More Than Meets the Eye
The estimable
economist Milton Friedman stated his forgettable opinion in 1974 that OPEC
would collapse and oil would never get up to $10 per barrel. In all fairness to
Professor Friedman, we must recognize his position as coming from a staunch
monetarist, emphasizing money supply as the "true religion" for the
Federal Reserve to keep the US Dollar as good as Gold. At times, he
half-seriously argued for the abolition of the Federal Reserve in light of the
simple monetary policy guidelines that could serve in its stead, with the
economy returning to a state of self-regulation. (In the past sound-money days,
economic hardships were far from unnatural, and they were not necessarily
attributable to acts of government. However, modern attempts to centrally
manage the economy ensures that any blame for systemic difficulties today may
be clearly laid at government's feet.)
Milton's mistake
was two-fold. First was his knowledge that Arabian oil could be produced for
one dime of real money, and that inevitable competition among OPEC members
would surely keep the price close to cost of production. Second, and most
importantly, Milton failed to account for the possibility that the government
would abandon such reasonable monetary management to keep the dollar nearly as
good as Gold. This fact was NOT lost, however, on the oil producing countries. Ask
yourself, what would YOU do if your business or trading partners suddenly
started offering you payment with Monopoly money instead of "real"
money? Would you shun real money as though it were the plague, and embrace
Monopoly money as the greatest thing since sliced bread? If you would, then I
have got a job for you!! Bring your shovel and some work-clothes, you have been
hired for life...
Upon the 1971
declaration by the United States that redemption of dollars for Gold would be
terminated, the entities in receipt of dollars for balance of trade settlements
had no difficulty recognizing this as an outright default on payment contracts. The scramble
was on to make sense of this new payment system in which the dollar was no
longer a THING of value (a small amount of Gold), but was now reduced to a
CONCEPT of value; an undefined unit with which the world would denominate the
amount of value in contracts for goods and services. The problem ever since has
been in coming to terms with the meaning of value for this shifting and
undefined unit, and its vulnerability for mismanagement and abuse.
Jelle Zijlstra,
who became head of the Bank for International Settlements, said while with the
Bank of the Netherlands in regard to the 1971 severing of Gold from the dollar,
"When we left the pound, we could go to the dollar. But where could we go
from the dollar? To the moon?"
As I continue this
tale, I hope it becomes clear that not only have we gone to the moon, but that
Gold is going there also.
Do you see the
world as it is? Or, do you see the world as you are? A
tough obstacle, to be sure, as our experiences weigh heavily on our
perceptions, and many people have no practical earthly experience with real
money. There is hope..."the Truth is out there!" as a popular show is
quick to proclaim. Albert Einstein puts an interesting slant on this theme: "My
religion consists of a humble admiration of the illimitable superior spirit who
reveals himself in the slight details we are able to perceive with our frail
and feeble mind."
So with a ready
admission our minds are frail and feeble, let's prepare to tackle something so
ponderous it must hopelessly remain an abstraction to us mere mortals. I refer
to the U.S. national debt, expressed in dollars, that stands at 5.6 trillion.
Wow! What does that really mean? To put it in some perspective, we will revisit
the 1970's, and try to get our arms (and feeble minds) around some much smaller
numbers, and yet numbers that themselves are large enough to be abstractions.
Let's examine the incredible and overwhelming wealth and economics of oil.
Imagine having
claim to a sandy and barren land that reaches 120 degrees Fahrenheit in Summer,
making your living through the ages on goats, dates and Pilgrims to Mecca. Not
a posh existence when compared to America in the Roaring 1920's, but the
passage of time reveals the fortunate few that were in the right place at the
right time. When the Standard Oil Company of California was granted an
exploration concession for Saudi Arabia in 1928, the 35,000 Gold sovereigns
paid by Socal were reportedly counted by Sheik Abdullah Sulaiman himself. Wispy
shades of things to come! This can be thought of similarly to how you might
view a collection of skinny stock investors who found themselves heavily
invested in penny internet stocks when the technology market exploded in the
1990, making them all millionaires. Except this: Oil is much, much bigger! We
will soon examine what it means to be in the right place at the right time.
I will talk about
pricing and balance of trade in the next part...stay tuned for the biggest
transfer of wealth the world has ever seen. The key-currency gets debased in
1971, and Gresham's Law rules the land.
Having purchased
this Saudi Arabian concession, in subsequent drilling Socal's Damman Number 7
struck oil in 1937 (I believe old Number Seven is still flowing.) Socal
partnered with Exxon, Mobil, and Texaco to form the Arabian-American Oil
Company. Over a thirty year period, Aramco discovered petroleum reserves in
Saudi Arabia in excess of 180 billion barrels...a quarter of the known reserves
of the planet at that time. And as the world aged and changed, the amount of
oil consumed daily in world trade climbed dramatically, from 3.7 million
barrels per day in 1950, to 9.0 mbpd in 1960, to 25.6 mbpd in 1970, to 34.2 million
barrels per day in 1973 during the first Oil Crisis.
Consider this for
better perspective: the average yield per well at the end of the 70's in the
United States was 17 barrels per day per well, in Venezuela (one of the
co-founders of OPEC) it was 186 barrels per day per well, and in Saudi Arabia
(the other OPEC co-founder) it was 12,405 barrels each day per well. Wow! Just
imagine if the internet companies today issued new, additional shares each day
at this same rate as oil consumption...the stock price would plummet! But unlike
internet stocks, because this oil is consumed, it must be replaced (and paid
for) every single day.
But before I can
move into the fascinating region of this miniseries that sheds light on how and
why the Gold market is as it is today, this background is vital, so please bear
with me, and I shall thank you for your patience. Oftentimes, understanding is
its own reward, but in this case it may well prove essential for wealth
preservation at a minimum. To begin, we must look at life in these United
States (and in the process we will see a compelling reason that import barriers
must be fought tooth and nail)...
What does the
Texas Railroad Commission have to do with this story? Plenty. So much oil was
being produced in Texas in the 1930's that engineers were concerned about
depletion and wastage, and the owners would fret over the effects of oversupply
that would at times bring the price per barrel down to ten cents. Tiny
independent producers were often drilling side by side with the majors, but
when the price slumped their profitability suffered more because they didn't
have income from the downstream processes like the majors did. Because some of
the individuals operating these independent companies happened to be
multimillionaires, their complaining voices were heard thanks to their political
contributions.
The state
government responded by giving the Texas Railroad commission the power to
regulate drilling. And while they didn't have the authority to set prices, they could
regulate production levels. By setting an appropriate rate of production, oil would be conserved and
this restricted supply would achieve price levels high enough to keep the
independents in gravy. This Texas price became the American price, and also the
world price (in the 1950's the U.S. was producing half of the world's oil.)
This meant pure profit for the major companies with overseas production that
cost only ten cents per barrel. To keep the price of oil up, what started as a
gentlemen's agreement among the American oil companies to limit the imports of
cheaper oil later became enforced by the U.S. government--known as the
"invisible dike" against the outside world of cheap oil. Throughout
the 1960's, the Persian Gulf offered the world oil at $1.80, while inside the
"invisible dike" oil was being sold to the nation at the Texas price
of $3.45 per barrel by the end of the decade.
The great irony is
that a Venezuelan lawyer (and oil minister) named Juan Pablo Perez Alfonso
studied and used the Texas Railroad Commission as his model for OPEC, which he
co-founded with the Saudi Arabian director of the Office of Petroleum Affairs,
Abdullah Tariki, in 1960. OPEC from the beginning maintained that oil was a
depleting asset, and it had to be replaced by other assets to balance national
budgets and fund developments.
Now that we know a
bit about the producers and the price and cost of oil during the era of
"real money," let us take a look at the dollar itself. The dollar and
the world was pegged to Gold via the post-WWII Bretton Woods agreement in which
$35 was convertible to one ounce--but for foreigners only, not U.S. citizens.
The rate for international currency exchange was coordinated through the
International Monetary Fund (IMF), with each currency pegged to each other
through the dollar and Gold. The U.S. economy steamed along nicely in the
1950's, producing half of the world's oil as I've already stated, and half of
the cars that burned up this oil. By the arrival of the 1960's, American
industry was buying foreign factories, equipment and raw materials. In
addition, the government was spending for its foreign bases and troops, and
Vietnam was funded largely in the red.
An overhang of
dollars was developing overseas--and while at first the foreigners were
reassured that the Gold guarantee of the dollar was solid, as ever more dollars
piled up, ever more of them cashed in the dollars for Gold. General de
Gaulle summed up the sentiment, saying that America had "an exorbitant
privilege" in ownership of the key-currency. By that he meant that the dollars America was able
to issue via simple printing carried the same value in trade as the dollars
that had to be earned by other nations through meaningful productivity. It
quickly became clear that too many claims had been issued on the limited Gold,
and President Nixon was prompted to close the Gold exchange window in the face
of a certain run on the Treasury.
In a quick repeat
from Part 1:
" Upon the 1971 declaration by the United States that redemption of dollars for Gold would be terminated, the entities in receipt of dollars for balance of trade settlements had no difficulty recognizing this as an outright default on payment contracts. The scramble was on to make sense of this new payment system in which the dollar was no longer a THING of value (a small amount of Gold), but was now reduced to a CONCEPT of value; an undefined unit with which the world would denominate the amount of value in contracts for goods and services. The problem ever since has been in coming to terms with the meaning of value for this shifting and undefined unit, and its vulnerability for mismanagement and abuse."
With OPEC in
place, and the dollar now rendered meaningless by traditional standards, the
stage is adequately set to describe what followed. With OPEC now united and
able to conserve, and threaten to cut back in the grand tradition of the Texas
Railroad Commission, they were able to name their terms of payment, and decide
essentially what value the dollar would have in oil terms. That is important
enough to repeat: They were able to name their terms of payment, and decide essentially what
value the dollar would have in oil terms. The
increased world demand for oil ensured that the price would be met (Texas was
pumping around the clock and still coming up short), and the printing presses
essentially ensured that there would be no lack of dollars, so to speak.
It is important
here to realize the attitude of OPEC, and notably the Middle East. In the mid
1970's, the finance ministers of both Kuwait and Saudi Arabia stressed that their
needs were only to provide for the welfare of their citizens, and that oil in
the ground is better than paper money. Who from the West can argue with that?
They called our money's bluff, fair and square. So in 1971, while the Texas
price of oil was $3.45, OPEC re-priced their Middle Eastern oil up from $1.80
to $2.20 (such audacity, don't you think?) only to see the market price due to
demand in 1973 overtake the official posted price, at which point OPEC saw the
writing on the wall, and in October raised the price per barrel to $5.12 while
curbing production. By December, the Shah of Iran called a press conference to
announce the official price would now be $11.65. Well, why not? It's only paper
to you if you are not in NEED of this currency through a debt to someone else.
And so began the First Oil Crisis of the 1970's.
Just as America
had been issuing claim checks on the national Gold throughout the 1960's, its
spending habits didn't change with the advent of the all-paper dollar. As a
consequence, the world's greatest transfer of wealth was underway. Watching the
rising cost of real estate became a national pastime in the 1970's--an odd
distraction from the gas lines and cost of fuel. By raising the price of oil
$10, from $1.80 to $11.65, at those current production levels OPEC raised its
annual revenues by approximately 100 billion dollars. Now recall from Part 2
where I promised you we would tackle some large numbers, though nowhere near as
incomprehensible as the $5.6 trillion U.S. debt. Here we go...
How much IS 100
billion dollars per year? It can't be much, because we all know the Middle East
is heavily in debt with struggling economies even now at the end of the 1990's.
Right? Well, I invite you to follow along, and judge for yourself. Let's try to
spend that $100 billion, and remember...it is 1974. And let's not waste time on
small stuff, we'll go right for the big ticket toys.
How about some
F-14's? Fully equipped (minus missiles because we are a peaceful bunch) they
are ours for $9 million each. Grumman on Long Island assembles 80 each year.
Hell, let's take 'em all for $720 million. How about some F-15's too? At $12
million each, we conclude our visit to McDonnell Douglas with 100 under our arm
for a cool $1.2 billion. Let's take home the biggest brute the U.S. has to
offer--a top of the line nuclear-powered aircraft carrier for $1.4 billion.
Better yet, make that two carriers. Throw in some destroyers, some
submarines...let's see... We've spent a total of $2 billion on a kicking air
force and a little more than that on a fine little navy. How much money is left
in round figures? About $100 billion. And this amount comes in not only this
year, but the next, and the next, and the next... [a side thanks to Mr. Goodman
for these historical prices.] $100 billion is a large annual paycheck, and we
haven't even touched the $30 and $40 dollar prices brought about in the Second
Oil Crisis. Now consider again that America has written future claims on $5.6
trillion dollars. Can you imagine how such a figure might be settled? Ouch.
Where did all of
this money come from? It would seem that America found an efficient means to
issue claims on the country in exchange for something that goes up in smoke.
Would OPEC own America lock, stock, and barrel? What would OPEC do with all of
that cash? And would there be any end to it? How are the poorer countries that
must EARN their dollars, as General de Gaulle indicated, going to fund their
own oil needs? Banks are the answer. Buy banks, fill banks, and recycle the
petrodollars. Oh, and let's not forget Gold. Straight from two ministers of
finance, "We would rather keep the oil than have the paper money." We thank you
for that insight.
Now that I have
properly set the stage, in the next part I shall relate the really good stuff
of Aragorn's tale suggesting where this money went, and how the system survived
20 years after the end was nigh, bringing cheap Gold crumbs for anyone mindful
enough to pick them up. To quote that good knight, "With a payday reaching
that magnitude, the question of destiny begs no answer. You set your own, and
hope for nice weather."
One Oil Crisis
down, one to go. We looked at some pretty incredible figures in Part 3. Where
did this money go, and maybe more importantly, where does it come from? For the
sake of brevity I will assume the reader is well acquainted with the process of
money creation via modern banking. If not, then you have some important
questions to ask and research to do. For now, accept on faith that new money is
created (as a simple ledger entry at a bank) through the process of borrowing.
A loan creates new money, and banks collectively may create money far in excess
of what they hold on deposit. As acontract, the loan is quite real, but
the dollar is not. A dollar is an undefined concept--an
undefined unit of measurement for value, so to speak. You can see how such an
arrangement favors those in a position to name their price.
As you can well
imagine, for a country such as Saudi Arabia that had been subsisting on simple
agriculture and the business of Pilgrims, a sudden infusion of such a magnitude
of money can be seen as pure profit, and a fine opportunity for capital improvements
to national infrastructure. Much of this money flowed back to the rest of the
world to pay for international contractors and materials. But clearly, much
more money was coming in than could possibly be spent. Vast sums of it found
its way into the world's largest international banks--the five largest
American, three largest Swiss, three biggest German, two biggest British, and
then on to the next tier... Suddenly there were over one hundred banks that set
up shop in tiny Bahrain: Citicorp, Chase Manhattan, Barclays, and Bank of Tokyo
among them; all competing for surplus oil profit deposits. Paris suddenly found
itself host to over 30 new Arab banks.
So much money
flowed in, and so much was lent in turn to the poor countries that could
scarcely afford to buy oil with their meager exports, that the financial
system became a large game of musical chairs, and the biggest risk was that the
music might stop. There were no chairs to sit on! To protect themselves from the
unthinkable--that the Arabs might pull their deposits out of an individual
bank--the banks developed a system. This system provided for the relatively
smooth inter-lending of funds. Because even though a bank can create new money
"out of thin air," they have to have deposits in the bank as a starting
point. If these funds were to be withdrawn, the bank must locate other deposits
to cover their outstanding loans. If the money were pulled, say from a British
bank, it had to go somewhere; the amount of money was too great to
"hide" for long. This British bank could call around, and arrange to
borrow the funds back from a Swiss bank, or German bank, by paying a nominal
interest rate on this inter-bank loan. The important concept to grasp here is
this: as long as the petrodollars stayed in the banking system, the banking
system would survive.
In fact, that is
how the world weathered the storm of the First Oil Crisis. Such a grand scheme
of inter-reliance was formalized by several central banks in a meeting in
Switzerland to handle any event should money come up short in one area or
another--the Basel Concordat. Have you ever heard of the LIBOR in any of your
financial reading? Some credit card issuers make use of the LIBOR instead of
the US. prime rate in their contracts. It is the London Inter-bank Offered
Rate, and functions as the international bank borrowing rate, and it is the tie
that binds the group together into a nearly seamless global financial System.
When the First Oil
Crisis caused a global tightening of belts, only America, as the issuer of the
key-currency, could shamelessly create new money with ease to pay its bills.
Other countries had to balance their own books with productive output, or else
turn to the banks to borrow the needed funds. And borrow they did! Let there be
no doubt that these petrodollars were recycled through the banking system.
Throughout the Oil Crisis and the distractions of the Nixon Watergate scandal,
the former Secretary of Defense under the Johnson administration, and then
president of the World Bank, Robert McNamara, was focused on one thing
only--maintaining the good graces of OPEC. McNamara had to ensure continued
access to OPEC's funds. During 1974, the World Bank had drawn on OPEC for $2.2
billion, for a total at the time of $3 billion--one quarter of all World Bank
debt. For Euroland banks, business was booming because lending was their
business. And the IMF had its hands full trying to hold together the
international currency exchange system.
Some of the
countries that quickly found themselves behind the eight-ball: Brazil, Korea,
Yugoslavia, the Philippines, Thailand, Kenya. (You can easily imagine that
there aren't enough coffee drinkers in Saudi Arabia to achieve a meaningful
balance of trade of coffee beans for oil for a country like Kenya.) So in a
move driven more by politics than banking to ease the financial squeeze upon a
nation's citizens and industry, the governments would turn to their central
banks and to the international and multinational banks to secure the needed
money. And the banks couldn't stop lending, because many countries relied on new
loans to pay off the old loans in addition to their continued need for oil.
Loans in default were simply rescheduled. There were no chairs, and the music
could not be allowed to stop.
If a bank were to
fail, what would the Arabs do with their remaining deposits, now clearly in
jeopardy? Further, the inflationary impact of all of this borrowing was also a
fact not lost on the OPEC nations. Many of the OPEC members' advisors and
ministers held Ph.D.'s from prominent American colleges. They did not have
their heads in the sand. The inflation would lead to a new price of oil just to
recapture the value that was lost, and the cycle would intensify in the next
round. OPEC knew the western currencies were depreciating faster they were
compensating with price hikes. They were getting less "real" money as
a result. Hopeless.
Remember Jelle
Zijlstra with the "moon" comment earlier? As head of the
BIS in 1980, he confidently predicted that the Second Oil Crisis could be worked
through, slowly, but that the System (international financial system) could not
survive a Third Oil Crisis--the inflation would make it impossible to recycle
the petrodollars to the oil importing countries with any hope of repayment,
trade would crumble, and the System would be brought to its knees. On that grim
note, we need to take a quick look at how the world reacted to the Second Oil
Crisis. It opens the door to everything that follows.
By now you are
patiently awaiting mention of Gold. There it is. Now back to the story... No,
seriously, pay attention here, and things will start to fall into place. I hope
you have noticed the few references to oil prices throughout this series. In
most cases, the oil was made available at a posted price. In the 1960's, OPEC's
posted price was $1.80 (though sometimes the producers would undercut that to
gain an advantage through additional volume), then it was $2.20, then $5.12,
and within weeks it had been changed again to $11.65 (in late 1973). By May 14
of 1979 the posted OPEC price was $13.34 per barrel, but life was about to
change. The key element to keep in mind is that oil was not priced directly by
the market. It was mostly sold under long-term contracts at posted prices that
were set by the producers after careful analysis of what the market could bear
under self-determined production levels.
When the Ayatollah
Khomeini's revolution deposed the Shah, Iran's 6 million barrel per day
production fell off dramatically, and the resulting shortage sent the downstream
processes scrambling for sources of oil anywhere to feed their refineries. Many
turned to Rotterdam for oil, to fill their empty tanks. The deepwater port at
Rotterdam was the principle harbor where huge tankers could be found to deliver
oil on the spot, and hence the spot market for oil was often referred to as the
Rotterdam market--but in truth, the spot market was available worldwide. This
spot market was never meant to determine the price for oil, but was only
supposed to supply day-to-day purchases.
Due to the
stresses of low supply, the Rotterdam price sailed above the $13.34 posted OPEC
price on Tuesday, May 15,1979 to $28, and two days later it reached $34. Iran
immediately took what little production remained and sold on the Rotterdam
market. OPEC then set a ceiling price for oil at $23.50 per barrel, but that
was soon broken by Libya and Algeria. Obviously, Rotterdam was the place to
sell oil at the best price, so many tankers with long-term contracts for oil
stood empty waiting for delivery while ever more of OPEC-member production was
diverted through Rotterdam. Countries and many companies looked at the low
levels in their storage tanks, and soon they were rushing to support the
Rotterdam market with their business. The "spot" price reached $40
per barrel as uncertainty about the future brought forth every empty tank or
dilapidated tanker out of retirement to be filled.
Gresham's law can
help explain this phenomenon-- bad money is spent and good money is saved. Oil
was being bought and saved as a store of value, while paper money was spent.
The flames of this Rotterdam inferno were eventually cooled as the last
available storage tank was filled to capacity. This display of the spot value
for oil reinforced OPEC's concept of value, and they had no qualms about
raising the posted price to the spot value. Please recall, "We would
rather keep the oil than have the paper money." Any student of history
will also recall that the explosion in Gold prices also occurred in 1979 to
early 1980, showing us Gold priced at $850 per ounce.
So what exactly
has changed in the world since 1980? There haven't been any similar blowups in
the pricing of important assets...so how was this wild tiger tamed? Is the
money better than it once was? Or are the OPEC nations now suddenly and truly
beggars upon the West's doorstep? What happened? Are the multinational banks
(once scrambling to hold together the System) now calling the shots with nary a
care in the world?
In Part 5, I put
an end to this tale, and answer the biggest mysteries about Gold in the easiest
of terms. The road will seem so straight and fair to travel, you will kick
yourself for struggling through the brambles for so long, and wonder at your
neighbors who STILL can't see the path, though it is truly a freeway.
Before I conclude
this commentary, let me first express my gratitude to USAGOLD for hosting this
illuminating site, and for the tolerance I've been extended by so many here for
my four long posts that up until this moment probably didn't seem germane to
the topic of Gold.
On any journey,
the first few steps are the most important, and in this case they were also the
most difficult--to include enough for context without drifting off-topic. This
last part is easy. The task at hand is to provide an explanation of Gold's
pre-eminence as a monetary asset. Gold is, in
fact, Money, while the dollar and others are merely currencies--an importance
difference!
I am not claiming
to be offering new findings of my own. The inspiration for this tale originated
from many sources, comments Aragorn III offered to a small group last month, a
knowledge of history, and keen perception. I have been challenged to render
this tale into the clearest of terms suitable even for those not acquainted
with Gold and worldly economics. If I have succeeded in my challenge, at the
conclusion of this final part you will fully grasp how the free market has
managed to provide a sophisticated asset (Gold) at a laughably minute fraction
of its relative value. You will know that Gold is Money, and will gain new
respect for its "price." Although this information isn't new, it might
be new to you, and hopefully this explanation of financial operations with
Gold, together with the background information of the 1970's Oil Crises, will
help you anticipate and conclude for yourself an outlook for events ahead, and
will also help you to better understand and evaluate the important messages
being presented by ANOTHER and FOA, in addition to the other worthy knights of
this Table round. Knowledge is power, and with it your destiny shall be yours
to decide.
To start, I'm
going to paraphrase some specific remarks made by Aragorn III that some people
need to hear and think about, though most of the Forum posters are already in
tune with this.
'The falling price
of Gold has had various effects on people. The common person says, "Of
course it is falling, because Gold has been demonetized." The Goldheart
knows better, so the falling price has a more remarkable effect, bringing out
insecurities and irrationalities of some. Though these people don't question
that Gold is money, their insecurities start to question whether the
world really needs money at all...that somehow this greatest device of
mankind has been antiquated. Simply preposterous. If they knew the truth they
would confidently buy today at triple the price and call it a bargain of a
lifetime. People ask, "Why waste effort to dig up Gold from the ground,
only to rebury it in vaults?" I say, "For the same reason the central
banks toil to print millions of fancy notes that nobody reads. If you've read
one, you've read them all." The effort is needed to prevent cheating,
though we easily see the fancy cash does not stem the abusive tide of money
from nothing. People also say, "Gold is a dead asset. It does not earn
interest." What is the point of such a comment, to demonstrate their
naiveté? Did banks not pay interest when coins were stamped from Gold?
You see, it is not
the nature of money itself to earn interest, but rather, it is the investment
risk that maybe earns a reward. A modern dollar in a shoebox is as a Gold coin
beside it. No interest for either. You should know
the interest paid by a bank savings account is not a product of the money
itself, but instead it is the rewards on the risk the bank takes with the money
you have provided for their investment use. Sometimes these
banks choose poorly, and in those cases even the modern dollar earns no
interest, and does not come back at all--lost with the closing of the bank
doors. Money must be risked (invested) to expect a yield, and in this regard,
the big players in the world risk Gold money as they do paper money (though
often not as aggressively), while the small players are content with the
shoebox yield. You are forced to be more aggressive (more risky) with paper because its
value dies quickly, unlike Gold that stands forever even in a shoebox of no
risk.'
With that, I will
now conclude this tale that shows Gold functioning in its role as Money. And
because preconceived notions of words often cloud a person's ability to see the
case before them, I shall try to deliver this message with the slightest use of
such terms as Gold loans, leases, shorts, etc. In fact, I will be so bold as to
simply refer to Gold as Money (I will write it as "Money (Gold)" to
ensure you know my meaning, but as you read, simply pronounce it as money).
As far as what you might think is money (dollars, yen, pesos, etc.), I shall
from this point forward not call them money, but refer to them by their given
name (dollars, yen, pesos, etc.) or else will call them "fiat
currency," or just "currency" for short. Fiat means "by
decree, and fiat currency is currency because the government tells us it is.
Enough of the
preamble. Let's pick up where we left off from Part 4. In days past, the oil
exporters had been poor to modest countries scraping by when two things
occurred. They discovered that they owned lots and lots of oil, and they also
found that the rest of the world had developed a voracious appetite for oil.
Think how different the world situation would be today if this supply of oil
had simply never existed.We are certainly lucky to have its availability, and it is a reasonable
expectation to pay fairly for all that we take. As bald as that statement is,
it is necessary because some people have suggested (as Kissinger did in the
1970's) that warfare is a possible alternative to obtain what isn't ours. Such
a world!
We've already
discussed much of the turmoil that resulted from consumption that outpaced
ability to pay. Payment in Money (Gold) was terminated, and many payment
scenarios were developed in addition to the ever rising prices in paper
currency. While it can be suggested that currency is a reasonable means in which to
track balance of trade accounts (equating oil exports with similar value of
imports such as infrastructure improvements), it should be readily admitted
that paper currency is an unacceptable means in which to pocket one's profits.
Book the trade balances with paper currency, but pocket the profits (savings)
with Money (Gold). That's what I do every month, too!
Paper currency was
falling fast in value when it was no longer tied to Money (Gold), and this was
causing international settlement difficulties on many fronts in addition to
oil. It is instructive to investigate some of the tools of the international
financial System, because what worked for Money (Gold) and currency back then, certainly
works for Money (Gold) today. (Please reread the paraphrasing of Aragorn's
money comments if you have forgotten them already.)
Back in the 1960's
when dollars were still tied to Money (Gold) under the Bretton Woods agreement,
the American penchant to spend for goods abroad led Kennedy's Undersecretary
for Monetary Affairs, Robert Roosa, to fear a mass "cashing in" of
these dollars in international hands for Money (Gold)--a run on the Treasury. Roosa created a
new financial device, referred to as a "Roosa bond," which was a special issue of Treasury bonds that
were denominated in Swiss francs. As the bonds were sold to the world, they would sop up excess U.S.
dollars with the terms that repayment at a future date would be in a given
quantity of Swiss francs. (Notice I said quantity, and not value.) While these
Roosa bonds stemmed the tide of a possible run on the Treasury, they ended up
costing America more because the Swiss currency appreciated versus the dollar
during the life of the bond.
In 1978, the
U.S. issued 10 billion dollars worth of bonds denominated in foreign currencies
(marks or yen) to milk extra life out of a dying dollar system, and the fix
lasted until the 1979 Oil Crisis made mincemeat of it. It was an acknowledgment
that some foreign investors wouldn't hold U.S. government obligations that
would be repaid in dollars worth less than originally spent on the bond.
Further, it was at this time that the U.S. promised to sell Money (Gold) from the
Fort Knox stockpile to foreign central banks unwilling to hold dollars. (On his last day
of office, March 31, 1978, Federal Reserve chairman Arthur Burns suggested that
the entire $50 billion of the nation's Gold stock be sold for foreign currency
in defense of the dollar, at which time the foreign reserves could be used to
buy up the collapsed dollar in international markets. While this plan was
originally rejected, within three weeks the Treasury Department was forced to
announce it would auction Money (Gold) on a regular basis.)
Treasury Secretary
Michael Blumenthal pledged in a meeting two days later with top-level Arab
businessmen that the integrity of the dollar would be defended vigorously, and
asked them to do their part to stabilize the global economy by keeping a price
freeze on oil in place at least through 1978. (You should have no questions now
about where the dollar found its value after the 1971 delinking with Money
(Gold). The asking price by oil--influenced by many factors--is what established
the dollar's value.)
It is also
important to realize that not all international arrangements are conducted on the open market. For example, to avoid the
German mark from being bid up in strength with a
result of ever more people bringing them dollars for an exchange, Germany's
Bundesbank issued bonds directly to the Middle Eastern buyers, avoiding the
marketplace impact altogether. This was at the time Saudi Arabia was swimming in cash and spreading the
excess among the world's largest banks (as mentioned in Part 4). My point is
this (which I shall expand on soon): don't be
surprised that banks are far more creative in their operations than revealed in
your common experience through savings and checking accounts and home loans.
Eliyahu Kanovsky,
an oil economist, won renown by many for accurately forecasting long-term oil
production and pricing trends by OPEC where all others had gotten it wrong. In
the 1970's he maintained that economics, not politics, were the determining
forces behind the decisions of OPEC. In 1986 he wrote in response to the prevailing
notion that OPEC would eventually own the world as a result of its oil wealth:
"It is, by now, abundantly clear that these forecasters committed gross
errors not only in terms of magnitude of change, but, far more important, in
terms of direction of change. Instead of increased dependence on OPEC and
especially Middle East oil, there has been a very sharp diminution. ... Oil
prices have been weakening almost steadily since 1981 and there has been a
collapse since the end of 1985. Instead of rising 'petrodollar' surpluses, most
OPEC countries, and Saudi Arabia in particular, are incurring large current
account deficits in their balances of payments, and are rapidly drawing down
their financial reserves."
In the 1990's,
Kanovsky maintains that OPEC has lost its ability to raise income through
raising prices, and that oil below $20 is virtually assured. (This should
remind you of Milton Friedman's poor prognostication from Part 1.) Kanovsky
claims competition among producers ensures an end to price fixing. They can
only pump it and sell it for whatever the market will provide. He contends
(rightfully so) that Iraq can be counted on to "pump like mad" upon
lifting of UN sanctions. He also contends that with the current account
deficits of many OPEC members, notably the Saudis, they have no option
themselves but to add to the oil glut with overproduction to raise revenue.
Since it has been
brought to our attention by Kanovsky, let's take a look at the Saudi budget,
and the toll taken on it in the aftermath of the Gulf War. IMF data reveals
that the Saudi deficit climbed from $4.3 billion in 1990 to $25.7 billion in
1991. Oil had been selling at around $14 per barrel until June 1990 when Saddam
Hussein pressured OPEC to raise the price to about $20 to help repair Iraq's
national budget (which had been wiped out and sent into the red by their
1980-88 war on Iran). Iraq's subsequent invasion of Kuwait in August 1990
temporarily spiked the price higher.
Here I must ask
you to pause for a moment to reflect on those huge oil trade surplus figures we
toyed with in Part 3, and recall that they were from early 1970's oil demand at
a price of $11.65 which caused the First Oil Crisis. What happened to the vast
amounts of petrodollar revenue that was being pumped into international banks,
and recycled as fast as the loans could be written to borrowers throughout the
1970's? Further, what happened to the earnings that were surely being generated
on these deposits through the activities of the lending institutions? As I
noted at the end of Part 4, the System miraculously survived the Second Oil
Crisis of 1979, and concurrently the skyrocketing price of Gold promptly abated
in 1980. Further, Kanovsky points out that oil prices started weakening in
1981, and then plunged in 1985. Force yourself to make the connections. You
will be one step ahead of Kanovsky, who has identified the effect, but no doubt
has missed the cause entirely. Let us now tie together everything we know, and
fill in the remaining pieces.
Historically, the
price of oil had been simply posted by the producers for contracted delivery
until it was unleashed to respond to daily supply/demand forces on the
"spot" Rotterdam market, at which time the price exploded in 1979-80.
Although the dollar had been historically fixed to Money (Gold), after it was
unpegged in 1971, the currency price of Money (Gold) was determined by the
daily supply and demand, similar to Rotterdam. Gold auctions began in May of
1978 because the U.S. had trouble getting international entities to accept its
dollar currency. After "booking" their trade balances with dollars,
the House of Saud, among others, wanted to "pocket" their profits
with Money (Gold), and therefore competed with everyone in the world for Gold
on the spot market. As the price shot right through $700 it was clear
that every ounce purchased made it that much more difficult to purchase the
next ounce. There was little trouble raising the price of oil as needed, except the
financial structure of the world was coming apart at the seams. Each dollar
withdrawn from international banks to buy Money (Gold) made life ever more
difficult for the banks to square their books against outstanding loans or to
write new loans. There had to be a better way...the return of Money!
The high price of
Gold brought mining companies out of the woodwork. The Earth was suddenly
crawling with geologists looking for the next jackpot Gold deposit. The mining
companies needed capital to finance the construction of these numerous new
mines. It's not strange to you to accept that banks can lend currency. It should
not be difficult for you to accept that banks can lend Money (Gold) also. Struggling with
that thought? Don't. They lent Money (Gold) in the days prior to Roosevelt's
1933 confiscation of Money (Gold) in exchange for currency, and they can lend
Money (Gold) today. In fact, they can even create Money (Gold) out of thin air,
in a manner of speaking, and I'll walk you through it.
Sometimes a
parallel familiarity assists comprehension. Consider the existence of
Government-Sponsored Enterprises (G-SE's) such as the Federal National Mortgage
Association (commonly known as Fannie Mae). Fannie Mae is in the business of
creating financing for people to acquire a house. The government's involvement
in this affair is that they underwrite the risk of a default on the repayment
of the loan. Dollars are borrowed, dollars are lent, and dollars are repaid. It doesn't
matter what happens to the exchange rate of the dollars versus other
currencies. A certain amount of dollars are owed, plain and simple, under the
terms of the loan contract. If a home mortgage loan is sold on the secondary market, the purchaser of
the loan is effectively buying not the house that was financed by this loan,
but rather the rights to receive the borrower's scheduled repayments over a
span of time.
Think of a loan
to a mining company in a similar fashion. Interest rates
on Money (Gold) loans are often much less than on currency loans because the
Money (Gold) holds its inherent value over time (despite its "price,)
whereas the paper currency fails so fast you must return more for the lender to
at least break even, not to mention show a profit for the risk. Because miners
will be pulling Money (Gold) out of the ground, it makes the most sense to them
to seek a loan of Money (Gold) rather than currency in order to finance their
new mine construction. But because Caterpillar has its head in the sand, it
requests dollar currency for the purchase of its mining equipment, so an
exchange must be made for paper currency as an integral part of this Money
(Gold) loan. These arrangements can take place in every conceivable fashion,
but this following example will be representative.
As 1980 arrived,
the Saudis naturally still wanted Money (Gold) for their oil, and the rest of
the world was struggling with liquidity. Much currency "wealth had already
been transferred to OPEC, leaving many countries toiling to service their own
debts--much of their credit existing as recycled petrodollars. Let the lending
continue! Bullion banks would facilitate these deals, and central banks (CB's)
would act in the same capacity as with the G-SE Fannie Mae, guaranteeing
ultimate repayment in the event of a borrower's default. In this simple
example, the House of Saud could be looked at as the principle lender (although
the borrower doesn't see this)...providing the currency equivalent of the Money
(Gold) borrowed by the mining company to pay for Caterpillar's equipment to
build the mine. Because this is contracted as a Money (Gold) loan, Money (Gold)
must be repaid over time. In a sense, from the Saudis' viewpoint it is similar to the Roosa bonds where
U.S. dollars are paid for the bond, with a fixed amount of another currency (in
this case, Money (Gold)) expected to be returned upon maturity.
With the simple
but vital central bank guarantee against the default of these Money (Gold)
loans, the House of Saud, for example, would have no qualms about supplying the
cash side, effectively buying not the Gold metal immediately, but rather the rights to
receive the borrower's Gold repayments over a span of time. Just like buying a
home loan on the secondary market. And the Money (Gold) of the central bank need not ever move or change
ownership unless the borrower defaults on the loan, and the CB is obligated to
deliver on its guarantee for the full repayment in Money(Gold).
There is nothing
sinister in all of this. The price of Gold has fallen simply because anti-gold
sentiment has been fostered throughout the common investment markets while the
principle buyer at the Golden "Rotterdam market" had found another
avenue in which to obtain the Money (Gold) desired in exchange for oil profits.
This is very much like the off-market Bundesbank offerings that I
mentioned about earlier. Please appreciate the patience in this approach, and
the commitment it shows to Money (Gold), knowing full well that for many years
it might be getting ever cheaper, while they would appear the fool for buying
it from the top prices all the way down to the lowest. But the big payoff is in
the end--which is near--and I'll get to that.
Now that you grasp
the basics, let's take things up one level. So many Money (Gold) loans were
written, that the House of Saud in our example spent down their past
petrodollar surpluses. What now? It is time for banks to do what banks do
best...create new money. This is the typical example I
promised you earlier:
The miner
approaches a bullion bank for a Money (Gold) loan. Let's assume the current
dollar price of Money (Gold) is $400 per ounce, and the miner needs $20 million
to pay Caterpillar for equipment. The bullion bank (such as can
be found operating in the network of the London Bullion Market
Association--LBMA) writes the Money (Gold) loan contract specifying the term of repayment of
50,000 ounces of Money (Gold) plus interest at 1% - 2%. The borrowing
miner collateralizes this Money (Gold) loan with company stock, the deed to the
mine, etc., and is sent down the road with $20 million in currency for Cat.
Where did this cash come from? The bullion bank turned to the House of Saud,
which is currently out of currency. However, using their oil
in the ground as collateral, the bullion bank is able to write them a currency
loan out of thin air (just like banks can do) with which the Saudis purchase
the repayment rights on the Money (Gold) loan. They will be receiving future
Gold for their future oil! As they sell oil, they will use their dollar revenue
to repay their currency loans, and in the meanwhile, the miner's Gold loan
repayments will be directed to the Saudis' account.
What does the
bullion bank get for all this trouble? First, the central bank gets 1% - 2% for
underwriting or guaranteeing the loan. (Just like the underwriting done with
Fannie Mae.) The bullion bank had added on top of this low interest rate an
applicable margin for its cost of funds to establish the final interest rate
for the miner that borrowed the Money (Gold). This rate might run 3% - 5%
(while currency loans would demand much more.) Each year the miner produces
Gold, and after paying the required installment of Money (Gold) for the Loan,
the remainder of his annual production can be sold on the spot market for
currency used to meet business expenses.
There's one hitch. Because the
biggest Gold buyer is no longer shopping on the spot market, the pricing
pressure has come off, and prices could very well be expected to fall. To
protect against this leading to the possible bankruptcy of the miner, and hence
his default on the repayment of Gold, the terms of the Loan might also require
that the miner lock-in a certain amount of future production at the current
Gold prices at the hedging counter. (Economists first scrutinize the mining plan
to ensure that it will in fact be viable at current prices before granting the
Loan.)
As described so
far, it should come as no surprise that the House of Saud would also step right
up to purchase the delivery side of this hedged production. Enough must be
hedged to ensure the mine will remain viable (even at lower prices) at least
long enough to repay the Loan. Lets assume this mine is operating today with Money (Gold) at $260 per
ounce, while their cost of production is actually $320. The current price of
Money (Gold) is not a factor on the Loan repayment...they owe 50,000 (plus
interest) ounces, regardless. Any additional production would be sold under the
terms of their hedge, at $400 per ounce, and they can pay their bills
comfortably and stay in business. Is the House of Saud a fool for paying $400
long ago for the Loaned ounces, and for paying $400 today to honor such hedged
ounce agreements? You or I could pay $260 today for that same ounce on the spot
market. Have you started to develop a new opinion of your currency, or at least
a new opinion of Money(Gold)?
OK, so what else
does the bullion bank get out of this, other than the applicable margin on the
Money(Gold) loan mentioned above? It also collects the interest on the currency
loan that was written to the Saudis using their oil as collateral. You can see how
the mechanism that has brought us temporarily cheap Money (Gold) over the years
has also given us cheap oil not subject to the same shocks witnessed in the
Seventies. You can also see why the economists can look at the Saudi balance books
and see tremendous currency debts and budget deficits where once there were
surpluses that threatened to buy up the world. They have in fact bought up a
significant portion of the Gold mined well into the future...through Loans and
Hedges bought all the way down from the top. So who are we to question whether
to exchange our currency for Gold now or tomorrow, and to gripe over a missed
opportunity of $10? The equation is simple. If you have cash, buy Gold immediately, because the
downward trend has become terribly unstable. Here's why...
The various
financial Hedge Funds saw how easy it was for miners to raise low interest capital,
and further appreciated the fact that even if they were not themselves a
producer of Gold, the Gold itself needed for repayment could be purchased on
the spot market at ever lower prices. The Hedge Funds could meanwhile invest
the capital received through taking out this Loan and expect to have a double
profit potential in the end. (The infamous Gold Carry Trade would invest the
currency received through the 1-2% Gold Loan into U.S. bonds that yield over 5%.) And of course,
with the proper central bank guarantees, the House of Saud would be there to
buy up the repayment contracts expected on these Money (Gold) loans also.
The problem is
that these speculating Hedge Funds have cumulatively driven the price so low (well
beyond where mines would have long ago stopped seeking this type of Loan) that
some unhedged mines are shutting down or going bankrupt. This aggravates the
spot market with thin supplies of real metal reaching it (due to so much
production already having delivery obligations) such that it becomes
hypersensitive to any real effort to make substantial purchases there.
As a result, the
Hedge Funds will be in for a rude awakening in their efforts to purchase the Gold
needed to repay their Loans. And the bullion banks are sweating, because they
stand next in line having facilitated the Money(Gold) loans and pledged to the
CB's that they were credit worthy of the CB Gold guarantees. And the important
Oil Producer sees that the big bucks paid long ago for future Gold delivery has actually
purchased only uncertain arrival. And further, some miners, despite their hedges, have played fast and
loose liquidating them for cash, and through general mismanagement have not been
able to stay so viable as to ensure future operation and delivery of the
repayment terms.
The CB's are
fretting because their guarantees were used over and over again, and they are
on the hook for a lot of Money (Gold) when the speculating Hedge Funds and
bullion banks find it impossible to cover their Loan repayment obligations on
the spot market as the price races away from them due to the hypersensitivity
that low supply has caused. Shades of Rotterdam. Currently aggravating this
spot market problem is the massive demand by individuals brought about by the
low prices and concerns for Y2K. I hope this give you new perspective on the
push lately by some CB's to free up some Money (Gold) from the vaults, whether
it is Bank of England, IMF, or maybe even Swiss. It should also give you
perspective on the anti-gold propaganda delivered regularly by the media.
Consider that a skyrocketing price of Gold would not only be viewed by the
masses as a viable investment avenue, it would also tend to shake the confidence
in paper currencies, and threaten the banking system and Wall Street in
general.
It is this same
currency, borrowed against oil collateral for the purchase of Gold, that has
added the massive liquidity to the world over the past decade and a half that many
people have used in turn to fan the flames of the stock markets here and
overseas. That's a lot of cash born unto Gold, and were it not for the
prospects of receiving the real wealth of Gold metal, this supply of currency
would have been stillborn, and oil would likely only come forth by way of brute
force rather than by civil, economic means. I realize that I
have left a lot out, but this should get you started along the clear road
traveled by smart currency. Now, knowing what you know, what would you do with
your dimes? Because this is really his tale, not mine, I'll leave you once
again with perhaps my favorite statement made by Aragorn one evening last month
among his old friends. "If I were given a dime for every time I cursed the
market for providing easier gold, I'd have a dime...and that one was found on
my way over here.
Everyone, your
comments are welcome. And thanks again to MK for the USAGOLD forum and for the
opportunity to obtain a world-class Money education and shiny yellow metal
diplomas all at the same place!
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