Erik: Joining me next on the program is Alhambra Investments Chief Investment Officer, Jeffrey Snider. Our regular listeners, I’m sure, recognize Jeff’s name. Because of course he’s been the star of Eurodollar University, which is still available at macrovoices.com/edu (edu is for Eurodollar University). That is a very in-depth examination of the Eurodollar system.
We’re going to take a look today, though, at gold – coming from a different perspective. Jeff’s experience and knowledge of the Eurodollar system uniquely qualify him to understand a bit deeper picture than you hear and read about on the internet when it comes to gold.
Jeff has provided an outstanding slide deck to accompany this interview. You’re definitely going to want to download it. You can find the download link in your Research Roundup email. If you’re not yet registered just go to macrovoices.com and look for the download instructions next to Jeff’s picture on our home page.
Jeff, why don’t we go ahead and dive right into your slide deck here? As you talk about the history of paper gold, starting on Slide 4 you talk about the “gold swap.” And I think that’s a really important concept. A lot of people know that central banks engage in these gold swaps, but, frankly, a lot of us don’t understand the backstory of why they do this, how it affects the system, and what the mechanics are.
So, what are gold swaps? Why do central banks engage in them? And how did this all come about?
Jeff: Thank you, Erik. I think the first gold swap, or at least the first recorded instance of a gold swap, is a good place to start. There were some gold swaps that happened earlier in the 19th century. But at least the for one in 1925 there is some recorded history with it and some information about it.
I think that your listeners, at least those who are interested in gold, are going to recognize the year 1925 for its significance. Which was that the United Kingdom in that year went back to the gold standard after being off of it since the beginning of World War I. Winston Churchill had insisted that, if the UK were to go back on the gold standard, that it do so at the pre-war parity. Which meant that there was significant strain in the financial markets and in the economy for doing so.
The US central bank, the Federal Reserve, stood ready to aid the Bank of England in trying to defend the pre-war parity, despite all of those of difficulties. And one of the ways in which it did was this first gold swap in 1925.
Essentially, what happened was the Federal Reserve Bank of New York on behalf of the Federal Reserve system made $200 million of gold bullion available to the Bank of England for its disposal in whatever transactions it might take in defending sterling at that pre-war parity price.
What’s important about that is that it aids both sides of the equation. Because the way a gold swap works is that, essentially, the central bank agent that is providing the gold exchanges it for what’s called a gold receivable.
If you look at Slide 5, for example, I’ve sketched out roughly what this gold swap meant. $200 million in gold was made available to the Bank of England, which it would then sell in the market for sterling at the price that it wished to defend. They put the sterling currency into an account in London on behalf of the Federal Reserve Bank of New York.
So what really happened was gold disappeared from New York and ended up as cash in the UK denomination in London. But, for accounting purposes, the Federal Reserve Bank of New York showed a gold receivable where gold used to be.
You’ve heard the expression “as good as gold.” In this case it’s literally taken to be that. A collateralized account on behalf of a counterparty central bank was, in the thinking of people in New York and London, as good as having gold.
Because if (for whatever reason) the Federal Reserve Bank of New York needed its gold back, there was sterling in an account where it could theoretically buy it back. So the gold receivable was taken as equivalent to actually having bullion on hand in a vault in New York City.
So both parties were satisfied. The Federal Reserve Bank of New York got to continue reporting the same amount in its possession, while the Bank of England was supplied additional metal in order to help defend the sterling at pre-war parity.
Erik: Joining me next on the program is Rick Rule from Sprott Global. And, for anyone who’s not familiar – which is hard to believe, because he really gets out there and explores new opportunities in the resource space, whether it’s getting off the next airplane to go look at a junior goldmine or whatever is going on, Rick has the reputation for being the guy who knows the most about it.
And, Rick, what I’d like to start with is we have so many people that are Wall Street guys, whereas you tend to be out in the field really looking at natural resources. I think this really is a different animal. It’s a different style of investing.
So why don’t we start with the big picture? How do you think about the world around you? Where is the opportunity? Why natural resource investing in the first place? And how do you approach it?
Rick: Well, I think probably every one of your specialists would suggest that they were off Wall Street in a way, but not all businesses correlate. I would of course agree with your premise that natural resource investing is different than most mainstream forms of investing.
The first is that resource investing is unusually capital-intensive, which means that it is unusually cyclical. The truth is that, in resources, the old truism: “A bear market is the author of a bull market and a bull market is the author of a bear market” is particularly true.
And that’s important to understand. Because, during periods of time when mature natural resource companies appear cheap (that is their enterprise value relative to their EBIT is low), they normally correspond with periods of very high commodity prices. Meaning that the price of the commodity is about to go down, so that the free cash flow is about to go down, so that the debt is about to go up.
When, by contrast, mature natural resource companies seem expensive on an EBIT to enterprise value basis, it’s normally when commodity prices are low. Meaning that cash flow is going to get higher and debt is going to get lower.
So it turns out that, from an investor’s perspective, the best of times herald the worst of times. And the worst of times herald the best of times.
In truth, in the 40 years that I have been involved in the game, one looks first for commodities where you believe that ongoing demand for five or ten years is assured, because of the utility afforded by that commodity to society. That is where ongoing demand is assured. Where the price of the commodity – the price that the commodity sells for worldwide – is below the median cost of production.
In other words, you buy the best producers in industries that are literally in liquidation. What that means is that you have a circumstance where, either the price of the commodity goes up, or society does without the commodity. In terms of the broadly traded commodities, the truth is that our way of life depends on commodities. And I would suggest that that’s what sets apart the resource business from other businesses.
Erik: Joining me next on the program is Eric Peters, CIO at One River Asset Management. I want to let our listeners know that we are taping this interview on Wednesday afternoon, so our conversation will not reflect anything that happens on Thursday. Normally we don’t need to tell you that, but things are happening so quickly in the market I wanted to make that point.
Eric, I think that the question on everybody’s mind is – we’re looking at the tape on Wednesday afternoon just before the close – it looks like we’re going to get back above 2,700.
Is a relatively small market dislocation just ending now? Is this all over? Or is it more the case that a really big event is only just beginning, and we’re looking only at the appetizer in a bigger story here?
Eric: I think it depends on your time horizon. If you step back, what we’re seeing is another what I would call trail marker on the path to what seems, quite obviously to me, to be a changing macro environment. I think the things that we look for most often, that are most meaningful to markets, are moves that happen, seemingly out of the blue, that lack really good explanations. This is exactly the type of move that you see when you’re in a transition phase for markets.
In other words, it’s fine for people to look at this move and say a point three increase in average hourly earnings precipitated it at 10 plus percent decline in the market out of the blue.
But I think that there’s a lot of backfitting going on. There’s no specific and good reason for this move. I think it’s reflective of some major forces changing underneath the market. That’s not to say that there aren’t buyers of the dip. There clearly are.
I think that there are still an awful lot of people in the market that are conditioned to sell volatility and to buy the dip, and I think we’re seeing that happen. But this, I think, was a very important move.
Erik: Joining me next on the program is Jared Dillian, the author of the extremely popular The Daily Dirtnap newsletter.
Jared, obviously, everybody’s mind is on the equity market this week. But I think it’s really important to bring the volatility complex into this. As you know, your friend Devin Anderson appeared on this program back on November 30th and he explained that an equity move the size of what happened on Monday could potentially blow up the volatility complex.
But I think what a lot of people have started to talk about is it may have actually been the tail wagging the dog, that what exacerbated – or some people would even say caused – this equity selloff may have been the vol complex blowing up. So it’s a question of cause and effect.
What do you think is going on here? Is it possible that vol caused the equity meltdown? Or did the rate hike cause backing up in interest rates and cause this to start?
And how do you see the interplay between what’s happened in equity markets in the last week and what’s happened with the volatility complex? And of course the XIV ETF being terminated after it blew up.
Erik: Joining me next on the program is everyone’s favorite petroleum geologist, Art Berman.
Art, I’ve got to hand it to you. The last time we had you on the program, back in October, you talked us through your comparative inventory model and you said, if I look at where we are on the yield curve it says to me that prices are headed higher. And, furthermore, we’re at an inflection point where they could head much higher pretty quickly.
And I remember being skeptical at the time. Because you’d had a lot of success with this comparative inventory price model that you have, but I kind of felt like aren’t we talking about apples to oranges?
Because in the past exports were not legal. Now that they are legal, we’re exporting a lot of oil. There’s a lot of inventory drawdowns that are not coming from a change in consumption, they’re just coming from exports. I though, does that really mean that the same model is valid? Or not?
And when we discussed it at the time you said, you’re right. It’s a different game now. But, at the end of the day, inventory is drawn down. It’s drawing down fast. And every time that’s ever happened in history before, prices have gone up. And you said you were sticking to your guns. And that’s exactly what’s happened.
So my hat’s off to you there. My question, though, is – here we are a few months later, we’ve seen this tremendous run-up in prices. Something that I’ve seen you tweet about quite a bit, as have several other people, is, that we’ve gotten to a positioning point now where there’s a 12:1 ratio of longs to shorts.
And we’ve got more record net length in petroleum products, be it WTI and Brent and so forth. This is just ripe if prices do start to go down. But everybody’s on one side of the boat.
So are you concerned about a significant downside correction at this point because of the positioning? Or do you think that we’ve got further to go higher in oil prices?