Gold Crush

Well it looks like Sell-in-May is apparently a couple of weeks early this year, though without wanting to repeat myself too much, lower commodity prices will quite likely end up being a good thing. It always pays to pay attention to commodity markets – when managers feel queasy and reconsider investment plans, they pause commodity buying months before anything shows up in official statistics. The sell-off is broad based, the most spectacular facet is gold:

Gold meltdown

(Source: Izabella Kaminski at Alphaville)

On the plus side this is bit of a relief – if the loony libertarians and anarchists who bought both large hordes of gold and chronic amounts of  Bitcoin kept making so much money I might have had to throw in the towel and join them.

What’s the story

As always, the price is set by who’s buying and selling. In this case we have:

    • 1. Central banks
    • 2. Real demand (jewellery, industry)
    • 3. Speculators

Gold Demand Trend 2012

1. Central Wankers

In the gold market central banks have proven true to form and have screwed their populace through poor market timing (though I do think Bernanke and Glenn Stevens have done some excellent work)

UK readers may know that Gordon Brown decided to sell 60% of UK’s gold reserves in 1999-2002 at around $300 per ounce. He even told the market what he was doing before he did it. Needless to say, commodity markets tend not to rally when a government announces it’s dumping the majority of its stock. This was at a 20 year low.

Not that we can be particularly smug down under. Typically our politicians follow the political trends coming from overseas, and in this instance we certainly played by the rulebook. We sold our lot at around $360.

Australian RBA sold gold


If central banks were selling at around $300 range, what were they doing the past few years when prices ranged between $1600-1900? Naturally, they bought more gold than at any time since 1964.

Central bank purchases of gold

2. Industry

While the central banks sold at the bottom and have been buying at the top, the fact that industrial and jewellery demand (mostly jewellery) moved in opposite direction to the price restores some faith in economics, despite what you may hear about an Indian/Chinese gold rush. In terms of picking price drivers, relatively steady industrial use pales in comparison to the huge swings in speculation and the movements and hoardings of central banks.

3. Speculators

This is where it gets interesting, as a quick inspection of the demand chart above shows what you would have assumed anyway – recent years investors have piled into ETFs and physical gold.

It’s amazing how otherwise intellectually rigorous individuals so easily accept silly notions and accept bizarre illogical statements of faith on the topic.

a) Gold does NOT protect you in a sell-off (necessarily)

Since 2001, this trade has worked very well. But nothing lasts forever, and in recent days this paradigm has completely changed. All the people who bought for this reason (e.g. Jim Cramer ‘you should always have some gold in your portfolio’) if they have any logical consistency, should now be selling.

b) Gold is NOT an inflation hedge 

This oft-expounded theorem-as-fact is easy to disprove – take a look at the picture:

Screen Shot 2013-04-16 at 11.07.24 AM

As you can see, while there has been some truth in the statement in the past, without overstating it there has been a considerable divergence lately. While we’ve been about as close to deflation as you can get without calling it such, the gold price has rallied strongly.

If anything that implies a negative correlation – but the reality is it has nothing to do with it. There is no mysterious hand here – the price is determined by real factors: who turns up to buy and sell each day. No rule of thumb or market is going to make up for actually understanding who these people are and why they are doing so.

c) Gold is a better and safer store of value than cash in a bank

While certainly true when the gold price is going up, in a nutshell, it simply makes no sense to hold gold when (real) interest rates are positive

When banking cash in the UK, US and Europe gets you close to zero, then perhaps it makes more sense than usual to swap it for bullion. But when rates normalise then holding gold makes no sense at all. Think about it – if rates hit 5% (and that is well within norms – you’ve been able to get that in Australia throughout the crisis), then effectively government guaranteed increase in wealth of 5% beats the hell out of (negative) storage costs.

Should inflation pick up and purchasing power erode, central banks will jack up rates. Cyprus aside, you are safer in a too-big-to-fail bank.

So in summary, all the main speculative reasons for holding gold make very little sense right now. Now imagine what would happen if the speculators chasing capital gains start to unwind their positions that have been building since ~2001…

But what about hyperinflation!

Pundits fall over themselves trying to predict the next time this will happen.

A cursory flip through the history books shows hyperinflation is actually far rarer than everyone seems to think. This is something of a cognitive bias – the results can be so horrific that it’s easy to overstate the actual occurrence.

And no matter how inclined-toward-conspiracy you are, there is no indication that the major central bankers in the world are sulkily printing cash to plea poverty while keeping full employment a la Weimar , or are as brazenly thieving and felonious as the villainous Mugabe and his cronies in Zimbabwe.

But even so, there are actually some excellent ways to deal with hyperinflation

For example you could:

  1. Borrow in local currency and buy real assets overseas. The currency will be on a oneway trip to hell and the value of the loan will erode just as fast.
  2. Borrow and buy real assets for which there will always be demand – like central housing. Again the face value of the debt will erode in real terms, but the living space will be worth something regardless of the payment terms

What you should not do is have any savings whatsoever, or even worse, be on a fixed rate pension. Apparently the much-maligned veterans of World War I (who could hardly have picked a worse time to be born) were particularly screwed by this one.

So in conclusion: sell your gold (if you have any) and keep some cash ready for the far more interesting opportunities the market is about to throw up.

Next post: Hedge Fund Villain #1: Mr Paulson.

FYI: A chemical anomaly

Gold has always fascinated, not really due to its rarity (after all, many things are more scarce) but due to its colour and lack of reactivity, that suits it perfectly for beautiful and lasting jewellery.

Apparently an (admittedly hand-wavy) explanation is that at the lower ends of the periodic table, the increasingly (positive) charge of the nucleus causes (negatively charged) electrons to approach relativistic speeds. By the time you reach Au,  the energy levels have been pushed to the point where gold is coloured differently to the other metals – one of the many periodic crossovers that chemistry examiners love to probe.


Don’t be hasty

1. Xivvie has prone true to form and is up about 400% since I sold my entire position at around $8 last year, proving once again stop losses are the devil’s work and have no place in anyone’s strategy. Whoops.

XIV 1 year

On the flipside, the world has proven remarkably good at knocking down risk markets, so there’ll almost certainly be another chance to pile back in, though if we have a few years like 2003-2006 (likely) I’ll probably have to watch one of my favourite plays quadruple again from the sidelines.

Typically the lack of market volatility over the past year is the exact opposite of what (dare I say) everyone was predicting a year ago. Even lil Kim hasn’t been able to shake things around. The commentators gleefully stating that the Korean markets are at ‘four month lows’ completely miss the point: big picture there’s barely been a ripple.

10 year KOSPI

(Kospi, Korea’s market index)

Fortunately, having watching XIV and it’s ETF cousins for some time now (of particular interest ZIV – it’s like a smoother version using futures further down the curve that inherently jump around less than the front end) and actually read their legal docs, at least I now have a firm strategy and some level of confidence to put on a position that, in my weak defence, I just didn’t have this time last year.

2. While I’d prefer it didn’t, that sort of opportunity may come relatively soon. There’s hints of the now-typical mid year slow-down in the US, Eurozone statistics are somehow managing to worsen, and there are signs wherever you look that market exposure is at extremes. This all suggests the annual Sell in May and Go Away collapse might happen once again, for what must be something like the fourth year in a row now.

Eurozone unemployment:

Eurozone unemployment 2013

3. Meanwhile the broad road-map has been playing out according to plan. The Eurozone hasn’t collapsed as the pundits predicted, and it will take far more than economic statistics to shake it now. Meanwhile the shale story played out more or less as expected, and while this hasn’t resulted in the fall in crude I was expecting, I think downward pressure is a relatively safe bet over the next few years.

Pressure on commodity prices will likely be the theme of the next couple of years, and you don’t need to be an expert to guess what impact the wave of supply will have on commodities like iron ore.

The second and third order impacts are harder and more interesting to ascertain. Most likely prices will stay low (as will inflation statistics) and those who need cheap fuel and cheap raw materials will benefit. Perhaps steel makers will finally have their time in the sun, and some of the pressure on airlines, shipping and transport companies will be alleviated.

4. To be honest though, considering the run so far, to be long in this market is not a clever move. Better to be patient and wait for a real opportunity. If you were set at much lower levels last year, or better yet, at any point in the four years preceding, that’s a different story, but this bandwagon is not for jumping.

Enough with the boring recap.

Next post: Anarchy and Bubblecrap

Speculations on the Currency

I’ve spent the last few months working in the principal investment area of a bank with typically harsh restrictions on social media and comment of all sorts, and as such have been unable to post. With that episode now over (and I’ll comment on the experience when the dust has settled), it’s time to wade in to the national pastime of speculating on the aussie dollar (forgive any repetition from previous posts).

For all the doom and gloom surrounding the humble aussie, and considering it basically halved in 2008, then doubled again, it has been remarkably stable. Over the last three years, every time things have gotten a little shaky, it has traded as traded things should trade: plunging sharply, causing a price driven market reaction, and getting pushed back to – dare I say – equilibrium.

Yet everyone seems to think the aussie dollar has somewhat peaked and is heading downhill. The argument seems strong: the comprehensively heralded coming collapse of the iron ore price will reduce the multi billion dollar bids of AUD.

This misses the point. The reason ore prices are heading downhill is due to increased supply – the demand growth side is quite strong. Fortunately, as a command economy, China actually tells you what it’s going to do, five years in advance, and the urbanisation story is by no means complete.

So as dirt cheap Australian ore comes online, while there will almost certainly be a price reaction southward, what matters s the total flow of cash, and the lower price will be counteracted by the increase in total export. Where the balance ends up is anyone’s guess and unmodelable.

There’s another part of the picture. Australia has a major export that has barely got of the ground: natural gas. Australia is not exactly a low cost producer, but tens of billions have already been sunk into these projects. As with all mining and high capital investment, once the initial expenditure has been made to build the mine, gas plant, liquification terminal or ship, the economics are hugely in favour of continued production, even if it ensures the project makes a loss. Better to recoup at least part of a failed investment rather than write the whole thing off.

Time and again analysts are caught completely off guard and have to hastily and humbly restate their forecasts when their object of expertise falls straight through its arbitrarily declared ‘price floor’. I think I’ve harped on about htis before.

And no matter how low aussie interest rates seem from a seat in Sydney, or how much chest-beating there is from armchair economists, they are still substantially above the rest of the developed world, even compared to our Northern Hemisphere economic equivalent, Canada. The carry trade is still on – from a yield perspective it makes sense to hold AUD.

So, as although the iron ore price will almost certainly fall to the industry’s pressure point, it will be balanced by the huge increase in total ore exports will easily accomodate it. The stability of the AUD is likely to continue. In fact, once you take natural gas into account, there is actually a feasible case for a higher aussie dollar.

And finally, there’s a mathematical quirk that increases stability in the AUDUSD, as well as pairs like EURUSD that almost noone ever seems to consider. The giants in the room – central banks with huge foreign currency holdings – determine their weightings as percentages. To keep it simple, if an Asian bank holds half its currency in EUR, and half in USD, as one falls relative to the other, it buys the falling one. In enormous size. This rarely considered stabilising impact can barely be overstated. As foreign central banks have diversified into the AUD (as they should), this natural steadier comes into play.

To put it another way, if a central bank has set percentage holdings (as they generally do), when there’s a sharp shift in a currency movement,) you can guarantee there will be a market-moving order in the opposite direction. Typically hedge funds have been the losers on the other side of the trade – think of the fortunes lost in bets against the Euro every time the continent flares up.

Unfortunately neither being long or short the aussie is a particularly interesting trade right now. If you want to bet against the recovery (we are, after all, about five years into it) or perhaps more rightly, commodity deflation, then there are other places to look.

Turnaround Tuesday

But for the first time in a while, I feel like walking away for the market. Something’s not right..

Let me count the ways:

1. Chinese inflation figures where high, making monetary easing that much harder

2. No mention of QE3 from the Fed.. given their communication policies, I’d say that’s now looking quite unlikely

3. Germans are talking about fiscal discipline again – as if inflation has anything to do with anything right now, or their loose talk and inopportune rate rising didn’t screw things over last year

4. Rising spanish debt yields – predicator of the annual euro slump we’ve come used to

5. Expectations for a very good US jobs number which massively underperformed on Friday.

6. There has just been a stonking rally.

Finally, the Chinese market is getting dicked, and for the past five years that has meant stay the fuck away from risk.

There’s not much to be positive about, save to hope April is a wipeout and that sets us up for a ripping second half of the year. ‘Sell in may and go away’ can’t work every year.

I’d say copper’s looking pretty exposed from here (yes that is a head and shoulders pattern)


In fact, the whole market is a head and shoulders pattern.

I’ve had a pretty good run since december (well, less good after the past couple of days) but now face the age old dilemma with all the tricks for the unwary and general mindfucks contained within: hold them or fold them.

Shale on.

The world’s best investment bank Squid just issued an excellent note on shale gas. I posted on this a while ago and the story is certainly filling out.

A few points stood out: 1. Natural gas prices, in both absolute term and relative to oil, have tanked. I often hear people assuming they will go up. If something drops dramatically, the first thing people seem to think is that it will go back up, and now it a buying opportunity. That is true if it’s a cyclical case. If it’s secular, i.e. driven by factors that aren’t cyclical, then there is no reason for something that has gone down, to go back up. Similarly, something that has gone up, won’t necessarily go back down if the story has changed. You probably won’t be able to buy Apple for $100 ever again, for example.


2. There are some big winners. US, Australia, China and Argentina stand out.


3. US energy imports are falling drastically as expected, but fortunately China is there to pick up the slack or prices would fall. Actually this is quite unfortunate as we all would benefit from lower energy prices, while only a handful of violent sexist extremist hoarders Western allies in the Middle East benefit when prices are high.


So how to play it? There are obviously some simple ways.. buying shale producers. But the easy money is certainly already made there.. not that you won’t still get decent returns on capital. The cost of sucking otu shale gas is so much cheaper than conventional drilling that the whole industry is likely to perform well.

My favourite pick? Buy US fertiliser producers. Natural gas is much lower in the US than elsewhere – one of the real anomalies in global finance right now. Natural gas is a key input, so US producers will have a huge advantage for a long time. And they are relatively cheap. Daniel Shand picked CF Industries, and I’m going to back him on this one.

Very volatile so a good candidate for selling puts, if current price seems a bit high.

Whilst on topic, has anyone noticed this? Doesn’t seem particularly bullish. Perhaps you could balance a long shale producers / short copper trade for a commodity neutral trade on this theme.


Oil Bear

The price of oil is going down.

The resilience of oil prices in the face of an onslaught of grim economic and political developments around the world implies supply is currently quite tight. But don’t be fooled by oil over $100: The energy market is about to be turned on its head, and it’s all about shale.

A rather lax regulatory regime (courtesy messrs Bush and Cheney) has led to rapid exploration, immense investment in technology and huge increases in estimates of US shale energy reserves. It is quite likely that in a matter of years the US will shift from being an oil importer to an exporter – with interesting consequences for the global economy and political ecosystem. The percentage of US oil that’s imported has dropped from 60% during Bush’s second term to under 45% now.

As a sign of how fast reserves are being discovered, in 2011 the US Energy Information Administration more than doubled its estimate of technically recoverable shale gas reserves to 827 trillion cubic feet (for a sense of scale, in 2010 the US consumed about 24 trillion cubic feet). This is not the sort of thing that would lead to an increase in global energy prices.

The consequences within the industry are no less dramatic. Currently most oil in the US is travels South from the oil sands in Canada – with a production cost of around $80 per barrel. The cost of producing a barrel of shale oil is around $60, with some fields potentially as low as $40 – Royal Dutch Shell announced it could produce in Colorado at $30 a barrel. The numbers themselves tell the story. Once these fields pumping at full capacity, higher cost producers are up the creek, so to speak. Since they’ll have already made huge fixed investments they will have to keep pumping, as even producing at a loss would be better than idling the wells and losing more. The result will be disaster for the weaker capitalised and vast profits for the shale producers.

The impact will be far more broadly felt than that. Cheap energy, the lifeblood of industry, is exactly what the world needs right now. Cash saved on petrol is cash left sitting in all of our wallets. Every industry relies on the price of energy, so lower prices would be a boon to all. Traditionally periods of low energy prices have corresponded with booms (think 1970s vs late 90s), while the mid-2008 oil spike is arguably the most under-estimated causes of the sharp recession that followed. Perhaps this could be the boost to growth that the global economy is lacking right now. Hope so.

A good way to play it would be on the futures curve. Selling 12-18 months forward would have better risk-reward – the price will respond less sharply to any positive oil shocks while a clever move would be to cover the position by selling long-term puts around $50-60, or higher, giving you a much wider range of profitable scenarios. I’ll post later on specific long-short equity plays that also make sense.

Now there are obviously darker consequences to cheaper energy, most obviously the effect higher consumption has on global warming. There are also concerns over the health, safety and environmental impact of harvesting shale. The process involves pumping oceans of water underground, which ominously appears to increase local seismic activity, while there are (perhaps a little hysterical) concerns gas could enter the water supply, with a video of tap water igniting recently going viral. These concerns, magnified by higher population densities, have left Europe years behind in developing the legal and technical structures to make use of their own vast reserves. Whether these fears play out and the US slams the break on shale development is impossible to discern, though a health disaster in the headlines would probably have more impact than simmering environmental concerns, valid though they may be. But with whole continents stagnating and no end yet in sight to the crisis, almost into its fifth year, it would be a foolish politician who wasted this potential windfall.

Spread that.

The WTI-Brent spread has gripped the attention of the financial world. Historically trading in a tight band the spread dramatically blew to as high as $28 intraday before plunging just as dramatically to around $9 where it is now – particularly odd considering the greater refining yields and lower sulfur content of WTI.

A bottleneck at the Cushing terminal in Oklahoma, where the Nymex WTI contract is settled, caused incremental Canadian oil to build with only expensive barges to transport the crude to refineries.

Exacerbating the problem was ConocoPhillip’s decision to keep the Seaway pipeline flowing towards Cushing. In doing so the company protected the profits of its Midwest refineries by keeping WTI crude artificially cheap, all at the expense of Canadian oil sand producers who were pushed to breakeven levels.

The sudden tightening of the spread occurred after the sale of Conoco’s 50% stake in the Seaway pipeline to Enbridge for $1.15 billion, which allowed the reversal to take place. Curiously, the spread began tightening as early as October when WTI entered backwardation, a clue that supply/demand story was tighter than thought.

An initial capacity of 150k barrels / day by 2Q12 is expected to expand to 400k barrels / day by early 2013. This will probably displace the use of the congested and expensive barge market from 2Q12-4Q12.

Whenever prices get this out of whack the gods of economics demand a physical respones. In this case rail capacity was immediately planned with the aim of circumventing Cushing, which may induce further tightening as Cushing prices rise to encourage more oil flow through the terminal.

How I’d recommend playing it: inventories at Cushing will likely build up in anticipation of the opening of the Seaway pipeline. The best risk reward is probably in longer dated Brent spreads, while perversely inventories at Cushing may actually build as oil is pumped there in anticipation of the opening of the pipeline. This would push down prices at the front end of the curve, while leaving the back end free to compress below $6.50 – which is the cost of transporting WTI to Brent.

On this theme, selling the March 2012 WTI-Brent spread and buying the March 2013 spread would benefit from a rotation of the curve – simultaneously profiting from any short term widening while betting that by March 2013 the excess inventories have cleared out. Quite a likely scenario.