Friday, December 25, 2015

Commodity Prices to Remain Soft

The Wall Street Journal reports that oil companies are writing down assets and that the SEC is pressuring the companies to reveal how the falling prices will affect their asset values.  News like this may come a little before a bottom, although the Journal also wrote a piece on December 11 suggesting that a bottom is in.  A contrarian attitude toward newspaper reports is often right. It's when the newspapers say that there is no bottom in sight that the bottom is in. Hence, I'm not convinced that a bottom is in.

I pulled out of my MLPs and oil-related holdings in October 2014. My doing so resulted in some issues with my stock broker, so I moved my entire portfolio to TIAA-CREF.  I lost a bit on my investments in MLPs and oil stocks, but I made some back shorting oil at a few points. 

Recently, I attended an alumni meeting of the UCLA business school in New York, and several of the MBA students were interested in oil. In the course of our conversation, one asked me how I knew to pull out of oil at the beginning of the decline. I'm not a technical analyst, but I do subscribe to a technical trading letter, Sunshine Profits, that helps me. My chief interest is in their gold reports by Przemysław Radomski, CFA, but I also get a monthly oil report by Nadia Simmons.  

My overall thinking, though, was influenced by my friend Howard S. Katz, who died in 2011 and was an early advocate of the application of Austrian economics to gold trading. Murray Rothbard once called Howard an "absurd Robespierre" because of  internecine squabbles in the early days of the Free Libertarian Party. (I joined afterwards.)  Howard was a gold standard monomaniac who argued in his book The Paper Aristocracy, published in the late 1970s, that the paper money system was resulting in income inequality.  As a result, gold traders have a moral obligation to advocate the gold standard.  

I was an oddball at UCLA, where many of my fellow students were interested in Wall Street careers, but I was an advocate of policies that would have significantly shrunk Wall Street if not eliminated it entirely.  America would have been much better off  had it done so, but Wall Street's control of political discourse goes back at least to the 1912 presidential campaign, if not earlier. 

Actually, it was earlier, for there were six pivots in the evolution of America's bankocracy.  The first was the establishment of the First Bank of the United States by Alexander Hamilton and his colleagues, which was abolished and then reincarnated as the Second Bank in 1816.  The second pivot was the Civil War, which enabled the passage of the National Banking Act. A third was the establishment of the Fed and World War I.  A fourth was Franklin Roosevelt's first abolition of the gold standard and establishment of the New Deal.  Roosevelt was the nephew of Frederic Adrian Delano, the first vice chairman of the Fed, and the great great grandson of Isaac Roosevelt, cofounder with Alexander Hamilton of the Bank of New York.  In America the bankocracy is partly hereditary as well as economic.  A fifth pivot was Nixon's abolition of the gold standard in 1971.  A sixth was the financial bailout of 2008. 

Notice that each of the pivots was associated with a war.  The First Bank of the United States ensued from the Revolutionary War; its successor, the Second Bank of the United States, ensued from the War of 1812. The National Banking Act ensued from the Civil War.  The Fed preceded World War I by only six months.  The first abolition of the gold standard preceded World War II by four years. (The Gold Reserve Act was passed in 1935 and World War II began in 1939.) Nixon's abolition of the international gold standard occurred during the Vietnam War.  The monetary collapse of 2008 occurred during the Iraqi War. Concerning the relationship between the Fed and World War I, Federal Reserve writes:

[T]he conflict accelerated the evolution of the Federal Reserve into a true central bank by increasing its financial resources and transforming the US dollar into a major international currency. 'The war reshaped the Federal Reserve System in many ways,'  writes economist Allan Meltzer in his landmark work A History of the Federal Reserve.

"Reshaped" is an odd word because the Fed was established during Christmas week of 1913 and World War I began in July 1914, although the US did not enter the war until 1917. Both the establishment of the Fed and the entrance into World War I were under President Woodrow Wilson. JP Morgan (a) knew Wilson from Wilson's days as president of Princeton (for Morgan was a donor), (b) financed the Progressive Party, which was responsible for Wilson's election, and (c) was involved with the drafting of the original Federal Reserve Act bill in the famous Jekyll Island meeting.  In 1936 the Nye Committee in the Senate investigated  JP (Jack) Morgan Jr.'s direct involvement in the entry of the US into World War I, but it did not prove it. 

Each of the pivots was associated with a major financial disruption.  The establishment of the first bank occurred after states' issuance of paper money, hyperinflation, and collapse of the continental.  The National Banking Act was associated with inflation resulting from greenbacks. The establishment of the Fed was followed by a hyperinflation and depression in 1919 and 1920.  The first abolition of the gold standard followed a deflation and a banking collapse. The second abolition of the gold standard was associated with the stagflation of the post-Vietnam War era.  The 2008 financial collapse was associated with the takeover of banks and the tripling of bank credit. 

These disruptions resulted in secular shifts in the economy: The National Banking Act was associated with expansion of big business and the railroads.  The establishment of the Fed was followed by the stock bubble of the 1920s. The first abolition of the gold standard and its reinstatement in the 1944 Bretton Woods agreement were followed by the post-1945 stock market bubble, the boom in urban redevelopment, the expansion of the suburbs, the creation of interstate highways, the expansion of reliance on the automobile, and the expansion of automotive air pollution. 

Not all of the banking disruptions have been inflationary.  Inflation results from excessive creation of money, but roughly half of the money of the US is held overseas, and it's possible for banks to hold reserves without lending them, and that's happening now. The National Banking Act was followed by inflation as were the establishment of the Fed and Nixon's second abolition of the gold standard, but the inflation of the post-Civil War period was followed by what Milton Friedman called the crime of 1873, the establishment of a strict gold standard with no silver bimetallism, and a consequent deflation; that was also true of the results of bank failures in the 1930s. There's no guarantee that inflation will occur in the short term from printing money--in fact, just the opposite, for there are effects on commodity prices resulting from misallocation or malinvestment that result in short-term deflation. 

Such misallocation has occurred in all current commodity markets.  From a long-term perspective, demand for oil is  greater than it would have been in a free market economy.  From today's short-term perspective, the early stages of a monetary expansion push down interest rates and expand investment in mines, resulting in falling prices. The falling prices are deflationary.  Thus, in the short run monetary expansion can cause deflation or subdue inflation, which occurred during the Greenspan years.  The later stages are usually inflationary, and commodity prices rise because the excessive competition produced by low interest rates causes bankruptcies of mining companies. More money chases fewer goods, and inflation ensues.

The commodity-price-decline cycle that began with the Volker tightening in the early 1980s culminated about twenty years later, and the gold price began to increase early in the millennium. The price peaked in 2011, but the intervening hyper-monetary-expansion of the Bernanke Fed inserted the beginning of a new cycle in 2009. The new cycle was superimposed on the preceding one, so it took a couple of years for gold to peak. We're now riding the Bernanke cycle downward. 

When will the cycle turn around?  I initially thought that the massive monetary increases would result in a brief, several year downturn, but it has extended to four years.  On the other hand, my increasing pessimism may signal a near bottom.  I am skeptical that we have hit bottom just yet, although in the coming year or two we will hit bottom. That point might coincide with economic-and-financial instability and a declining standard of living among Americans.  (That has been occurring for decades now, but the public has been susceptible to media propaganda claiming that "the economy" is improving and that borrowing large sums to buy big houses is a sign of economic health; when Americans have to cut back in basic ways, they may not be susceptible to the caricatures.) At that point, commodities will be important hedges, and prices might climb to the $3,500 level that I claimed for gold during the bull market.  

An important difference between the oil and gold markets is that the oil industry is oligopolistic; in particular, it's dominated by sovereign producers, especially Saudi Arabia.  The 19th century's fears of a private monopoly in oil were misguided.  Standard Oil had steadily reduced costs and increased efficiency throughout the 19th century. In contrast, Saudi Arabia can manipulate the price of oil, although it is sensitive to political pressure.  The political pressure for a transition to alternative energy may be spooking them. Economic theory says that a monopolist will produce to the point where marginal cost equals marginal revenue, but the Saudis' marginal revenue may still be above their marginal cost, which may be as low as $25.  If the Saudis want to dump their oil so that they are the last producer standing (in advance of a transition to green energy), then a $25 bottom is possible.

In the case of gold, the cost of production is unclear. According to Brent Cook's Exploration Insights Barrick Mining's cost of production may be $1,346.  Mining says that cash costs for 39 major miners average $649. Any number of small producers can be bankrupted, though, before we get to $649.  I had mistakenly bought GDX a couple of times over the past few years. This is the one-year GDX chart: 

How low can it go? There is a floor of demand by Chinese and other sovereign buyers. The Chinese may be interested in having the yuan replace the dollar as the reserve currency, and the Chinese like gold as an investment. As well, India demands gold for cultural reasons.  In October 2015 Bloomberg reported that gold demand in China is at an all-time high in response to the Chinese stock market. That may not, however, compensate for the excessive investment in junior exploration that responded to the low-interest-rate regime.  Notice that in both gold and oil the low-interest-rate regime saw increased production (fracking in the case of oil and gas) and subsequent price declines. 

Thus, I am relying on Przemysław Radomski to guide my gold thinking right now. There is a bottoming process, but I have no conceptual framework for when it can occur. There is going to be a bottom; we may or may not be at the bottom.  My bet is that we have further to go downward.  If oil hits $25, I will buy the leveraged ETF; meanwhile, I'm relying for technical guidance on the price of gold.  If it does not bottom around now or at $900, it can go to $400.

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