Hope I’m not getting too cute here, as I think the long-term trend in oil prices remains upward. But all the “oil crisis” talk on CNBC, along with some other indications that the market is a little frothy here, have led me to take my money out of the oil ETF in hopes of using the same amount of cash to buy more shares later.

What did Goldman Sachs’ Abby Joseph Cohen call a “pretty good hedge against inflation”?

“We think that equities in general tend to be a pretty good hedge against inflation,” she said. “Equities and shares do well in a period of moderate inflation.”

A comparison of our tax returns would no doubt indicate that Abby’s opinion is more highly valued than mine. Nonetheless, I will give mine here.

First, what does she mean by “moderate inflation?” Stocks have tended to do well over time, and inflation has been moderate over time, so I suppose that is all correct. Meaningless, but correct.

Typically, to be considered an inflation hedge, an asset’s returns should be highly correlated with inflation rates. Alternatively, if the asset returns preserve purchasing power over time it can be considered inflation resistant.

Equities do seem to cover the second criteria. According to Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series), “companies’ earnings tend to increase with inflation, whereas payments on conventional bonds are fixed in nominal terms. [However…] corporate income taxes and capital gains tax rates typically are not inflation indexed.” Also, the earnings multiple is inversely related to inflation in the same way that bond prices are (a higher discount rate).

As a result of these conflicting signals, “the very-long run real return on stocks in the United States has been relatively insensitive to realized inflation rates.” (Emphasis added.) Equities are not so much a hedge against inflation as an asset class that does not fare as poorly as some others. Furthermore, they have a negative correlation (ibid p. 526) with unexpected inflation (such as we are seeing today).

Commodities, by contrast, and particularly storable commodities directly related to economic activity, have a positive relation to unexpected inflation. Energy, and to a lesser degree precious metals, are true inflation hedges. Is it then any wonder that such commodities are doing well now, and equities aren’t? Whether this will continue is a function of where inflation goes from here, not a function of equities being a “pretty good hedge against inflation.”

Another asset class that has typically been a good inflation hedge is real estate - and raw land in particular. However, in light of the current economic situation the past may not prove to be a reliable indicator in this case.

Disclosure: At time of publication William Trent is long oil (USO) and gold (GLD) through ETFs.

Disclosure: Author is long STREETTRACKS GOLD (GLD) at time of publication.

Market Insider blog: On May 9, what did John Kilduff say was his upside target for crude oil?

Kilduff said “We continue to maintain an upside target of $138 per barrel for crude oil.”

Disclosure: At time of publication, William Trent owns shares of the Oil ETF (USO)

With oil reaching new highs on the back of the oil inventory drawdown, I decided it was time to update my chart on the topic.

People who know more about energy investing than I have objected to my naive supply/demand analysis, so for now I make no attempts to draw conclusions. I’m still not convinced, but will keep my trap shut unless I can back it up with more substantial data.

Oil prices rise as demand worries fade - Yahoo! News

The U.S. government reported Wednesday that stockpiles of gasoline and distillates, which include heating oil and diesel fuel, dropped last week by a larger amount than analysts had forecast. Gasoline and distillate inventories are lower than they were at this time last year.Light, sweet crude for April delivery rose 17 cents to $61.63 a barrel in early afternoon trading on the New York Mercantile Exchange, after falling as low as $59.92 in electronic trading on the worry that U.S. and Chinese fuel demand growth could decelerate.

We’ve felt some pain with the recent decline in oil, as our position in the USO ETF is down more than 13% since we bought it.  Still, we held on, and part of the reason for the rising prices now is the change in weather that was all too predictable.

Still, what does the overall picture for supply and demand look like today? According to the EIA, total stocks have come down from record highs and are now approximately in line with the 20-year average.

However, we have never felt it made much sense to compare long-term averages in inventories to a generally rising trend in demand. Looking at the number of days the inventory will supply, the last two weeks have presented what may be a downside breakout for supplies (and thus present the possibility of an upside breakout for oil prices.) Note too that the economic slowdown fears would probably be reflected by a rising days of supply even if inventories were flat - so the declining days of supply pretty much washes out that excuse for prices to fall.

So we’re optimistic that our USO holding will recover its losses and then some.

Despite plummeting prices for oil in recent weeks, we still don’t buy the bear case, which calls for a slower economy to rein in prices. The problem is, in the 1974, 1981, 1991 and 2001 recessions that failed to happen. We don’t see why it would this time. Meanwhile, the weakness is all about the pleasant weather we’ve been having.

Oil & Gas Journal - MARKET WATCHEnergy prices fall as warm weather continues

“Weather continues to be the name of the game, as crude oil prices continue their slide from yesterday in early morning trades today,” analysts in the Houston office of Raymond James & Associates Inc. said Jan. 4.”That said, the latest 2-week weather forecast for the US shows cold weather beginning to set into the Lower 48 states by the latter half of the month, and natural gas has rallied on the news in early morning trading. However, a warm winter till now has prompted us to take a more cautious stance on winter-ending natural gas storage and near-term North American drilling activity,” the analysts said.

The thing is, weather fluctuates. And while the weather has been far warmer than normal inventories remain well below their historic average iin terms of days of supply. What will happen when normal weather resumes?

When we last visited the oil patch, we found the arguments against higher oil prices lacking. It remains our view that demand for oil is rising at a faster pace than supplies of oil, and that the imbalance will be solved through the price mechanism. We don’t think the correction is even close to done. However, an article we found in Oil & Gas Journal titled CERA study challenges ‘peak oil’ theory suggested it was time to update our analysis. The article states:

The “peak oil” theory, stipulating that world oil production will soon peak and sharply decline, is flawed, according to an analysis by Cambridge Energy Research Associates (CERA).Instead of a peak, CERA says, production is more likely to trace an “undulating plateau” that will last for a decade or more beyond 2030.

It seems of little consequence to us, as we believe demand will continue to rise without further drastic discouragement through higher prices. Whether supply is declining or flat, it will not keep pace with demand. The article continues:

The CERA report contends that the often-cited Hubbert model, which patterns production as a bell curve, fails to recognize that recoverable reserve estimates evolve with time and are subject to significant change. The model also underplays the impact of technological advances.

Although M. King Hubbert accurately predicted timing of the peak in US Lower 48 oil production in 1970, the CERA study says, he underestimated the peak rate by 20% and total cumulative Lower 48 production during 1970-2005 by 15 billion bbl.

Again, not exactly right is likely to be close enough for our theory to play out.

Finally, we often included a chart of the current days of oil products on hand in the US as part of our analysis. With the recent drop in prices, days of inventory made a run at breaking out of the long-term downtrend. However, the breakout failed and stocks remain low compared to long-term averages.

We’ll stick to our long position in the oil ETF (USO),

We originally wrote this post in response to a comment on one of our recent articles.

There is no doubt that businesses have tried to become more efficient in the last 20 years, and not carrying excess inventory is a part of that. Ask Ford if high days of inventories is a good thing. We agree that days inventory have not been a predictor of prices over the last 20 years. We do contend, however, that looking at total supply in barrels (rather than days of supply) as some of the bears were doing is an incorrect metric for considering supply/demand balance.

Our belief is that the long-term trend of shrinking inventories was due to the fact that holding oil during that time was a money-losing proposition. As oil prices fell producers, wholesalers and retailers were more willing to hold less inventory, as holding the inventory presented both storage costs and the potential that prices would decline further. For the same reason, companies also underinvested in finding new sources - whether they be new oil fields or alternative sources - there was no business incentive to do so.

Even now, with oil in the range of $70 per barrel, alternative energy sources have major drawbacks. To make a tank of ethanol deprives the world of enough food to feed someone for a year. So in addition to the actual cost there is an opportunity cost that makes ethanol effectively cost something like $350 per tank. Solar? MIT’s Technology Review talks to the inventor of the most efficient solar cell, who says:

A very reputable journal [Photon Consulting] just published predictions for module prices for silicon for the next 10 years, and they go up the first few years. In 10 years, they still will be above three dollars, and that’s not competitive.

Yes, people are trying to make silicon in a different way, but there’s another issue: energy payback. It takes a lot of energy to make silicon out of sand, because sand is very stable. If you want to sustain growth at 40-50 percent, and it takes four or five years to pay all of the energy back [from the solar cells], then all of the energy the silicon cells produce, and more, will be used to fuel the growth.

And mankind doesn’t gain anything. Actually, there’s a negative balance. If the technology needs a long payback, then it will deplete the world of energy resources. Unless you can bring that payback time down to where it is with dye-cells and thin-film cells, then you cannot sustain that big growth. And if you cannot sustain that growth, then the whole technology cannot make a contribution.

With regard to the dye-cells [he invented], silicon has a much higher efficiency; it’s about twice [as much]. But when it comes to real pickup of solar power, our cell has two advantages: it picks up [light] earlier in the morning and later in the evening. And also the temperature effect isn’t there–our cell is as efficient at 65 degrees [Celsius] as it is at 25 degrees, and silicon loses about 20 percent, at least.

If you put all of this together, silicon still has an advantage, but maybe a 20 or 30 percent advantage, not a factor of two. [Meanwhile] a factor of 4 or 5 [lower cost than silicon] is realistic. If it’s building integrated, you get additional advantages because, say you have glass, and replace it [with our cells], you would have had the glass cost anyway.

So realistic solar cell production that are cost-effective without subsidies are still a few years away. In the meantime, we’ll have to dig deeper and deeper for new energy sources.

Meanwhile, demand continues its steady upward march. The last five years have been the wake-up call, saying “Hey, you need some new energy capacity.” Now higher prices are starting to provide the business incentive but it will take years for the new supplies to make it to market. Eventually they will, and when they do they will come in large numbers just as consumers have started switching en masse to more energy-efficient products and prices will plummet for 20 years. That’s the way the free market tends to work in the commodities business.

But for now - we expect higher prices. In the interest of fairness, though, here is the other side: Forbes has the case for oil going to $45. But the Forbes pundit once again says “inventories are at record levels” when justifying his belief - we reiterate that the amount of inventory is only relevant in the context of how much is being used. And while that number too is rising for now, it is at least 20% below record levels.