The thing with gold is; it’s not really about itself. It’s all about what’s happening with it’s biggest competitor: fiat.

With fiat you basically have four scenarios: 1.) deflation, 2.) weak inflation, 3.) high inflation without loss of confidence, and then you have 4.) loss of confidence (hyperinflation).

I think most people can agree that gold is a hedge against the two last scenarios, let’s start with #3 above, these graphs pretty much sum it up (chart basket #1). Open it in a new tab or something because I’ll get back to it later.

Note how gold shot up like a rocket from 78 to 80 when inflation almost went hyper. This is exactly the same scenario gold investors are hoping to bank on this time too. The inevitable devaluation of fiat money, trust me, this is where we’re going, there won’t be a Japan style deflationary scenario for the US, or Europe, or China, or… The Bernank will see to that.

Obviously gold seems like a good bet, as evidenced by the charts above. But that was 30 years ago, at the moment there are so many more instruments you can use as a small investor. Take for instance TBT and how it correlates with GS20 (chart basket #2).

An increase in the interest rate from 3.5% to 4.2% makes the TBT go from 30 to 40. By extension, if the interest rate goes to 15 (chart basket #3) the TBT will go to almost 200. If we follow the same logic, gold will go from 23.5M/t to roughly 40M/t, a “mere” 100% to compare with the 400% we can expect the TBT to go. Sure, if you bought gold in 2002 the numbers are comparable but if you’re thinking about jumping on the gold train at this point in time (Apr, 2011) then you should think twice.

Let’s finish off the TBT discussion with these graphs (chart basket #4, open them in a new tab because they will be referred to later). As you can see, gold and GS20 rates were both correlated to inflation “in the good old days”, but as you can see at the end there the correlation has broken apart, we’ve entered more “modern times”, courtesy of the QEs and the POMO actions. Can this dislocation continue? The answer to that question and how it will affect the stockmarkets is important in our search for more gold alternatives than the TBT.

We’ve just had good job numbers and it looks like the commodity inflation will finally start to spill over into the CPI, add to that the Nov 2010 GOPs in the congress and the picture for further open market operations look bleak. Even the ZIRP might be in jeopardy. Oh dear…

When the FED completely stops its purchases of treasuries the following will happen:

1.) Treasury rates will go up, a no-brainer of course.

2.) Higher rates will force congress to start to get more serious about fiscal responsibility and they will start to make the appropriate noises (just like EU politicians are making appropriate noises at the moment, that on top of #3 seems to be what keeps the EUR buoyant). And by noises I mean more than bar tabs on the Titanic, much more. This one will fight #1 of course but will probably not be enough, it will however affect the mood, in a big way, in other asset classes (think gold for instance).

3.) The USD will go up absolutely against all other currencies and commodities (including gold) as a consequence of money inflows due to #1 and increased market morale due to #2. Remember what has happened with the EUR since Trichet made noises about abandoning ECB ZIRP some weeks ago.

4.) The carry trade might start to stutter as a consequence of an appreciating dollar, emerging markets might take a hit.

5.) As a consequence of #1 and #2 all other debt instruments will start to look less appealing, corporate junk for instance. Beware of companies with high debt burdens, you should always be but especially in the near future.

6.) The stock market will go down as a result of the increased opportunity cost of not owning treasuries and more expensive corporate debt, apart from #2 of course which will act like a drag. I don’t expect it to be affected in a big way though.

7.) Whatever other consequences of the above that I forgot which flips the binary on and off button.

All of the above is of course bad for gold and good for other instruments that might also be good in case the QE madness goes on uninterrupted. As you can see, high inflation is only correlated with an appreciating stock market up to a point (chart basket #5)…

So if the US starts to approach double digit inflation without the Bernank being able to stop it we might get a tanking stock market and then a plethora of various volatility and bearish papers will probably be better investments than gold. Granted, gold will go another 100% practically maintenance free in this scenario whereas these other instruments will need a lot of baby sitting. On the other hand the same instruments will probably be good investments if QE ends whereas gold — in that case — will suck.

OK so QE and POMO ends and now everyone warily await the results…

1.) The consequences don’t take long to materialize, CPI starts to edge towards 0 and unemployment edges upwards as a consequence of #2 above in the form of public sector layoffs. These poor bastards are considered unemployable by the private sector so it will increase the structurally high unemployment which itself is a result of the globalization. The Bernank turns on the money spigot again…

2.) Not much happens, most of the budget cuts happened in social security and health care, unemployed people starve and die, just like in Africa, but employment stays up and so does CPI, the Bernank abandons ZIRP…

What will happen in the first scenario is quite hard to predict (at least for me). The market has already started to signal that never ending QEs are not OK in the form of treasury rates increasing despite all the FED purchases. We might have some kind of adverse reaction in anticipation of a repeat of the seventies (see chart basket #5). Only an idiot thinks the Bernank is Volcker 2.0. It’s either that or back to “normal”, ie. what we have now, gold up, stocks up, everything up up up, well except for the USD of course (which is the whole point). It won’t stop until a typical manufacturing wage in the US approaches that of China.

In the second scenario we will get more of the same stuff we got when QE was abandoned, only much more pronounced due to the fact that all that leverage will get more expensive. Look forward to a collapse of the carry and hence emerging markets. Commodities will tank like nothing else when producers realize that prices won’t go up forever and start to dump bloated inventories. The only thing that will stay up is the dollar. But there will be a killing to be made in the bearish ETFs on virtually everything.

To sum it up, gold seems like a bad investment at current levels from an opportunity cost perspective. And it stays a bad investment for the same reason, no matter which scenario that will play out. Back in the late seventies and early eighties there weren’t as much choice as there is now (at least when it comes to retail) to play the high inflation scenario, gold was one of few things available. It is truly a relic in every sense of the word.

I think I’ll stop there, I’ll reflect on the hyperinflationary scenario in a future post (hint, I still think gold is a bad investment).

As you might know there’s a lot of discussion at the moment about whether the high price of virtually all commodities is the result of speculation or true demand. Various politicians are decrying the evil speculators and it seems fact finding commissions are deployed daily.

Before we begin, lets separate spot prices from future prices. It would require a hardcore speculator to push up the spot price directly. With hardcore I mean someone who is actually prepared to take physical delivery. Of course there are highly publicized examples of this happening, but let’s face it; it’s pretty darn rare.

No, usually people buy futures with absolutely no intention of holding them to maturity, in the hope of selling them for more than they bought them. Pretend we buy the right to buy a barrel of oil for $100 in 6 months time, this right costs us $110. In three months time, if the spot price of oil is still at $100 that right might only be worth $5. We would then have lost $5 on the trade.

As you can see this speculation will do nothing to the actual price of the oil sold (spot price) if real oil producers and consumers are not affected by changes in the prices of futures. But do you really believe that?

Let’s take oil again with the numbers we used above. Pretend you’re the CEO of Exxon for instance. Your company has invested X amount of dollars to get all the equipment in place to extract oil from a well containing Y barrels of oil.

With the bearded madman and his colleagues having pushed interest rates to virtually zero that X amount of bucks you borrowed to put everything in place are pretty cheap, the yearly interest payments are not much, some 5% maybe. Having established that fact lets look at some more components of the cost of carry, what will for instance the infrastructure cost that contains that oil you are planning on not selling right away?

Ah yes it’s the subterranean cavity containing the unpumped oil, you got that one for free… That leaves us with personnel costs because unfortunately you can’t just fire those oil platform workers and rehire them in 6 months, even if you could it would be a very stupid and expensive way of saving a few bucks so we add that to the “tab” which now contains salaries for more or less idle workers and interest payments.

Now pretend this is all happening in January and the plan is to suck up 10 million barrels from this particular well this year, the current price is $100 / barrel so the total take on this year’s oil from that well is a cool billion bucks. But then this news hits the screen about the June futures going to $110. That’s a hundred million difference…

The loan amounts to 500 million which means 25 million in interest payments, add to that 20 million in staffing costs / year. A total of 45 million. Now of course you could lock in this sudden “profit” by issuing June futures at 110 since obviously there are buyers at that price in June. By doing that however you would need to somehow make 5 million barrels available instantly in June which means you can’t make that oil languish in the well in the meantime since it’s impossible to pump 5 million barrels in a month or a few weeks. No, if you sell futures in June you will have to store 5 million barrels in tankers or cisterns which ups the cost of carry by amounts that are not insignificant. They are in fact very significant, so significant that that plan is off the table.

However, if you could lower production in the first half of the year by 50% and then run at 150% during the second half you could sell 2.5M barrels for 100 and hopefully 7.5M barrels for 110. That would net you $1075M. Sure staffing costs would increase during the second half of the year but you see how the 75M contrasts to the 45M we talked about earlier. A more realistic scenario is probably running at 100% in the second half and taking home a total of $800M and still have 2.5M barrels left in the ground.

A quick call to the PR department which announces that “production has hit a snag and we can only run at 50% capacity for the first half of the year bla bla bullshit” and we’re a gogo. The spot price shoots up as a result of rising June futures which went up because speculators bid it up…

The same logic applies to any other non perishable commodity, in fact the storage costs for metals are much less than oil so you can continue extraction at whatever rate you wish, you don’t have to “store” this stuff in the ground to lower the cost of carry.

But what about food?

A wheat farmer can probably not wait for “better” times too long before the grain rots, at least not more than one year when the next harvest comes in if he doesn’t want to build more silos and I suspect he doesn’t want to. For the more productive farmers that can get both 2 and even 3 harvests per year the procrastination time is even shorter.

The result should be that sure, speculators can bid the price of food up but the produce needs to hit the market much sooner than other commodities which means that any speculative dislocations will probably have to correct much sooner than a non food commodities bubble. Neither the producers nor any speculator taking delivery can store this stuff for long so it needs to hit the market pretty soon and therefore push prices down.

To add injury to insult, it’s much easier for a farmer to switch crop than it is for a miner to switch metal, if suddenly the price of one particular crop goes up a lot more than what the farmer in question normally grows he might be able to switch to the expensive one and therefore help push prices down in a few months time.

What we can infer from this is that speculating in non perishable commodities, especially metals, is probably better than speculating in agricultural commodities since the very nature of non perishables enable more severe speculation which in turn should result in bigger swings. On the other hand when the bubble pops the fall will probably be so much harder due to all the speculators dumping their stocks at the same time.

Note that by the above reasoning the very fact that futures markets will turn producers into speculators to some degree is more or less certain. Especially oil and metals extractors. Any other behavior (with regards to the CEO for instance) would be either stupid or disloyal towards the share holders and we didn’t even bring up bonuses here.

So next time someone tells you that speculation doesn’t really affect real prices of commodities you can call him out for what he is, a pot head or an academic.