Gold, Oil and a Weaker Economy Jude Wanniski August 20, 2004

In two previous reports this week, we covered the reasons oil has been  marching toward $50/bbl. while the trading specialists in oil believe that  the price should be closer to $35 or even lower. At 1.2 trillion bbl in  proven worldwide reserves, there certainly is plenty of oil. However, where  OPEC producers (the Saudis in particular) had managed oilfield development  to assure an excess capacity of at least 5% of world consumption in past  years, there now is almost no excess capacity. The world now is consuming 81  million barrels per day, or almost 30 billion barrels per year.   

We now believe that geopolitical risks are not the primary reason for  the high oil price, and elimination of those risks will not bring that much  relief. That will come only if those countries that have the undeveloped  reserves decide to devote the financial resources necessary to bring fresh  reserves to market. Already, Saudi Arabia has announced that it soon would  tap an oilfield that it had not intended to develop for another year or two  and these lofty prices are an economic inducement to other countries to do  the same. Oilfields that had been tapped out at lower prices are being  brought back into production elsewhere, with more expensive extraction  methods justified at this level. This will all take time, but there should  be a point in the very near term when this news alone will turn the oil  market to at least the $40 level. This should be sufficient -- everything  else being equal -- to invite a catch-up on the excess-reserves front.   

How long will that take? That depends primarily on monetary policy  here in the United States. If the higher dollar oil price is watered down by  a higher dollar gold price, which is happening now with gold jumping to $413  today, there would be less incentive for the world oil industry to tap into  reserves. The reason oil went to $12 from $3 in 1973 was the recognition by  Aramco that gold`s rise to $140/oz. from $35/oz. had led to a quadrupling of  commodity prices and they were losing out at the $3 price, which had been  steady in its relationship to gold since the Bretton Woods agreement of  1944.   

Fed Chairman Alan Greenspan - who has a lifelong appreciation of gold as the primary information signal on inflation - should have persuaded President  Clinton that monetary policy should be used to stabilize gold at $350 when  it came through that range in early 1997 on its way to a deflated $255 in  2001. However, Greenspan looked the other way, and presided over the  consequences of the worldwide deflation, given the fact that so much of the  world linked their currencies to the dollar or at least keyed off the  dollar. Oil was driven down to $10/bbl. and an oil industry that had been  counting on oil over $20 to justify capital expenditures for further  exploration and development pulled in its horns and stopped spending. To  this day, the industry and those who provide its finances, are reluctant to  make long-term commitments. They do not know how soon and how far oil will  fall in the next cycle, should this "bubble" burst in a recessionary slide  of global proportions.   

Gold`s rise to today`s $413 from $380 during the past several months is  coincident with the Fed`s decisions at the last two FOMC meetings to raise  the federal funds rate from 1% to 1.5%, in order to head off what it believed to be an incipient inflation. We questioned the reasoning because  we were worried that the mechanism is designed to slow the economy, not to  prevent inflation. To the extent a higher funds rate would supply less  liquidity to the banking system, it also would cause the business community  to demand less liquidity in what they would perceive as a weakened economy.  I posited that an ever-higher funds rate might be accompanied by a rising  gold price, a vicious cycle that would not end until Greenspan & Co. found  the "natural" interest rate they say would be sufficient to stop inflation  without damaging economic growth. There is, as you can see, an intellectual  inconsistency here, which is why Greenspan cannot say when that natural rate  will be reached, or how we will know how long it should remain there when it  is reached.   

Treasury Secretary John Snow, who has the misfortune of not having any  grounding in monetary theory, has been showing up on the financial news  networks to assure everyone that the economy is still strong and that it  will continue to expand. With President Bush`s re-election at stake and the  GOP convention in New York City next week, there is every effort being made  to put the best face on the statistics being churned out on the state of the  economy. To be sure, the economy is still in an expansion mode, benefiting  from the tax structure on capital put in place last year. The economists who  say the 2003 tax cuts did give the economy a boost, but have run out of  steam do not understand that when an efficient tax structure is put in place  it does not stop inviting fresh growth. Most of the recent disconnect comes from the difference between the Establishment Survey on job growth, which  has been so-so, and the Household Survey, which has been robust. The Household Survey is the more accurate of the two because the bulk of the  expansion has been the result of the more favorable capital tax structure,  which favors entrepreneurs and business start-ups whose jobs don`t make the  Establishment Survey. Senator Kerry and his team are barking up the wrong  tree on this issue and cannot benefit from it at the polls.   

In the aggregate, the electorate knows how many people are employed without  reading the papers. While individuals may answer pollsters with concern  about jobs, having heard the Democratic pitch on political ads, when they do  vote, those concerns are outweighed by reality. There is a genuine concern  about the availability of "better jobs" with higher wages and health  benefits, issues that flow from the new "globalization paradigm" that I  addressed earlier this year, but these concerns cut both ways when neither  political party is presenting the electorate with practical ideas on how to  address them.   

I will be writing a second installment on the Presidential race next week  after sizing up the realities of the GOP convention, but this report is only  meant to assess the cross-currents in the financial and commodity markets.  At this point they suggest slightly weaker economic growth during the coming  months, but concerns that if gold continues to misbehave, the Fed soon will  face inflation statistics that will lead to further errors in trying to  stamp out rising prices with ever higher interest rates and even weaker  economic growth.