Thursday, December 3, 2009

Market shift in equities

I believe that we are about to witness a market shift. For three weeks now the S&P 500 has been pushing above 1100 only to close below that level. Given the fact that there has been very little in the way of selling over the past 8 months, and given the extremely low volume, I think the preponderance of evidence suggests that we are at a market top. I would give equal chances to the S&P first touching either 900 or 1150. Therefore I believe the risk profile of the market justifies being flat or short equities over the next 2 months or until there is a 10% correction.

I'm not sure how this will affect precious metals in the short run. The question becomes - if the equity markets do start to tank like last Sept/Oct. will the dollar keep its anti-correlation or will the dollar fall alongside? If the dollar falls with the stock market than gold and silver could very well rally (particularly gold.) At this point however, I am rather skeptical. Until silver breaks $21.5 and gold demonstrates it is uncorrelated with the stock market, I would be lightening exposure to precious metals as well.

Wednesday, December 2, 2009

Close to meeting the final condition for a gold breakout

Although it is totally obvious that gold has made strong price advances in the past few weeks, I thought it was worthwhile to mention the three conditions that I felt were needed for a sustainable gold advance. The first and most obvious, was for gold to break and hold above its previous nominal high of $1035. This happened in October. The second condition, which was met in November was for the dollar index (dx z9) to hit 75. The third is for silver and the gold equity index to break to new decade highs (~$21.5 in silver and 520 for the HUI.) Although this still has not occurred, we got very close to a new high in the HUI today (516.6).
It is also worth mentioning that in the past week gold has made and sustained a new all time high in euros.

The most important rule in money management is to establish and follow intelligent and appropriate levels of leverage and the use of debt/margin. A level of margin that is appropriate for one asset class, is most certainly inappropriate for another. Financial crisis is almost always born out of using too much leverage for a given asset class, or making false assumptions about future valuation/income. The market where this was most obvious in the past decade was the real estate market.

Monday, November 9, 2009

2 conditions of gold breakout are met

This will be a short post simply to observe that 2 of the 3 conditions that I listed for a sustainable gold breakout have now been met. First, gold broke above nominal highs back at the beginning of last month. More recently the dollar broke important support at 76 and has now confirmed the break, touching 75 and "rejecting" a rally above 77. There is heavy selling in the dollar this morning.
The final condition - silver and the HUI index breaking to new decade highs- has not yet been met, but the HUI is looking particularly strong this morning, and is at a 20 month high. I expect silver to play catch up if and when doubt fades about the reality of our economic recovery.
There are plenty of reasons to think that economic recovery could continue for another few quarters. As I posted last month, the last 40 years of data show that moderate input prices lead to above trend growth. I define moderate input prices as quarterly prices that are below the local three year high. For example, crude prices reached an average of ~$120 in 2008Q2. As long as prices stay below that level, I would guess that the effect on the economy would be positive. Translating this to physical reality, prices below their old highs indicate the presence of slack in the system - in this case the ability of Saudi Arabia and the UAE to increase oil production by 1 to 1.5 million barrels a day.
The contraction of consumer credit is worrying but the increase in government debt can substitute for this. The economy can grow in spite of being run poorly and/or in an unsustainable way.
Until there is some sort of crisis in the interest rate market, or a major shift in the faith placed in the US dollar, the economy can continue to grow in an unsustainable way. And so long as this is true, it is very likely that the gold:silver ratio will continue to fall.
Since gold has already advanced so strongly, I am thinking of buying silver on a break out. Thus if silver breaks above $21.5 I would expect it to advance strongly and play "catch up" to the gold break out.

Saturday, October 31, 2009

Inflation in China--->default in the US

An interesting truth emerges from the discussion in the previous post for a given theoretical maximum rate of repayment of debt (government budget surplus), the interest on the debt must be less than (rate of repayment)*GDP/(total debt). Let me give an example. If the theoretical maximum budget surplus is 5% of GDP, and debt is 80% of GDP, then any interest rate over 6.25% would mean the country was insolvent. In this case, inflation and economic growth are an enemy of the state, for if nominal GDP growth>6.25% the country is insolvent, but so long as inflation+GDP growth<6.25% the country can remain solvent. For a country like Japan with a debt 170% of GDP, a maximum budget surplus of 5% of GDP would imply that nominal GDP growth>3% implies insolvency for the country. This is a worry that has been getting no small amount of play in the media recently, as the demographics of Japan are decreasing the savings rate and major Japanese investment entities are starting to divest themselves of Japanese (Samurai) bonds. Looking back at this reality though, it is no wonder they have had a lost decade!

The issue of a necessary current account surplus presents another dilemma for US policy makers. How do we get a budget surplus without an accompanying current account surplus? This is, by definition, limited by the amount that savings exceeds investment:
(1) Budget surplus/deficit (taxes-gov spending) + domestic (saving-investment) = CA (exports-imports)
And how do we get a Current Account surplus without decreasing the relative value of our currency (which in turn stokes inflation)? The only way that I can see this is possible is if there is significant deflation in other countries. This would allow us to devalue our currency while not stoking domestic inflation. However, is this likely in an era of tightening supplies of oil and other natural materials? Not unless we have a concurrent worldwide depression. Healthy economic activity will lead to higher natural resource prices and worldwide inflation pressures.

Of course, this dilemma is inoperative until there is some demand for repayment of money loaned to the US government. But when that day comes, healthy economic activity and inflation abroad would lead to a default on US borrowing.

Some graphics on the US fiscal position

At the end of my last post, ( I mentioned that we were between a rock and a hard place as far as the fiscal situation of the US goes. Below are some graphics to show the history of our government expenditures, receipts, and deficit. All of the underlying data in this post are taken from two pages (GDP, FISCAL sections) of the St. Louis Fed website.

Perhaps the most salient point is that since 1947, expenditures have never represented a higher percentage of GDP while government receipts are the lowest percentage of GDP since 1967! (PLEASE CLICK ON THE PICTURES TO ENLARGE)

Peter Bernholz's work studying hyperinflation has been cited widely in the financial press recently. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government’s deficit exceed 40% of its expenditures. This is mathematically equivalent to when expenditures>1.67*receipts. The graph below illustrates this ratio through 2009q2; it will continue to deteriorate for at least 2 more quarters and probably several more after that.

Just as alarming from a creditor perspective is that government receipts are lower now, in real terms, than they were in 2000! The fundamental ability of any entity to service its debt has an upper bound determined by two variables: available revenue, and creditor faith. Of course practically speaking, costs cannot drop to zero, but from a strictly theoretical perspective, revenue provides an upper bound to how fast the debt can be repaid.

The faith of creditors is integral because it determines the interest on the debt. If the interest on the debt was >30% we would already be incapable of servicing our debt even if the government had zero expenditures. It is amazing how quickly a country can go from totally credit worthy to bankrupt just based on the perception of risk from investors. As David Einhorn put it in a recent newsletter: "events can move from the impossible to the inevitable without ever stopping at the probable." a pithy interpretation

To get an idea of what would be necessary to repay the government debt, we look at revenue stream, future expenditures, perception of risk, and nominal GDP growth.

First let's suggest a maximum theoretical revenue stream available to the US. The historical maximum (in % of GDP) for receipts is 31.9%, achieved in the first quarter of 2000. [WWII and the early 1980s both had percentages approaching 30% of GDP]. There is good reason to think that we cannot achieve a rate much greater than 30% of GDP. This is because the incentive to dodge taxes goes up exponentially with the tax rate. There is also an argument that high tax rates disincentivize the activity that is being taxed (particularly true for capital gains taxes.) For the purpose of argument, let's be generous and assume that we can achieve a sustainable rate of taxation of 32% of GDP. With this assumption, we can say that the US must default if the interest payments on our debt exceed 32% of our GDP. We are far off from that point now, as the interest on our debt represents only 5% of our receipts, and a little over 1% of GDP.

At first glance, 1% appears to be a pretty safe number. However, there are several things that must be true to keep it at that level. Most obviously, we must stop increasing the debt:GDP ratio. Most importantly however, market interest rates cannot rise. The current low cost of servicing out debt is merely a function of record low interest rates. These record low interest rates are dependent on two things: the nominal market interest rate must continue to hover around zero, and creditors must not perceive a risk of default. Market interest rates are (essentially) zero now only because those are the current expectations for returns. If the market shifts to the perception that GDP growth is sustainable, then interest rates will increase by an amount corresponding to the shift in perception. It is likely that fiscal and monetary policy will remain accommodative
until this perception changes! Therefore, we will continue to increase debt levels and increase monetary stimulus until perceptions of future growth, and the real interest rate, shift. So it is only a matter of time until the interest on the US debt will rise. If the average interest on US debt rose to a very modest 5%, interest payments would suddenly jump to 10% of our maximum receipts. Keep in mind that these calculations are made on our maximum receipts, not maximum budget surplus. Expenditures in the future will certainly not be zero.

Incorporating a realistic but austere forecast of expenditures, let's say that the country can cut government expenditures to 15% of GDP (which is less than half of our current expenditures of 35.5% of GDP). To be clear, cutting government spending to this level would seem draconian: social safety nets would be cut, defense spending would be decimated, medicare and social security would only be token programs, etc. We would be down essentially to education, a reduced military, bare-bones infrastructure spending, and emergency local and state services. With this austere assumption, the budget surplus could theoretically be 15% of GDP; even in this best-case scenario however, a 5% market interest rate would imply 20% of our budget surplus would go simply to service debt, and only 80% to pay down the principal.

Finally, and most importantly, we come to the risk premium demanded by investors. If investors think (for whatever reason) that there is an "x" percent chance of default, than the interest on government bonds will be approximately x%+real market rate. Let's illustrate this with an example: if the market perceives a 10% risk that the US will default on half its debt, then the risk premium charged on debt would be 5%. So if the nominal market rate of interest was 5%, and investors felt they were risking 5%(10% chance of losing half their principal) of their capital to default, the real rate would be 10%. A budget surplus of 5% of GDP with an interest rate of 10% on our current debt would imply that we were spending 120% of our surplus on servicing the debt. If we could not increase this rate of repayment, then we would be in default. You can see how quickly a loss of faith results in insolvency.

Adding in the element of inflation and GDP growth completes the picture. I talk about this more in the next post, but briefly, the rate of inflation needs to be added to the real interest rate to give a nominal interest rate. If there is a 5% rate of inflation and 3% rate of GDP growth, even with a zero percent risk of default, the nominal interest rate would be about 8%. This would mean even a 5% current account surplus would not be sufficient even to service the debt on the US balance sheet.

Saturday, October 24, 2009

Revisiting effects of oil on GDP

Over the next week, I will revisit a paper that I wrote last year predicting the effect of high oil prices on GDP. In short, however, I would say that the lion's share of the effects of high oil prices on the economy have passed for now. Of course it is impossible to know what prices lie in the future, but so long as oil prices stay below $115, the effects on the economy will be minimal. In fact, since there appears to still be at least some resource slack in the system, there is room for above-trend growth starting in 2010q3 and lasting until 2011q2 or until oil prices move above their previous highs.

My prediction for quarterly growth (using oil price and consumption as the only determinant!) is as follows:
Of course there are wide error bars on these predictions and there are other determinants of GDP, but the wide brush prediction here is that resource prices are supportive of improving economic growth in the US.

The other determinant I would keeping a close eye on is of course the degree to which fiscal and monetary authorities continue their stimulative efforts. If the stimulative efforts are withdrawn, then this is going to create a negative effect on GDP for several quarters. Note also that we may be between a rock and a hard place when it comes to this subject. If we try to continue stimulative efforts (either fiscal or monetary) and foreigners balk at further bond purchases, or lower the value of the dollar, then this will undoubtedly cause oil prices to spike. So we will see.

Conclusion: although there is a menacing cloud still on the horizon, the weather should be good for the next several quarters!

Wednesday, October 7, 2009

Revisiting Triffin's Dilemma, and gold as an escape hatch

This will probably be my last post on gold for awhile. I want to move back into energy issues over the next few weeks, but I felt there were a few more things that I wanted to say about gold. I will return to the paper I wrote in March on the dollar and comment on what appears to be a growing reality - that gold's use as a monetary asset is waxing.

The paper I wrote in March commented on the special dynamics that apply to the US dollar, that prevent the adjustments one would expect from a country with a large and persistent trade deficit. While there seems to have been a marginal resumption of the bearish dollar trend, anecdotal evidence appears to support the idea that foreign asset preferences remain favorable to the dollar (the past 5 months of TIC reports are one piece of anecdotal evidence that this is the case.) Furthermore, although foreign creditors such as China have been vocal in their opposition to large US deficits, their actions do not match their words. Trade deficits and budget deficits have a strong correlation The Chinese might want the US to have more fiscal responsibility. However, the continued pegging of the Yuan (and pegging of other trade partners) to the dollar means that either the US government or the US citizenry must be in deficit. It has been widely observed that the US consumer is "tapped out" and is not going into more debt. So long as the Chinese, Saudis, etc, keep their exchange rates pegged at stimulative levels, either the US consumer or the US government will have to be in deficit. Actions speak louder than words, and the continued currency peg means that the Chinese prefer a US deficit (either public or private) to a fairly valued currency.
As much as the Chinese want a pegged currency for economic reasons however, they are now realizing that at some point their store of dollars will not be worth much in real terms. The possibility of replacing the dollar as the reserve currency is immaterial to this fact. Regardless of whether the US dollar is replaced as the reserve currency, its value will decline so long as economic activity is healthy. The fact that gold remains as a monetary asset that cannot be devalued is a fact that I think is slowly dawning on the large dollar holders of the world. It is for this reason, more than any other, that the continued increase in gold price is assured. Gold will be the safety valve, the escape hatch, and the attempted route out of the dollar holder dilemma.

I like to theorize about various options the Chinese face in dealing with their large dollar foreign exchange holdings. Assuming that they will at some point realize their dilemma of dollar exposure, how might they go about a change? If you feel I have missed any possibilities, please feel free to comment below.

Option 1: Increase the value of the Yuan
Costs: 1) decrease in exports, employment, and GDP
2) a decrease in the value of the dollar relative to the Yuan decreases the nominal Yuan value of foreign exchange holdings.

Benefits: 1) Increased purchasing power of the Yuan.
2) Long-term financial and economic health of the US is increased. Since the majority of foreign exchange is held in US dollars, this means the long term real value of these holdings might be stabilized.

Option 2: Continue the pegging of the Yuan.

This is the inverse of option 1
Costs: 1) Supporting a dynamic that results in continued budget deficits or private deficits (S-I<0) in the United States. Since the majority of foreign exchange is held in dollars, this destabilizes the long term real value of the large Chinese foreign exchange. This is a cost that may well be discontinuous, meaning that it will seem to be a small cost, and then dramatically shift to being a huge or total loss. Amazingly, this cost seems not to have dawned on the Chinese monetary authorities until after the 2008 financial crisis.
2) Decreased purchasing power of the Yuan; so long as economic activity is robust, this increases the price of real goods (particularly energy) and would stimulate inflation in China, (in spite of sterilization by the CB.)

Benefits: 1) Continued strength in exports support short-term employment and GDP goals.
2) Continued pegging allows the nominal value of Chinese foreign exchange to remain high in Yuan terms.

Option 3: Continue pegging but divest foreign exchange into gold and other real assets

Benefits: 1) Allows the continuation of advantageous trade terms. Exports>Imports keeps employment and GDP numbers high.
2) Nominal Yuan value of foreign exchange holdings are maintained.
3) Real value of foreign exchange holdings are maintained due to a diversification into real assets.
4) Dependence on the long-term solvency and productive capacity of the US is decreased.

Costs: 1) Potential for a bubble to form in real assets (particularly real monetary assets such as silver and gold).
2) The real value of foreign exchange will still go down since the possible scale of divestment into real assets is limited compared to the size of forex reserves.

In essence the costs of option 3 are more subtle but still present: either the amount of divestment is not significant, or it will create bubble values in the assets that are chosen for diversification. In spite of these costs, I think that option 3 probably represents the smoothest transition for Chinese and other dollar holders out of their dollar trap dilemma.

For the US the implications of this strategy will be increased financial stability, but an increase in the cost of real goods in the US market. The Federal Reserve will continue to be placed in an untenable position: any attempt to head off inflation will increase the value of the dollar but immediately crash the US economy. This appears to be the holding pattern that we are currently in, but I imagine that we will need to go through at least one more iteration of crashing the economy before the Fed catches on to this dynamic.

Speculation on the Gold/S&P ratio

Above and below you see a picture of the ratio between gold and the S&P (click for a larger picture.) This is a chart from 2000-present representing the fraction of one S&P index that can be purchased for one ounce of gold. It is a logarithmic chart, and you can see that from the minimum to the maximum, there was an increase of roughly a factor of 8.

To my eye, it looks like gold will likely advance on the S&P once again. It may be that there is a longer correction, or that there will be further consolidation, but it seems very likely that before any sustainable decline in this ratio, there would be one more retest of the maximum.

The ratio had its recent maximum value of 1.366 on March 6, 2009, one day before the low in the S&P. The ratio has backed off quite a bit in the past 6 months, reflecting the fact that the S&P has rallied more strongly than gold. The thing that I would like to point out is that it is very likely that we will see at the very least some sort of retest of the previous high in this ratio. The recent low in this ratio of 0.914 was put in on August 24th. A 50% retrace of the ratio to 1.14 would represent a pretty large shift in either gold or S&P at this point. Assuming the S&P stays put at 1050, this would imply gold would hit $1197. If gold stays put between $1000 and $1040, this would imply a correction of the S&P to between 880 to 910. A retest of the 1.36 ratio would put gold at $1425 or the S&P at 764. Take a good long look at the chart of the ratio again, and I think it is pretty clear that gold will make one more advance on the S&P.

Tuesday, October 6, 2009

New high in gold

We had a new high in gold this morning. The precious metal markets were looking jumpy on Sunday night, and we were seeing almost no determined selling. Almost all of the big market orders were buy orders, and you can see this on the charts by steep or parabolic moves up in price followed by largely lateral movement. This indicates large amounts of buying motivated by time, followed by consolidations with a firm bid to take any sellers.

This new high is NOT confirmed by either the dollar, silver, or the gold stock index. As I outlined at the beginning of last month this is the first of three events necessary to assure a healthy breakout. We are well on our way to the second condition being met. The dollar is close to breaking below support at 76, and getting to 75 would probably follow shortly. The third condition (a new high in the HUI and in silver) is still some ways distant, but that distance could be made up very quickly as these markets are capable of moving 5 or 6% in a day.

I had a funny dream over the weekend. I was with a friend and we were trading gold at an old board, the way things used to be traded back in the day. It was a large board with electronic prices of gold, silver, platinum, various gold and silver stocks, etc., essentially a trading pit dedicated to precious metals. In the dream, I had a large physical position that I had established with my friend, and we were watching the price of gold as it broke out through its old highs. It then went from $1000 to $10,000 in about 6 minutes, literally burning through the numbers! In the dream I remember frantically searching for a firm bid for physical, because I wanted to sell at $9,500. All of the orders getting filled were futures positions, and I was struggling to find a firm bid for the physical. It was a fun dream though.

Cheers to all,


Thursday, October 1, 2009

End of the quarter and social security

The quarter ended yesterday with gold above $1000. This is actually a new high for the end of a quarter and the end of a month. I believe this to be yet another signal that gold is likely to move higher; I think that we will have a new high in the gold price in October, and will challenge $1200 by the end of the year. It will be interesting to see what happens to the price of gold once it breaks significantly above the 2008 highs. Will the increase be gradual? Will it inspire some frenzy buying and then crash? Will it trigger a larger shift in consciousness or sentiment about fiat money?
We will see, and I don't think there will be long to wait.

On a related front, there was a news item over the last weekend on social security that surprised me. Apparently the social security system will be paying out more than it is taking in the year 2010! Wow.

If you read through the article it says at some point:

"Social Security has accumulated surpluses from previous years totaling $2.5 trillion"

You have to have a finely developed sense of irony and Orwellian humor to fully grasp this surplus. This "surplus" is nothing more than US treasury bonds, meaning that the government borrowed this money to pay for other things and deposited treasury bonds (debt) in its place. Kind of hard to wrap your mind around isn't it?

The bottom line is this: there is no surplus. A true surplus would be represented by some store of value such as cash, ownership in productive capacity, crude oil reserves, gold, real estate, etc! Instead, any social security taxes that were in excess of social security payments (the surpluses) were borrowed by the government and spent somewhere else on something else. There is no direct or proportional way that this spending will be returned to the social security trust fund. Thus the surplus has already been spent.

What will happen now is that the US will have to go into debt that much faster because the social security will be in deficit each year instead of surplus. The fact that the "trust fund" will not run out until 2037 is largely irrelevant. The trust fund can only be turned into real goods to the extent that the government can increase real taxes on the American population. The rubber hits the road in 2010, because that is the year that social security is in deficit, and there is no surplus of real goods or cash sitting anywhere.

This is one of the three most important economic challenges facing America. The other two are expensive/constrained energy production, and the end result of a monetary system based on debt and paper.

Monday, September 14, 2009

COT report and Barrick

I'm sticking to posts on precious metals, as gold continues to brush against $1000. The two things that I want to mention today have to do with the commitment of traders report, and the admission by Barrick that they plan to close a large portion of their hedge book.

First the COT reports for gold and silver can be found here with nice graphic options:

Of course, we first have to realize that this is not showing over the counter positions, nor is it showing positions in GLD or other ETFs. This is purely a measure of the US futures market. Be that as it may, it is clear that the commercial short position in gold is as large as it has ever been, and the commercial short position in silver has grown but is not as large as in previous extremes.

Looking at gold, it appears that commercials are short 75,000 more contracts now than they were at similar price levels in February. Generally, commercial entities have a very good trading record with precious metals. Their strategy appears to be rather simplistic: if the price goes up, they sell and if the price goes down they buy. If the price goes up more, they sell more, and eventually I think they figure that the price will come down and then they can cover all their positions at a profit. Generally speaking, this seems to work pretty well for short-term price movements. However, there have been 2 instances in the past 5 years of commercial entities being very short at precisely the wrong time. These instances were October 2005-May 2006, and October 2007-March 2008.
Taking a closer look at these two instances, the maximum commercial short position in October 2005 was 212,000 contracts. At the price top in May, the commercials had roughly 170,000 contracts. Between the two points, the price of gold moved from $450 to $700. It is noteworthy that gold has not yet been back to the $450 level, so some commercial entity lost a lot of money covering these positions (or leaving them open.) In the second instance, the maximum commercial short position was between 240,000 and 250,000 contracts, and hovered around this level for much of the period between Oct 07 and March 08. This time the price went from roughly $750 to $1000. There wasn't the same phenomena of short covering by the commercials this time however. The commercials just basically sat on the same short position the whole way up, and then covered their positions only when prices fell in fall of last year.
Now, with gold challenging $1000 again, commercial entities have increased their short positions yet again to a new relative high of roughly 270,000 contracts. Aso, zooming in on the past three weeks, there has been a dramatic rise of both large trader AND small trader long positions to offset the commercial shorts. What does this portend for prices?

Well, generally speaking, commercials are right more often than they are wrong, so statistically it is likely that we are at a top in gold. Also, the rise in small trader positions is unusual, and generally speaking small traders have the worst track record. So this would also point to a bearish outcome.

However, the commercials have been notably incorrect in a big way a couple of times, so we can't rule out the possibility of prices moving higher. Also, it seems that the short position must be concentrated in banks rather than gold producers. Whether this is bullish or bearish, I am not sure, but it seems likely that a break higher would be made more explosive by the fact that the majority of the shorts are almost certainly banks.

What clued me in to this difference was all of the attention recently about Barrick's decision to close all of their fixed hedges this year and a portion of the rest of their gold hedge book.

First of all, isn't it a bit strange that they are announcing their hedge closure in advance of actually doing the deed? When they closed a large portion of their hedges in 2006, there was no mention of it until after the fact. I'm not sure what it means, but I just found it strange that they would announce such a fact. I mean, it would be a little like telling a used car salesman that you absolutely had to walk off the lot with a car, that you had just raised a large amount of money to buy the car, and that you only had 10 minutes to make the deal. The salesman would fleece you because he knows that you are a forced buyer and knows you have a time limitation. So why are they announcing their intentions to close their hedges (i.e. buy 3 million ounces of gold?) Was it just that they were desperate to raise the money they felt would be necessary to do the deed? Are they lying? Are they really increasing their shorts even as they say the opposite? Who knows but I think it is an interesting puzzle.

The other question this news report brings up is what I already alluded to: if all the gold producers have busily been reducing their hedge positions over the past 3 and a half years, who in the world is now short 900 tons of gold in the futures market? After all we have the largest commercial short position ever seen in the COT report; and yet we are learning simultaneously that producers have been closing their hedges. So what commercial entity could be left? Banks.

My feeling is that it is an entity or group of entities who is playing the game "heads I win, tails you lose." And the firm that likes that game more than any other is GS.
HEADS I WIN: The price of gold falls, and gold shorts make 27 million times however far it falls.
TAILS YOU LOSE: Gold breaks out and never looks back, and the short holders can default through a paper settlement or some government sanctioned order. Even if the shorts could deliver, 900 tons is a lot of gold. It is more than Japan's official reserves, and almost 1/3 of the gold that the IMF holds. Is it possible that short entities hold this much gold? Yes, it is certainly possible, but if this much gold actually changed hands it would represent a huge shift in wealth. I would submit that a mining company hedging its production is a much different animal than a bank delivering its holdings of gold.

So, we will continue to wait and see what happens with gold and silver over the next few weeks. My feeling continues to be that we are in the middle of a breakout, and that there will not be any meaningful retrace below $1000 gold.

One final note about Barrick. Because Barrick is such a large percentage of the HUI, it has been dragging down its performance in the week since they made this hedge book announcement. While the rest of the index is up 2-3%, Barrick is down more than 6%. This has created a drag on the HUI of almost about 1%. Not a great deal but worthy of noting. There has been a lot of question about why gold stocks have performed badly compared to the metal itself over the past few years. These hedges have obviously played some role in the under-performance of gold stocks.

Friday, September 11, 2009

Formal devaluation is unlikely

I am coming back to this idea of devaluation today. I think that a formal devaluation is unlikely because there is nobody capable of undertaking such a devaluation who has an incentive to announce it formally. I think that the two groups that have the power to devalue the US currency are:
1) The Federal Reserve
2) Foreign countries who maintain a peg with the US dollar

There is a third group that I would group together and generally call "private investors"; this group is also powerful enough to devalue the currency. But this group is not cohesive to the point that they would make an announcement, or an overnight adjustment. Investors can affect the value of the dollar if a critical mass of them completely lose trust in the dollar and shift their preferences to exclude any sort of dollar based asset. This has happened on a microscopic scale, and could be a growing force in the coming months. But the two groups who are powerful enough to create an overnight adjustment both have incentives not to do so. Let's start by looking at the Fed.

The Federal Reserve will not announce a devaluation, even if their policy indicates that a significantly weaker currency would help the economic situation of the world. The reasons for this are complicated, but I think a short summary would be that they would find an abrupt devaluation to be too blunt and unrefined of a tool. There would also be (legitimate) worries about what such an action would do to future expectations; once a monetary authority loses the faith of its citizens it requires years, if not decades to regain that faith. I think that the Federal Reserve rightfully considers inflation expectations to be one of the most important determinants of monetary policy. Finally, the Federal Reserve, like all dominant institutions, suffers from hubris, and they will continue to think they can find a more elegant solution to continued problems. Thus far, I should note, they have been correct in that assumption. The Federal Reserve may come under political pressure should economic conditions worsen from where they are (or not get better for a long time.) But I think that it is safe to assume that the Fed will be resistant to extreme ideas such as announcing a double digit inflation target or anything else that could constitute a devaluation.

The second group, countries who peg their currency to the dollar above the market rate, could devalue the dollar simply by getting rid of the peg. Countries such as Saudi Arabia, UAE, Kuwait, and China fall into this category. These countries may abandon their peg, but I think that the most powerful devaluing effects would come from shifts in asset preferences rather than peg abandonment. If the large dollar hoders of the world switched out of dollar assets into real assets (plants, equipment, natural resources, equity in existing firms, precious metals, energy storage, commodity storage, etc.) there would be a powerful effect depreciating effect on the dollar. I believe this is the source for future devaluation of the dollar, but countries who take this strategy have every incentive to cloak their intentions and prop up the value of the dollar while they are making these purchases. As I have talked about in other posts, it appears more and more likely that China is taking exactly this tack. As the strategy becomes more clear, it could escalate in such a way that the dollar (and all other currencies to a lesser extent) could come under an incredible amount of downward pressure. This is the type of devaluation that I am watching for, but it will not be formal. It will start slowly and build in speed. It is pretty clear to me that, barring another deflationary/de-leveraging wave, we are already well underway in the process I have just described.

Tuesday, September 8, 2009

Comments for Tuesday September 8th

Gold and silver pushed higher in early morning trading, as the dollar broke to multi-month lows. However, after pushing above $1000, gold fell in New York trading, with the price closing at roughly the point where it opened. Silver and the HUI gold equity index had similar action with strong advances followed by a fall in price into the close. Usually, this type of action can indicate a price top, particularly after a strong run-up in prices. However, I am still of the opinion that there is more strength in the market, and that this will later appear as a false top. It would be particularly noteworthy if a break to new highs occurred during the Asian trading hours tonight or tomorrow night.

I have gotten a late start on the article I intended to write on dollar devaluation, but I will give my argument in a nutshell now and expand upon the argument tomorrow. I will begin by citing 2 historic cases of devaluations (America 1933, and Argentina 2001) and then compare these cases to the current situation. In both of the previous cases, the money being devalued was "pegged" to the money it was devalued against. In the case of America 1933, dollars were pegged to gold, and in the case of Argentina 2001, pesos were pegged to the dollar. Currently, the dollar is not pegged to gold or any other currency. The dollar is pegged to an ephemeral substance called faith. Therefore, any devaluation will occur due to a shift in faith.

However, this does not make an overnight devaluation any more difficult. In fact an argument can be made that such a devaluation was already announced on March 18th, 2009, when the Fed announced purchases of $1.75 trillion in US treasuries, agency debt, and mortgage backed securities. The difference lies in that the meaning of the devaluation is more difficult to gauge, and takes longer to have an effect because it must first work through the perceptions of the market.

The reason the devaluation of 1933 had an instant effect was because it allowed the holders of gold, both foreign and domestic, more purchasing power for everything else that was priced in dollars. This higher purchasing power included the price of labor. In fact, there would have been much the same effect if the government had simply confiscated gold and then ordered by decree that all prices in the economy, including labor, were to be cut by 40%. One problem with that solution is that people's perception of their worth is often tied to the number on their wage statements, and so a devaluation of the purchasing medium (gold) was more practical, more easily enforced, and more politically savvy.

Fast-forward to today. Today, people still attach a great deal of psychological value to the number on their pay-check. "5 figures, low 6 figures, high 6 figures, etc." And that number has lost all formal pegging to gold, so most Americans are oblivious to that relationship. Additionally, Americans seem to accept that there is a 2% decrease in purchasing power every year; I think that most don't realize or don't care that the depreciation acts as a seigniorage tax that benefits the government. The honest truth is that most Americans don't care simply because life is so good! The loss of purchasing power is subtle, and many of the side-effects of money debasement are confusing and can't be understood without honest and diligent study. The ultimate example of confusion came with the housing bubble in the last few years. People were buying houses that were worth 15 times their yearly salary with no money down. This to me is the best example that Americans have accepted that the relationship between money and what it can buy is esoteric. It is because of this that I think it is unlikely - very unlikely - that the dollar will debase from within because Americans are too busy and too happy to lose their faith in the dollar. The debasement of the dollar will come from abroad, as foreign countries lose their faith in the future value of the dollar. The foreign countries that matter, China, Japan, OPEC, and to a lesser degree Russian and Brazil, will want a store of value. Since they are opposed to letting their own currencies appreciate, they will look for an alternative that is not a currency. Gold is an obvious choice, as well as oil, copper, or any other commodity that can be inexpensively hoarded for long periods of time. In the long run, gold and silver will return as the most logical choices because their of their inherent monetary properties. Oil is another possibility even though the storage and transportation is much more difficult.

The productive capacity of the US is below where it needs to be in order to maintain the faith of the world. Ultimately the buck stops here: by the amount of goods and services that foreigners can purchase from Americans with their dollars. Our productive capacity has been decimated by mal-investment in houses, cars, and domestic services. Thus, the foundation for a loss of faith.
When debasement comes, it won't come as an announcement from the POTUS. It will come as foreign holders of dollars slowly and silently abandon ship.

One final note. The larger the deflationary contraction the US experiences in the near future, the better for these foreign holders of large dollar stashes. Ultimately, the worth of the dollar is tied to the productive capacity of the US. But in the short term, if holders of dollars can exit by purchasing assets on the cheap, so much the better for them. The worst possible outcome for the US as a nation would be another round of devaluation, allowing China et all to buy even more assets in their exit from the dollar. I believe that our current predicament is best characterized as a dance between the Fed and foreign holders of the dollar. The Chinese try to goad the Fed into tightening money and credit, to ensure another wave of deflation and increase the purchasing power of the Chinese hoard yet more. The Fed tries to pretend as though they might tighten money and credit in order to head off any abandonment by the Chinese and others. I think the Chinese understand the strategy of the game, but the Fed only sees the tactics of the game.

In 1933, shortly after being elected, FDR called for a bank holiday, simultaneously passing an edict that made it illegal to hold gold bullion. This type of event is highly unlikely simply because the dollar is not pegged to gold anymore. Holders of gold are seen as a curiosity but not as a force of deflation in the economy. Some sort of announcement by foreign powers is even more unlikely. After firing a few shots over the bow, foreign powers will speak with their feet and leave the dollar quietly.

I'll end today with the executive order given by Roosevelt to confiscate gold. I found this to be a fascinating historical record, even if I don't see anything similar happening during present times.

Executive order: By virtue of the authority vested in me by Section 5(B) of The Act of Oct. 6, 1917, as amended by section 2 of the Act of March 9, 1933, in which Congress declared thata serious emergency exists, I as
President, do declare that the nationalemergency still exists; That the continued private hoarding of gold and silver by subjects of the UnitedStates poses a
grave threat to the peace, equal justice, and well-being of the United
States; and that appropriate measures must be taken immediately
to protect the interests of our people.

"Therefore, pursuant to the above authority, I herby proclaim that such gold
and silver holdings are prohibited, and that all such coin, bullion or other possessions of gold and silver be tendered within fourteen days to agents of the Government of the United States for compensation at the official price, in the legal tender of the Government. All safe deposit boxes in banks or financial institutions have been sealed, pending action in the due course of the law. All sales or purchases or movements of such gold and silver within the borders of the United
States and its territories, and all foreign exchange transactions or movements of such metals across the border are hereby prohibited.

"Your possession of these proscribed metals and/or your maintenance
of a safe-deposit box to store them is known to the
Government from bank and insurance records. Therefore, be advised
that your vault box must remain sealed, and may only be opened in the
presence of an agent of The Internal Revenue Service.

"By lawful Order given this day,
the President of the United States."

After confiscating gold and silver, he then changed the underlying relationship between gold and the dollar, from roughly $20/ounce to $35/ounce. This was a devaluation of roughly 40%.

Monday, September 7, 2009

If gold is money, why quote it in dollars?

Commodities are quoted in dollars out of habit and because New York and Washington command so much economic and military power. The dollar was the most stable currency for almost 200 years. For more than 100 years, the value hardly moved at all. It has only been in the past 40 years that the value of the dollar has dropped significantly. Gold is quoted in dollars because that is still the milieu de jour. Dollars have been the numeraire of world commerce for the past 70 years and so they are the de facto quote. If the dollar loses its numeraire status than people will quote the price of goods in terms of the numeraire, and the dollar will have lost its worth, unless it is somehow convincingly tied to the new numeraire. But in the meantime gold theorists would appear out of touch if they did not quote gold in terms of dollars but chose instead barrels of oil of BTUs of natural gas or some other metric. The dollar is still the most commonly used monetary metric in the world, but that does NOT ensure it has any intrinsic value. In that sense a dollar is kind of like an out of the money option. It has time value, and the possibility of intrinsic value so long as the US financial ship remains in decent condition. But if and when enough holes are poked in the financial ship of the US then the dollar will expire worthless at some unmarked point in the future.
I recently listened to a podcast from a website called Financial Sense Newshour. On this podcast, the host Jim Puplava indicated one possibility for the future was a dollar devaluation. A number of his listeners called in to ask him what a dollar devaluation would look like. I have started to think about this question and will post on this tomorrow. Come back and read the post if you'd like!

Advantages and Disadvantages of a Fiat currency

The important distinction between gold and fiat money is that fiat money can and is created in arbitrary amounts, and is made available on a favorable basis to the government and commercial banks. Now I admit there are both advantages and disadvantages to flexible money creation. You can't meaningfully increase the supply of gold over a short period of time. Think about what happened to the Fed balance sheet last fall - in 10 weeks the Fed increased supply by more than 100%! You couldn't do that with gold.

The advantage of being able to do that is that you can manipulate the system to mitigate panics and disasters. Last fall would have definitely been a bigger mess if gold was the monetary numeraire. However, the downside is that the advantages of the credit creation are distributed unfairly - big banks vs little banks, GM and Chrysler vs. other manufacturers, etc - and generally have been rewarding failure. Long-term that isn't good. Plus, it concentrates power in Washington and New York, because that is where the money is coming from - also not good. And finally it is a common and I believe correct argument that it tends to concentrate money in the banks that are closest to the policy decisions (read Goldman and JP Morgan) - really bad! That's what I meant by available to a select few - the big banks, particularly the ones influencing policy decisions, and industries selected by the government. That couldn't happen if gold was the numeraire.

Again, the downside would be that last fall, instead of a scare there would have been a catastrophe.

The upside is that when using gold as money, failure, thievery, oligarchy, corruption, etc. get washed out of the system more regularly.

How can the dollar crash without the world ending?

I would like to address a question that I have seen over the past few years that I think belies a basic misunderstanding of gold, the dollar, and their relationship. Many people in the US (and actually in many parts of the world) consider the dollar to be inviolable. Therefore, the end of the dollar is always somehow equated with the end of civilization. I have seen this sentiment voiced by friends, family, and all over the internet. Let me make an analogy: GM was the greatest car company in the world for decades. The bankruptcy of GM was inconceivable to many (including Rick Wagonner up to a month before the event.) And yet we all know that GM did go belly up, and that the world continued on much as it did before.

Likewise, the US dollar was as good as gold for close to 200 years, and to most in the world it would have been inconceivable that the dollar would be worth just a few percent of its value early last century. Fast forward to the present day, and we are in a situation where the dollar has been depreciated by a roughly 2 percent for the better part of a century, but it has been managed so well that it is inconceivable to most that it would spin out of control (and create a dollar crash.)

The following are typical of the comments that I regularly see, most recently from some intelligent posters on MarketForum:
"When I see gold's value stated, it is always stated in terms of the dollar...

If - according to the gold theorists - the US dollar is not worth anything because it is not backed by anything, then how does a gold bug come out ahead if he is investing in something that is valued in another entity (dollar) that is itself essentially worthless?

Your home, garden, tractor, truck, irrigation system... they have real value.
Gold and the dollar are worthless in the end."

These are attractive arguments but there are valid counter-arguments. There is a widespread belief that if the dollar was worthless, then essentially we are at the point of armageddon. I have felt the same way before so I understand the impulse, but I think taking a hundred steps back or so, it is pretty clear that this viewpoint could stem from cultural hubris. I suggest that there are items of tangible intrinsic value but that even intrinsic value is relative to circumstances. If you can't breathe, then you have no use for staying warm and dry. If you can't stay warm and dry, then you have no use for hydration. If you can't get hydrated, then you have no use for food, etc. True, you cannot eat gold or put it over your head to keep you dry. But people have valued "money" for eons now - because of the efficiency and convenience it contributes to trade. If we are talking about a survival situation then, yes, gold is useless. But we are so far from survival living that it is a joke! I was in India for four months a few years back, so I know a few things about what "subsistence" living looks like. And let me tell you - our standard of living can drop a heck of a long way and we still won't be at subsistence, let alone survival, levels of existence.
America has an incredibly productive population - we have some of the most creative, entrepreneurial, intelligent spirits in the world. Ask any foreigner that and they will tell you the same. True, the average American has dumbed down over the past couple of decades, but that is simply the result of easy living, much of it subsidized by a currency system that allows us to over-consume on the backs of future generations and on the back of a powerful currency. If the brown stuff hit the fan we would return to our hard working roots within a decade. And I seriously doubt - given the amount of capital and natural resource available in this country - that a decade is enough to get us to subsistence, much less survival levels of consumption.

Therefore, assuming we are above subsistence levels of consumption, then there will still be the existence of normal commerce, just as there exists in the backwaters of India. And from the backwaters of India to the richest chateau in France, people have always needed a convenient way of settling accounts. Gold has an intrinsic value not just because it makes pretty jewelery, but most of all because it has historically functioned as money; that is (1) a numeraire for all other goods, (2) a means of exchange, (3) a store of value (i.e. it doesn't go bad) (4) a source of liquidity (5) easy to transport and identify, (6) durable, (7) easily divisible, (8)hard to counterfeit (9) easy to store and (10) not arbitrarily available to a select few (as is fiat money.) If Americans lose their faith in the dollar which they could in any number of scenarios, they will still want something to function as money. And they won't want to carry tractors or trucks or gardens or irrigation systems around in their back pocket to negotiate business.

US dollars derive their value from the same place as gold: its use as money. However, US dollars have an Achilles heel: the US dollar has no intrinsic value if people lose faith: faith in the issuing agency (Federal Reserve) printing policies, faith in the future growth of the US economy, or faith in the political structure of the US. Therefore, I would suggest that the intrinsic value of US dollars is on a lower rung than that of gold. Gold has an intrinsic value so long as we need an efficient means to trade. The intrinsic value of the dollar also requires faith in a list of other things.

The reason that I feel, like so many others, that the US is behind the 8 ball is that our increased debt levels. Our financial situation, and particularly our net international investment position has deteriorated so much in the past 30 years. I would add to this the possibility that natural resource constraints will lower the natural rate of growth in GDP over the next decade. If the natural rate of growth is low or negative, than this affects all of the debt-GDP ratios negatively. If the natural rate of growth goes negative for a 5 year period, there could be a game changer regarding the incentive to save and invest. I think we are starting to see this in China, as the central government is focusing more on consumption and less on investment.

Saturday, September 5, 2009

Fed balance sheet

Thought of the day: the Fed announced in August that they would slow the pace of treasury purchases in order to last through October:
To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October.

However, as of September 2nd, they already hold 288 billion in treasuries. They have been averaging 12.5 billion of purchases a week since April, and 8.5 billion/week over the past 2 weeks. With only a total of 12 billion of purchases left over the next 8 weeks, they will either
a) be purchasing an inconsequential amount (1.5 billion/week) for the remaining 8 weeks
b) will finish their purchases sooner than the end of October
c) purchase more than 300 billion total.

I'm guessing "c" is the correct answer and that they will taper down about a billion a week (8 7 6 5 4 3 2 1) and overshoot by 25 billion. That's a rounding error.

With $700 billion of purchases left in the MBS and agency debt markets, does it really matter that they are ending treasury purchases anyway? The MBS is a lot bigger deal, since that will be harder to get off their balance sheet without losses. We will see, but no matter how you count it, we are past the halfway mark on the intended Fed purchases.

Friday, September 4, 2009

Silver/gold cleared for take-off

There was a powerful rally in precious metals this week, with silver up close to 10% and gold up 4%. To my eye, this rally looks like the start of a much larger move. As I remarked on Tuesday, there was an unusual divergence in the first couple of days with the gold equity index (HUI) falling while silver was rising. The vast majority of the time HUI leads the markets, but in this case HUI wound up following precious metals higher - rallying 10% on Wednesday, 5% yesterday, and 1% today. So the divergence was resolved in a bullish manner, with the HUI now leading the market higher.
Gold has traded up to $1000 3 or 4 times now, so it would be very unusual to not see a significant breakout above those levels after testing it for so long. The reasoning for this? There are only so many sellers and so many ounces that are up for sale in the $950 to $1000 range. Since the market has traded into that range a number of times, there are less ounces up for sale than if this was the first or second time we traded to $1000.
From my sample size of intelligent traders and associates, the majority are not bullish precious metals right now. My sample size is small, but I would say that roughly 1/3 are bullish, 1/3 are neutral, and 1/3 think gold and silver will trade to much lower levels. What is remarkable is that most people in my sample are normally quite bullish on gold. I have a friend who was long silver for years and has sold the majority of his physical over the past 6 months. Every retail gold/silver shop I've been to in the past couple of weeks has been bulging at the seams with bullion, and seemed to be short cash. Perhaps gold bugs have been exhausted by precious metal prices advancing less (or falling more in the case of silver) than was expected. I think there may be a subconscious feeling that if precious metals didn't perform in the past twelve months, then under what circumstances could they possibly perform? Also, the majority of intelligent market watchers are now convinced that deflation is the likely outcome and inflation is almost impossible given the capacity utilization levels. So a lot of people are on the sidelines right now.
The most convincing breakouts are (ironically) the ones with the fewest people already "on board." This makes technical sense because it means there is a lot of sidelined money that can change its mind. Neutral money in particular can easily switch to bullish, and I think that a significant break of $1000 in gold would bring in a lot of neutral money.
As this week's action proved, you don't need the dollar to fall to get a big rally in precious metals. But a falling dollar would probably contribute to a rally. I've been pretty well convinced by friends and associates that the dollar will rally in a second wave of deflationary recession, but the technical appearance of the chart points in the other direction. Rallies above 79 have been rejected last week and this week. We broke an important support at 78 several weeks ago, so there isn't much to support the dollar if it starts to fall.
The bottom line is this: there was an impulsive move up this week (I define "impulsive" as a trend move on high volume and a low degree of variance from the trend) in precious metals. Silver led the way higher, and HUI and silver are both rallying more in percentage terms than gold. Sentiment is at a level that is consistent with a breakout as well.

The next steps to watch for in a breakout would be:
1)Gold takes out its March 2008 highs (70%)
2)The dollar falls to 75 (65%)
3)HUI and silver take out their highs from March 2008 (50%)

Tuesday, September 1, 2009

Silver-interesting action today

There is a lot of interesting action in the silver market today. After two minor sell offs earlier in the session, silver has now spiked up to a daily high on high volume, with 20% of a average daily volume trading in 3 minutes.

This was unexpected, because there are many reasons to expect silver to be significantly down today.

1) Weakness in the HUI index yesterday and today
2) commodities are down today
3) the dollar is up today

This combination rarely occurs on days when silver is up.

First, the HUI index has been weak, and was particularly weak yesterday. Silver/gold and HUI are a classic case of co-integration and error correction. (Google "drunk and her dog" for an amusing presentation of what co-integrated series with error correction looks like.) The error correction terms are larger for silver and gold than they are for the HUI. This means that when HUI moves a large percentage in a given day or over a given period and silver/gold does NOT, then silver/gold will likely move in that direction in subsequent sessions/periods.
Second, silver has correlated highly with the overall commodity index for the past 12 months.
Finally, there is the long-standing and obvious inverse correlation between the dollar index and precious metals.

So a peculiar movement today, made more-so by the heavy volume buying silver into the pit close.

Monday, August 31, 2009

Natural Gas-I've changed my tune

The last 4 weeks of inventory reports have gotten progressively more bearish. In my previous post making a bull case for natural gas, I calculated that there was a supply/demand imbalance of roughly 25-30 BCF per week. After accounting for changes in weather, it appeared that the supply/demand disposition was very bullish through July. However, that imbalance has since completely disappeared. So now we have a very distended inventory (which is bearish) and a flow that is neutral (rather than bullish.)
It is still likely that natural gas will bounce back to the $5 area in the near future, but that is already priced into the strip (January natural gas is already at $5) so there is no money to be made on that expectation. The fact that back months have continued to hold up so well in price may be evidence that we are still a good distance from the next bull market.
Generally speaking, bull markets are born out of pessimism, and the steep contango (Dec 10 futures are more than double Oct. 09 futures) is still evidence that the pessimism does not exist. We have started to see some selling in the back months over just the past couple of days. Whether this turns into something more serious remains to be seen, but the capitulation in the front month has not yet been matched by capitulation in the back months.
There are other signs that lead me to believe we are in a bear market. Mergers and acquisitions are proceeding at a snail's pace in the energy sector. This is another sign of lack of capitulation, and until we see mergers, gas companies will likely continue to try to bleed each other into submission. Witness Aubrey McClendon's recent comments at a Chesapeake conference call:
I think the second thing is, given where storage is it was our analysis that we are going to be full up on storage by the end of the year. As we get closer to that, pipeline pressures are going to increase and that is going to cause involuntary curtailments. I think our view was that there was no reason for us to voluntarily curtail gas, when pretty soon, everybody is going to start involuntarily curtailing gas and so, we didn't see any reason to take it on the chin for the team, more than we did and instead, we will just let the system work, to spread the pain across the whole industry here over the next couple of months.

While prices did bounce back relatively quickly from their absolute lows in 1999 and 2002, there was still a 6-12 month period after that before prices really took off. Also, looking over the data carefully, it seems the industry is more concerned with stock of storage than the flow of storage. Prices don't bottom until the excess stock of storage over normal has come in by 200 BCF or so. And bull markets don't seem to start until stocks of storage return to their 5 year average.

And finally, I'm still waiting for some sort of pronouncement from a major media source (time, newsweek, etc.) that we have infinite amounts of natural gas, and it will serve all of our future energy needs. Publications like that often mark extremes in sentiment and price.

So, we are in a bear market. Before the bear market ends, there will be a number of signposts, and they are:
1) We need to see a less steep strip, and would particularly like to see some more backwardation between March 10 and May 10.
2) We need to see lots of gas driller/producer bankruptcies, and a high level of M&A.
3) Storage excess over norms needs to reduce by 200 BCF before prices will bottom. This will probably happen going into October as inventories get full.
4) Storage levels need to return to 5 year averages before a bull market can really get started.
5) Some sort of marker from a major media outlet would be a nice confirmation, although they don't always occur.

Sunday, August 30, 2009

Two items of interest for dollar followers

There were two news items this week that have potentially substantial implications for the US dollar.

The first is that a new political party, the Democratic Party of Japan, has swept into power in a landslide election victory. While these results will not be a surprise to the markets, it is a potential concern for the dollar. This is because the DPJ has a much cooler stance on Japan's relationship with the US, and certain officials have taken the stance that Japan should reduce its exposure to dollar holdings.
More recently, officials from the DPJ have seemed more reticent about the possibility of dumping the dollar, focusing as usual on the assumed valuation effects of their savings. I still don't understand how they are savings if the act of spending them reduces their value. This truth underlies how the currency manipulators of the world will get their comeuppance. This election is not a direct threat to the US dollar, but the new power in Japan at least pays lip service to increased flexibility in their relationship with the US and monetary issues. If you want to read a op-ed piece from the leader of the party you can do so here:

The second item has to do with announcements made by the Chinese sovereign wealth fund CIC.
It appears that the CIC is starting to increase its risk exposure, and thus far the investments seem to favor non-US entities. A short list of the possible investment already made include Teck Resources limited, Canada
and Songbird Estates PLC, England. The fund also has been active in the domestic banking market, and is rumored to be looking at Japanese equities. The reason that this has implications for the US dollar is simply a matter of asset preferences. If the CIC uses cash equivalents (the majority of which are dollars) to purchase equity and to finance debt (the majority of which are not denominated in dollars) then this will depreciate the dollar, all else equal. We saw the reverse of this in the financial crisis last fall when US and non-US entities both liquidated non-US investments in order to cover dollar obligations and to raise dollar liquidity. So long as we avoid a further financial crisis, the tide on asset preferences will now be heading in the other direction, and the CIC purchases and planned purchases are an excellent and important example of this.

From a technical perspective, the dollar is in an ambiguous stance. The recent break below below 78.5 in the dollar index was short lived; however, the rally since then has also been lackluster. We now sit at the support area around 78.5. As trading picks up in the next couple weeks, we will likely see a new trend develop. A higher dollar is likely (but not a sure thing) if the market perception starts to lean toward a further deflationary contraction of the economy. Likewise, a lower dollar is likely if the market perception continues to expect a market expansion.

Wednesday, July 22, 2009

The Bullish Case for Natural Gas Prices

1. Supply and Demand
2. EIA inventory reports – why aren’t they bearish anymore? Over the past 2 weeks, demand is outstripping supply by 25 BCF/week, and the infamous NG glut would disappear in 16 weeks at that rate.
3. Supply: rig counts. Rig counts continue to fall. Since supply continues to fall even after rig counts start to grow again, we can be assured that supply will continue to fall for at least another three or four months.
4. Demand: If the recession has in fact bottomed, then we can expect natural gas demand to boomerang higher, as economy wide production levels are currently below economy wide consumption levels, and inventories are down 10% YOY. Inventory/sales ratio is still higher than it was in 2006-2008, so industrial demand may remain weak in the short term.
5. Previous examples of rig lay downs, their duration, scope, and the related price action. There are two cases where the number of rigs decreased by 40-45% (1999 and 2002). They were both in similar periods of excess gas storage and the correlated low price. In our current situation, the number of rigs has decreased by 59%(‼)There is a gap between where a company will lay down a rig and start one up again. It requires a significant move higher in price before companies will increase the rig count. If a company will lay down a rig at $4, they won’t necessarily put it back into operation until $5 or even higher. In previous examples, prices moved by 50-75% off their lows within 2 months.
6. Technical price support for a bullish conclusion
7. Conclusion

1. Supply and Demand

On Thursday every week, the Energy Information Agency (Note that all the data presented in this report are taken from the EIA unless otherwise noted) releases national storage data for natural gas. This report is an important data piece for traders and economists who are looking for clues to the supply/demand disposition of natural gas. The inventory follows a similar pattern every year, whereby inventories build from late March to mid November, and then draw down quickly during the cold winter months (Figure 1).
Figure 1 Natural Gas Storage (Source EIA)

Note the cyclical nature of gas inventories. Since the spring and fall has neither excessive heat nor excessive cold, these periods are called the shoulder months and have the least demand for natural gas. Demand is elevated in the summer due to air conditioning, but inventories still grow in the summer, just at a slower pace. Since the expected number of degree days is different in every calendar week, the most meaningful comparisons of natural gas disposition are achieved by comparing the same week in different years. Additionally, other factors affecting demand (holidays and scheduled industrial furloughs) generally fall in the same calendar week and are neutralized by comparing year over year data.
While comparing the same week on a YOY basis can provide “first-order” estimation for changes in supply and demand (footnote 2: When speaking of supply and demand in this paper I do so informally; I intend to mean quantity supplied (excluding changes in inventory) and quantity demanded. Thus if I say “supply exceeds demand by 20 BCF” the reader can take it to mean that, ceteris paribus, the quantity supplied is 20 BCF greater than the quantity demanded, and that difference is made up by inventory levels) , it will only give an accurate depiction averaged over many weeks of data. This is because one finds that even in the same calendar week the weather can vary greatly from one year to the next. Therefore, a more sophisticated approach must account for changes in weather between the two years. This is done by constructing a regression using weather data as explanatory variables and inventory changes as the dependant variable. Once you know the predicted effects of changes in heating and cooling demand, you can then back out a decent estimate for the year over year change in supply and demand disposition.

2. Why The EIA reports aren’t bearish anymore

First two weeks of July 2009 (i.e. the last two inventory reports)
Average cooling degree days for the past two weeks=62
Average inventory fill for the past two weeks=82.5
First two weeks of July (2006-2008)
Average cooling degree days for the first two weeks= 75
Average inventory fill=85.5
Look at the difference in cooling degree days between this year and the average over the past 3 years (62 versus 75). How big of a difference could that make in cooling demand?
That big of a difference in CDDs is good for about 25 BCF less use per week,
(Footnote 3
I ran a least squares regression using the difference between changes in inventory in two consecutive years as the dependant variable and changes in heating degree and cooling degree days as the independent (or explanatory) variables. I use terms for the differences in the square of the CDDs and HDDs as well to allow for a non-linear relationship (for example, if 10% of the population uses an air conditioner at 80° F, but 50% use an air conditioner at 90° F, then a linear specification won’t give us as accurate of a specification). The equation generated by the least squares regressions to explain inventory changes based on differences in degree days is the following:
d(dINV)= -2+0.97*d(HDD)+0.79*d(CDD)+0.0013*d(HDD^2)+0.0096*d(CDD^2)
dINV=change in EIA natural gas inventory from one week to the next
d(dINV)= difference in dINV for a given week, between year x and year (x+1).
d(HDD)=difference in Heating Degree Days for a given week, between year x and year (x+1).
d(CDD)=difference in Cooling Degree Days for a given week, between year x and year (x+1).
D(HDD^2)= difference in the square of the HDD for given week, between year x and year (x+1).
D(CDD^2)= difference in the square of the HDD for given week, between year x and year (x+1).

The fact that the constant term at the beginning of the equation is -2 instead of 0 reflects the fact that we have had a YOY inventory build of approximately 100 BCF per year over the past three years. In the long run this constant term will equal 0!
end footnote)

so based on simple weather YOY comparisons, we would have predicted fills in the 110 range over the past two weeks. Instead we got 82.5, a fact that signifies less gas was put in storage than what is predicted based on the regression.
Based on the past two weeks of data, and assuming the regression is roughly accurate, demand is outstripping supply by 25 BCF/week or almost 4 BCF a day! Normally this level of discrepancy would create an absolute panic in the market. However, because the stock of natural gas is currently 450 BCF above average, the market reaction was muted. Still, the price has moved up 10% since before the release of the July 3rd inventory report.
One way to think of the current situation is to parse the bearish or bullish reality in terms of stock versus flow.
The stock:
Stock of natural gas is 450 BCF above normal. VERY BEARISH
1st derivative (The flow):
After accounting for changes in weather and other exogenous factors, I estimate that demand has outstripped supply by 25 BCF/ week for the past two weeks. Over the past 4 weeks, demand outstripped supply by 21 BCF/week. While four weeks is a small sample size, this level of discrepancy is statistically significant. Future inventory reports will continue to confirm, deny, or accelerate this apparent disparity between supply and demand. BULLISH

2nd derivative (change in the flow):
In 2009Q1, the supply demand disparity was the opposite: supply outstripped demand by 40 BCF/week. Thus, in one quarter, the market went from a 40 BCF/week surplus to a 25 BCF/week deficiency. Obviously, this implies the second derivative of the stock (change in the change of the stock) is negative and steeply so. Why this is and whether it will continue will be the focus of my discussion in sections 3 and 4. BULLISH

In summary, if a trader were to focus only on the stock of natural gas, they will see a 450 BCF glut. Examples of natural gas prices getting driven into the ground during the fall shoulder months abound (and under much less extreme storage gluts then the current one). However, if the trader considers the flow (1st derivative) and change in flow (2nd derivative) a different perspective emerges. Assuming the previous calculations are accurate we are currently running 25 BCF/week below expectations, at which rate the entire storage glut would be gone in 18 weeks. If the 2nd derivative (change in flow) is negative, then the glut could disappear even faster. How can we estimate which effect will dominate prices in the near future? Well, this is not the first time the market has been in this scenario: we had a natural gas glut in both 1999 and 2002, and history can be our guide. In section 5, we look for possible rhymes in these previous instances to divine the probable outcome of our current situation.

3. Rig Counts

Every week, Baker Hughes publishes the number of active gas rigs operating in the world and in the United States. This rig count data correlates with the number of new gas wells that can be expected to be drilled in any given week. In order to simply maintain supply, a certain number of rigs need to operate. The necessary number depends on the initial flow rate of new wells, and the depletion rate of the existing resource. If the number of new drilled wells goes above this number, then supply well increase, and vice-versa. One of the important metrics to know is what the average depletion rate is in existing wells. Unfortunately, that piece of data is extremely difficult to calculate because there are so many types of wells in different types of rock and the overall distribution of quality and type is constantly changing. What we do know is that
1. Depletion rates steadily increased between 1980-2006 (see and
2. Average flow rates have been decreasing over the past 30 years (Figure 2)
3. Initial flow rates for shale gas are impressively high (anecdotal)
4. Depletion in shale wells is very high, particularly in the first few months of operation (Also anecdotal)

Figure 2

The only two years in the past decade when production per well increased were 1999 and 2007. These years featured relatively low prices in natural gas, so the increase in per well production may be due to producers:
1. Only drilling their best prospects that year
2. Reducing the number of existing wells since the low price did not justify the existence of marginal wells.
It is also clear that 1998-1999 represented a turning point in the production per well. This could be due to a number of different factors:
1. A decrease in the quality of available resource
2. A shift in the type of well being drilled (conventional versus unconventional)
3. An increase in the rate of drilling after 1999. Starting in 1999, there was an explosion in the rig count and the number of new wells drilled. The acceleration of drilling would more quickly change the demographic of total wells toward lesser quality or unconventional wells.
This is consistent with data on the number of operating drill rigs. Glancing at a graph of drill rigs, it is clear that there was a noticeable increase in rigs starting in 1999 (Figure 3).
Figure 3 (Source: Baker Hughes)

While supply stayed more or less constant from 1998, the number of existing wells increased dramatically, and the rig count exploded. This trend continued through 2007 when shale natural gas wells started changing the dynamics of the market.
Take a close look at Figure 3 and you will see that there have been 3 dramatic falls in rig counts in the past ten years: 1997-1999, 2001-2002, and 2008-current. These drops in drilling activity correspond to very low prices for natural gas (as the famous quip goes: low prices are the cure for low prices). In section 5 the rig drops in 1998 and 2001 are examined and used to model what might be expected in 2009. Speaking generally, as drilling activity slows, there is a point at which depletion of the total existing supply exceeds new marginal supply, and total supply starts to fall. Because the rig count falls below the maintenance level, supply continues to fall even after the rig count starts to climb. This is because it takes a period of time to activate the number of rigs necessary just to drill at the level necessary to maintain supply. In Figure 4, there is a graphical estimation to prove the point.

Figure 4 Rig count starts at exactly the level necessary to maintain supply. We assume an annual depletion rate of 25% and also assume a 40% decline in drill rigs from peak to trough that declines linearly over a period of 40 weeks. Finally we assume that once the rig count has bottomed, the rig count then has a linear increase back to the initial rig level in 25 weeks.

This figure gives a first approximation for how supply responds to decreased rig counts. In order to try to model the 2006-2009 period a little bit more accurately, some assumptions need to be made. First, it is pretty clear that we were expanding supply from 2006-2008 at a meaningful (some would say blistering) pace. Therefore, the drill level was above the level necessary to maintain supply, and this is confirmed by the increase in supply during 2008. Furthermore, the increase in rigs during this time period was particularly marked for horizontal rigs in shale deposits (footnote 5:The emergence of horizontal drilling for shale natural gas is probably the most significant development in the energy sector over the past 3 decades. Some market participants have noted the extremely fast depletion rates of shale natural gas wells. While a fast depletion rate will present a challenge after the supply of shale gas peaks, it actually makes the resource more flexible and responsive so long as the resource is increasing. While this paper generally holds the view that natural gas prices could spike in the next 12 months, shale natural gas and its high depletion rate will actually act as a damper on this price increase. Since initial flow rates are so high and a larger percentage of a shale well’s production occurs in the first few months, this decreases the amount of time necessary to increase supply by significant quantities) : the number of these rigs expanded by more than 100%. When the total number of drill rigs peaked in late 2008, producers could very well have been drilling 50% more wells then was necessary to maintain then-current levels of supply. That will be the baseline assumption in the estimate that follows.(footnote 6:Other assumptions include: horizontal rigs are modeled to drill twice as much gas per rig as other types of rigs to reflect the elevated initial flow rate of shale gas. Depletion rates are assumed: horizontal wells deplete at 70-80% per annum, and other wells deplete at 40-50% per annum. I am not suggesting that Figure 5 is a completely accurate depiction of reality; for one thing, it does not account for supply that was lost during Hurricanes Katrina, Rita, Gustav, and Ike. It also aggregates different types of wells, and makes assumptions about depletion rates that may or may not be accurate. But it will give a better broad view of supply then what is suggested in Figure 4. The red curve at the end of the graph reflects an estimate of what future supply would look like if rig counts started increasing next week and increased linearly at a rate of 30 rigs a week.)
Figure 5 Rig Data from Baker Hughes. Curve depends on depletion rates estimated by author

This figure is meant to illustrate the concept that supply will continue to fall even after rig counts start to recover. This is because we have now overshot the number of rigs necessary to maintain supply, and so supply will fall until we return to that number of rigs.
In conclusion, by comparing to past instances where rig counts fell below the level necessary to maintain supply, we can expect that supply will continue to fall for at least another month or two. If rig counts stay at current levels (or continue to fall) then the nadir in supply will be pushed out that much further. To relate this back to section 2, an expected reduction in supply would cause, everything else equal, the second derivative of natural gas storage (that is, the change in the flow rate) to be negative

4. Demand

Evidence is starting to accumulate that production of goods is stabilizing. Consumption data also appears to have stabilized. According to the most recent Census report, sales did not drop between March and May. While inventories are still dropping, the underlying production levels seem to have stopped declining, and are at a level slightly below consumption levels. Again we are faced with a stock versus flow situation. The stock of goods is too high, but the flow is now negative (that is, the production of goods is lower than consumption of goods.) Unless consumption drops further, we can expect production to come up at least to the level of current sales. This point is fleshed out with a particular focus on natural gas by an investor and trader named Rob and with a tag of Robry825. For those interested in looking in more detail at the demand for natural gas, I recommend reading his weekly blog post at, and also his near-daily postings at the Investor Village CWEI message board :( for detailed and disaggregated data on demand for natural gas.
A quick comment on weather: one of the big stories in the natural gas market this summer has been the bearish weather. With the exception of several weeks of hot weather in Texas, this summer has been remarkably cool, and there has not even been the threat of tropical storms in the Gulf of Mexico. As of mid-July, we have predictions of continued unseasonably cool weather across most of the CONUS. The psychological effect of weeks and weeks of cool weather may be leading market participants to overemphasize the importance of bearish weather. Weather forecasts are only accurate to 14 days, so we could very easily have a bullish switch in weather, such as a hot August or a cool October.
In conclusion, I think that the demand side for natural gas is uncertain. There exists the possibility that goods consumption and natural gas demand will fall still further, particularly if our fate is to plunge into a deflationary depression. Barring such a worse-case scenario however, we might expect industrial demand to pick up soon, since current industrial production is below current consumption levels. This again points to a flat or negative second derivative for natural gas storage levels.

5. What History Tells Us: Previous Examples of Rig Lay Downs

Summarizing to this point, the bearish and bullish factors affecting the natural gas market are:

1. incredibly high storage levels
2. consistently bearish weather since February
3. emergence of a new resource (shale gas) with lower costs and high initial flow rates

A. low price (which is below the marginal cost of all but the most cherry new wells)
B. the past few weeks of EIA inventory data
C. the change in the supply and demand disposition over the past 4 months

One might think that the battlefield is level at this point, and the incredible price volatility over the past 2 weeks affirms that market participants are even more uncertain than usual about price. However, previous examples of supply gluts and rig lay downs point to a decidedly bullish outcome.
In Figure 6, we model the last three instances of major rig lay downs.
Figure 6

The first thing to note about Figure 6 is that the percentage of rig lay downs is greater in our current episode than in the previous two episodes (roughly 60% vs. 45%). Therefore, even if drill rates in late 2008 were substantially greater than what was necessary to maintain supply, we have now certainly fallen to a drill rate that will not maintain supply.
In the next two figures the thing to note - and this is crucial - is that in both 1999 and 2002 rig counts continued to fall even after the price had reached its nadir (Figures 9 and 10).
Figure 7

Figure 8

The fact that rig counts did not start rising until 8-12 weeks after the price nadir has serious implications for the current volatility of natural gas prices. If market prices don’t start rising until storage flow is clearly negative (that is quantity supplied is obviously less than quantity demanded), and if rig counts fall even after prices start rising, then the market is set up for a potentially serious shortage. I don’t think it is a coincidence that in both cases (1999 and 2002), prices spiked by more than 500% within 20 months after the rig cont low. Extreme volatility in input prices has been shown to create a drag on the economy.

{(footnote 7: Among others, see Bernanke, 1983; Irreversibility, uncertainty, and cyclical investments. Authors comment: The problem of volatility has no obvious solution and without the futures market, the volatility would likely be greater (and the chances of shortages higher.) As much demonizing as there has been of speculators in the past year, this is clearly a place where speculators can improve Pareto Optimality of the economy. By taking a risk to buy at market bottoms, speculators can smooth what would be an even greater disruption of the natural gas market. It is also true in both cases that rig counts did not start falling until prices had fallen significantly from their peaks, so speculators have a function in both rising and falling markets.)}

To examine the two cases in Figures 7 and 8, it appears that in 1998-1999 producers reduced rig use so long as prices were below $2.50. In the second case (2001-2002), producers reduced rig counts so long as prices were below $3.25. In both cases, these were approximately the same price that producers started to reduce rig counts. The significance of this can be seen by looking at the current situation (Figure 11). Rig counts started to fall in late 2008 after prices had fallen from $13.75 to approximately $8. However, prices have now fallen on top of that by more than 50%! This suggests that prices might have to rise substantially (perhaps greater than 100%) before rig counts start to increase.
Figure 9

Once again, to balance the argument, we must consider shale natural gas. If the shale natural gas resource is large enough, the industry will be able to offset the depletion in the entire resource base by only adding more shale wells. If the marginal cost to drill these wells is significantly below $8 and they can be brought on fast enough, then it is less likely that we would see $8 in the immediate future.
To conclude this section, in previous episodes of natural gas gluts that resulted in laying down a substantial portion of rigs, the rig count did not start to increase until 8-12 weeks after price had reached its ultimate nadir. Since breaking contracts is very expensive, gas producers will operate at a loss (selling gas for less than the cost to produce it) so long as it is less than the substantial loss incurred by capping a well or not using already leased equipment. This retards the rate at which they would otherwise lay up their rigs. On the opposite side, a company will not take a rig out of storage until they are sure the project is profitable. Therefore there is a gap in the price between which companies have neither incentive to lay down nor start up rigs. This is what leads me to predict that supply could continue to decrease for at least another 4 months (2 months until rig counts to start to increase, and another 2 months until supply stops falling.) It is worthwhile to note that in each of the previous episodes, rig counts did not start to rise until prices had achieved the level where rig counts had started to fall. While shale gas could certainly alter the dynamics, this suggests that rig counts may not start increasing until prices reach $8.