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Bedfellows: The Prices of Gold and Oil

Peter McKenzie-Brown
February 26, 2008

I’ve been a gold bug since the beginning of 2001, and you will probably notice on this chart that my timing was pretty good – especially so since the market in gold shares turned before the price of bullion did. In my opinion, the volatile price of gold shown here is directly tied to the recent dramatic increases in oil prices.

I think this chart is the best available picture of gold prices over the last quarter century. It's a point-and-figure chart, consisting of columns of Xs and Os that represent filtered price movements over time.

As explains, there are several advantages to using P&F charts instead of the more traditional bar or candlestick charts. Briefly, point-and-figure charts automatically eliminate the insignificant price movements that often make bar charts appear ‘noisy;’ remove the often misleading effects of time from the analysis process; make recognizing support/resistance levels much easier; make trend line recognition a no-brainer; and help you stay focused on long-term price developments.

Within that context, please note that The Privateer's technical analyst recently drew a tentative but extremely bullish trend line on this chart – the dashed green line on the far right. If this is correct, we won’t see $900 gold again for a long, long while. Point-and-figure charts can’t tell you when gold will run through $1000 per ounce, but this one gives a very strong opinion that it will. Perhaps you should buy some gold producers - or, if you can handle even greater volatility, a leveraged bull fund like HGU.

Why? In my opinion the price we are paying for gold is directly related to the price we are paying for oil. And gold's fast-moving price reflects a rapidly deteriorating situation in the petroleum industry.

A few weeks ago I answered the big question of the day – will oil prices climb or collapse? – with arguments that prices are still on an upward trajectory. I recently had a discussion with an oilman just back from the Cambridge Energy Research Associates conference in Houston, where one of the speakers was Matt Simmons. Author of Twilight in the Desert, Simmons is a fierce sceptic of Saudi Arabia’s ability to increase or even maintain oil production capacity beyond the next few years. In a recent pronouncement, Simmons proposed that the world reached maximum production two years ago. The apparent increase in supply since that time has been essentially a drawdown in global inventory.

Gold prices reflect political instability. And if Simmons is correct, the near-term geopolitical outlook is quite dangerous. Imagine battles for supply, complicated by Jihadism, disrupting the world order. Imagine regional conflict between large landmasses, as in the US vs. the Middle East and Islamic terrorism (already reality); Putin keeping his hand at the pump to dictate terms to Europe (already reality); regional struggles between India and China for Southeast Asian resources, especially petroleum; America using the terms of the US/Canada free trade agreement to demand ever more of Canada’s oil and gas production.

Peak Oil: And that, of course, takes us to the topic of peak oil - the notion that the world has produced about half its producible reserves, and that implied demand will soon outpace available supply.
You usually see a peak in oil prices in the spring, and the low point for oil demand is usually in December, but that is not what peak oil is about. What it is about can be seen more clearly in this simple fact: we have $90 oil, and most companies are still missing their production targets. Maybe the oil just isn’t there.

Let's look at that in a broader context. It took about 250 million years to create all this oil, and we have used about half of it in the last three generations. That’s amazing.

Worse, western oil companies are now decapitalizing – buying back stock and otherwise returning cash to shareholders, rather than exploring for large new fields which aren't there. Decapitalization is one way to acknowledge the problem of peak oil.

Whether you do or don’t believe in peak oil, there hasn’t been sufficient reinvestment in the business. There’s been a classic cycle of underinvestment. What are the major companies doing with their cash flow? Spending some of their cash on new development and buying back stock to increase shareholder value. Some major companies are replacing as little as 15% of their reserves.

This underinvestment has several causes. For one, 80% of the world’s reserves are national oil – owned by countries where aliens can’t invest directly. These countries are mostly not known for their efficient use of capital: Venezuela, Sudan, Saudi Arabia. Other known reserves and resources are located in places that are difficult and undesirable to explore, like the Arctic.

The problem has been articulated for a full century. The oilman I was talking to put it in these no-nonsense terms: “Petroleum is a capital-intensive business. You’ve got to keep offsetting depletion and there’s a massive amount of capital required just to maintain production. And suppose there’s not enough investment to both offset the decline and grow production in the near term. What’s going to happen if India and China continue to boom and expand their requirements for energy?” That is a good question.

After listing a number of large producing basins and giant fields in decline, he points out that “the only country that has the potential to grow production over the next 5-10 years is Canada, because of the oil sands.” He returns to his central theme: “Whether you believe in peak oil or not, there is not enough money going back into the oil industry to offset production. It’s a huge issue.”

There are a couple of ironies in this. For one, a logical conclusion from peak oil theory is that, by accelerating production to meet demand, you are accelerating oil depletion. We consumed the first half of the planet’s oil reserves in three generations. How long will it take to consume the rest?

Using a geologist’s understanding of the underworld, peak oil prophet M. King Hubbert suggested that the world’s crude oil production will take as long to decline as it took to peak – roughly speaking, three generations. But isn’t it possible that, because of improved production technologies and much greater markets in the post-peak world, it will actually take much less time? The question matters.

The other irony is that oil companies, whether they understand the peak oil issue or not, are responding to developments through a program of decapitalization – as I have already suggested, returning cash flow to investors, with an eye to eventually leaving the oil part of the business. Giant and other large fields not being available through exploration, much of the private sector is now involved in the orderly and efficient liquidation of existing assets through mergers and acquisitions. This matter matters, also.

Peter McKenzie-Brown
February 26, 2008

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