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OIL,
SILVER, AND FEAR Many people have heard of the relationship between oil and gold, but there is also a correlation between oil and silver. Back in the bull market of the 1970s, silver and oil prices generally moved together. Adam Hamilton of Zeal Intelligence notes that oil and silver had a .78 correlation from the 1973 oil crisis through the blow off precious metals top in 1980 (see http://www.zealllc.com/2005/sor.htm for some great charts). This makes sense when you realize that mining is very energy-intensive, so higher oil prices should eventually force metal prices upward. Like other commodities, both oil and silver experienced overinvestment during the bubble of the late 1970s. When the demand dropped below available supply in the 1980s, prices dropped precipitously. OPEC countries like Saudi Arabia pumped so much petroleum that supply periodically flooded the market. In contrast, consumption of silver has outpaced mining for over 60 years according to Ted Butler. Unlike oil, the silver price had to battle both excessive short positions and dishoarding of silver stockpiles by the U.S. government. There was much more silver available 26 years ago, yet in relative terms, silver is over 9 times cheaper today! The Federal Reserve's own inflation calculator states that silver would have to pass $132 per ounce in order to surpass the 1980 spike high in today's depreciated dollars. So why did silver surge dramatically in 1980? I believe that much of the demand for silver in the late 1970s was monetary. People inside and outside America lost much of their faith in the U.S. dollar. Richard Nixon severed the last tie between the dollar and gold in 1971. At that time, the U.S. was running a trade deficit, the Vietnam War was increasingly unpopular, and consumer price inflation was accelerating. The stock market was performing poorly, and more and more investors switched to hard assets to try to protect their wealth. Eventually, they placed their trust in silver and gold which have been real money for thousands of years. The price move in precious metals turned parabolic and unsustainable. Like any mania, the bubble had to burst. People were willing to switch back to the dollar and paper assets because they had become cheap compared to tangibles. Paul Volcker, the Federal Reserve Chairman from 1979 through 1987, had the will to tighten the money supply which pushed the prime rate over 20%. Paper assets became attractive once again, and the stock market began to appreciate. During the stock market boom of the late 1980s and most of the 1990s, the silver/oil relationship became quite weak. Oil experienced some spikes, especially during the first Gulf War, while silver was generally flat or declining. When you factor in inflation, the price of silver dropped to 600 year lows. Recently, it seems that silver is trying to catch up to oil to assert its traditional relationship. The silver/oil ratio slipped to a record low of .09 last year, requiring over 11 ounces of silver to buy one barrel of oil. Today it takes about 5 ounces. According to Hamilton's research, since 1981 the silver/oil ratio has averaged .26, or about 4 ounces to every barrel of oil. If the petroleum price remained stagnant, silver would have to jump to $18 an ounce just to revert to the mean. However, when prices correct upward they usually blast past the average. One standard deviation above the mean would equal $23.46 silver, and that's at an oil price of $69. Increase the oil price or have volatile silver jump up another standard deviation or two as it has in the past, and we could see some real fireworks. Oil has plenty of reasons to continue its upward march. Mainstream networks like CNN have reported that there is less oil available than previously thought. Many major oil fields like Cantarell in Mexico, and Burgan in Kuwait have peaked. No matter what technology is used, they will produce fewer barrels per day in the future. Remarkably, 22% of oil production in the Gulf of Mexico is still offline, and it's not economical to replace many of the rigs destroyed in last year's hurricanes. New discoveries are not compensating for increased demand from the developing world. Even President Bush has mentioned that America is "addicted to oil" produced by unstable countries, and needs to develop alternative energy sources. History shows us that wars and global political tensions are bullish for both oil and silver prices, and the world has no shortage of conflicts today. The civil war in Nigeria has caused Royal Dutch Shell to stop producing 455,000 barrels per day. There are still battles in Iraq and Afghanistan, and sporadic terrorist attacks in nearby petroleum producing countries. Energy itself can be used as a weapon. The President of Bolivia, Evo Morales, just announced that foreign oil producers have six months to rework their contracts or leave the country. His neighbor Hugo Chavez has threatened to seize oil company assets in the Orinoco River area. Last week, Chad used their oil pipeline as a bargaining chip in a dispute with the World Bank. Almost three decades after the hostage crisis, the U.S. government has renewed problems with Iran. The Iranians didn’t comply with an April 28th U.N. deadline to cease enriching uranium, and the U.S. is pushing for sanctions. The Iranian Deputy Minister of Petroleum, H. Nejad Hoseinian, warned that energy prices would spike if any sanctions occurred. Both Iran and Venezuela have threatened the U.S. with curtailing oil supplies, and dumping the U.S. dollar if America acts aggressively. Tight energy supplies and the threat of disruption have added a "fear premium" to oil, but that anxiety is also driving the precious metals higher. Silver and gold are pushed by higher energy costs, and pulled by distrust in paper assets. Some large countries such as Russia have announced they are diversifying their reserves out of dollars and acquiring more gold. Chinese and Indian citizens are purchasing more precious metals with their new-found wealth, and Dubai now trades silver and gold on their exchange. We are witnessing a generational rotation back to hard assets, and the precious metals are leading the charge. Silver has jumped over 56% in 2006, and gold is up almost 31%. In contrast, the Dow is up less than 7%. If you're concerned about the high cost of energy and other essential items, ease your worries with a precious metal purchase. When the world is in turmoil, bullion appreciates faster than inflation can steal your savings.
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