The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“We’re at a grand financial experiment where central banks and central planners have tried to do things like this, never to this scale, but somehow we are convinced that because the scale is so much bigger this time around, the result is going to be better, and I think that defines foolishness, and I think ultimately that defines a catastrophic ignorance, which will destroy people’s finances.”
– David McAlvany
Kevin: David, you are not in the studio today with me because you have been in Oklahoma City, you have been in Houston, some of the American energy capitals. I think it is interesting because we are seeing record volatility with oil right now, and it has huge ramifications, not just here in the United States, but worldwide.
David: There has been a major trend, Kevin, over the last several years, increased production here in the United States, utilizing our resources in a pretty spectacular way. Of course you know that the increase in production has come from a change in technology. Hydraulic fracturing has allowed for very quick production, unfortunately, a very quick fall-off as well, in terms of that production. They are not continuous pools, but they do give us a short, sharp increase in supply, to where now, on a global basis, we have about 2 million barrels per day in surplus, that is, a million barrels of oil per day.
And a lot of that surplus has come from U.S. production. So, if you look at Oklahoma City, look at Houston, these are boom towns where the cranes are out, the buildings are going, and refashioning the downtown area. Why? Because the money is flowing in a way that it hasn’t since the last major boom in oil. Well, clearly, the volatility of the last several weeks and several months, in particular, which really just sort of increased considerably this last week and put the brakes on, to some degree. Oil, on Sunday night, reached a low of 63.72, that is West Texas Intermediate, and Brent, which is traded more internationally, was a few dollars higher than that. But if you look at that, Kevin, that was down well over 13½ percent in one week, massive volatility for a market as large as the oil market.
Kevin: David, I remember a few decades ago that there was a behind-the-scenes war going on. If you look at OPEC, if you look at the Saudi royal family and how firmly they have been entrenched for decades as far as the controllers of the oils price, this drop in oil prices, could it also be observed that this is maybe a price war? OPEC didn’t cut production when they voted on it, and it basically is sending a signal that they are willing to produce at very low prices. Is that to force this U.S. increase in supply into the red?
David: I think that is a large part of the story. It is not the only part of the story, however, and what is important to recall, Economics 101 has two variables, supply being one variable, demand being the other, and when you look at soft growth in the emerging market, soft growth in Asia, dipping into recession in Japan, with the potential for doing so in China, looking at Europe, and clearly, they are not out of the woods. Russia is on the cusp of recession. You can go around the world, and as you see a decline in economic activity, there is also a decline in demand for oil, and so that is the demand side where there has been a fall-off in demand for oil at the same time we have had an increase in supply, and the guys here in the U.S. aren’t real interested in dropping their production. They need the cash flow, they have huge debts to pay that they have used to finance these projects, and they need every penny they can get.
Of course, they would like a higher price, but when you put something into production it is a little bit like when you have a huge barge and you want to turn it into water. You have to anticipate, and it may be three, six, nine, twelve months, before you can really turn off the tap. That is one of the reasons why the Saudis and OPEC are so critical in the short run in the oil market, because they are the ones who aren’t working on new projects, but have old, established fields and it is very easy for them to increase or decrease supplies by half a million barrels a day, a million barrels a day, and make a major difference in terms of that glut of oil that is on the market as it grows on a per-day basis.
So, the fact that in Vienna OPEC did not decrease oil production sends a very loud message to the oil markets, and it is simply this: OPEC has declared a price war. They have much greater flexibility, and of course, when you are talking about OPEC, you are really talking about the largest contributing members, those in the gulf states. When you get to the periphery of OPEC, they are suffering, but they are less of a substantive vote in OPEC – Nigeria, less of a player, Venezuela, less of a player, even Iran, and these are countries that will suffer greatly with lower oil prices.
But here is what is at stake, and it is really quite simple. Market share for OPEC has shrunk to the lowest level in 25 years, and that is in large part because of the increase in U.S. production. U.S. supplies have been increasing, and yes, that threatens Saudi and OPEC market dominance. They still are 40% of total production, but again, they have been pressured, and they have the flexibility, in terms of cost per barrel, to see the price drop and continue to make money, continue to make money hand over fist, quite frankly. That is not the same position that we are in here in the U.S., with considerably higher costs per barrel.
Kevin: Dave, their power of retaliation, let’s say that retaliation of us replacing their supply with our own, could also come in the form of currency. We have really enjoyed a sort of gentleman’s agreement, we scratch their back, they scratch ours, in that all OPEC oil has been traded in U.S. dollars. What we are starting to see is agreements between countries where they are bypassing the dollar with trade agreements that could ultimately upset OPEC, and affect the U.S. currency.
David: Let me add one thing to that, because of course we know our ability to finance our fiscal deficit has everything to do with running a trade deficit and thereby exporting dollars into the world, which causes what we have talked about in past shows as a recycling effect where those dollars get reinvested by our trade partners. It shows up as a trade surplus on their part and they take those trade surplus dollars and re-invest them, or recycle them into U.S. debt issues, like treasury bills and what not. When we decrease our trade with OPEC countries and decrease the amount of oil that we import because of an increase in production domestically, it also decreases the surplus dollars that the Saudis and other Middle Eastern countries have to recycle into U.S. treasuries. So, on the one hand our trade deficit improves if you are concerned about a large trade deficit, but on the other, that trade deficit has been very critical to back-door funding of our budget deficit.
Kevin: We interviewed Richard Duncan a couple of weeks ago. He was talking about the inputs that it takes to run this country on debt. One of the key inputs, of course, was to run this trade deficit. He sees that as critical, otherwise, we have to print the money. We have to come up with that money somewhere to buy our own debt, don’t we?
David: Yes, and so there are some positive things to U.S. production, and that, I think, is intriguing. Estimates are that production is going to be flat in 2015. If it increases, it could increase to as much as, but no more than, a million barrels per day, in addition to what we have now. Compared to the current daily surplus, that would be a 50% increase on the current surplus in the oil market. We would be going from a big glut, to an even bigger glut of oil on the market. But, as you say, there are pros and cons here.
I think some of the things that are eventually destabilizing from a global standpoint is the implications that this has for the emerging markets, the implications that this has for non-OPEC countries like Russia. Russia is going back into recession as we speak. They have better than 50% of all their financial needs as a country taken care of by taxes on trade in oil and gas, and with the price of oil and gas being low and there being tensions with Europe, and now with a canceled pipeline project, the Rosneft, which is disastrous for Rosneft, one of the largest gas and oil producers in the country. You have, basically, an unwind, financially, in Russia, like we haven’t seen since 1998 when we did use oil as a bully club. We basically bankrupted Russia by driving the price of oil down.
And what no one really notices since that timeframe is the radical change in the ruble. In the last three months, the ruble is down 25%. It is down close to 50% since 2008 and 2009, and if you roll the clock back to when we were last putting pressure on the Russians via the oil market, and I don’t know if we are, or if it is just circumstantially, and we don’t mind it because politically it does help us in some ways. You look at the differential in currency from then to now, 1998 to 2000, that time frame, the exchange rate, dollar to the ruble, five rubles for one dollar. Now it is 54 rubles per one dollar. There is a massive devaluation.
Kevin: It is interesting, Dave, as we look at this, we looked at each other when Russia went into the Ukraine, and we started saying, “Well, gosh, forget supply and demand for oil, forget price wars. Let’s forget all of this. Let’s just simply look at strategic. And what you brought out, in the late 1980s, early 1990s, driving the price of oil down to put Russia out of business, and then, of course, we increased our military spending under Reagan, as well. We increased military spending, they tried to do the same, and then we drove their main generator of income down to virtually nothing. You have geostrategic and political reasons to see that this would definitely be a power play. But let me ask you something, is there anything that your gut says about a guy like Putin, who, economically, is in a corner. Do you think he is the kind of guy who is going to do the best thing for Russia, or do you think he is the kind of guy that would push a button on a larger weapon at some point?
David: The best thing I can say is, you are not really dealing with a global player in the sense that when you think of the move toward globalization over the last 20-25 years, this is a guy with a strong sense of national identity. I don’t fault him for that, it is just merely an observation, but what is his calculus? What is going to please the global elite, or ultimately, what is best for Russia? And that could end up being more of what we have seen with Crimea and the Ukraine, as we talked about with Richard Duncan just a few weeks ago.
At this point in the deterioration of global finance, it is pretty normal to launch a war, a global war, and your war cycle studies, as we discussed with Charles Nenner, would also imply a world war, right now. Right now. And to see some pressure on various currencies, to see pressure in the commodities market, which has a huge impact for all of your emerging market economies which are very, very commodity price-sensitive, you are dealing with greater degrees of social unrest at the periphery, and the real question is, when does that social unrest at the periphery move toward social unrest at the core, where the developed countries all of a sudden are seeing the same kinds of social upset and dissatisfaction with the status quo? I am not talking a sort of Missouri-style social unrest, maybe more of what we see today in Hong Kong, but on a larger scale in Chicago, San Francisco, New York, Los Angeles, London, Paris, Rome, where there is something of a revolt from the status quo, which is in decline, which is in deterioration.
It is one thing for the guys at the top to say all is well. I am thinking of Japan this week. Not only did they get a debt downgrade, but in a recent poll amongst Japanese 70% say the economy has gone from bad to worse. Meanwhile, the guys who crafted Abe-nomics and this major monetary push, are basically dislocating their shoulders patting themselves on the back for what a great job they have done. So, the Nikkei is up, and that is supposed to be some indication of economic recovery. No, that is just speculative dollars flying wild in the stock market, and it is not an indication of how well or how poor people are doing in the general Japanese population. So, I think the great surprise for the global elite is going to be that they have believed their own B.S. so long, that when there is social unrest they are going to be scratching their heads saying, “But we felt we did the right thing.”
Kevin: I’m thinking about interest rates right now in Europe, Dave. Talk about out of step with the dangers that we have just been talking about, the bond market in Europe right now is acting as if Italy can certainly pay their bills back, Greece, you name it, Spain. These interest rates, which are a measure of people’s perception of risk of debt repayment, those interest rates are hitting record lows as we speak.
David: That’s exactly right, and again, if interest rates are an indication of risk, or classically, that is what they have been, a litmus test for risk in that particular market price where an investor is demanding greater compensation for the inherent risk in that marketplace. Well, you would have to say that there is zero risk in Italy. You have the Italian ten-year yielding less than 2%, and that with debt-to-GDP figures of north of 130%. That is not normal. Spanish ten-year debt is 1.9%. There is something askew. Something is off. And it basically is the world’s central banks trying to cover over, and trying to print their way out of what Richard Duncan described as the ultimate financial end game, and this is where you begin to see gyrations in the gold market and realize, these stakes are so high, if you are concerned about the short-term price volatility, you just don’t understand.
We are talking about global finance and a system of market normalcy that we have grown accustomed to over the last 30, 40, 50 years, which is going the way of the dodo bird. We aren’t talking about a small cyclical correction. We are talking about something that could, as we talked to Joseph Tainter, be one of those instances in history where you erase 500 years’ worth of progress. That is not taking us back to the stone age, but that certainly makes things a bit medieval. I fear that people overestimate, not only central bankers’ control, but they underestimate the extreme upside volatility in gold and silver. When the general world population figures out that, no, Mario Draghi does not have the tiger by the tail; no, Janet Yellen does not have things under control; no, the folks in Japan, printing like mad and claiming success, are actually closer and closer by the day to complete implosion.
And so, it is curious to me, I watch last week’s price volatility, gold up 50 bucks, down 50 bucks. There are extremes in the marketplace because behind the scenes you have no idea how extreme the desperation is, and it is very easy for me to sit in a position with gold and silver, knowing that this, too, shall pass, in terms of price volatility. If you understand the fundamentals, this is absolutely the right time, the right place, no better solution to the problems at hand, and again, it is for lack of wisdom and insight that the world goes headlong into things like Spanish debt, Portuguese debt, French debt. This is insane. I just came back from France, where literally, talking with French bankers, they are scratching their heads and wringing their hands, and yet, ten-year treasuries, the equivalent treasuries in France, are yielding less than 1%. 0.97%. Absolutely insane. The Irish haven’t solved their problems and yet their ten-year treasury is 1.38%. This is absolutely nuts.
Kevin: Dave, when you read stories of eye witnesses of the Titanic, one of the things that was confusing, after they had struck the iceberg, the experts on the boat understood that that boat was probably going to go down within several hours. The people who were on board, however, didn’t see really much activity as far as putting lifejackets on, what have you. In fact, if you were on a boat and something had just happened, and you didn’t realize that it was going to be terminal, if no one was putting a lifejacket on you probably would say, “Well, maybe things are fine.” That’s what the central banks seem to be doing with the bond market right now. But I think you have to pay attention to who is putting their lifejacket on. I am going to use the Dutch as an example, Dave. The Dutch interest rates right now are paying less than 1%. I think it is 0.82, something in that range.
David: On that ten-year treasury.
Kevin: But at the same time, the Dutch have done exactly the same thing that the Germans tried to do last year with their tonnage of gold that we hold here. Many European countries hold a lot of their gold here in America. But the Germans didn’t get their gold back. The Dutch were able to repatriate over 120 tons.
David: That is what they are working on right now, up to 122 tons requested, and this is the interesting thing. You will recall the major price volatility, which began in 2011, was on the heels of the Venezuelans requesting their gold delivered to them.
Kevin: What was that, about 100 tons?
David: I hate to say it, but it is as if the world of global finance still has a major underpinning of support in the gold market, and yet this is a place where not very many people have dusted out the cobwebs and looked recently: Who owns what gold? What has been re-hypothecated? Who actually has it in supply for immediate delivery? These are questions that haven’t been asked for 20, 30, 40 years, and now that they are being asked, it is like the question is asked and you immediately need a straw man. You immediately need something to distract attention and take away the pressure from those withdrawals.
So, seeing price volatility is actually becoming par for the course whenever central banks act on their suspicions about the viability and solvency of their fellow central bankers. And I think that is really what is interesting, that crazy price action and manipulations seem to coincide with central bank suspicions of one another. They have good reason to be suspicious of one another, and they have good reason to want their hands on the stuff. Ultimately, I think the history books will show this. When we look back at this chapter in world finance and economic history, we are going to say, whoever acted first were the smart ones. Whoever acted second, third, and fourth, they acted too late and they couldn’t do anything about it. There was nothing for them.
Kevin: It is not just the Dutch, Dave. The frontrunner for who may be the next president of France has also put together a request that France repatriate their gold. We saw the Swiss folks, this weekend, vote against repatriating their gold, but what we are actually seeing behind the scenes is the people who are making decisions without votes when they don’t have to vote about it, to repatriate gold, bring it back home. I think we should repeat that Germany had 1500 tons of gold here in America. They asked for one-fifth of it back, which was 300 tons, last year, and we told them that it would take seven years to deliver that gold, and only a fraction of that gold has been delivered so far. Publicly, they back-pedaled. Publicly, Germany came back out, they realized that they may have let a cat out of the bag that was very dangerous to the world economy. They came back and said, “No, I guess it doesn’t matter as much. We’re fine with the gold in America.”
David: Yes, we’ll see what letters exchange across leather-topped desks in the Netherlands, and who gets what threats, to see if the Dutch also withdraw their requests for 122 tons. I think this is high-stakes poker, and the world’s central banks are trying to keep a straight face. Watch the beads of sweat on their brow and I think that says a lot more than what they say they have in hand. What we are watching in Switzerland is very interesting. I think whoever drafted the legislation did so as a perfectionist, they did so as an idealist, and that is unfortunate, because had it been worded differently I think it would have been far better received. You had the idea of moving their currency reserves up to 20% in gold, and then they added to the legislation this very important little byline, and then from that point forward you may never sell those gold ounces. The idealist would say, “That’s right, you need something backing your currency, and you don’t want people playing games with it.”
But the Swiss National Bank has made a public commitment to peg the Swiss franc to the euro at roughly 1.2 to 1, and that relationship they need, and guard, for the sake of manufacturing viability. They need to maintain the export and compete in the global economy with a currency that is relatively cheap, or cheaper than it would be otherwise. So, the notion that they can never sell a gold ounce in order to defend that peg went over very poorly with the voter. The voter recognized the need to maintain fuller employment, and maintain growth in the economy via a weaker currency, and this is, I think, something that could have been addressed in a very different way had they given some flexibility, given perhaps a ban, an amount which they could liquidate in a certain timeframe, no more, no less, but to say, “No, we will never, ever, ever, ever sell an ounce of gold once we have reached that 20% mark,” that’s what killed it.
Kevin: It was written, really, not to pass, but I guess, to make a statement. I would like to read a quote, Dave. You probably read this yesterday. A regular guest of ours, Bill King, is talking about this lack of real physical gold and this demand, quietly, of the sovereign nations bringing it home, and here is what he said. He said, “Sovereigns, under the strain of unserviceable debt and unaffordable welfare, are issuing ginormous amounts of debt to central banks and investors. Now, some sovereigns are doing the other leg of the trade, grabbing for the gold. Some leaders obviously see solid reasons to grab for gold.” Here is how he ends that. He says, “When the global central bank sovereign bond corner ends, there will be insatiable demand for gold.” We are not talking about contracts here, we are talking about physical gold, aren’t we?
David: We are talking about physical gold. We are not talking about anything other than the physical gold. And what kind of timeframe is that? There is the system of Ponzi finance, which we have today, held together by bailing wire and chewing gum, and I suppose you could argue it goes one leg further. But we are on borrowed time already. What do I mean by borrowed time? We have gone from 2001, at 5.8 trillion dollars of national debt, to 2014, we just started fiscal 2015, and we are at 17.9 trillion. Let’s call it 18 trillion dollars in debt. And by the way, last Wednesday just before the Thanksgiving holiday, the treasury had to issue over a trillion dollars in new debt just to refinance and pay off the old debt.
Talk about a system of Ponzi finance, it is getting to the point of absurd, and yet, the general perception in the marketplace is peace, calm, everyone in the higher echelons of the world of elite finance have this all in hand. I agree with Bill King. When this corner in central bank game-playing ends, and you no longer can sustain Italian debt at 2%, no longer can sustain Austrian debt at less than 1%, Dutch debt at less than 1%, Irish debt at less than 1.4%, when these become absurd, and they are absurd, but when the market recognizes them as absurd, that is the stampede, and it is the final move in terms of gold’s long-term structural bull market. How can I even describe that as a bull market in the context of price decline? Listen, we have had the Dow move up 38% since the year 2000. We still have gold up 223% in the same timeframe.
In terms of bull market dynamics, gold has every fundamental at its back. The fact that you have had three years of weak pricing – who cares? With any amount of perspective, you realize just how dangerous it is. We are at a grand financial experiment, there are shades of familiarity where central banks and central planners have tried to do things like this in the past – never to this scale – and it has failed miserably. Somehow we are convinced that because the scale is so much bigger this time around, the result is going to be better, and I think that defines foolishness, and I think ultimately that defines a catastrophic ignorance which will destroy people’s finances.
Kevin: I think one of the things that is difficult, Dave, you put it in perspective, when we look back at the last 13, 14, 15 years, in fact, I look back at the last three decades almost that I have been here, gold goes up and down, but gold goes more up than down, period, because governments keep printing money. So yes, it goes up and down. The timing thing, though, people ask, “What’s the timing?” Last week you had Charles Nenner on, and he said, “Okay, I’m a man who does timing.” He thinks timing is right for gold, so using just that cyclical system, he said timing is right.
But going back to the analogy, Dave, let’s say we are on the deck of the Titanic, we have heard the iceberg hit, nobody is really putting lifejackets on yet, except for a few informed souls, let’s say, maybe central banks getting their gold back, what have you. But really, there is not a general panic going on at this point. I think the difficulty for people is to say, “Well, if I knew the timing when this thing would sink, then I would know when to put my lifejacket on, but that is completely impractical, isn’t it?
David: Just put it on and forget about it. The reality is, you cannot have perfect timing. And I think Buffet is very in tune with this concept. Timing never has to be perfect, but trends, you should identify a trend, and certainly, if you can identify value, then you have two things that fight for significantly higher prices and returns in the future. Kevin, we have a deflationary collapse in our midst, and we have central banks who are running printing presses à la the hyperinflationary 1920s in Germany, and that contrast is very difficult for people to grasp, that you can have both/and instead of either/or, and the central banks are doing everything that they can to maintain the status quo, while the markets, themselves, are telling you that it is not working, it is not working, it is not working. The edifice of debt is simply too large, and it has to, and is, imploding.
Oil at these levels is sending a very clear message. We have talked about the canary in the coal mine in terms of deflation, and copper dropping 6% this last week, to the lowest level since 2010, and below the critical $3 per pound level, that is significant. We have talked about the Canadian currency, we have talked about the Australian currency. These are signs and symptoms of emerging market and commodity-sensitive economies which depend on growth in the global economy for their products and goods to be purchased en masse, and it is not happening. It is simply not happening. We started out by saying, yes, we have a price war with OPEC, but guess what else we have? We also have lack of demand. At the same time there is an increase in supply on the oil front, we also have lack of demand, and that is an indication of a slowly grinding down global economy.
We have to pay attention to this. We have to pay attention to the emerging market weakness. Debt markets in the emerging markets have been terrible for the last several weeks, copper sending a very clear message, the emerging market currencies sending a very clear message, oil sending a very clear message. And I think the central banks that have figured out that this is not going to be a game that they win are doing exactly what the Dutch are doing, they are doing exactly what the Germans began a year or two ago. They are moving for the gold because they know they are in the process of rebuilding the economy. They are going to need to do that if the legitimacy of their currency, future tense, will depend on their basis, will depend on their foundation. And ultimately, when trust founders, guess what you come back to? Guess what sociologically, psychologically, financially speaking, becomes the bedrock for a new growth cycle in terms of the global economy? When trust founders, people go back to gold. It is really quite that simple.
When does trust founder? Listen, I think we are seeing it in fits and starts all over the world, and again, as you suggested, Kevin, if you are just waiting for that ideal moment just before you jump into the icy cold water and absolutely must have your lifejacket, if you don’t already have it on, you need to have your brain checked. You really do. Because you are talking about risk mitigation, you are talking about insurance. You are not talking about rank speculation on price increase, you are talking about preserving financial assets intergenerationally, in a context where these financial stresses and strains have never been witnessed on this scale before. Never.