This is chapter VII of the Gold Drivers 2005 report. It discusses the historical Gold/Oil ratio which suggest a price of Gold exceeding $700 nowadays and shines a light  a light on previous oil shocks and their consequences. Furthermore it discusses PEAK-OIL and why it is about to bring a nasty Oil shock coming years.

As we will see, previous oil shocks were a perfect call for higher inflation figures and recession. Will this time be any different ? According to Alan Greenspan yes, he says that higher oil prices won’t be much of a problem for the economy these days and inflation won’t pop up as during the seventies. Well, energy experts such as Mathew Simmons and Colin Campbell do think otherwise. They make a powerful case for the end of cheap energy. The nasty consequence of a lack of cheap energy is the end of economic growth. Will we ever come out of a recession again for a sustained period of time ? Well, Richard Heinberg author of “The Party is over – Oil, War and the Fate of Industrial Societies” doesn’t think so. Matthew Simmons (energy advisor for Dick Cheney) just uses different words, he says :

“ there is not one serious economist in this world who would say that you can have significant economic growth without the availability of cheap energy.” END.

Simmons rules out the possibility of cheap energy coming decades. When asked if there is a solution to the impending energy crisis he said :

“I don’t think there is one. The solution is to pray. Under the best of circumstances, if all prayers are answered there will be no crisis for maybe two years. After that it’s a certainty.” END.

We’ll have to get used to oil prices far exceeding the $100/barrel mark. This leads us to the Gold/Oil ratio which is at an historic low these days. Such imbalances won’t stay there for a long period of time so what gives ? Oil going down or Gold catching up ?

Let’s focus on the following issues :

• Previous Oil shocks and their consequences
• Gold as a financial protection against coming Oil shock
• PEAK-OIL and the end of cheap energy

Previous Oil shocks and their consequences.

Stephen Leeb (president of Leeb Capital Management and editor of the prestigious newsletter ‘The Complete Investor’) wrote an excellent book this spring called ‘ The Oil Factor – Protect Yourself (AND PROFIT) from the coming Energy Crisis’. In this book he explains how to use the Oil indicator in order to predict upcoming stock bear markets and economic recessions.

In an interview with Jim Puplava on the Financial Sense Newshour Stephen Leeb says :

It’s so easy, nothing has been a more reliable indicator for an upcoming recession as the price of Oil. Every major bear market, every major economic decline has been preceded by a large spike in oil prices. The  73-74 recession, recession of beginning 80’s and the recession of  2000. Oil prices jumped 80% between 1999 and 2000. Oil prices have been the most important indicator of major economic disasters. Whenever Oil prices rises about 80% from year ago levels, a fair chance does exists that a recession/bear market will follow. END.

So any sudden increase in the price of Oil should be something to fear or at least pay serious attention to it. Furthermore Stephen Leeb warns for the rapid rise in the price of Oil in the face of a less rapid growing demand. He says :

When you are facing rising commodity prices in the face of a declining or less rapid growing demand, it tells you something. It tells you that you can’t count on the supply being there when needed. It tells you that the world has changed. END.

It tells you that the world has changed. Stephen Leeb sounds serious, maybe even a bit alarming. What consequences Stephen Leeb expects from rapid rising Oil prices ?

Stephen Leeb says :

Sharply rising energy prices, similar the the 70’s, will lead to double digit inflation figures  over the next 10 years. It’s going to turn the economy on its head.END.

But wait, the FED can fight inflation by engineering a recession (rapid increase of interest rates) as former FED chief Paul Volcker did in the early 80’s right ?

Stephen Leeb says :

Today, we cannot engineer a recession. In 1980 when Paul Volcker took over the head of the FED, he was able to say : Well, inflation is at 12%, I don’t care what it takes, I’m getting Inflation down and he was willing to engineer a big recession.

Today because of all that debt, that’s not a policy alternative. Sure , the FED will raise interest rates a little bit here and there but not in such a dramatic way to create a recession. In the face of the giant total US debt, a recession would be a catastrophe. END.

Stephen Leep’s Oil indicator has worked remarkably well over the last 30 years. If this Oil indicator is going to perform as well in the future as it did before than investors should be on high alert for possible nasty future economic events and be prepared to take appropriate measures in order to protect themselves financially.

Gold as a financial protection against coming Oil shock

So why to buy Gold when Oil prices are rising rapidly ?

The reason for this is two-fold :

• Gold as an Inflation Hedge
• Gold/Oil ratio says Gold is a screaming Buy.

Gold as an Inflation Hedge

Gold is being considered as the ultimate Inflation Hedge. The most obvious example is of course the 70’s whereby Gold really took off when inflation kicked in.

In 1977 when inflation began to pick up steam it reached 9% by 1978. Gold followed by breaking its previous high of $200. When Inflation hit 10% in 1979, Gold really took off skyrocketing to $500.  Excitement kicked in and a Gold rush mania  launched the yellow metal to its all time high of $850 in 1980.

In times of Inflation you are losing money by holding paper money. A flight from paper money into real money (Gold) is just a logical result.

The Gold/Oil ratio

The Gold/Oil ratio says Gold is a screaming Buy.

Over the last 30 years Gold has been trading at an average of 16-17 barrels of Oil per ounce of Gold. At the moment Gold is dirt cheap compared to Oil and trades for about 9 barrels of Oil for an ounce of Gold. Such extremes won’t last for a long period of time so what gives, lower Oil prices down the road or Gold catching up ?

According to Matthew Simmons we shouldn’t count on cheap Oil anymore coming decades. Let’s repeat once more what he said when asked if there is a solution to the impending energy crisis he said :

“I don’t think there is one. The solution is to pray. Under the best of circumstances, if all prayers are answered there will be no crisis for maybe two years. After that it’s a certainty.” END.

So with these kind of statements in mind, would you bet on lower Oil prices or higher Gold prices ? (see chart below)

OK, fine you’ll say, higher Oil prices should make a case for Gold indeed but how serious are those people screaming about the end of cheap Oil ? Should we take their claims seriously ? Why hasn’t the mainstream media hardly picked upon it ? Why didn’t we hear anything about it during the presidential debates ? I’ve heard that at least for the next 30 years there should be plenty of Oil, what about that ? Well, many questions which deserves serious attention.

PEAK-OIL and the End of Cheap Energy

Alarmist preaching a peak in oil production within a few years are referring to studies by Shell geophysicist Dr. Marion King Hubbert. Hubbert predicted already in 1956 that US domestic Oil production would peak around 1970. Unfortunately Hubbert wasn’t taken seriously at all. But what happened ? US Oil production indeed peaked in 1970 as predicted by Hubbert but still it took many years before geologists were willing to admit that Hubbert was right and that US Oil production indeed had peeked in 1970.

So based on what theory Hubbert made his predictions and how reliable is this  theory in order to predict a future peak in world wide oil production ? It goes far beyond the scope of this article in order to explain the scientific background of PEAK-OIL  (Hubbert’s Peak) , it’ll just focus on its conclusions backed up with data available for the last 100 years.

Hubbert says more or less that oil discoveries and oil production do follow a so called Bell Curve. The production curve follows the discovery curve with a 40 year delay.

Prof. Kenneth Deffeyes who wrote the book ‘Hubbert’s Peak – The Impending World on Shortage’ explains in detail the scientific background of Hubbert’s theory. But let’s focus on just two important issues here :

·         Oil discoveries do follow a Bell Curve

·         Oil production does follow a Bell Curve with a 40 year delay compared to the discovery curve.

OK, fine you’ll say, but what does actual data regarding oil discoveries and oil production tell us so far ? Could Hubbert be right ?

Dr. Colin Campbell is most probably the dean among Hubbert’s followers. He worked for Texaco and Amoco as an exploration geologist working in countries as Borneo, Trinidad, Colombia, Australia, Papua New Guinea, the US, Ecuador, the UK, Ireland and Norway. Later on he was associated with Petroconsultants in Geneva, Switserland and brought about the creation of the Association for the Study of Peak Oil (ASPO). Dr. Campbell did a tremendous amount of research regarding Peak-Oil and published his findings in his book ‘The Coming Oil Crisis’. His findings indeed confirmed what Hubbert predicted so many years ago.

Let’s focus first on data available regarding world wide Oil discoveries. We’ll see that the peak of Oil discoveries already occurred in the 60’s, see chart below :

Now please digest this carefully. If Hubbert is right then the world Oil production should peak somewhere during this decade (40 years after discovery peak). But the problem is that you can’t say with certainty that Oil production indeed has peaked until several years after the fact. So the only thing we can do is to analyze the production curves of oil producing countries which had a discovery peak way earlier than the 60’s. A good example is the US which saw it’s discovery rate peaking during the early 30’s. Hubbert concluded that the US therefore should experience a peak in Oil production somewhere during the early seventies. At the time Hubbert made that prediction in 1956 he was ridiculed by Oil experts and economists, but nevertheless Hubbert’s prediction came true in 1970, see chart below :

So the US Oil production peeked in 1970 indeed and declined ever since then just as Hubbert predicted.

When examining the production curves of all Non-Opec countries combined we’ll see a production curve which matches the predicted Bell Curve almost 100%. See chart below.

So what do we see so far :

• US Oil production already peaked in 1970.
• Non OPEC Oil production already peaked in the early 90’s.

What does it tell us ? It tells us that the world oil production still hasn’t peeked because OPEC Oil production still hasn’t peaked. So in order to make predictions about world peak production one should focus on the main OPEC producers.

So when will OPEC peak ?

According to Bush energy advisor Matthew Simmons OPEC will peak when Saudi Arabia peaks.

So what about Saudi Arabia ? When will Saudi Arabia peak ?

Matthew Simmons says :

When Ghawar peaks (Ghawar is the largest oil field ever found) Saudi Arabia peaks and when Saudi Arabia peaks the whole World peaks. END.

But the problem is that Ghawar is aging rapidly. It’s one of the oldest Oil fields in production and lots of water injection is needed in order to keep production going. At one moment more water injection won’t be able to keep production going and Oil production will fall off a cliff meaning the Oil field dies.. According to Matthew Simmons, the end for Ghawar must be near. It goes far beyond the scope of this article to specify why Matthew Simmons does think so but interested readers can study Simmons findings themselves at :

Matthew Simmons : Saudi Arabian Oil – A Glass Half Full Or Half Empty

http://www.simmonsco-intl.com/files/Hudson%20Institute.pdf

So with the peak of world Oil production in sight, what kind of production curve could we expect for total World Oil production ?

Dr. Colin Campbell calculates the following production curves :

Any case whether it’s the  high case, base case or low case, what should be obvious is that the end of World Oil production increase is near. A World which requires ever increasing amounts of energy (eg China, India, increasing world population etc…) and facing a limit in increasing Oil production simply has to face an increase in Oil prices. It simple as that. Demand outstrips supply by a great margin coming years. Yes, people arguing that there is still Oil left for 30 years, they are right. The Earth contained approximately 2 trillion barrels of Oil. We just consumed 1 trillion barrels of Oil by now so still 1 trillion barrels of Oil to go. With current demand of 80 million barrels a day it’s easy to see why people come up with an estimate of another 30 years of Oil supply. Again, it’s not the problem of No Oil, but it’s the End of Cheap Oil what causes economic turbulence. Matthew Simmons says that Oil prices exceeding $100 / barrel is unavoidable and that should be a wake up call for all investors out there because the end of cheap energy could lead to an unwelcome economic slowdown.

Highlights :

·         Oil discoveries have peeked already 40 years ago

·         According to M King Hubbert Production peaks follow Discovery peaks after approximately 40 years.

·         US Oil production already peaked in 1970.

·         Non OPEC Oil production already peaked in the early 90’s.

·         World Oil production will peak when OPEC peaks

·         OPEC peaks when Saudi Arabia peaks

·         Saudi Arabia peaks when Ghawar peaks

·         Ghawar is aging rapidly and its life expectancy isn’t rosy. Matthew Simmons says that the end is in sight.

·         World Oil peak production means the End of Cheap Oil

·         The End of Cheap Oil means continuing rising Oil prices which translates itself into Oil shocks.

·         Previous Oil shocks were an perfect call for recession/Inflation

·         Gold is the ultimate Hedge against Inflation

·         Rising Oil prices brings the historical Gold/Oil average way out of balance

·         Historical average of the Gold/Oil ratio suggest a price of Gold exceeding $700 nowadays.

Historical average of the Gold/Oil ratio suggest a price of Gold exceeding $700 nowadays. Please think about that !

NOTE : I’m a bit behind schedule but I’ll try to finalize the entire report before Christmas. Next week Chapter II ‘Gold & Inflation, Interest rates and negative real rates’. Readers interested in the entire report can drop a mail. I’ll send the entire report in PDF format somewhere in December.

Eric Hommelberg

ehommelberg@planet.nl

December 05, 2004

-- Posted Sunday, 5 December 2004 | Digg This Article