Gold under the Mattress...again?

• Physical buying by EMs explains the gold rally of the recent past

• Given macroeconomic developments and monetary policy Gold's fundamental direction is down

• Any short-term rally due to US Congress wranglings should be faded and seen as opportunities to sell gold

• Oil Supply outages are coming back on-line and in 2014 supply should outweigh demand, weighing on the oil prices and time spreads

• Oil is especially vulnerable if we believe the Iranian situation will be resolved peacefully, which has more credibility now than ever before

• We are shortish of oil and oil spreads but are unwilling to risk a lot on this trade since a single event risk (Iran) has the power to change the landscape substantially

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GOLD

Gold had a very strong rally from the lows it made at the end of June, where it reached below 1200US$. The rally that followed requires explanation since it was a fast rally to prices reaching above 1450US$. Now gold prices have begun to come off again. This truly does require an explanation.

If you dig down into the data, you will find that cumulative gold imports through July surpassed the 26.7 million ounces (831 tonnes) that was imported to China for the whole of 2012.

Gold had its 'golden moment' (excuse the pun) back last year when the prices rallied to near 2000us$. As soon as the Fed signalled a pullback from its monetary stimulus (QE) and the markets began to understand that this would mean an effective rise in real rates and with it a fall in gold prices. The markets were very long gold for the last number of years and hence the metal fell dramatically and quickly. It fell until it reached lows of 1182US$. At the same time funds were fleeing EMs and finding its way back to the strengthening DMs, after a near 4trillion US$ had left them for EMs after the 2008-9 crisis. 

EMs ended up with much weaker FX rates, a falling equity market and higher interest rates. Policy responses were relatively muted. Especially, raising interest rates in order to stabilise their faltering FX rates was unpopular, as some EMs were concerned with diminishing their growth rates if they intervene too aggressively. The response from the population was key to lack of policy response from governments. (Central banks excluded, who also supported in the buying of physical gold especially in Russia and Turkey).


The population of these EMs seeing their investments falter and their currencies becoming less valuable with limited policy responses became fearful that an EM crises would develop and bought physical gold in vast quantities. So vast, in fact, that the physical demand for gold began to overshadow financial demand (or lack thereof), the gold curve shifted into a rare backwardation and prices rallied fast and hard.

This kind of panic-induced rally cannot be a longer term driver of financial instruments in the medium to long term and we believe that the Fed by effectively delaying tapering has given the EMs more time to adjust their policy responses and have also eased the panic-buying of physical gold by EMs.

Even the current wranglings of the Congress will have difficulty in creating a sustained rally, since a debt default is unlikely (even a short term technical payment delay would have very little impact on the underlying economy) and the current shut-down should be over before permanent GDP growth numbers are affected. Given that Congress has already agreed a bill that will retro-actively reimburse all payments affected by the shut-down the economic effects should be limited and reversible, unless this wrangling becomes a multi-month event. In such a case real harm to economic growth would be done which could delay Fed tapering beyond end of year or even beyond Q1 next year. We believe such an event as unlikely and see an agreement reached within the next 10 days (even if the agreement is a temporary one.) In sum, we believe that a default will not occur. In essence, this implies that all spikes caused by the current uncertainty represent selling opportunities for gold.

When tapering commences in earnest probably around year-end or latest Q1 2014 the reactions should be more muted and the outflow out of current account deficit EMs more orderly. In short, there is not much to prevent much lower gold prices going forward even though some short-term pressures are holding the glittering metal up at the moment. Perhaps it is time to get the gold from under the mattress...

OIL

Supply Surprise

We wanted to take the opportunity and highlight some of the issues that have caused our oil call for this year to be wrong. Our analysis was based on a fundamental analysis which demonstrated that supply would substantially surpass demand. However, with supply outages in Lybia, Sudan, Iraq and the Iranian embargo have culminated in a supply disruption of more than 2.7 million b/d. This in a market where demand growth is around 1.3-1.5 million b/d per annum. The supply outages added to the around 1.3-1.5 million b/d expected Iranian embargo effect and have meant that additional supply had to be provided by the Saudis of around 1 million b/d in order to balance the market. As a result stocks were not built and prices and time spreads did not fall (and as our longer term readers know, we were stopped out of that trade).

It seems, however, that the landscape may be shifting, that the worst of the supply disruptions may be behind us: For one, Lybian supply has started to come back on-line and it is expected that they will begin to supply more than 750 k b/d of oil shortly, after its supply fell from 1.4mill b/d to 250k b/d. Even more of supply should start coming online from Lybia as problems with the striking fractions there are being overcome.

Let us look at the demand side of the equation: Even if the world economy is slowly recovering, current demand is only around 1.2m b/d and even if next year's demand figures would rise to 1.5mill b/d, supply from increasing oil production from the USA combined with non-Opec supply should be able to cover all of next year's demand increases. (USA supply increases should be around 1million b/d, while non-OPEC supply should reach 500k b/d in 2014). Add to this a potential for the Iranian embargo to end and the other outages to come crawling back and we could have a potent mix for lower prices.


Iran - the Wildcard

If we now see the surprise supply outages come back online, we should have more oil supplied than demanded. The big unknown in all of this, is Iran. If the USA can reach some agreement on a peaceful resolution of the Iranian nuclear programme issue, then the US and EU embargoes of Iranian oil would cease and an additional 1.5million b/d would hit the market. This would in essence swamp the market with oil, even if the Saudis withdraw their additional 1million b/d. Even if the Saudis withdraw enough oil that causes the market's supply to balance demand, it nevertheless means that stocks in the world would be built, and spare capacity would increase, giving the oil markets a larger buffer for unknown oil shocks. This in itself should lower prices and especially reduce the backwardation within the oil curves.

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