Perspective on Correction, the U.S. Downgrade and Oil in Gold Terms

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Excerpt -- August 15, 2011 Issue of the Powers Energy Investor

In a market that has seemingly gone mad, where selling begets selling that is only exacerbated by modern high frequency trading, taking a step back and looking at the sell-off in a historical context can help you remember why you own what you own.  In this issue I will compare the sell-off of the past few weeks to the violent correction of 2008/2009 and why energy and precious metals will likely outperform all other investment classes. 

While the downgrade of the U.S. federal government, and the many government sponsored entities that have been downgraded in recent weeks, is news to some and unjustified to others, I view the recent downgrades as well as future downgrades as both inevitable and deserved. 

The short-term fluctuations in the market in recent weeks have distorted many long-term pricing relationships—such as the drop in gold equities while gold hits new highs, but I believe the noise of the markets has done nothing to alter long-term pricing relationships.  I will also examine the price of oil in both dollar terms and gold terms since 1945.  The oil/gold relationship has remained remarkably stable while the price of oil in dollars has risen dramatically. 

Finally, I will discuss how investors can profit from the volatility of recent weeks and how best to position oneself for the coming rebound in oil and natural gas prices and energy-related equities.

The market sell-off of the last month has been unpleasant for nearly all investors and has brought back memories of the brutal market drop the ended in March 2009.  Over the past week, I have read several accounts comparing recent days to the prior period.  Though both periods experienced severe market dislocations, I see several distinct differences.   First, the 2008/2009 market sell-off was precipitated by the failure of numerous financial institutions around the world; while the market turmoil of recent days appears to be related to sovereign debt and budgetary concerns in both the U.S. and Europe. 

Three years ago the U.S. dollar was seen as a haven for investors looking to hide from crashing markets and performed extremely well against nearly every currency around the world.  Now, the U.S. dollar is seen as a pariah due largely to the continued debasement it has undergone in recent years. While it has modestly risen against several of the commodity currencies such as the Canadian dollar, the realization has set in amongst traders the world over that the dollar is a seriously flawed currency.  The Swiss franc is now seen as the only haven currency amongst the many bad choices out there.  However, due to the strength of the franc against the currencies of many of its trading partners and at the behest of the country’s export driven industries, the Swiss National Bank (Switzerland’s central bank) has recently begun a money printing regime that will likely have little to no impact.  Gold setting records in every major currency should be seen as a repudiation of the fiat currency system and its re-emergence as the world’s most trusted form of money.  [I know, I know, the Ben Bernank says gold is not money.  But this is the same guy who said on 60 Minutes he is not monetizing the debt.]

The 2008/2009 vintage of market turmoil saw dozens of banks in both Europe and the U.S. choking on bad real estate debts bailed out by their national governments.  This time around, we will likely see far fewer blow-ups.  That said, the bank meltdowns that are happening as we speak (think Bank of America) are going to be far uglier since these banks are not only more problematic than they were three years ago, they are now much bigger.  As uber-analyst Chris Whalen has repeatedly pointed out in recent months, Bank of America needs to be restructured due to the steaming pile of mortgages on its balance sheet that are the result of its weak to non-existent underwriting standards and its acquisition of Countrywide Financial and Merrill Lynch.  More importantly, the bailing out a larger and more toxic bank--ones that needed government funds less than five years ago--will be politically far more difficult and will likely result in a downgrade of the sovereign entity writing the check. (Bank of America has plenty of company in Europe. i.e. SocGen)

The most important difference between the market meltdown of three years ago and today’s is that commodities—especially precious metals—are now de-coupling from the rest of the market due to the increasingly popular view that they are stores of wealth.  For example, as I write these words on a plane from Calgary to Chicago on August 10th, both gold and oil advanced nearly 3 percent and silver a whopping 4.5 percent on a day when the S&P 500 dropped nearly 4.5 percent.  While one day does not a trend make, I expect to see commodities of all stripes grossly outperform nearly all other asset classes.  Additionally, while shares of precious metals producers and energy companies have yet to grab the attention of the investing public and have been caught in the recent downdraft, strong oil prices and record gold prices should lead to a period of substantial share price gains for commodity producers.

While I would like nothing more than to write about how S&P’s downgrade of the U.S. debt rating served as a wake-up call to Washington, the recent downgrade has done no such thing. The formation of a committee to make recommendations on how to cut the deficit is simply another policy half-measure doomed for failure.   The cutting of a measly $25 billion from current year discretionary spending growth (not actual spending) from a budget of nearly $3 trillion means virtually nothing.  It is unclear at this point how bad things will have to get before a serious attempt will be made to narrow the budget deficit and tackle the tens of trillions of unfunded liabilities that have no chance of being met.  Serious fiscal reform is needed and soon.

In additional to new downgrades from the ratings agencies, the continuing fiscal woes of the U.S. federal government and many states—which are likely to lead to many municipal defaults in the next two years—is finally causing the funding crisis that I first discussed in issue 6 in November 2009.  This was at a time of QE1.  A funding crisis—a phrase coined by Bill Fleckenstein—is when a country is cut off from rolling over its existing debt and is unable to issue new debt without a large increase in interest rates.  What we are now seeing in Greece, Portugal, Ireland etc. is a funding crisis and it appears Italy and Spain are in the early stages of the same.  The rising cost of the Greek and Irish bailouts and a banking system that remains highly levered is causing rate increases across Europe.  In an unusual twist, U.S. Treasuries rallied subsequent to the S&P downgrade, largely on the back of problems in Europe.  However, any uptick in Treasuries will likely be temporary.  Things will change once the bond market wakes up to the enormous challenges facing the U.S. federal government as it attempts to roll over its existing debts and issue new debt that will be required to support future $1 trillion annual deficits.

Though some might still consider gold a barbarous relic that has little significance in today’s modern economy, I consider gold the ultimate canary in the coalmine.  Gold is not only a great indicator of confidence in paper money but has also been a great measurement of account for commodities over long periods of time.  For example, as you can see in the below chart, oil in dollar terms has risen substantially since 1945 while oil in gold grams has remained relatively stable for the past six and a half decades:

 crude oil prices

Source: GoldMoney, James Turk 2008 GATA Presentation http://www.goldmoney.com/gold-research-videos.html

While there can be significant fluctuations in the price of oil in gold terms in the short-run, the two commodities have held their pricing relationship to one another over the long-term and I do not see this changing.  Should gold continue into the five-digits—which I think it will given the rampant money printing that is occurring in nearly every central bank around the world—oil will likely hit new all-time highs irrespective of the state of the world economy.  It is important to remember that oil, like most other commodities around the world, is priced in US dollars and that those countries with the biggest influence over the price of oil, namely OPEC countries and Russia, are less than thrilled with the concept of pricing their country’s most important asset in green pieces of paper.

So what is the best way to participate in the rise in gold and oil prices?  The brutal sell-off of the past two weeks has created enormous buying opportunities all along the risk spectrum in both energy equities and gold mining shares.  Though many of the Powers Energy Investor Model Portfolio companies have seen their shares sell off in recent weeks, nearly all members have continued to grow shareholder value and appear very cheap by nearly every metric.  As I will discuss in the Model Portfolio section, many companies recently released excellent Q2 2011 financial results and are well positioned for profitable growth during the next several quarters. 

© 2011 Powers Energy Investor, LLC.  Used with permission.  Information presented in this article was obtained from sources believed to be reliable but accuracy, completeness and opinions based on this information are not guaranteed.  Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein.  The editor may have an interest in the companies mentioned.  All data and information and opinions expressed are subject to change without notice.

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