Circle September 26th on Your Monetary Calendar

Some day this crisis is going to end. And when it does, people can go about their lives again in what passes for normal fashion. But before that, some drama has to play out. And much of it is unpleasant. But not all of it!

Today’s Markets and Money is equal parts optimism and reality. The reality could be construed, by some, as negative. But it is what it is. So let’s get to it. Optimists may want to smile obliviously at this point.

First cab off the rank is oil. Crude futures fell by as much as eight percent in New York during Tuesday trading. A global recession tends to dampen demand for oil. And with traders expecting today’s American Petroleum Institute Inventory report to show high gasoline stocks in the U.S., crude it taking its direction from other economic news in the U.S, most of which is awful.

Call us a common horse fly, but we find bad news strangely attractive. There’s just something about it we can’t resist. Having just completed a fuller look at the oil market for the January edition of Diggers and Drillers, today’s oil price action is a good sign. That is, the short-term focus on the fall in crude demand is making energy stocks extremely attractive for the upcoming “back draft” in oil prices you can expect to see later this year.

The seeds of future scarcity in the oil market have been sown by this price crash. The nice thing about stocks is you don’t have to wait long to reap. For example, Oil Search (ASX:OSH) was up 4.8% yesterday on the Australian market. It was no Rio Tinto (ASX:RIO), up 10.9%. But it was better than the 3.1% gain on the ASX/200, which itself was a welcome relief for investors shocked by Friday’s freefall.

As mentioned in the January D&D issue, Oil Search is one of Credit Suisse’s top energy picks for 2009. Credit Suisse rates the firm as “outperform” and says it has target price of $7, an upside of 60% from yesterday’s close at $4.36. The other tip from Credit Suisse, by the way, is Santos (ASX:STO).

Neither of these tips are exactly State secrets. But what’s interesting is that investors seem to be focussing on Oil Search’s LNG future, and not its crude oil production in Papua New Guinea. Fourth quarter sales fell by 42% at OSH, which is what you’d expect when both prices and production volumes fall.

What’s more, OSH averaged US$58.15/barrel for its oil in Q4. That was down 39% from the year before, when its average price per barrel was a robust $95.18. You should watch for just this same phenomenon-lower prices and production volumes-to sweep through the base metals and bulk commodity sector earnings later this year (especially after contract prices are renegotiated for iron ore and coal in March and April).

The good news for OSH? It has more cash now that it did the same time last year! Cash increased from $326 million last year to $517 million this year. And the company has no debt, which is nice during a Credit Depression. But the big driver for the stock price, at least according to Credit Suisse, is the $11 billion LNG project the company is planning with ExxonMobil.

“The story for Oil Search is not a production story and therefore by definition not an earnings story either-it’s all about delivering the next phase of the progress on LNG,” says the Energy 2009 Forecast. “The stock is a leveraged play into the PNG LNG project, which we believe will be one of the few (lower risk) conventional LNG projects to reach final investment decision (FID) in the next 12 months.

All of this is not to tout Oil Search, which is not a stock we’ve recommended in Diggers and Drillers (nor is it a stock we own). It IS to show that there is plenty of opportunity in the LNG sector in 2009. It’s a story Kris Sayce has been dominating over at the Australian Small Cap Investigator for the last two months. What makes it an entrepreneurial story (rather than a strictly resource story) is that LNG is a relatively new industry in Australia. No one knows what its worth yet, or even how to measure which projects will be the most lucrative (or the most likely to find partners and funding and eventually reach production).

What we do know is that Australia has an unusual amount of unconventional energy reserves (coal-seam-gas, LNG, etc). The cost of extracting and producing those reserves is higher than conventional oil and gas production. But global integrated oil companies are eager to get their hands on new reserves wherever they can find them. Thus, start-up Aussie LNG firms are finding big partners with deep pockets. That’s where the share price gains could come, despite the collapse in oil prices in 2008. See Kris’ story below.

See? There is good news after all.

What about gold? We keep harping on about it. And yes, it’s still shiny and money-like. But it did fall back under US$900 overnight. What gives?

The big driver of the gold price this year will be, as always, weakness in the U.S. dollar. Granted, gold is rising against other currencies too (the euro and the British pound). But it’s the large increase in the supply of U.S. dollars that will ultimately catapult the yellow metal higher.

Keep in mind, though, that the unwinding of the dollar standard is not going to be a rapid affair. Too many people have too much to lose from a rapid dollar depreciation. We’d expect gold’s move to be driven by gradual investor capitulation on common stocks and government bonds. And THAT will be driven by market returns and inflation concerns (both of which should mount as the year progresses).

Another date to watch for is September 26th, 2009. That’s when the current European Central Bank Gold Agreement (CBGA) on sales expires. The first CBGA was signed in 1999, and depending on whom you ask, had a rather ambiguous goal. European central banks agreed to limit and publish their announced gold sales.

The reason, we suspect, is that European Central Banks own gold as a reserve asset. Signatories of the first CBGA controlled 43.6% of the world’s above ground gold reserves, according to the World Gold Council. The second CBGA was signed in 2004 and limited sales to a maximum of 500 tonnes per year over five years (2,500 tonnes over the length of the agreement). With the expansion of the EU, CBGA signatories now control 46.1% of the above ground gold reserves.

So why cap official CB sales? As much as they prefer their own product-paper money-central banks own gold as a reserve asset. In 1999, the gold price languished at just US$252/ounce. For the CBs, this meant that value of a reserve asset was falling. And with the market wary that further CB sales could flood the gold market with excess supply at a time of lethargic demand, something had to be done to put a floor under the gold price.

In order to assure the market that Central Bank sales would not (at least publicly) be used to suppress/depress the gold price, the CBGA was signed. Since then, it’s provided transparency to planned central bank sales of gold. According to the WGC, France and Switzerland were sellers of gold least year, while Russia was a notable buyer.

What will happen, then, when the current five-year agreement expires on September 26th of this year? Well, there’s every chance a new agreement will replace it. But since we’re in the business of looking for Black Swans, let us entertain the possibility that Central Banks abandon the agreement this year. Why would they do so?

Global central banks are also large holders of U.S. dollars and U.S. dollar-denominated bonds. How reliable do you think either of those as reserve assets? Hmm.

Also keep in mind that gold is now accessible to retail investors in a way it wasn’t in 1999. Gold ETFs (if you take them at their word) own over 1,000 tonnes of gold. This makes ETFs the sixth-largest holder of above ground gold (behind the U.S., Germany, the IMF, France, and Italy).

It’s not a rash speculation to suggest that Central Banks will prefer to hold on to their gold this year rather than sell it at all. As competitive currency devaluation sweeps the globe in an all-out effort to fight asset deflation and recession, gold will become much more desirable as a reserve asset worth owning (not selling).

Bankers are bankers, after all. Their product is money. But they have gold in their vaults for a reason. It was money before paper was money. So September 26th may mark the end of the orderly and coordinated management of gold sales by European Central Banks. And it may mark the beginning of a new monetary era where gold reasserts its importance as money.

Is this good for gold miners? You bet it is! More on that tomorrow.

How about some reader mail?

Dan Denning,

Very interesting and I concur with the prediction regarding higher energy prices later in the year.
One thing I have a hard time accepting is the deflation argument. How can you have deflation with only fiat currencies left in the world? Deflation means that currency (paper) will rise in value relative to tangibles like houses, cars, oil, steel, copper, etc. etc. I suppose that argument is based on the belief that things will depreciate in value faster than currencies lose purchasing power.

Since there is nothing backing any currency except the good faith and credit of the issuer, how can that “paper” ever be worth more than tangibles when the issuer also controls the printing presses?

Frankly, I can only foresee more inflation big-time as nations print more and more currency to offset (pay off) the enormous deficits that are being created worldwide in the attempt to ward off a recession/depression. What am I missing?



You’re not missing anything Arthur, as far as we can tell. In a world where the output of goods and services is declining, while the supply of money is going up, you would expect rising prices. The hitch in the giddy up is the massive overhang of debt in the Western world. With $52 trillion in total credit market debt in the U.S. alone , asset values (housing and shares) are already grossly inflated. We reckon they will have to fall a lot more before the factors you cite-paper currencies and deficit spending-begin to cause inflation. The money supply is headed in one direct (up), while total credit market assets are headed in the other (down). The closer they get to each other, the more you’ll start to see rising prices.


I think you are overlooking one factor on the housing affordability. And that is the standard of the house. This is why housing affordability has gotten less – expectations. New 21-year old home buyers now want a modern 4-bedroom first home with a gourmet kitchen, not a ramshackle 2-3 bedroom house to get started like we all bought 30 years ago. Australia may have the least affordable housing, but it is probably the highest housing standard too in some pretty nice bits of the world. Sure a flash house on the Gold or Sunshine Coast is going to be more expensive that a crappy house in the US mid-West.


You get what you pay for? Maybe. Location certainly matters. In the beautiful parts of the world, we reckon there is always someone willing to pay just a bit more for the privilege of a good view. But eight times median income? Is that some kind of new sunshine/square metre multiple we’re unaware of?


I’m puzzled by your support for the theory of Peak Oil. It seems to me that this theory belongs with the predictions of Thomas Malthus, on the scrap heap.

While it’s true that there is only a limited amount of oil in the world and that therefore production must eventually reach a peak and decline, that only addresses the supply side of the equation, and only in part. It could make a difference in the short term, but the shorter the term you are using to judge it is, the less impact it can make.

Over a longer term, one must also look at demand. As prices rise, demand contracts. People start taking public transport more often, car-pooling, or switching to hybrid or electric cars (which are fuelled, ultimately, mostly by coal or uranium). As prices rise, demand falls, over the medium and long terms. Further, demand switches to alternatives that, like uranium, have much greater reserves.

The price rises also affect supply. Suppliers pump their existing facilities faster. Alternatives to drilled oil that are more expensive to produce, such as oil/tar sands, deep-sea oil deposits (if they exist) and biodiesel, become economically viable, increasing supply. Supply does not necessarily increase sufficiently to replace that which has been lost, and because some of it is more expensive it puts a higher floor price under oil. However, it does mitigate the increase in oil price.

The overall effect of this is that even though oil production is declining, any rise in price caused by that decline will act to increase supply and reduce demand. Even though this may not happen much in the short term, nor will oil supply decline much in the short term (or rise – oil production facilities take a long time to turn on or off). So whilst I agree with you that oil prices will go up this year on short-term supply and demand, I think you are very mistaken to cite Peak Oil as a reason.


Be puzzled no more! You write a very sensible e-mail which we’d not argue with too much. It comes down to a few issues: production and substitution. It’s true high prices induce producers to produce more.

But this, in our view, only accelerates the rate of production decline(depletion) in the world’s major oil fields. And it’s worth noting that the incentive of high prices has not led to new highs in annual world oil production (about 86mbpd). It’s hard to argue that global oil production has not truly peaked.

Price rises also reduce demand, as you note. But that merely lowers the depletion rate of existing oil fields. It doesn’t solve the problem of inevitable production declines as reserves are fully produced. And you are also right than in a normal market, rising prices lead to substitution. Savvy shoppers begin looking for cheaper ways to get the same benefit or service.

The trouble is there is no easy substitute for oil as a transportation fuel. If you’re eating bananas and they get expensive, you can always switch to apples or grapes. But oil is not fruit.

We have nearly 100 years of fixed capital investment in a transportation and industrial production system based on hydrocarbons. That amount of sunk investment can’t just be switched over night to, say, biofuels or electric cars. It’s a massive economic and social transformation.

Or, put another way, there is no easy substitute for oil. Malthus was wrong because he did not account for human innovation and increased in productivity through technology (which allow us to feed more people). Malthus assumed that human population would grow faster than human food production (geometric vs. arithmetic growth).

But, in no small part thanks to the use of petroleum in fertiliser products, it was food production that grew even faster than human population growth in the 19th and 20th centuries. This allowed for millions of people to move off farms in the country and into factories in the city powered by oil, and building goods that would run on hydrocarbons. The energy boom created massive caloric surplus.

In fact, population growth has since exploded. The planet has plenty of resources to feed 6.5 billion people. But bungled national trade and farm policies get in the way and make food more expensive than it ought to be. However we digress.

The plenitude economist Julian Simon held that resources are never physically scare, only economically scare. Simon believed that when a thing became too expensive to use (price signals) a free economy would find or migrate toward a cheaper substitute or alternative. All things being equal, we believe Simon is generally right.

In this case, the energy we get from oil has to be replaced by energy from somewhere else. But where? That is a question for physics, not philosophers. The energy returned on energy invested (EROEI) is a real calculation that measures how realistic any given energy source is as a substitute for oil. There are not a lot of good substitutes, and by good we mean competitive with oil and an EROEI basis.

Our forecast? The car is here to stay. But the internal combustion engine’s long reign of dominance may be at an end. Over at the Australian Small Cap Investigator, we’ve been looking at electric cars and plug in hybrid electric vehicles (PHEV). New batteries (with lithium and rare earth elements) are the key to viability of this new industry. And surprisingly, Australia has several firms with some cards t play. It’s not all bad news!

How about one more?

Is it possible in your view, that the present turmoil is an early warning that while capitalism is a fine self regulating system in the short to medium term, it must by definition ultimately fail?

Since it is dependent on constant growth, and a reduction in the rate of growth seen as recessionary, does it not breach the fundamental law that perpetual growth in a finite system must ultimately implode?

If growth is the product of consumption and population is it not inherently self limiting?

John C.

Gladstone Queensland

This is too big a subject for today’s e-mail. But we promise to address it tomorrow. Send your own thoughts to

Dan Denning

for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "Circle September 26th on Your Monetary Calendar"

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Dan, I am honoured that you would use my comments to reply to LM’s emails ;)
(you do say it better…)


What team do you barrack for?

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