Oil’s plunge contains the seeds of financial debacle

Although cheap gas is great for motorists, it could wreak havoc with Canada’s energy sector, as well as the market for junk bonds.

Central banks throughout the West last year found it easy to impose their will on precious metals. Nonetheless, gold remained the second-strongest currency in the world, slipping only 1.7 per cent against the U.S. dollar, while all other paper currencies fell by a greater amount.

So gold’s strong showing should come as no surprise, given its centuries-old status as a currency, says John Embry, chief investment strategist for Sprott Asset Management in Toronto. He writes:

Moreover, precious metals have become more popular, now that the market has been shaken by the plunge in oil prices, as well as higher volatility in U.S. stocks. And if that’s not enough to give investors the jitters, there’s always Europe’s spavined economy and Japan’s failed experiment with “Abenomics.”

Move was a surprise

Of course, gold and silver’s lack of counterparty risk has made both metals more popular, as has  Switzerland’s surprise move in mid-January to abandon its currency peg to the euro.

For a long time, I believed any number of things could go wrong with the world economy, given just how fragile and over-leveraged the global financial system is. But I confess I never thought the current crisis would be set off by a collapse in the price of oil around the world.

Consider: six months ago, when West Texas Intermediate was trading north of US$100 a barrel, you’d be hard-pressed to find a “permabear” who thought oil would fall far below US$75.

Given the Mideast’s ever-shifting tectonics, most observers thought any decline in petroleum would be moderate and that an improving global economy would buoy prices.

But oil’s plunge of US$60 a barrel over the past six months contains within itself the seeds of worldwide financial disaster. True, optimists cite the positive impact of cheaper oil on consumers everywhere. But they’re missing the havoc it will almost certainly wreak on financial markets, as well as on the world’s oil-producing regions.

Bankruptcy likely

In fact, if petroleum stays below US$50 a barrel for any length of time, many energy producers will go bankrupt, while thousands of oil and gas workers around the world will lose their jobs. Peripheral industries — those sectors that supply the oil patch — will also take a hit.

The junk bond market could see carnage as well, given the more than US$200 billion that’s been poured into fracking in the U.S. — the process by which hydraulic fracturing and horizontal drilling are used to squeeze oil out of the ground. There could also be a crisis in the derivatives market.

What a lot of observers overlook is that many oil companies had hedged future production when petroleum fetched roughly US$100 a barrel, thereby putting somebody — most probably a financial entity — on the wrong side of the trade.

No one I can think of believed oil would sink as low as it has. So, any predictions of future prices are at best a guessing game. But sentiment, not surprisingly, has turned negative. And the usual suspects, such as U.S. market guru Dennis Gartman, are falling all over themselves to see who can predict the lowest price.

Evidence exists

Considerable evidence suggests that prices could remain under pressure. But no one can say if this will really happen, given the many moving parts — economic, geographic and political — to the oil and gas story.

What I do know is that the global economy is materially weaker than most of the world’s “experts” now believe. Both the U.S. and China, for example, are blatantly falsifying their macro numbers to paint a more positive picture, while Europe and Japan remain in dire straits.

In the interim, Russia is being flattened, while much of the Third World’s capital is being chewed up by the U.S. dollar.

Of course, Canada, the U.S. and Brazil logged big increases in oil output over the past five years — so much so that the market share of the Organization of Petroleum Exporting Countries quickly began to shrink.

But Saudi Arabia, OPEC’s biggest and cheapest producer, has recently raised its output, thus helping to glut the market. Ostensibly, the Saudis figured that by knocking high-cost production — Alberta’s tarsands come to mind — out of the box, they could regain market share. But Saudi Arabia’s move must be seen in light of its implacable hatred of Iran, its main rival in the Mideast, whose production costs top those of Saudi Arabia.

For his part, U.S. President Obama admitted that lower prices were a weapon to wield against Russian President Vladimir Putin.

Superimposed on all this is the futures market where many hedge funds, believed to have gone long, have had to unwind their positions in a rapidly falling market.

The bottom line? Anyone who thinks he has a handle on where things are going over the next 12 months has a lot more foresight than me.

I earnestly hope oil bounces back to US$70-$75 a barrel. But there’s no guarantee of this happening, given that we’re now on the brink of a global recession — thanks to our unprecedented level of worldwide indebtedness.

Implications are scary

And even though oil at US$50 a barrel will put some more change in the consumer’s pocket, the economic and financial implications of low petroleum prices are scary.

Why? For starters, there’s the employment picture. Most of the well-paid jobs in North America over the past five years have come from the oil patch. Since the end of the 2008-’09 market meltdown, for example, the five U.S. states with significant fracking operations have generated the bulk of America’s jobs.

And in Canada, it’s no secret that Alberta, ground zero for our oil and gas operations, has attracted thousands of workers from the other provinces, as well as from many countries overseas. But now the picture is clouding over; in fact, the layoffs are just beginning.

Damage may be worse

But this may be the least of the problems. Rumors abound that damage in the oil derivatives market may be worse than what existed in sub-prime mortgages before the last financial crisis. After all, banks are more over-leveraged than almost ever before, while levels of bad debt have zoomed.

In addition, the sovereign governments which bailed out the spendaholics last time are themselves now severely impaired. Moreover, interest rates can’t be cut by any big amount. So, this time around, there’s no safety net. As an aside, this may explain why so many western countries have legislated bail-in provisions for their banks.

But there’s been one big beneficiary from this growing chaos: the entire gold and silver sector. As I noted before, both gold and silver bullion have been garnering more attention recently as investors increasingly begin to question the viability of their overvalued financial assets.

Yet, there may be even greater upside leverage with gold and silver producers, almost all of which are severely undervalued. With the recent rise in gold, along with the precipitous plunge in petroleum, the gold-oil ratio has exploded to 25:1 — no mean feat, considering that not too long ago, the ratio was in the single digits.

And because energy is a major operating cost, the higher ratio is very bullish for those companies that mine precious metals. Because of the higher multiple, these companies are likely to get a big boost in their cash flow in 2015.

In addition, thanks to the surging U.S. dollar, precious metals miners that operate outside the U.S. are getting considerably higher gold prices in their domestic currencies while their costs outside remain relatively flat.

Price will help earnings

In Canada, for example, gold goes for more than $1,500 an ounce, now that the loonie trades roughly 16 per cent below the greenback. This too will be balm for both cash flow and earnings.

So, it’s no surprise that gold and silver producers have caught a serious bid recently; in fact, the NYSE Arca Gold BUGS Index (NYSE─HUI), better known as the HUI, has broken out in a big way above the key resistance level of 180.

So, when the companies on the index report their results, I’d expect it will move dramatically higher as the year unfolds.

Luster is enhanced

That investors up until recently have shunned precious metals simply adds to their luster.

But in choosing precious metals producers, stick with small caps; they tend to be undervalued compared to their bigger brethren.

Moreover, I’d also focus on those companies with well-defined, but unexplored, ore bodies, if only because this makes them attractive takeover targets.

 

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846