The game changed on Thursday, June 23rd

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Thursday, June 23rd, 2011 was a day of infamy: The International Energy Agency surprised the world by announcing that 60MM barrels of oil would be released over 30 days, as an answer to the disruption of oil supplies from Libya.

Personally, we were slow to react to the announcement. Naturally, we first viewed it as unnecessary: If a market suffers from a supply shortage, the best way to encourage supply is to allow prices to increase, to boost production of the good in question. As the day progressed, we read, watched and listened to commentators throw the idea that because the price of oil was going to come down, as it did, the markets in general were going to welcome the decrease: Long stocks was the way to go!

But what totally caught our attention was the performance of gold. A day earlier, on Wednesday June 22nd, gold had moved from the $1,540-5/oz range to $1,550, with the expectation that at the press conference held by Ben Bernanke (after the release  of the FOMC notes) a hint of further monetary policy easing would be given. That was not the case. Mr. Bernanke was as neutral as he could in his conference and that brought gold back to the $1,540/oz range, at the close of the session. That was the range gold should have held on Thursday, but events on Thursday changed the game dramatically. As a consequence, since then, gold backed all the way down to $1,499 on Friday, only to close barely above $1,500/oz. What triggered the sell-off? Was it “technically” dragged by the correlation with oil? We are not so sure, and here’s why:

We first note that the decision to release oil reserves on Thursday was of a global nature. Some analysts have made the point that the decision was tailor-made for those affected by the widening in the spread between Brent and West Texas Intermediate crude, and we tend to sympathize with that view. The next conclusion obviously was: “If politicians were able to pull this one of a global nature, ruining in the process a lot of market participants, what would deter them from selling the gold reserves of the US Treasury if, say tomorrow the debt ceiling for the US is not expanded? “

Selling reserves of any good that is in short supply is only a very short-sighted solution, for by temporarily lowering the price of that good, its production is further discouraged, causing higher prices longer term, which will have to be paid, to restore the same reserves. In the process, as the reserve bid is unleashed in the future, final prices end higher than previously expected.

Now, if the collapse of the current fiat currency system finally arrives, the easiest way out will be a system that still allows fractional reserves (i.e. reserve ratio below 100%), but without a lender of last resort, with the central bank of the world’s reserve currency (presumably still the US) backing its notes with gold. It’s an imperfect solution that would only delay the final deleveraging this crisis demands, but it would work. Would it not make sense to see, before this occurs, that gold reserves are sold by necessity at fire sale prices, ending in the hands of friends, who later sell them back to the government, at higher prices? It would. After the intervention on Thursday, it does. Anything goes.

Those who last week recommended taking advantage of the low prices in shares of oil producers, speculating with future higher prices of oil, do not capture the essence of the problem we are facing. We have entered the stage where the world will need goods, but government intervention will discourage their provision: The world will need more oil, but nobody will find it profitable to supply it, given the risks involved. The world will need a safe reserve currency to park savings, but governments will deny it even in the form of gold. The world will need a stable financial system, but banks will be prohibited from providing it. This will bring misery to the point where basic needs, such as food, will be precious, but given price controls, will not be profitable to produce. Furthermore, these interventions of global reach generate the resentment of those nations affected, with one event leading to the other, including military interventions that eventually get out of hands.

In summary, we see the relationship between cause and effect differently: We don’t see future higher oil prices driving energy stocks higher in the long term. On the contrary, because interventionism is destroying wealth, lowering asset valuations (i.e. stocks), production will be affected and the lower supply will push prices higher. If central banks validate the higher prices by printing money, the process will spiral. Until Thursday, we wanted to own physical gold. Thursday was the game changer and cash is now supreme. Financial repression has arrived sooner than most expected and is now the order of the day.

 

Martin Sibileau

Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person. All rights reserved.

Mr. Sibileau currently works as Director for the Loan Portfolio Management team of a Toronto-headquartered financial institution. In his free time, he regularly writes on global macroeconomic developments at www.sibileau.com.

Since 1997, he has held various positions in the areas of corporate finance, strategy consulting, international banking, commercial banking and risk management.

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2 Responses to “The game changed on Thursday, June 23rd”

  1. HI Martin

    First you say

    Would it not make sense to see, before this occurs, that gold reserves are sold by necessity at fire sale prices, ending in the hands of friends, who later sell them back to the government, at higher prices?

    Then you say

    Until Thursday, we wanted to own physical gold. Thursday was the game changer and cash is now supreme. Financial repression has arrived sooner than most expected and is now the order of the day.

    From what I can see here you are seeming to say that the US Govt will continue to print money? Or that the price of gold will continue to rise?

    But then you say that "Cash is Supreme"

    I was wondering if you could go a bit further into the mechanisms of why gold will fall in price?

  2. Ryan says:

    Fascinating analysis.

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