Wow, did you see the oil price action overnight? OPEC concluded its meeting in Vienna by deciding not to cut production levels in response to the recent oil price plunge.
The result? Carnage. Brent crude dropped 6.3%, a massive fall for a single day’s trade. The Financial Times reported the move was an attempt to undercut the US shale oil industry. US oil has flooded markets in recent years. However, it’s a higher cost product than traditional OPEC production and would certainly be struggling with oil prices at these levels.
From the FT:
‘Opec threw down the gauntlet to US shale oil producers by deciding not to cut its production, in a move that sent the oil price tumbling by more than 8 per cent to a four-year low.
‘The cartel said it was leaving its output ceiling of 30m barrels a day unchanged, in a significant departure from its traditional policy of cutting production to prop up falling oil prices.
‘Any further fall in the price of crude, which has dropped by nearly 40 per cent since mid-June, will mean more pain for oil exporting countries and global energy companies, and could endanger billions of dollars of investment in new oil projects.’
The price drop certainly poses a massive risk for Australia. Over the next few years, Australia will supposedly become the largest exporter of LNG (liquid natural gas) in the world. That’s thanks to tens of billions of investment decisions made by companies when oil prices were much higher.
More importantly, those decisions were made on the assumption that prices would remain relatively high. A bit like the iron ore expansions…and look what is happening there now.
So that means two of Australia’s great export hopes, iron ore and LNG, are under pressure. That’s what happens when you undertake major investment decisions in a worldwide credit bubble. The excess credit creates price distortions that lead to mal-investment.
So Australia has now overinvested in residential housing, iron ore and LNG…and coal too. What a record…
‘Brent remains in a steep decline. With the sharp falls overnight, the price has lost more than 35% in the past five months.
‘This steep decline is likely to lead to further losses in the near term. However, if you’re yet to sell, consider that a cluster of price support zones are rapidly approaching.
‘There is also the possibility that we are in the ‘capitulation’ phase. This is when even the most diehard bulls throw in the towel.’
We might be close to a short term bounce, but if you do see a prolonged period of lower prices, it will certainly put pressure on the US shale oil industry. But there is a wide range of production costs across that industry, and the big fields — like the Bakken and Eagle Ford formations — are still profitable with oil at these levels.
Saudi Arabia, on the other hand, needs oil at around US$90/barrel to sustain the welfare spending of its autocratic state. It can handle lower prices for a while though. It has a huge pile of US Treasuries in reserve that it can sell while enduring a low price environment.
Which brings me to another topic — gold. Oil and gold have always traded within a broad range, as shown in the chart below. The long-term gold/oil ratio is around 15/16, which means one ounce of gold will buy 15 or 16 barrels of oil on average. That ratio is now right on the average.
The relationship stems from the Middle East’s preference for payment in gold once the West started to exploit their oil fields in the 1930s and 1940s. This arrangement changed somewhat in the 1970s when Henry Kissinger managed to convince the Saudis that US dollars were as good as gold (despite Nixon having just broke the US dollar’s link to gold).
Despite that, gold and oil have always traded (loosely) in unison. Viewed from that perspective, it’s not a great surprise that gold peaked and started to decline in 2011, around the same time that the US oil industry hit its straps…and brought US energy independence from the Middle East back into the equation.
That means there were less US dollars flowing to the Middle East, reducing the demand for gold.
The bigger issue for US oil independence is not necessarily the price. It’s the longevity of the wells. I’m no expert on shale oil, but the shale wells generally produce abundantly in the first few years before dropping off precipitously.
Anyway, how did gold respond to the overnight oil price drop? It sold off marginally, but the damage may have been worse if not for the shortened trading session due to Thanksgiving Day in the states.
As I write this morning, the gold price is under a little pressure in early Asian trade.
The bigger perceived issue for gold is this weekend’s Swiss referendum, where the Swiss people vote to decide whether the country should repatriate its gold and increase its gold reserves to 20%.
A yes vote would mean the Swiss National Bank would have to buy around 1,700 tonnes of gold over the next few years to meet the target. This has the gold bulls excited.
But I’m not sure you should get too carried away. As I’ve written before, physical gold demand does not set the price of gold. It’s just a very minor input into the whole gold market.
Where physical gold is important is in the ‘flow’. That is, there needs to be a physical flow of gold to underpin the huge amount of paper trading that goes on. If this flow dries up, possibly the result of hoarding because the price gets too low, then it will blow up the market and physical gold would probably move into the many thousands overnight.
That’s a low probability event though. It doesn’t mean it won’t happen, but I wouldn’t bet on it happening anytime soon with a large sum of money.
So which way will the referendum go? I asked my mate Jordon Eliseo, from ABC Bullion in Sydney, for his thoughts. He recently returned from Switzerland, and I thought he might have some insights.
Here’s what he told me:
‘I was in Switzerland a couple of weeks ago — and no one I spoke to outside the gold traders I was meeting with had heard of the referendum. Maybe they were all too busy getting ready to watch Switzerland take out the Davis Cup. Either way, I wouldn’t be surprised to be see some of the shorter term money unwind their bets leading into the weekend — just to play it safe. But the whole thing could end up being a bit of a damp squib — there’s just too much expectation that it is going to fundamentally change the gold market.’
‘Bulls will definitely be emboldened if it passes (which looks unlikely btw), whilst you could see some hedge funds go to work on the short side if it fails, hoping to book one last winning trade leading into December and Christmas bonus time.’
Look, I’m a gold bull. I hope the price goes up by a lot. I would benefit from that. But I just don’t think this is a fundamental reason to get carried away.
Gold’s time will come…but it’s a bit like the watched pot idiom. It’s not going to boil if you keep staring at it.
Lastly, RIP Phil Hughes. What a tragedy. I was a big fan of his ever since watching his amazing debut in South Africa. I felt for him in the following Ashes series and always hoped to see him back in the baggy green cap…he was due for a recall to replace the injured Michael Clarke.
It’s just very sad, and tragic for the bowler Sean Abbott. He must be devastated.
For The Daily Reckoning Australia