Black Gold or Bubbling Crude?

by

Ross M. Miller
Miller Risk Advisors
www.millerrisk.com
May 24, 2004

Oil is trying to hold above $40 a barrel. With 42 gallons to a barrel, that translates to almost $1.00 a gallon. Even at its all-time highs, oil is still cheaper than the $1.39 that my local supermarket charges for a gallon of name-brand spring water that probably does not come from a spring. The first time I ever heard oil referred to as "black gold" was in the overture to the Beverly Hillbillies, but have you ever considered what a gallon jug of gold might cost? At Friday's close of $384 per troy ounce, it works out to a bit more than $900,000. (There are 2,349 troy ounces of gold to a gallon.) That makes oil—dead dinosaurs in their most toxic form since they chased Raquel Welch—seem more like black water than black gold.

To read the papers, one could get the impression that a rising price of oil was "baked into the market" just as a string of Fed funds rate hikes is already baked into the fixed income markets. A quick look at the futures prices for oil tells a rather different story. On Friday, December 2004 NYMEX light, sweet crude closed at $37.91 a barrel, more than $2 below the close in the spot market. For oil to be delivered next June, the price goes down to $34.71. If you can wait until December 2008, you can get it for $29.37. Economists call this pattern of decreasing futures prices "backwardation"—possibly the ugliest word in the English language, though an apparent favorite of John Maynard Keynes.

As it has been and likely always will be, the reverse is the case for gold—future gold is more expensive. December 2004 Comex gold closed on Friday at $389 an ounce and June 2005 gold closed at $394.50 an ounce. If you want your gold delivered in June 2008, be prepared to pay $439.40 an ounce today.

That gold costs more as time slips into the future reflects the cost of carry. To transport gold from the present into the future one has to finance, insure, and store it. The recent increase in the financing cost is what has driven the spot (current) price of gold down and dragged the futures with it.

I dubbed the previously prevailing wisdom that higher interest rates would not only drag bonds down but would take everything else (notably, equities and gold) down with it the it's-all-one-market meme in an earlier commentary. Well, it looks like it's not one market anymore. For oil and some agricultural commodities that rose smartly while rates were climbing, it never was. The new challenge facing the struggling bull market in stocks is oil.

The backwardation in oil prices is very telling. Under normal circumstances, oil prices, like those of gold and most other commodities, also march upward over time if one overlooks the seasonal hiccups. Recent circumstances are anything but normal. The fear of a disruption in the flow of oil, especially one resulting from a range of possible problems in Iraq (or, even worse, Saudi Arabia) has spooked the market. The rational response to being spooked is to hoard oil and refined petroleum products, especially gasoline, as a hedge against a disruption. A shortage of domestic-grade gasoline in the U.S., which requires not just crude oil but somewhere to refine it, is an extreme form of the kind of bottleneck that I warned could derail the bull market and turn the incipient inflationary boom into a stagflationary bust.

While statistics from the oil industry show that inventories are increasing, these numbers understate the hoard of petroleum products that is being created. The same inflationary psychology that I posited would keep the economy (and the stock market) rolling along for some time to come could be behind the current rise in oil and gasoline prices. (I know that is what the Saudis have been saying all along, but they could be right.) Petroleum industry inventory numbers do not account for the substantial stashes of gasoline being kept in the SUVs, Hummers, and RV that dot America's highways. As consumers become conditioned to seeing prices rise steadily, they will tend (whether they consciously realize it or not) to buy more gasoline sooner. One consequence of this behavior is an increase in the inventory of gasoline held in their gas tanks. While those who live from paycheck to paycheck may be running on empty much of the time, their drop in demand is more than offset by the hoarders.

The backwardation in oil prices indicates that as grim as a major disruption in oil would be, the market is telling us that the more likely possibility is an increase in the supply of oil. In that case, oil prices would not take years to inch their way back to $30 a barrel. On the contrary, they would crash their way through $30 and not be inclined to stop there. Once prices start going down, they have a tendency to snowball as speculators bail out and drivers stop rushing to fill their tanks and wait for prices to drop further.

And, so what of the stock market? Just as rising oil prices have weighed on the market, a return to lower prices would give the market a boost at the perfect time, as any conspiracy theorist will tell you. If one leaves the usual set of geopolitical worries aside, the biggest problem that the bull market faces is a transformation of inflation from a benign stimulant to a problem of Volckerian proportions. Lower energy prices, which in turn ease pricing pressure on others goods, are the prescription for keeping inflation in check and the economy rolling along. (Side note: Expect an upward revision in first quarter GDP.)

Currently, the stock market is phlegmatic—the best that can be said of it is that it has not fallen significantly in the face of three weeks of largely dreadful news. If we avoid disaster and oil prices turn the corner, stocks could head up in a hurry.

In honor of Memorial Day, I will take a break from my cheerleader role and philosophize a bit in my next piece, "Open Your Eyes," which will hit the Web on the morning of Tuesday, June 1.

Copyright 2004 by Miller Risk Advisors. Permission granted to forward by electronic means and to excerpt or broadcast 250 words or less provided a citation is made to www.millerrisk.com.