A Tangled Mess - Why Oil Mixes With Gold
Considerably higher oil prices are coming to the world at the worst possible time. Not only is the world far from being ready with oil alternatives when demand is on the brink of surpassing production, but this is happening at a time when the world economy is in danger of implosion caused by massive debts. The perilous fiscal situations around the globe make it even tougher to make the right long-term decisions surrounding energy.
Central to appreciating the circumstances we are facing on energy and oil is an understanding of political motivations. Once this is understood, particularly surrounding the issues of government debts and currency, it is easy to draw parallels to issues around oil. Gold prices have climbed for over a decade in response to irresponsible government fiscal policies.
Most gold investors understand the government reluctance to make the tough policy decisions necessary to remedy pressing financial problems or even potential calamities. Rather, motivated by self interest, elected officials simply opt to “kick the can down the road”.
Politicians know that the general population does not like to hear negative news, especially news that could mean major changes to their way of life and years of pain before issues can start to improve. Politicians are well aware of this and know that their bases of support, from voters to unions to corporations, will likely evaporate if they stand up and propose measures that will require sacrifice. This is why it is so hard to enact major change: the people do not demand it. Politicians tend to react to a crisis rather than to get in front of it.
The World’s Monetary System is Unsustainable
Unfortunately, the interconnected world economy is rapidly approaching a major crisis. Rather than just one smaller country (in terms of GDP) such as Argentina facing the threat of bankruptcy and oft-resulting hyper-inflation, many of the largest countries, from the U.S. to much of Europe (including the U.K.) and Japan, are effectively bankrupt.
If these countries were companies, the consequences of bankruptcy would have likely been dealt with years ago. However, because they are not, politicians have been able to continue to act in their own self-interest and manage for the short-term. By not addressing the issues sooner, the problems are exacerbated, until they results in a crisis much worse than if the cause was dealt with appropriately in the beginning. We are near this crisis point today.
The U.S. national debt of $14.1 trillion is at an unsustainable level, at more than $170 thousand per each of the over 81.6 million U.S. families. The U.S. Treasury, however, reports debt on a cash basis so it does not take into account unfunded obligations for entitlement programs such as Social Security, Medicare and Medicaid. According to Shadowstats.com, the total debt on a GAAP basis from 2002 to 2009 was on average 6.4x greater than the debt on a cash basis. Applying this same methodology equates to total national debt of close to $1.1 million per U.S. family today. To make matters worse, in 2009 nearly half of American households paid no federal income tax; so with only half of households paying taxes, the national debt burden on a GAAP basis could be over $2.0 million per tax-paying family. This is clearly unsustainable and likely past the point of no return.
The situation is set up to only get worse. The U.S., the world’s largest consumer of goods, spends 80% of the federal budget on interest, defense, and entitlement programs. The country could cut spending in all other programs and it would continue to result in annual budget deficits that increase debt. Interest rates have nowhere to go but up; which will place an even larger burden on the government. Beginning 2011, the first group of baby boomers reached 65. Baby boomers increasingly leaving the workforce will put even more stress on unfunded entitlement programs such as Social Security.
Meanwhile, many states such as Illinois and California have incredibly large unfunded pensions and deficits themselves that are primed to put them in precarious financial positions as we have witnessed recently in Greece and Ireland. Billions of federal stimulus dollars to the states are scheduled to run out in the spring. It is just a matter of time before the states look to the federal government for additional bail-out funds.
The debt issues inevitably lead to weakness in a country’s currency. All of the world’s major currencies are fiat, meaning they are not backed by a commodity such as gold. Over the course of thousands of years, no fiat currency has ever survived on a long-term basis, yet governments around the world continue extensive money-printing and policies that make their fiat currencies weaker. On top of this, many of the fiat currencies that have crashed throughout history were around for less time than the U.S. has been off the gold-standard (which will be 40 years this August). Meanwhile, world government debts are out of control and the same policies, mainly increased spending and large deficits, that got us into this mess are being continued and promoted further.
Accordingly, it should come as no surprise to even a novice investor that current government fiscal and monetary policies are leading to a crash of the monetary system. A large part of investing is being skeptical – rather than believing everything you hear from today’s political leaders, you need to start judging their actions and applying your own common sense. For example, just recently U.S. Treasury Secretary Timothy Geithner reiterated the country’s strong dollar policy - but every action taken by the Fed, from near-zero interest rates for 25 months counting, to extensive money printing, tells a different story. While Europe pursues aggressive spending cuts through a myriad of austerity measures, the U.S. has done the opposite by substantially increasing spending, which continues to add greatly to its deficit.
Structural issues in the Eurozone along with debt issues in countries such as Japan sometimes make it seem like the U.S. dollar is stronger than it really is. In reality, all of the major world currencies have been on a prolonged decline when compared to gold.
Much about investing in gold is common sense. Despite what may seem like a complex financial world, the principal underlying investment in gold is quite simple – gold has been money for thousands of years and in its physical form is much more difficult for governments to manipulate than paper currencies. This makes gold the safest investment in times of fiscal irresponsibility as we are seeing today.
People have been increasingly realizing that the government’s policies are imprudent and undermine the nation’s fiscal stability. They purchase gold as insurance against potential financial calamity. It also has the potential for outsized return, as the run-up of gold prices over the last decade has lagged the increase in the money supply. It is therefore no surprise that precious metals continue to reach all-time highs and are poised to continue being a fantastic sector to invest in for years to come.
World Oil Usage is Nearing an Unsustainable Level
Just as the issues in Greece and Ireland have sparked conversations about gold, the BP Gulf Oil spill has brought the topic of oil to dinner conversations. People recognize that oil is a finite resource and that drilling has moved to more difficult locations such as deep-ocean areas like the Gulf because much of the “easy” oil has been depleted. Unfortunately, it seems that people have not connected the dots with oil in the way they have recently begun to with gold.
The general public has similar views about the oil situation and the debts of various nations around the world. Everyone admits freely that running out of oil is a problem but to most people it lurks in the distant future and there is little urgency to deal with it now. They wishfully believe that our current way of life can continue and hope that future technological advancements will save the day. Such thinking is not only naïve but dangerous.
Oil is the lifeblood of the world’s economy and the main reason for the technical and economic advancements over the last 150 years. Since no one alive today has lived in a world without oil, the availability of cheap energy has been taken for granted. It has become commonplace to think that everyone can eat food transported to us from the other side of the world and that heavy steel can be easily shipped across oceans to and from Asia.
The world’s transportation system, from cars to boats and planes, is ill-equipped for non-liquid-based fuels. Oil is also a key ingredient in so many other products that we cannot easily replace it with alternatives. For instance, plastics are derived from oil and it has been a key component in expanding the food production to support the huge population of the world today (7.0 billion vs. 1.0 billion prior to the age of oil).
There is little argument about “Peak Oil” – the concept that oil production will reach a maximum point and then terminally decline, if it hasn’t already. Indeed, just this last November, the International Energy Agency announced that it believes Peak Oil occurred in 2006. Despite the implications, this news and other information about Peak Oil has received very little coverage in the mainstream media. Regardless of whether we have passed the point of Peak Oil, the key question is how a growing world will adapt to oil production declines in the face of rising demand; oil consumption continues to increase exponentially by the decade while new oil discoveries have lagged behind since the 1960’s.
The U.S. has less than 5% of the world’s population but consumes close to 25% of the world’s oil due to our style of living. Meanwhile, the rest of the world is racing to catch up with the U.S. Population and growth in emerging markets such as China and India continue to accelerate, offsetting any savings from more expensive energy alternatives. Cars as cheap as $2,000 in India are helping a whole new class of people consume oil faster, while new cars in China are growing at rates above 30% per year. You don’t need be a genius to see that these cars are leading us onto a crash course.
Just minor shortages in oil could result in drastic changes to our current way of life. Once the oil is gone it will never come back. On the other hand, with a crash of the dollar and other world currencies there is the possibility for fortunes to be lost, potentially resulting in new monetary systems being put in place. The main result could be a wealth transfer to people who have best prepared.
The stakes are incredibly high when it comes to the depletion of the world’s oil supply. Technology to find and extract oil is more efficient than ever; which allows us to extract as much oil from the earth as we can, leaving less for use in the future. Much like a Major League Baseball team that trades away its best minor leaguers and all future draft picks for a superstar with a one-year contract to try and win it all this year, the world continues to act in a way that helps them compete in the short-term but will leave them in an awful position for years to come. Whereas the oft-quoted adage goes that government debts are being passed on to our children and grandchildren, with oil we are outright stealing from them.
To help curb oil consumption the price needs to rise dramatically. The current pricing system does not take fully into account oil as a finite resource. Pricing is mainly based on output from oil production versus demand as well as on reported oil reserves. This system erroneously assumes that there is an infinite supply and that oil producing governments are not overstating reported reserves. As long as oil is considered inexpensive, people will continue taking it for granted and not change excessive use, and businesses will have less incentive to invest in alternatives.
Politicians recognize that a return to the high oil prices of 2008, which were as high as $147 per barrel in July 2008, would likely crush any hopes of an economic recovery and result in public outcry. So there is little chance that politicians will agree to disclosures and policies that could raise oil prices even higher than 2008 levels – even if such measures are the most effective way to address this dilemma.
Similar to the way politicians avoid dealing with the risks of exorbitant government debt and money printing, they have not been honest with us about Peak Oil and its consequences. Accordingly, the media and public do not fully appreciate the implications of Peak Oil and the effect it will have on our way of life. This results in a market price for oil that grossly understates its true value. With a full disclosure to the public of the shortage the price should rise naturally.
Unfortunately, the solution is not that simple. Since governments have avoided the issue for so long, resulting in a lack of sufficient alternatives, we have been pushed to the point where a full admission of the problems may no longer be in our best interests. Besides the U.S. being far from ready to deal with significantly higher energy costs, increases in oil prices will cause further transfers of wealth to the largest oil producing countries such as Saudi Arabia, Iran, and Venezuela. Similarly an open admission of the weak U.S. fiscal situation could result in panic from a loss of confidence in the U.S. dollar. However, this does not mean that government should ignore the issues, not aggressively promote oil alternatives, and not educate the public.
While alternatives to oil are being discussed, unfortunately we are nowhere near what is necessary to reduce our dependence. Instead, governments, particularly the U.S., have continued short-term policies that encourage heavy oil usage. When judging government actions, it is easy to see that the bailout of General Motors, the Cash for Clunkers program and massive stimulus dollars focused on road and bridge infrastructure do not consider the implications of Peak Oil. In addition, the oil production industry continues to be heavily subsidized by the U.S. through various tax breaks.
Despite government efforts to gloss over the Peak Oil issue and keep the price of oil down, it looks as if high prices are coming sooner rather than later. Inflation as a result of further declines in the dollar will continue to result in higher oil prices. Policies that weaken the dollar continue to threaten its use as the world’s reserve currency. An eventual change from using the U.S. dollar for oil transactions worldwide would further weaken the U.S. currency and mean much higher prices in the U.S., which would go a long way in reducing oil usage by the world’s largest consumer.
Prices will go much higher when the first major shortage hits as a result of Peak Oil and as the world gradually begins to learn more about its implications. Even after government debt issues are behind us and if the U.S. returns to some version of the gold standard, we should expect a much higher relative price of oil in the future as a result of Peak Oil.
Knowledge of the Issues is the First Step
A “Perfect Storm” is coming with government debt / fiat currency issues colliding with declines in oil production. The implications are just too great for everyone to keep ignoring the problems and trusting elected officials to make the right choices to get us out of this tangled mess. The decisions around energy and oil will be made that much tougher for politicians when faced with an economic collapse.
A recent example took place in the state of New Jersey. Unlike many other politicians, Governor Chris Christie rightfully acknowledged the horrible fiscal situation of his state and has made difficult decisions to attempt to rectify the situation. One of these decisions was to scrap work on a rail-tunnel project hailed by environmentalists that could double commuter-rail service to Manhattan from New Jersey. While this may be considered a prudent financial decision in the face of a large deficit, it is not clear whether this was the right long-term decision in the face of Peak Oil.
Unfortunately there is no easy answer. We are looking at a double-edged sword with high oil prices that could destroy our already fragile economy on one side, and a world without sufficient oil and energy on the other side. Neither is good but the truth is that the longer we wait to address the Peak Oil issue, the worse our situation will be.
The solution is going to be complex but knowing what the issues are is the first step. The way the entire world lives and uses energy needs to be rethought from the ground up. The people, investors, businesses, cities and countries that are best prepared for a world of high energy costs will be the most successful.
While the world’s financial system supported by fiat currency may hold on for months or years, it is clear that a collapse will occur. Notwithstanding monetary inflation, which is currently the main source of higher oil prices, it may take years before we have to deal with higher prices as a result of Peak Oil. Another stock market crash could even bring oil prices down to lower levels again. However, given that we could have already passed the point of Peak Oil, a shortage may come sooner rather than later. The issue of much higher oil prices can’t be ignored and we must prepare now.