What the Strong Dollar Does to Yellow and Black Gold and Why We’re Seeing Green by Frank Holmes
The United States is doing better than it has in years. Jobs growth is up, unemployment is down, our manufacturing sector carries the rest of the world on its shoulders like a wounded soldier and the World Economic Forum named the U.S. the third-most competitive nation, our highest ranking since before the recession.
As heretical as it sounds, there’s a downside to America’s success, and that’s a stronger dollar. For the 12-month period, our currency has seen a 1.1-standard deviation move, which has put pressure on two commodities that we consider our lifeblood at U.S. Global Investors: gold and oil.
It’s worth noting that we’ve been here before. In October 2011, a similar correction occurred in energy, commodities and resources stocks based on European and Chinese growth fears. But international economic stimulus measures helped raise market confidence, and many of the companies we now own within these sectors benefited. Between October 2011 and January 2012, Anadarko Petroleum rose 58 percent; Canadian Natural Resources, 20 percent; Devon Energy, 15 percent; Cimarex Energy, 15 percent; Peyto Exploration & Development, 15 percent; and Suncor Energy, 10 percent.
Granted, we face new challenges this year that have caused market jitters—Ebola and ISIS, just to name a couple. But we’re confident that once the dollar begins to revert to the mean, a rally in energy and resources stocks might soon follow. Brian Hicks, portfolio manager of our Global Resources Fund (PSPFX), notes that he’s been nibbling on cheap stocks ahead of a potential rally, one that, he hopes, mimics what we saw in late 2011 and early 2012.
A repeat of last year’s abnormally frigid winter, though unpleasant, might help heat up some of the sectors and companies that have underperformed lately.
September Was the Cruelest Month
On the left side of the chart below, you can see 45 years’ worth of data that show fairly subdued fluctuations in gold prices in relation to the dollar. On the right side, by contrast, you can see that the strong dollar pushed bullion prices down 6 percent in September, historically gold’s strongest month. This move is unusual also because gold has had a monthly standard deviation of ±5.5 percent based on the last 10 years’ worth of data.
Here’s another way of looking at it. On October 3, bullion fell below $1,200 to prices we haven’t seen since 2010, but it quickly rebounded to the $1,240 range as the dollar index receded from its peak the same day.
There’s no need to worry just yet. This isn’t 2013, when the metal gave back 28 percent. And despite the correction, would it surprise you to learn that gold has actually outperformed several of the major stock indices this year?
As for gold stocks, there’s no denying the facts: With few exceptions, they’ve been taken to the woodshed. September was demonstrably cruel. Based on the last five years’ worth of data, the NYSE Arca Gold BUGS Index has had a monthly standard deviation of ±9.4, but last month it plunged 20 percent. We haven’t seen such a one-month dip since April 2013. This volatility exemplifies why we always advocate for no more than a 10 percent combined allocation to gold and gold stocks in investor portfolios.
Oil’s slump is a little more complicated to explain.
Since the end of World War II, black gold has been priced in U.S. greenbacks. This means that when our currency fluctuates as dramatically as it has recently, it affects every other nation’s consumption of crude. Oil, then, has become much more expensive lately for the slowing European and Asian markets. Weaker purchasing power equals less overseas oil demand equals even lower prices.
What some people are calling the American energy renaissance has also led to lower oil prices. Spurred by more efficient extraction techniques such as fracking, the U.S. has been producing over 8.5 million barrels a day, the highest domestic production level since 1986. We’re awash in the stuff, with supply outpacing demand. Whereas the rest of the world has flat-lined in terms of oil production, the U.S. has zoomed to 30-year highs.
In a way, American shale oil has become a victim of its own success.
At the end of next month, members of the Organization of the Petroleum Exporting Countries (OPEC) are scheduled to meet in Vienna. As Brian speculated during our most recent webcast, it would be surprising if we didn’t see another production cut. With Brent oil for November delivery at $83 a barrel, a four-year low, many oil-rich countries, including Iran, Iraq, Venezuela and Saudi Arabia, will have a hard time balancing their books. Venezuela, in fact, has been clamoring for an emergency meeting ahead of November to make a plea for production cuts.
Although not an OPEC member, Russia, once the world’s largest producer of crude, is being squeezed by plunging oil prices on the left, international sanctions on the right. This might prompt President Vladimir Putin to scale back the country’s presence in Ukraine and delay a multibillion-dollar revamp of its armed forces. When the upgrade was approved in 2011, GDP growth was expected to hold at 6 percent. But now as a result of the sanctions and dropping oil prices, Russia faces a dismally flat 0.5 percent.
Volatility Has Returned
The current all-in sustaining cost to produce one ounce of gold is hovering between $1,000 and $1,200. With the price of bullion where it is, many miners can barely break even. Production has been down 10 percent because it’s become costlier to excavate. As I told Kitco News’ Daniela Cambone, we will probably start seeing supply shrinkage in North and South America and Africa.
The same could happen to oil production. Extraction of shale oil here in the U.S. costs companies between $50 and $100 a barrel, with producers able to break even at around $80 to $85. If prices slide even further, drillers might be forced to trim their capital budgets or even shelve new projects.
Michael Levi of the Council on Foreign Relations told NPR’s Audie Cornish that a decrease in drilling could hurt certain commodities:
[I]f prices fall far enough for long enough, you’ll see a pullback in drilling. And shale drilling uses a lot of manufactured goods—20 percent of what people spend on a well is steel, 10 percent is cement, so less drilling means less manufacturing in those sectors.
At the same time, Levi places oil prices in a long-term context, reminding listeners that we’ve become accustomed to unusually high prices for the last three years.
“People were starting to believe that this was permanent, and they were wrong,” he said. “So the big news is that volatility is back.”