With markets seemingly in turmoil, it’s always interesting and instructive to try to cut through the near-term hysteria and focus on the bigger picture as it relates to commodities.
The bigger picture as it relates to the oil sector remains simple: growing energy demand in emerging economies is set to put significant supply-side pressure on the world oil market over the next two decades. Of course to fully grasp this you need have to have an investment horizon that looks beyond the next few days or months.
What’s interesting is that oil prices have declined over recent months from a high in May of US$115 a barrel to a current low of under US$80 a barrel. Many investors are forgetting about the medium to longer-term picture and instead speculators and punters are driving prices and market opinion.
Oil prices in 2008 hit record levels of US$140 per barrel driven by surging emerging economy demand combined with supply-side fears; a situation exacerbated by speculators and ‘hot money’ flowing into the oil sector.
Because of this hot money, many dismissed oil’s significant rise as an aberration. As a result when the GFC hit, the price of crude oil fell back to below US$60 per barrel.
For a sizeable part of this year we’ve been pretty close to those former high prices, yet markets have been fairly complacent about these lofty price levels. There does seem to be a growing appreciation that higher oil prices of about the US$100 per barrel mark are becoming the norm rather than the exception. Furthermore, it will take a catastrophic meltdown and sustained stagnation in the world economy for prices to remain below US$100 per barrel.
Even afterthe GFC, which has devastated the economic landscape in two of the world’s biggest and most mature economies, the USA and the Eurozone, the price of crude has steadily climbed from its post-GFC lows because of burgeoning emerging–market demand, particularly from China. In the future, India will also play a greater role.
The oil industry is facing a tough challenge as it tries to generate enough production to meet growing demand. The industry reality is that it takes five to 10 years from discovery to first oil production, a long time when typically the size of the average field is getting significantly smaller, is more inaccessible and much more costly to develop.
The world effectively stopped finding large oil fields about 40 years ago. The production from the remaining large fields is falling every year and the industry simply cannot bring enough smaller fields on line fast enough to meet those declines and increase daily oil production.
The demand side of the equation isn’t providing any comfort either. While oil demand will be somewhat softer over the next six months because of international economic circumstances, the world’s population keeps growing each and every year.
If you consider how the populations of China and India (as well as other emerging countries) and how relatively little oil they currently use, it’s easy to see that changes in their lifestyle will inevitably involve more oil consumption, which will make a huge difference to the world’s oil demand-supply balance.
Apparently the gold bubble has burst – the weakening value of gold over the recent weeks in particular has led to many negative comments about the metal’s future. Like the oil sector, you have to take a step back and put gold’s price fall into its proper perspective.
Gold is 10.5% weaker (or US$192.70 in price terms) than it was a month ago, but by the same token the metal is still 26% higher (or US$339.40 in price terms) than it was 12 months ago, even accounting for the latest price correction. This is hardly a matter of the gold bubble bursting.
What we are seeing is a price correction that is healthy for the market – there was a similar correction in the latter part of 2008.
These types of corrections are normal and not unexpected. Since the start of the quarter, gold bullion had rallied by more than 25% to its recent record high of US$1920 on the back of investor nervousness. At US$1600 gold has merely reverted back to its trend-line.
One of the major anomalies of gold’s strong price run since late 2008 has been the corresponding underperformance of gold equities. During the immediate sell-off after the GFC, gold (like everything else) was hit hard, but gold equities were hit even harder. And gold equities have maintained their relative underperformance since late 2008 until now. In fact, the performance divergence is once again growing.
What this means is that investors have remained somewhat nervous about equities of all types since 2008. While gold equities should naturally benefit from the strong underlying performance of gold, investors have remained nervous about share market exposure. Hence, they’ve opted for the relative safety of physical gold rather than investing in gold stocks.
The important thing that investors have to understand about the recent gold price correction and the correction in late 2008 is that gold has been sold off because it has been a profitable asset. It has effectively been used as a source of funding for margin calls made on declining assets in investors’ portfolios, such as equities. This means gold is effectively undergoing forced selling.
Many inexperienced investors and market-watchers have an unrealistic expectation of how gold performs during a crisis. Gold, like everything else, gets sold down during the midst of a crisis as desperate investors attempt to raise cash. During the GFC this amounted to a 25% price fall for gold, from which the metal both strongly and rapidly recovered.
This time around it’s been a fall from a high of US$1,920 to a low of US$1,531 in late September (a fall of 20%), but the price has already rallied 8% (or US$114 in price terms) from that low. Again, you have to stand back and judge gold’s performance over a period that’s much more representative than merely just a few days.
When you do this, a la 2008, you do get an appreciation that gold indeed does retain and deserve its safe-haven status.
Over the next few months it is likely that the US Dollar will retain its strength and that the price of gold will underperform for the time being, in a scenario similar to that post-GFC. This provides a period of consolidation for gold and a buying opportunity for investors, before the next upward leg in gold’s price climb (US$1,600 in my view is the critical gold buying level for investors).
Market disenchantment with the US Federal Reserve’s Operation Twist and the likely clambering in some quarters for some form of additional fiscal stimulus (potentially QE3) to help resuscitate the ailing US economy, are all factors that are likely to kick-start the next phase of gold bullion’s price ascent.