FOUR PROBLEMS

featured in Resource Stock Investor, Sept 2006

 

These are momentous times for mining and one hardly knows where the next explosive news item is going to come from.  Will it regard international terrorism, will it come from renewed conflict in the Middle East, will it affect our world of petroleum, will it be a further difficulty for the United States - particularly for the US Dollar - or will it be some news story about the fundamental demand for minerals, coal, metals and even human expertise which is coming out of newly advancing nations such as China, India, Brazil and Russia?

 

The object of this article is to anticipate future price action in the base and precious metals by identifying four relatively new and powerful trends which have been growing in importance during recent years and all of which appear to defy easy solution.  These trends appear likely to impact the future price of both base and precious metals in a favourable manner over time.  They are:

 

INTERNATIONAL TERRORISM, particularly how it affects international transportation networks as well as the supply of petroleum around the world;

 

THE GROWING VULNERABILITIES OF THE UNITED STATES in two primary directions; namely petroleum and matters relating to the growing mass of American greenbacks in the form of debt obligations now piling up in foreign holdings around the world,

 

THE powerful increases in fundamental demand for raw commodities of all sorts, but particularly for the base and precious metals being created by, as the title to an important new book would suggest, “THREE BILLION NEW CAPITALISTS”, and

 

THE WORLD OF PETROLEUM which is undergoing a supply/demand transformation such as has never occurred in history.  It is this writer’s strong belief that demand will exceed supply by a growing margin in coming years, thereby putting upward pressure on prices and reigniting fears of rising inflation along with growing economic dislocations.

 

Let’s discuss each one in order......

 

We can define “International Terrorism” as acts that are inter-connected in purpose and which affect the entire international community.  Some examples would include the bombing of two American embassies in Africa in the late 1990’s; the massive and unprecedented attacks on America on 9/11, 2001; the bombing of trains in Madrid, London and Bombay along with the destruction of the night clubs in Bali or the recent threats to international air transportation.  All of these episodes, events, tragedies are interconnected.  All of them are part of the struggle of international Islam.

 

These acts of terror appear to have the goal of disrupting the social order of the West and the manner in which we have become accustomed to living.  Thanks to these international terrorist events, great changes are taking place in air travel, in international commerce and in the international political community.

We have seen that the threat of sudden acts of sabotage is real and the people who engage in this type of international terrorism to date have accepted no limits in the scope of their activities.  International terrorism has created, therefore, what can best be termed as an economic risk premium that wise investors must hedge against.  Importantly, this rising risk premium shows up as higher petroleum prices and also in higher gold, silver and platinum quotes because international terrorism affects the stability of currencies and, historically, one of the most successful ways to hedge against instability of currencies is to invest in precious metals.

 

The second important consideration is the growing vulnerability of the United States of America.

 

Anyone over the age of 60 can recall a long-lasting era when the United States dominated the rest of the world, not by military conquest, not by politically taking over nation after nation, but by the reality that American goods were the best in the world and they were desired everywhere.  The U.S. Dollar was the kingpin of international currency transactions, the United States took in more wealth than it paid out and the United States asset base grew stronger and stronger.  America manufactured the best televisions, automobiles, appliances and even textiles and clothing.  The fact that these kind of items dominated domestic and international retail merchandising gave the American dollar immense strength and stability as it rested on the powerful, fundamental strength of the American economy. 

 

However, all of that has changed dramatically.  In terms of manufactured goods America no longer supplies the world with an abundant array of quality merchandise.  Instead, the world supplies America.  The United States runs staggering trade deficits against nation after nation.  In many nations where a variety of quality goods are manufactured, U.S. dollars are spent paying for their importation into America.  In fact, many more dollars are spent for the importation of foreign goods than are received from the exportation of American-produced items. The net result is a Balance of Trade Deficit which has grown to humongous proportions.

 

Added to the manufactured goods trade deficit is a very special situation, one that is worsening with frightening speed.  I am referring to the ballooning importation of petroleum into America.  Not too many decades ago, America was completely self-sufficient in petroleum and, in fact, was the chief EXPORTER of petroleum products to the rest of the world.  But all that has changed dramatically.

 

According to the American Petroleum Institute, America now imports almost 14,000,000 barrels of petroleum PER DAY, and it is absolutely essential that the flow of imports continue in order to supply America’s industrial, transportation, energy, retail and social structures.  The cost of those petroleum imports is truly staggering, running close to US$300,000,000,000 per year and that amount, when added to the trade goods deficit, has helped the overall Balance of Trade deficit approach the unheard of figure of over US$64,000,000,000 per month - or an annualized rate of more than three quarters of a TRILLION American dollars per year.

 

Because of this worsening situation, America is enormously vulnerable in two directions.

 

First, the importation of petroleum must continue unabated, but the source for a significant portion of those petroleum imports includes nations that bear the United States ill will, nations such as Iran, Nigeria and Venezuela.  This leaves the United States vulnerable to increasing levels of political blackmail should any of those countries, individually or in combination, decide to pressure the USA into taking unwanted actions under the threat of petroleum embargoes.  We all saw the distress which happened in the mid-1970s when the importation of oil was only a small portion of America’s needs.  One can only speculate on what could occur in this day and age when the daily importation of petroleum is a matter of life and death.

 

Second, the Balance of Trade deficits, combined with the requirements to finance the past and present budgetary deficits, is creating oceans of American government debt, denominated in American dollars.  Many of those dollars are piling up overseas in enormous quantities and that reality is providing the potential for future serious problems for the American buck.

 

Under normal circumstances, holders of American currency such as the Chinese Central Bank would take the greenbacks and sell them via the international currency markets and purchase an equivalent number of Chinese Yuan.  However, these times are not normal.  So many American dollars are being created which are piling up in overseas banks that if large volumes were all sold on the currency markets, the Dollar could quickly collapse in value.

 

But the American dollar is no ordinary commodity.  It has been the lynchpin of international commerce for decades and the cash reserves of many foreign nations, corporations and individuals are held in American dollars.  If the greenback were to collapse, international commerce could be severely disrupted and much of the wealth presently stored in American dollars would vanish.

 

And so, in order to avoid these consequences, foreign nations have been buying American government and private debt paper.  According to Barron’s magazine, the amount of American government debt held by foreign nations is approaching one trillion, seven hundred billion dollars.  In addition, it is estimated that private and corporate foreign holdings of American debt amount to additional trillions.

 

So far, foreigners have been content to hold these vast sums in American dollars - but the great vulnerability is that conditions may change to where they will begin to fear that the greenback is headed toward collapse, or the American economy is going into recession (or even perhaps depression), or American political stability is at risk - and they would then attempt to convert those holdings OUT OF American dollars and into their domestic currencies.  Should that happen, the international currency markets would be overwhelmed with ‘sell’ orders for greenbacks resulting in, among other things, raging inflation as it took greater and greater numbers of dollars to purchase the same quantity of goods.

 

These two American vulnerabilities - the political vulnerability brought about by the absolute necessity to import vast quantities of petroleum from foreigners and the potential for a dollar collapse - could be sufficient, in an of themselves, to diminish confidence in the stability of the U.S. greenback.  Since gold historically acts in a manner inverse to the American currency, they could alone propel the price of the precious metals sharply, perhaps even unimaginably, higher.

 

The third consideration relates to one of the greatest fundamental change in the world’s supply/demand equation for all manner of raw materials that has ever taken place, perhaps in the entire history of mankind, certainly ever since the Industrial Revolution of the eighteenth Century.

 

For decades, the demand for most of the world’s raw materials came from industrial and commercial enterprises in Western Europe, Canada, America, Japan, Australia/New Zealand and the industrialized portion of South Africa.  These were the principal consumer-driven economies on earth and they totaled approximately one billion persons.  Development, production, distribution and transportation of the world’s resources were geared to markets based primarily to provide for those one billion people.  Now, with incredible swiftness, the situation has turned topsy-turvey. 

 

What has happened is best described in an important new book by Clyde Prestowitz, former counselor to the Secretary of Commerce in the Reagan Administrations, entitled “Three Billion New Capitalists.”  His central thesis, and one shared by many other analysts and observers, is that the world is straining at the seams trying to somehow accommodate continuing demands from those one billion already industrialized and prosperous combined with the staggering new demands created by the introduction of relative prosperity to three billion - or more - citizens of some of the most populous nations on earth.  These nations include the likes of:

 

China, with 1.3 billion people

India, with 1.1 billion people

Russia, with almost 200 million people

Brazil, with over 200 million people and

Indonesia, with almost 300 million people

 

Construction of modern housing units is skyrocketing.  Sale and ownership of private automobiles in China and India is exploding.  Ownership of appliance, entertainment and communication units is growing at almost uncontrollable rates.  Electric power demands are soaring.  Production of coal, iron, stainless steel, along with copper for plumbing and electrical components is rising vertically.  And all of this requires the production and distribution of staggering amounts of copper, nickel, lead, zinc and a host of other precious, base and rare metals.

 

In China and India, 30 million rural inhabitants are moving to their urban areas EACH YEAR.  They require modern apartments, appliances, plumbing and so forth.  That inundation alone consumes metals on a monumental scale and presently there is no end in sight to this growth.  China’s economy is now expanding at an 11% annual rate and India’s is growing in a similar manner.  It is difficult indeed to see how the mining industry will be able to keep pace with these rising demands.

 

As opposed to exploding demand, the mining industry is suffering from two trends which are limiting current production.  First, during the ‘bad years’ from about 1995 to 2002, expenditures for exploration and development within the industry nosedived and few major discoveries were made.  Therefore, few new ‘mega-projects’ were developed which would now be coming on-stream.  Second, those mines that remained in production during the low-price years ‘high-graded’ their ore just to increase revenues and stay in business.  As a result, many existing mines are now encountering diminishing returns per tonne of ore processed.

 

One can only wonder what lies ahead.

 

Fourth, we have “The world of petroleum.”

 

Many North Americans can vividly remember the events of the early to mid 1970s which followed the Yom Kippur War between Israel and its Arab enemy states.  As if to punish the western world for its support of Israel, the petroleum exporting nations of the Middle East temporarily cut off much of their supply to western markets.  Within a matter of months, gasoline, which had been selling for as little as 30 cents US a gallon, rose swiftly through 50, 60, 70 or 80 cents and even reached a dollar a gallon. 

 

Not only was it brutally expensive - more expensive than today when three decades of inflation are taken into effect - but it was hard to come by.  We all saw enormous gas lines as people continually topped off their tanks whenever they found available supply.  Lines at open stations frequently included dozens of vehicles.  The situation was chaotic, it was uncomfortable, and, in its own way, it was frightening.

 

However, the oil began to flow again in abundance and the price of all petroleum products declined to more reasonable levels, but the images remained and they made a severe impact on the psyche of America and the Western World.  The particular impact that made the most telling mark in America was the reality that this once-self-sufficient nation now was dependent upon foreign suppliers - who could indeed pull the plug whenever it suited their purposes.

 

Let us look at the figures.  According to the American Petroleum Institute, in the mid-1970s, worldwide consumption was on the order of 50 million barrels per day (MBPD) while supply capacity was close to 70 MBPD.  All that had happened was that a portion of that excess was artificially withdrawn from the market to create a shortage.

 

Several important trends have taken place since the 1970s and they are worth noting.

 

1 - The environmental movement has grown from a small, diffuse force, into one of the most powerful political constituencies in the western world.  Whatever their other merits might be, they have made it politically impossible to develop many promising petroleum  prospective regions.  Huge portions of Alaska are “unavailable”.  Huge portions of coastal offshore areas in Canada and the US where prospects are exciting are “unavailable”.  Huge areas having scenic attraction are “unavailable”.  Many places have been added to national, state and provincial park systems and have been rendered “unavailable.”

 

As a result, with the sole exception of the North Slope, American production has been declining since the 1970s and now, even that area has entered a period of decline - before considering the recent pipeline problems.

 

2 - The second great factor is a staggering and relentless worldwide growth in demand for petroleum products, a demand which is accelerating because of the factors resulting from the demands of ‘billions of new capitalists’.  It is estimated that daily consumption of petroleum is now on the order of eighty-six MBPD and is INCREASING at the rate of two MBPD per year.  The latest estimates of the United States government are that by 2030, total worldwide demand will be near 120 to 125 MBPD.

 

3 - In the face of this relentlessly rising demand, supplies have now become stagnant and there is growing evidence that production may actually enter a period of decline.  No new major ‘elephant’ fields have been found in the past few years.  The North Slope and North Sea Oil fields have entered a period of declining returns.  Production assistance techniques which cannot be sustained over time are now being employed in the giant fields of Saudi Arabia.  It is also worth noting that much of the world’s present flow of petroleum comes from inherently politically unstable areas such as Iran, Iraq, Nigeria and Venezuela.

 

It has become increasingly difficult for anyone to present a comprehensive, believable plan on just how the world is going to increase refined product delivery over time in order to keep up with rising demand. 

 

The specter of future failures in supply resulting in crushing personal hardships, industrial dislocations and even perhaps political upheavals is very real.  And, among the greatest forces which have acted historically to propel precious metals prices higher, rising levels of fear and panic have occupied a prominent place. 

 

One of the great literary works this century is Sir Winston Churchill’s six-volume series on the Second World War.  What is particularly relevant to our present situation is the title of his first such volume, “The Gathering Storm.”

 

In this presentation, I have mentioned not one, but four “Gathering Storms”; the growth of international terrorism, the growing vulnerability of the United States of America, the worldwide growth of fundamental demand for raw materials and the advancing imbalance between potential demand and production in the world’s petroleum markets.

 

I suggest that any one of these “Gathering Storms” is capable of driving demand - and prices - for both precious and base metals to enormous new heights.  In combination, they appear likely to provide the basis for a sustained bull market lasting the next several years at least.

 

Leonard Melman