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April 04, 2005

Of Oil and Silver
by Yi-Chang Wang

I was planning to write on another precious metals related topic and had been busy about other projects. Therefore, I will keep this article succinct. But before I go on discussing the topic of oil, I want to point out that I respect John Mauldin's work. I had always find his works fascinating and full of useful details for investment and financial management. However, his most recent article, "$100 Oil is the Solution," alarms me a bit.

(Just About) Everyone Knows

To be fair, the event is really not Mr. Mauldin's doing. Mainly it's that of Goldman Sachs. I was alarmed specifically about Mr. Mauldin's quoting of Goldman Sachs analyst's projection of $105 oil. I had received phone calls from my relatives who reside in East Asia citing this report. And they are not financial professionals!

I do, however, take the writers of this website (and writers of other websites that also post my articles) as financial professionals. Therefore, the consensus opinion of financial professionals as a whole, while not necessarily correct, would probably have a greater chance of being correct. As far as I am aware of, quite a few writers (too numerous to mention) had written, or hinted, that a possible commodities top is around the corner. And this may include oil.

Long-Term Bull

It's not the purpose of this article to criticize oil bulls. For one thing, I count myself in that camp. In fact, I am even more bullish than Mr. Mauldin is on oil. As far as I know the analyst who may be closest, in projecting the long-term oil price, is Kurt Wulff.

My reasons are as follows: First, I assume that there is a long-term bull market in the commodities. Many writers had already written on the arguments (China, India, monetary inflation, geopolitical risks, etc.) And there is likely to be a raging bull market very similar to that of NASDAQ in the 'Nineties. Under such circumstances, intuitively, in the early stage of the bull market, I assume that even the most bullish analyst can underestimate the price of oil. Among the analysts and writers that I had read on oil, Kurt Wulff has the highest target. In his March 22nd report page 2, he still sticks by his forecast of three to five times increase in oil price over the next five to thirteen years. For the entire week that ends at Friday, the First of April, oil trades above $50. Multiplying five to $50, we obtain a maximum projection, from Mr. Wulff, of something like $250 for the long-term.

And even this projection stands the possibility of being exceeded on the upside!

Canadian Tar Sands

I must point out that many analysts, as well as Mr. Mauldin, have pointed out the abundance of Canadian (and Venezuela) tar sands as an important reason to dampen the enthusiasm about oil. This point is often used to counter against the "doom's day" view of "we are running out of oil."

I must point out that this type of discussion misses an important point. That is: we are not running out of oil, but we are running out of cheap oil!

There are stories abundant that the OPEC may be very close to their capacity constraint, assuming that they are politically stable. And even though the production costs of oil from tar sands going down, it's reasonable to assume that the costs of oil production are likely to hit a permanently higher ground. Add to that the effect of monetary inflation on the costs of oil production, we have a truly bullish long-run scenario of oil price. Price simply has to catch up to a higher plateau of long-run costs of oil production.

I personally think that unless there's a major breakthrough in nuclear fusion technology, we are unlikely to see a termination of oil bull market.

As for relatively cheaper substitutes such as ethanol, one must look at all energy substitutes to get a more balanced view. For example, although ethanol and natural gas stayed relatively cheap or experienced relatively contained rising market, the large and rapid rise in price of coal and uranium stocks should also be taken into consideration. The energy market, as a whole, is truly tight such that the markets of some substitutes are already showing rapid rise in price. How long will it be before the prices of ethanol and natural gas rise rapidly as well?

Short-Term Bear

And that's what worries me. It seems to me that the mainstream media had already caught up with this story, just when oil had made a significant up swing. Even uranium stocks are making their way into research departments of mainstream brokerage houses (see Doug Casey's "Update on Uranium"). Personally, I am bearish about oil in the short-term; meaning about the next 12 months or so. However, rather than selling one's oil (and oil stocks) out right, I recommend a safer play. I have greater confidence in making this call.

Conclusion

I will conclude by saying that oil investors are in a quintessential relative value opportunity. The gold-oil ratio is already indicating a screaming value of gold relatively to oil. A few writers had already illuminated on this topic. On top of that, silver remains relatively cheap (or very cheap, depending on one's stand toward the issue of silver remonetiziation) compares to gold from a historical perspective.

Oil bulls should take note. The highest oil-to-silver ratio occurred around 1974-76. Oil prices stayed in the range of $12-$15 due to Arab Embargo of Yum Kippur War in late 1973, while silver traded between $4 and $6 per ounce during the same period. That's a maximum oil-to-silver ratio of 3.75 (=$15/$4), the peak of this ratio during the 'Seventies. As of last Friday, April the First, West Texas Intermediate Crude closed at $57.27 while silver on COMEX closed at $7.00. This works out to an oil-to-silver ratio of 8.18!

Another perspective is that as of last Friday, Yahoo Finance Energy Sector has reported market capitalization of all companies in the sub-sectors, Integrated Oil & Gas, Operators, and Services/Equipment Providers as $1623.6 billion, $469.6 billion, and $254.5 billion respectively. That's a combined market value of $2347.7 billion. 0.1% of this gigantic capitalization, or $2.34 billion, can overwhelm the current reported physical silver inventory in COMEX warehouse of 102,083,935 ounces, which works out to a current total value of $715 million. So less than 0.1% of oil & gas companies combined market value can take out the world's largest verifiable above ground silver inventory!

Let me state this that I am writing this not because that I am a silver advocate. Yes, I am a silver advocate. But what drives me to write this article is the very cheap valuation of silver to that of oil. It just seems to me that allocating at least a portion of oil or oil stocks investments to that of physical silver is a wise decision at this moment.

Yi-Chang Wang

DISCLAIMER: The author is not a registered stockbroker nor a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, the author recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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