think about the story of gold in the '70s,’ he says. "Gold went up 600%, and then it started correcting. It went down nearly every month for two years, nearly 50% from the high point. And everybody said, 'Well, that's the end of the gold market. It was just a fluke. It's over.' It scared everybody out. And then gold turned around and went up 850% from that level. This is what happens in markets. But the fundamentals of the secular bull market in commodities are not over any more now than they were for gold in the '70s.’
Where he expects the pain to be most intense is on Wall Street. He says he hasn't covered his short positions on the investment banks or Citigroup and won't for a while.”
All the touting, cheerleading and statistical massaging will not move the markets for long. The long term fundamentals eventually emerge and will both reward and punish the markets based on supply and demand factors, not self-interest or wishful thinking. For long term investors who understand the underlying fundaments, staying the course through the storms of volatility will likely be rewarded as the commodity bull runs its course.
“Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn.” Jesse Livermore (1877-1940).
U.S. stocks moved lower Monday, with investors trimming positions following a rally that saw the market rise in four of the previous five sessions, while the stocks of troubled financial firms also suffered from several broker downgrades.
The Dow Jones Industrial Average fell 108.03 to close at 12,635.16. The S&P 500 Index closed down 14.60 to close at 1,380.82. The Nasdaq also closed lower, ending at 2,382.85, down 30.51.
Crude-oil futures rose on Monday for the first session in three, boosted by the temporary closure of a key waterway in Texas, while economic data sent mixed signals with factory orders rising but layoffs surging. Crude oil for March delivery rose $1.06, or 1.2%, to $90.02 a barrel on the New York Mercantile Exchange. Crude had dropped more than $3 in the past two sessions.
Gold futures closed with losses Monday, extending their decline from the previous session, as investors continued to lock in gains. Gold for April delivery declined $4.10 to end at $909.40 an ounce on the New York Mercantile Exchange. Earlier, gold futures hit an intraday low of $896 an ounce.
Wishing you a good evening,
© 2008 Tony Allsion