Gold And Oil: A Long Term Play On The US Economy

If Samuel Coleridge were still around today, perhaps as an economist or a banker, he would have probably been caught saying, “Money, money, everywhere, but no one wants to lend.” Yes, this has been the theme this year ever since the Fed began cutting rates and using alternative methods to thaw out the credit markets. America is literally printing money and handing it out, yet no one is happy with what they have and are refusing to lend. Banks are unwilling to issue credit and investors are scared to buy corporate paper, leaving only the government to step in to facilitate the smooth operations of both the American and global financial system.

The credit crunch has left banks stingy and unwilling to lend, unsure whether to offer credit to populations not only across America but also across the world. Central banks across the world have simultaneously worked to pump billions of dollars into the world financial system to heat up the cold credit conditions. Unfortunately, the numerous days without sleep and the hours of painstaking negotiations have not yielded any immediate results. Many feel the problem is that banks are being told two different things: lend on one side but build up tier 1 reserves on the other.

During this time period, oil plummeted from highs of $147/barrel to below $100, leaving Russia on the verge of defaulting on the ruble, Venezuela struggling to operate with low oil, and many of the OPEC nations adjusting to a shortage of oil income. Gold also saw a massive rundown from highs around $1000 to present day prices of $868. This was after gold had retreated to the low $700 levels. Combine this sudden lack of cash inflows from oil with large scale government spending to prop up key sectors in the economy, and you have yourself a bunch of bad news.

The type of government spending witnessed today may help solve our problems in the short term, however in the long run the excess money supply will only stoke inflation. We are currently in a deflationary environment as commodity prices have pulled back, allowing the Federal Reserve and the ECB (European Central Bank) to slash rates to help offer liquidity to their respective regions. Now that we have established that money supply is ridiculously high to fix our credit problems, what can investors seek to battle this? How about gold and oil? Yes, I said gold and oil.

Since the beginning of the year through December 22nd, gold is up 2.59%, unlike the broad commodity index, the iPath DJ AIG Commodities Index ETN (DJP), that is down almost 42% during the same time period. Ignoring the underlying factors that make gold move (a topic for another discussion), this shows the resilience gold has for any economic environment, whether it be during inflationary times or present day deflationary times.

Several critics may bring up the point that TIPS would be more effective, and I will not disagree, but the idea behind investing in gold is two piece: one being that it simply diversifies one’s portfolio further, the second being that gold holds value worldwide, serving as a global inflationary hedge. Gold has returned over 180% in the last 5 years as gold bullion has had a return of over 100% in the last 25 years paired with significant tax advantages, further showing the difference between TIPS and gold.

Oil has been hammered thus far, reached highs of $147 and now trading a tad above $35. I believe this to be a GREAT time to invest in oil with such ETNs at great lows relative to the mid 2008 prices. Unlike gold, investors will have to use derivative instruments to harness the long term potential of oil. I like the U.S. Oil Trust (USO) that has been beaten down this year. The fund invests primarily in West Texas Intermediary, sweet crude oil with small exposure to natural gas and heating oil. In an inflationary environment, I believe that investors will rush to the safety of oil once emerging market demand returns. In order to understand the complexity of crude oil pricing, visit the Fundamentals of Crude Oil Pricing. Black gold will eventually face supply bottlenecks and will see price appreciation as demand skyrockets and the world realizes the true necessity of researching and developing alternative energy sources.

Before we part, it is necessary for me to reinforce the seriousness of long term inflation fears. It is extremely hard to quantify the relationship between the recent government spending binges and long term inflation. Let’s look at inflation this past summer as commodity prices rose due to the disparity between supply and demand (although many blame speculation solely). The PCE rate (less food and energy) came in at 2.5% while the CPI (including food and energy) was up a record 5.0% YOY. Imagine the long term inflationary pressures in the next 5 to 10 years once we overcome the current deflationary environment partially attributed to drastic declines in commodities and the “sudden” disappearance of wealth brought on by the credit crunch once the excess money supply rears its ugly head.

Money supply? The government has spent billions on the TARP, bailing out the nation’s financial institutions and the incoming Obama regime has plans of expenditures north of $850B to build up the aging U.S. infrastructure. Plans of even another stimulus are also brewing. There is a glut of cash out there and it is going to be extremely hard for Bernanke and his lieutenants to lap it back up as Obama pumps out more through government expenditures. In my opinion, the government must stop spending while loans should not be made to corporations outside of the financial services industry. Take my word for it, look for gold (if you can get your hands on it) and invest in oil. Speaking to a high end jeweler in Chicago, gold bars are extremely hard to come buy unless you are a large gold house due to high demand. Take my thoughts and perhaps gauge for yourself where to position your portfolio as we move towards a long period of high inflation where we will all be swimming in worthless money.

Disclosure: The author has interests in buying gold in the near future.

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