Are Commodities Set To Soar?

Are Commodities Set To Soar?

Continued volatility in many sectors has investors and fund managers scratching heads. Meanwhile key COMMODITIES, including crude oil, silver and gold, are set to explode; at least that’s the way many analysts see it.

Its basic law of supply and demand. When an economy, global or local, consumes more of something than it produces then you have the technical definition of a shortage. Eventually shortages lead to higher prices; the greater the shortage the higher prices will eventually reach.

CRUDE
Crude oil has exploded up an incredible 200% in the last 18 months. Inventories are now at 24-year lows and down 10 percent from a year ago.

Brent crude is of a lesser quality and normally trades at about a $1.50 discount to U.S. light crude futures. In mid August Brent Crude stood at a 50cent premium over US Light Crude, a differential not seen for 10 years. Analysts are suggesting that if oil traders are willing to pay such high premiums for Brent Crude (to be assured supply of oil), a short squeeze in the crude market could well be coming that would see much higher prices to the upside.

Arab oil producers are under extreme political pressure from within OPEC to let the price of oil go up. With an inflationary US dollar internationally, it seems it is though this pressure will not diminish for some time to come. Some petroleum analysts believe OPEC is already operating at 95% of maximum output, with only Saudi Arabia thought to have any significant capacity left.

An oil shortage already exists; too much oil is being consumed at too cheaper a price. Many believe that in order to equalize current demand with production, crude should be trading at $35 – $40 per barrel. According to Goldman Sachs, the risk of an oil shock to the U.S. economy is unusually high, and a 10% probability exists that crude prices could exceed $50 a barrel within the next year.

SILVER
In a issue of Money Changer, Franklin Sanders asks the question of Ted Butler “why has the price of silver gone nowhere for ten years in the face of persistent deficits?”

For a decade, silver, just like gold, has sustained a continued supply shortfall where demand has far exceeded supply. World Silver Survey estimates the total deficit over the last 10 years at 1.2 billion troy oz (US$6 billion at current prices), an average of 122 million oz per year. In 1999, fabrication demand totaled 877.4 million oz while mine production continued to fall to 546.7 million oz.

SILVER DEMAND CHARACTERISTICS
Silver is used in a large amount of industrial applications from photographic to electronics where there is just no other replacement for the metal. In most of these applications, the silver is consumed or lost; the silver can no longer be recovered at any cost. Over the last 2 – 3 decades the amount of actual silver used in these processes have been reduced to an absolute minimum, to the point where today many silver fabrication experts believe further reductions are just not possible or viable.

For several years a downturn in the use of silver in the photographic process has been spoken about, yet annual photographic silver demand continues to climb. While the west is slower than expected to embrace digital photography, developing economies (India and China) are just now starting to use traditional photography for the first time, further driving photographic silver demand.

Silver inventories are not large, relative to gold, and according to some analysts, no longer exist at the sort of levels required to fill the supply shortfall, making the silver market structural deficit far more acute. Some qualified silver analysts are now predicting a sustained price of US$20 per oz (up from currently US$5 per oz now) to reach an equilibrium between supply and demand in the silver market.

GOLD’S GLOBAL DEMAND
Gold continues to be priced at the lowest prices in 20 years, meanwhile the World Gold Council reports global demand running at record levels (around 4000 ton per year).

Some examples: Russia continue to buy physical gold. Lemtropolecafe reports Malaysia’s demand has increased 22%, with overall gold imports at 4 ton. Taiwan up 13 per cent with imports at 34 ton; in Taiwan, a government issue of 80,000 gold coins celebrating the inauguration of their President Chen Shui-bian helped increase investment to 10 ton, an increase of 67% on last year. China, Japan and Arab nations are all likewise accumulating gold at current prices. Physical gold continues to be extreme short supply relative to world demand.

PHANTOM SUPPLY
For more than a decade now, demand has outstripped new mine supply by an average 1500 tons per year. Many qualified observers claim this annual supply deficit is in-fact much larger.

The obvious question; how is this supply shortfall met in the physical market without dramatically driving up prices? In short; central banks have been leasing (renting) their gold reserves (at about 1% per annum) to London based bullion banks that in-turn are selling the gold into the physical market to meet immediate demand.

Recent examples: Uruguay joins Chile, Kuwait and Jordan in sending their gold to London. Between May and July 2000 the Central Bank of Uruguay sent over 261,000 oz. to London, the last remaining gold reserves in the Country.

ACCUMULATED SHORT
Short term, phantom supply keeps every one happy. The supply satisfies market demand, central banks get a (small) return on an asset that would otherwise sit in the vault, bullion banks make a killing and purchasers continue to accumulate while the price of gold remains stable and low. However these gold loans are an accumulating short position that will eventually unravel. Remember; when you consume more of something than you produce, you have the technical definition of a shortage, the greater the shortage, the higher prices will eventually reach.

Many are claiming this accumulated gold short is reaching dangerous levels, potentially endangering the entire global economy. Recently I conducted an interview with renowned gold analyst Frank Veneroso. Mr. Veneroso estimates total size of these gold loans to be in the order of 10,000 ton and could even be as high as 14,000 ton or more.

SHORT SQUEEZE
A short squeeze is caused by a market of limited tangible supply that is stormed by everyone at the one time demanding physical delivery of the given commodity, driving prices to extreme levels very quickly. When a bullion bank sells bullion (gold or silver) that it does not own, it is setting the stage for a future short squeeze. In many cases the gold or silver sold may be consumed and therefore is not recoverable any time, now or in the future. What happens when the central bank calls in its gold loan and wants its gold back? (i.e. if that countries currency is devalued and it wants or needs its gold back to meet its commitments as happened in Korea in 1997). Typically bullion loans are made in kind; 1000 oz of gold bullion loaned must be paid back in 1000 oz of gold bullion. Even if these loans could be settled in dollars, how will a bullion bank pay back a bullion loan in dollars when the price is going through the roof?

Any short supply or short position is only a temporary situation; it can’t last forever. Every market, whether crude, silver or gold must eventually clear, where the buyers (the demand side) meet the sellers (the supply side) at some price, and when the borrowers must repay the lenders (what happens when they cant?).

Many see the three commodities discussed here to be closely linked (consider the late 1970’s).

Historically, oil has a powerful price relationship to gold. Rising oil prices have a massive inflationary impact on any industrialized economy and all of these have a profound psychological effect on the mindset of the investor.

CATALYST FOR HIGHER GOLD PRICES
There are several including:

– Sustained increases in the price of crude oil.

– US Dollar collapse. Consider the Current Account Deficit of the US running at US$456 billion this year. Each and every day the US buys US$1.24 billion worth of goods and services from the rest of the world over and above the goods and services it exports to the rest of the world.

– Dept Liquidation (personal, corporate, government) where borrowers can no longer meet repayments or where loans are called. An extended period of low interest rates have seen the greatest levels of debt from all sectors in all of history. Now, six interest rates hikes since June 1999 in the US now have many overextended borrowers on the edge.

– A sustained stock market downturn. An oil lead rise-in-prices will effect the entire economy including corporate earnings that could well see an overvalued stock market start to reel. Devaluation of assets lead to further debt liquidations.

SUMMARY
Holding precious metals in recent years would certainly have perfected the virtue of patience in the holder. It can be especially hard holding an asset that earns the holder no interest when those all around are claiming 15 – 20% returns out of their mutual funds or dotcoms. As we have considered here today, many parts of the world still understand the meaning of buying low, and holding to sell high, explaining the high demand for the precious metals in the Orient and Arab block nations. At some point in the future (probably near future) the patient, and in many cases weary, holder of gold and silver will be amply rewarded for their patience.

by Philip Judge
2000