Summary
Crude may not see the highs of last year but will trade higher as 2009 ages and gold could test the highs as a result of actions being taken to deal with the financial crisis in America and the stimulus plans to restart the economy. While demand has fallen due to the current global economic crisis, the fundamentals for crude favor price increase rather than much lower pricing. Some of the same fundamentals that favor a price increase for crude will also have a similar effect on the price of gold.
Analysis
Before getting into price predictions for 2009 for these two commodities it could be beneficial to understand some of the primary fundamentals that factor into the pricing of each.By understanding these, it is then easier to look into the future and gain a better grasp of where prices are likely to go in any given time period.
Crude oil prices are set primarily on a global supply and demand formula. The two primary factors in the formula are global economic activity, including consumer spending and the status of existing production fields and the level of new production being brought into the supply side of the equation.
Gold prices are set in accordance with inflation rates, exchange rates and the status of the global geopolitical situation at any one point in time.
Speculative interest and direction in both of these commodities serves as a swing factor that can add momentum to the direction caused by the fundamentals.
Now to specifics of each.
Crude oil.
At the current price for crude, $49/bbl (NYMEX 01/06/09) the supply side of the pricing equation is out of balance to the low side. This means that suppliers have little incentive to provide supplies, make the investment necessary to bring new found reserves into production and even less incentive to search for new reserves.In short, the easy to find and inexpensive oil has been found, any new supply is going to be harder to find and/or develop and much more costly.
This will fundamentally force the supply side of the equation to be put into a better balance. That translates into higher prices for crude or it will simply not be brought out of the ground or from under the sea until prices are more in balance.
Indeed, as we have seen recently, the suppliers will cut production from existing fields, thereby taking supply off the market to stabilize or increase prices and will halt capital expenditures even in existing fields to maintain or increase production from those fields.
On average, OPEC members do not have any incentive for these activities with prices much below a range of $55 to $60 per bbl and we know that their domestic budgets do not enable them to manage their economies very well much below these prices.
Saudi Arabia is an exception to this rule but they do not have much incentive to continue to sell this declining commodity too cheaply despite having the ability to do so for now.
Non-OPEC producers are more in the range of $65 to $70 per bbl for the same reasons and, as we have seen in the case of Russia, some of these producers can and do take independent actions to defend their economic interest in this commodity to the detriment of users.
Therefore, we can imagine that at the current prices, production cuts will be made at existing fields, investment into existing fields will be reduced or abandoned completely and the development of newly found reserves will be halted along with the search for new reserves.
All of which will have negative effects for future production.Peak oil has been a subject of debate for as long as there has been production but, we did experience the reality of that debate last year.
Current top end production for crude oil globally is right at 87 million barrels per day. Part of the driving force to the price rise we saw in 2008 was the fact that global demand for oil had reached close to that number, topping out at around 85 million plus barrels per day.
At best, global demand has fallen up until now by approximately 4 million barrels per day. If we add into that the most recent cut in production of 600,000 bbls per day and the projected further cutback of 2.2 million barrels per day to begin in February, production will be at around 84 million bbls. per day with demand running around 78 to 79 million bbls per day.
Several of the major producing fields are experiencing significantly higher declines in production than projected and as such future production from these older fields is in question which will put strains on certain producers to continue to deliver the quantities they have historically been able to deliver or that they and their clients have contracted for or have planned.
Two in particular are of concern, Ghawar in Saudi Arabia (the largest field on the planet) and the Cantarell field in Mexico. Both of these mature fields are experiencing much larger than anticipated declines in output. Both are fields that have enabled the countries to deliver large quantities of crude almost at any price due to the relatively cheap extraction costs they had up until recently.
With the declines it has become much more costly for these suppliers to keep production limits from these fields at current levels and in the case of both, they seem to be approaching their viable limits and it will be downhill from here in terms of production, especially in the case of Cantarell.
Ghawar has been on the "endangered" list for quite sometime now and the level of water being pumped into sections of it to keep production flows up is getting to a point where the water cut is so great it won't make sense to keep this up for much longer, especially at these current prices.
There are other production problems in many of the other supplying countries but this is analysis is not intended to focus that deeply on this point. Suffice it to say that current levels of production from many of the major developed fields are in decline, some well above the norm and as such, supply from these existing fields is going to ebb and new production from new fields is not economical at current prices which will tend to move prices to the upside as this fundamental becomes more impactive to the supply side of the crude oil pricing equation.We are seeing "stimulus plans" being put together and implemented in most of the major economies, China and the US most importantly and these plans represent a two edged sword in terms of crude pricing.
The economic effect and job creation need inside these countries is much needed but, these plans will also have a natural increase effect on the demand side of the crude oil pricing equation.
As these stimulus plans are successful in any meaningful way and economic activity begins to re-ignite, we could very quickly reach the peak oil situation we saw last year or, if the production declines continue, it will become even more evident that on a global basis we have reached the era of peak oil and prices will spike, perhaps above the $147 we saw in July.Just these fundamentals alone set the stage for higher prices rather than lower.
Add into the equation the geopolitical side of the pricing equation and what do we see?
The current Israeli incursion into Gaza, while not directly impacting to crude, any major confrontation in that region of the world has a tendency to move crude prices higher and indeed we have seen some of that already during these last days of the operation in Gaza.
If this becomes a wider action or if some of the "shadow participants" (Iran and Syria) determine to push back against Israel in any significant way, we will have a significant price spike in crude prices.
The same thing could happen if the Arab States determine they have to find a means to pressure the West to put added pressures on Israel to cease their actions and use the oil faucet as a pressure mechanism, we would also see an even larger spike, depending on the extent and the participants.
Venezuela is a basket case economically and with the current slide in prices, Chavez has seen his petrodollar war chest shrink and is now nationalizing all of the gold production concessions.
This action will have impacts on both crude and gold prices in the future. With the current leadership in place and without any reasonable plan to manage this situation by the West (namely the United States) this supply source is not reliable and despite the natural tendency to believe that the supplier needs the import market as much as the import market needs the supplier, irrational behavior by leaders of this ilk cannot be taken out of the equation and we could see just that happening to Venezuelan supplies of both commodities this year and that will produce disruption to supply as well as price spikes.
So, to not get much longer in this analysis, 2009 has a higher potential for price increases and/or spikes in crude than to see lower prices.
How high is the next logical question?
Crude on a normal basis could reach back into the $70 per bbl range within the next six months. Sooner depending on the geopolitical events in that same time period.
If things gyrate more in the fundamentals or the geopolitical, we could see a spike to much higher levels, perhaps back into the $100 range.
One thing anyone looking at crude prices into the future should consider is a changing paradigm in the crude equation. That change is the supply side capability today.
It is not what it is thought to be or what has been projected.
Another indicator is the 7 to 9 year future contract for crude. It is still showing prices far above these current levels and for all the discussion about today's price on the NYMEX, these longer contracts have a tendency to show a truer value based on fundamentals than the spot or near term contracts.
Hold in the back of your mind the investment/speculator factor, as I will address that after looking at the fundamentals for gold prices.
Gold.
Gold is a "sentiment" commodity and has been for as long as gold has been around.
The fundamentals therefore are not as tied to reserves, production, cost to find, develop or deliver as are the sentiment factors, even though these fundamentals do have a role to play in pricing.
But, for this analysis, I will focus on the following:Inflation, currency values, especially the dollar and geopolitics.
First inflation.
While the current cry in most treasury departments is "inflation is not our worry, deflation is our enemy" may have some basis, it is not reasonable to hold to that cry while printing presses run three shifts per day trying to deal with the global economic and financial crisis we have in most of the developed economies of the world.
The running up of national debt by the United States, Europe and Asia cannot for long be viewed as having no inflationary effect, despite many fingers pointing at Japan as the poster child of deflation versus inflation arguments.
By any measure, by underwriting all that the US government has compromised itself to underwrite, current calculations put it as high as $8 trillion dollars; a period of inflation is almost a certainty.
That certainty, when the investment community begins to see its signs, will produce a flow into gold for a level of protection against this certainty.
Many arguments say that gold is no longer the inflation hedge or safe haven of choice, especially since the creation of derivatives and ETF's (Exchange Traded Funds) which can be used to hedge against inflationary effects on an investment portfolio.
To some extent that is true, however, the volatility risk of these "hedges" will discourage some investors and portfolio managers from using them to fully cover their inflationary risk.
Additionally, most investors will still use gold in some percentage as a worthy hold in any portfolio.
Somewhere into the second quarter of this year we could begin to see some of the inflationary pressures of all these bailouts and stimulus packages and perhaps even begin to feel these pressures in the form of interest rate hikes.
As that happens, gold prices will have a tendency to rise not fall.
Currency Values.
There is no need to beat around the bush on this one. We are speaking primarily of the US dollar here as it is, for the moment, the world currency and probably will remain so for a bit longer.
However, in any analysis of this nature, it would not be responsible to look at the US dollar and what gold prices could do in response to what the future for the US dollar might be.
In short, the dollar's future is to be depreciated, and by a great deal.
Why?
The US government is making the same horrible mistake that most of Wall Street made and that produced their demise.
The US is overleveraging its balance sheet.
In a monumental manner and while most pundits will argue that the US economy can underwrite these trillions of dollars it is currently underwriting, I for one, see a huge leverage factor being put onto the balance sheet that portends some very serious problems in the not too distant future.
The credit crisis in the US that has now infected most of the rest of the world and even those countries not directly impacted by this collapse are experiencing some of the "aftershocks" of the impact.
It is likely that these are not aftershocks as there are still quite a number of "shoes" that have to fall, some of which are equal in size or larger than the current focus for all the chaos-- sub prime mortgages.
In truth, sub prime mortgages have little to do with this collapse.
It has more to do with the layers and layers of derivatives wrapped around virtually every piece of investment paper or invented paper these Wall Street "financial engineers" were able to create and get rated by the likes of Moody's, S&P, Fitch and the rest of the rating agencies who in as conflicted a manner as one could ever imagine, supplied (for a handsome price) investment grade ratings to most of this now considered "toxic waste".
The size can only be estimated since most of the creators of these instruments have been able to avoid full disclosure and in point of fact, probably have no real idea themselves as to the amounts or the "toxicity" of what this paper is.
But, to give a small idea, the International Bank for Settlements estimated the size of these "derivatives" in 2006 to be $415 trillion dollars!
Let's print that again.
In 2006 the estimated size of the risk of the derivatives market to the world financial system was $415 trillion dollars.
Given the relationship of growth to these products by the collapse in 2008 this market was put at over $830 trillion dollars globally.
The size of the current TARP is nowhere close to what is needed nor the manner in which it has been deployed, to keep any significant percentage of these products or the holders of them afloat should any sizeable percentage of them begin to "land" on the collective roof of the world banking system and we have only seen the one shoe of this "centipede" for the moment-- mortgages.
Still up in the air we have, consumer credit card debt and those associated "derivatives", commercial real estate and their associated "derivatives" (perhaps the real next shoe to drop and one of substantial risk to the system, especially the regional banking system), municipal debt and those associated "derivatives", all the way to various governmental instruments and those associated "derivatives" and the paper goes on and on with virtually no limit.
There is not enough time in this analysis to get into that issue but, at the current rate of leverage, if continued (and it is almost a certainty that it will as we hear President Obama's plans), the US could find it's credit rating impacted (that is of course if anyone will trust the rating agencies after the current debacle in the financial system finally gets called for the scandal that it is in terms of rating agencies) and once that happens, we could see a substantial slide in the dollar's value, which will translate into higher prices for gold.
The dollar-euro rate could get back up to the $1.60 or higher level ($1.85) over the course of these next 6 months with an equal if not greater devaluation against the yen.
At some point, we could find the dollar falling from its position as the world currency and then these exchange rates will become incredibly volatile and gyrate in manners and levels that will have a significant impact to all commodity pricing and gold especially will be propelled to the upside.Many of these "shoes" could start to drop during 2009, some are already have left their orbits and are in-bound so to speak.
The impact is what remains to be measured.
No matter what, the tendency for gold from this part of the pricing equation will be more to the upside than downside.
Geopolitical Events.
Gold has always been the commodity of choice when world events turn negative or start to look like they could.
One does not have to go too far in reading any newspaper, magazine or listen to many responsible news stations to understand the risks in the geopolitical state of the world.
There are increasing terrorism threats (homegrown and exported) in virtually every major developed country on earth today.
Some greater than others, but it exists in a fashion not seen at any other time in history.
Ease of acquiring and deploying weapons and devices of potentially significant damage and death across the global community has never been higher nor the desire to inflict this damage by one group or another.
So much so, that it is not a matter of if only the questions of when, where and to what degree will some group manage to deliver a major blow.
This uncertainty and potential will daily manifest itself and is another reason to expect gold prices to trend upward as opposed to downward.
As President Obama begins a withdrawal from Iraq and puts pressure onto the terrorists in Afghanistan (if he holds to that policy) we will see additional pressures from those groups spread throughout the world and it is realistic to consider some very serious negatives in Iraq and the region of the Middle East.
Saudi Arabia itself, one of the cradles for some of these terrorist groups has had to deal with a significant number of terrorist attempts to disrupt every aspect of the society with a special emphasis paid to pipelines and production capabilities.
In 2008 alone, they have been willing to admit to thwarting over 20 major attempts on various facilities throughout the Kingdom. One can only imagine the real and continual planning that is ongoing.
Iran has been almost too quite on Israel to be forgotten in the apocalyptic scenarios for the Region and thereby crude and gold prices and one should not forget the number of centrifuges still spinning within the country and where and what that spinning is designed to produce.
Russia has shown nothing but added reasons for concern on the geopolitical front and the ambitions of the current leadership are becoming more evident as time passes. It is logical to expect continued pushes by the regime during 2009 to regain a resurgent and perhaps new position in the global hierarchy, especially with the inability of the United States to curtail any real push out and beyond current borders, both geographic as well as geopolitical.
China is spending ever greater percentages of their GDP on armaments and is itself facing a great deal of internal pressures brought on by the current economic crisis and global slowdown.
The leadership has population issues to deal with that no other country on earth is faced with, including riots in parts of the country brought on by everything from food and commodity shortages to unemployment taking place across a broad swath of their economy.
These pressures have the potential to stress decision makers and bring about policies that will have impact beyond their own borders and those pressures are building now and are likely to continue to build throughout most of 2009.
Now, for the speculator factor I mentioned earlier and what that meant and will mean for crude oil and gold pricing.
To go too far back in time as it relates to this issue would require too much patience for the reader, but, if we just look at the last 5 years and the expansion of hedge funds, sovereign wealth funds, pension funds and the myriad of private investors who brought more capital focusing on commodity markets, especially crude oil and gold and all the derivatives associated with those sectors of the world economy and markets than at any other time in history, one can also understand some of the pressures on this entire complex.
Daily volumes of crude oil contracts traded on the NYMEX reached astronomical levels. Several now defunct hedge funds had billions of dollars in contracts for crude oil and gold along with option contracts, derivatives of various natures associated with these commodities, to a point where the total value of contracts traded began to be many multiples of the physical capability for production or delivery of these commodities.
Of course, well over 90% of all future contracts are "offset" before delivery of the actual underlying commodity is required but, prior to any offset, the force of all the buying of the contracts drives prices upwards and creates a momentum of a nature that one only experiences when caught in the middle of a forest fire out of control that actually begins to create it's own weather system and moves at speeds that human beings cannot outrun.
Take this fact into consideration.
The total amount of capital that would be required to control virtually all of the NYMEX contract months for crude oil, based on margin requirements that hedge fund managers would face is a mere $16 billion dollars.
Considering that some hedge fund managers were in control of anywhere from $2 billion dollars to as much as several hundreds of billions of dollars, on any given day and allocating only a small percentage of the capital available to them along with the incredible leverage some were willing to take on (40 times to 60 times), the ability to push prices in virtually any direction by significant percentage changes from the day before and the levels of profit potential to be earned, "the game was on" as one would say.
And the game stayed on for well over 5 years and certainly for most of 2008, even as the price declines in crude oil began because, one must remember, a speculator can profit just as much from a price rise as a price fall or collapse.
In reality, the profit risk/reward factor favors the speculator more for falling prices than for rising prices since if the speculator is wrong on the down side he only has to suffer until it reaches zero (0) whereas, if he is wrong to the upside and cannot "offset" or "cover" his position the loss potential is infinity.
But, I digress. Back to the speculator.
With the collapse of the credit markets and the financial system in America, many hedge funds have been forced to close or have imploded.
However, many of these managers and some of their underlings have simply reformulated themselves, raised billions more under new models and parameters of return and risk and are now "on the sidelines" waiting to get active again or "back into the game".
This is true for both equities as well as commodities.
They will not remain on the sidelines for long as they have no incentive to remain in cash, especially with the new levels of returns they will have to give to their investors if they hope to earn any money in 2009.
While it is very early in the new year of 2009 to gauge where these mangers will deploy the capital they have available, they will deploy it and some will go back to the "playground" where they made their money and developed their models and two parts of most every one of these managers playgrounds are crude oil and gold.
Given the fall in crude and their basic understanding of these same fundamental points I have raised in this analysis, it is reasonable to anticipate they will take the "long view" of the market and position themselves accordingly.
This will create a tendency to higher pricing and higher volatility as many have now lowered their profit expectations from the upper 20% to 30% range to the lower to middle teens, the trading in and out will be in tighter ranges.
But, it is reasonable to expect upward pricing pressure on these two commodities as 2009 matures.
Greater momentum will be added to any move up or down produced by the fundamentals that affect these commodities, especially on any upward pressures as many managers will (only for a time) be more cautious to establish positions and thereby panic buy into any movement that finds them out of the markets or not as in as they would want to be.
Bottom line, 2009 will be a volatile year filled with risk and substantial profit potential in these two commodities and from this chair, it seems more reasonable to anticipate price increases for crude oil and gold than much further price declines.
Oh, and for those of you still holding onto the Black Sholes risk model to help you establish positions--- it was never right, is flawed still and most of the guys and gals who developed their risk profiles using it, are no longer gainfully employed and far less wealthy than earlier in their lives.
As the "illustrious" Mr. Greenspan finally admitted to Congress and the world, the basic model he relied upon for most of his career was flawed, thereby, in one short and sweet phrase, exonerating him of all culpability for what he had such a huge role in helping to promulgate.
Fundamentals rule the day, especially as it would apply to commodities.
If you will remember that and study them, you will reach your own conclusions on where prices are headed, especially on commodities like crude oil and gold.
