Gold, oil fundamentals still sound

(December 30, 2004) In 2004, commodities proved to be the sector to beat, as demand from developing economies drove prices higher. Gold and oil grabbed headlines throughout the year, but what lies ahead for these key sectors in 2005?

“Given the fundamentals in the gold market and what we’re seeing happen in the currency markets with the U.S. dollar, I think the current price makes a lot of sense,” says Bob Lyon, CI Funds vice-president and portfolio manager for CI Global Energy Sector Fund and Signature Canadian Resource Fund. “If you look at where we see gold going, the answer is: probably somewhat higher.”

Because gold is typically used as a safe store of wealth, it trades in an inverse relationship to the U.S. dollar. As the greenback dropped in 2004, the price of gold increased. Since gold is denominated in U.S. dollars, the metal did not fare as well in Canada and Europe in local currency, remaining relatively flat over the past two years.

“We do see the U.S. dollar continuing to slide against most major currencies, which would be positive for gold,” says Lyon. “In our minds, that means gold hovering in the high $400 to $500 range. To go much higher than that, we’d have to paint a disaster scenario that we’re not quite ready to paint at this stage.”

Lyon says gold will remain fundamentally solid due to declining mine production, with demand remaining strong. Prices have been particularly robust due to a shift in who is buying gold as well, as the deep pockets of the world’s central banks use it to shore up their reserves. Lyon says there is still plenty of room for this market to grow.

“One of the things we need to watch for is the central bank question. A lot of the central banks in Asia, in particular, specifically hold U.S. dollars as their main currency with respect to their reserves,” he says. “If you see some of that shift into gold — even a very small amount — that could have a potentially material impact on gold.”

With rising U.S. fiscal and current account deficits, rising interest rates and the potential inflation, Lyon says “the ducks are lining up” for investing in gold.

“We see gold as something you should be holding as part of a diversified portfolio and it’s one of the many metals you can hold within that portfolio and it has some different characteristics,” he says. “But we are seeing other great opportunities in other mining and metals markets as well. Gold is not the only good-looking metal out there.”

While base metals actually turned in one of the best performances in 2004, few commodities are as closely watched as crude oil. Every time the price of crude spikes, consumers complain at the gas pumps and investors fret over the economic impact of higher energy costs.

As with gold, Lyon says the fundamentals of the market should keep prices relatively strong.

“We had underinvestment in this sector because of the excess capacity that was sitting around the world,” he says. “We’ve chewed through that excess capacity now and it’s going to take a sustained period, multiple years I think, of historically high prices.”

Lyon says he doesn’t know if that means $35 or $65, though “it’s certainly not $20.” Fortunately for consumers and the economy, “historically high” can still be much lower than current levels.

There is already some indication that crude will continue to retreat from its highs, with oil stocks trading at a discount — priced for $32-$35 oil, rather than a sustained price in the $40 range.

“I don’t think the world is rapidly running out of oil, but I do think the world is running out of very cheap oil and that it will take a higher cost to bring the next barrel on.”

One problem facing the industry is that costs have also crept up. The easy-to-get-at oilfields are all exploited already. More oil will have to come from deep sea wells and oil sands.

“If you have continued reasonable growth in the global economy and you have ‘normal’ increase in year-over-year oil demand (1.5-2%), then I think we’ll see oil prices hold around the $40 level and show some decent strength.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(12/30/04)

Steven Lamb