OIL AND SILVER
Every once in a great while, there comes a change in general financial conditions that proves to be historic. There are strong indications that suggest we may be at such a turning point. Every financial market seems extremely overextended, and the dollar is also at multi-year extremes. The wild card of plunging oil prices threatens to undermine confidence in these overextended markets.
Crude oil is, by far, the most important commodity and its price decline has been stunning. The 50% decline means that producers’ annual income has dropped from over $3 trillion to $1.5 trillion. Oil prices have fallen so far so quickly that such a rapid decline will have profound consequences.
Initially, the consensus view was that the decline would be advantageous since more entities consumed oil than produced it. More recently, however, the consensus seems to have turned more guarded – and I believe for good reason. Financial instability threatens companies and countries which produce oil and those who are “long” the oil market. This is especially true for holders of oil derivatives, the largest commodities derivatives market. The decline raises the question of severe losses to counterparties that back the hedge. The quickest and surest path to widespread financial panic is the perception that a counterparty might not be able to fulfill contract responsibilities. If there is anything learned from the financial crisis of 2008 and the bailout of AIG it is that a counterparty derivatives failure can shake the financial system to its roots.
Very few “bodies” have floated to the surface as a result of the stunning decline in crude oil, but it would be naïve to think that there aren’t some very large victims. And just like the financial crisis of 2008, you didn’t need to be directly involved in credit default swaps sold by AIG to be affected when they defaulted. Likewise, defaults in oil derivatives will be felt by many with no direct involvement.
In addition to potential and some might say unavoidable counterparty failures, the nature of this oil price decline seems problematic in that there is little anyone can do to alter its course. I don’t doubt that government sponsored intervention occurs when there are adverse moves in the stock or bond markets. That is a pretty simple thing to do – just buy futures contracts. But if the oil plunge is due to a surplus, I’m not sure government intervention by buying futures contracts could do much good.
What does this change mean for silver? Stock, bond and real estate markets are sharply higher than they were in April 2011 and silver, I don’t need to remind you, is sharply lower. So much lower that silver is below the primary cost of production. While silver mine production hasn’t declined to date, you can be sure that potential production was killed and future production was delayed.
With interest rates the lowest in our lifetimes and stock and many real estate markets never higher, what is likely to happen in the event of panic caused by the decline in oil prices? With conventional assets at historic highs, where is the safe haven? It is the age old refuge of silver and gold. Some will also be drawn to the profit potential offered by a precious metal trading below its primary cost of production. A rush of safe haven buying may be at hand. There is such an infinitesimal relative dollar amount of silver available that the smallest increase in safe haven demand will send the price skyward. If there’s one thing that can overcome all other factors it is a sudden burst of physical buying.
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