Here’s a fact I bet you didn’t know…
Every $1 upward movement in the price of oil increases the earnings of BHP’s petroleum division by US$64 million.
Isn’t that incredible?
Well, if I’m right in the following analysis…
Oil is set to go from US$67…to $150 per barrel.
That’s a lot of extra potential extra zeroes for BHP.
So how will we get there?
Well…let me ask you a question.
What do you know about the velocity of money?
I know, I know…a bit analytical for a Saturday.
But hear me out. Because it’s one of the most fascinating subjects in economics theory.
What’s more, it shows you why oil prices, after years in the doldrums, could be about to make a shocking resurgence.
But you’ll rarely hear it discussed in the news.
That’s why it will hit everyone by surprise.
Market commentators seldom mention it.
And investors are mostly clueless about it.
Yet this theory is key to understanding why oil prices, and the global economy for that matter — despite efforts by the financial wardens to conceal it — is rife with inflation.
This week oil hit a three-year high. I believe this is a sign of things to come.
In short, oil could be on the cusp of a major price breakout.
To explain, we must come back to what economist refer to as the ‘velocity of money’.
Economists always overcomplicate things when explaining this concept, but it’s actually a very simple to wrap your head around.
Imagine you’re sitting around the dinner table with nine of your closest relatives…
In your hand is a $1 coin. No one else has any money in possession. In this example, your dollar represents the total money supply in your family.
If you stick that dollar in your pocket, you’d end up with what’s known as ‘zero velocity’.
This is no different to keeping money in the bank. All it means is that you haven’t given the dollar to anyone in exchange for something else.
No transactions means no velocity.
But let’s look at this from another angle…
Say you turned to the person seated to your right and handed them the $1 coin.
What you’d find now is that the velocity of money would’ve increased to 1.
Now let’s take this a step further…
As this coin gets passed around the table, every new change of hands adds an additional number to the velocity.
If the coin is passed around five times, you’d end up with a velocity of five. 10 times equals 10 velocity. And so on.
While a simple example, it illustrates what happens in the broader economy at large.
There are countless transactions taking place every day exchanging money for goods and services. This circulation of currency contributes to the total velocity of money — the number of times a single unit of currency exchanges hands.
How does this simple idea explain why the price of oil could be about to break out?
You’re about to see.
Keep that thought as we head back to the dinner table…
You’re still holding the dollar in your hand. But now everyone also has a piece of cake in front of them.
You’re feeling peckish, so you turn to the person seated to your right and ask to buy theirs.
They agree, so you hand them the $1 in exchange for the cake.
They then realise that they want a piece of cake too. So they buy a piece from the person next to them using that same dollar.
Since two transactions have taken place using the same $1 coin, you end up with a velocity of 2.
Imagine this goes around the table until you end up with a velocity of 10.
In this scenario, your family economy has a GDP of $10 — the total value of goods produced and services provided.
That is, the same $1 coin exchanged hands 10 times, which gave it a velocity of 10. $1 multiplied by a velocity of 10 equals $10. And that’s your total productivity.
Now this is where things get interesting…
Let’s assume that everyone around the table has both a $1 coin and a piece of cake.
You’re feeling extra peckish, and decide to buy a cake from the person seated to your right. They agree, but then decide to buy a piece of cake from the person next to them with their dollar. This goes on right around the table until everyone ends up with $1 and a piece of cake, just as they started.
So what do you think the GDP of your family economy is now?
Well, despite increasing the currency supply, the GDP hasn’t changed. It’s still $10.
Do you see what happened?
In spite of everyone starting with $1, each person only made one transaction with their dollar coin. Because each coin was only exchanged once, it means the velocity of the money remains 1. Compare that to the first example where you were the only one holding a $1 coin…that same coin went around the table and changed hands 10 times.
In both examples, you end up with a GDP of $10.
Here’s why this is important…
Understanding that the quantity of currency in circulation is not what determines prosperity is critical. Velocity is what truly matters.
Again, that’s because velocity measures the rate at which money in circulation is being used. Which means that it’s an important factor in determining the rate of inflation, as well as being a gauge of economic well-being.
It is not enough to dump more money supply into circulation to improve how people feel about the economy. This only makes things worse in the long run, as it leads to a slowdown in velocity, which causes the price of goods and services to rise over time.
You’ll note that this is exactly what central banks do when they infuse economies with money supply.
Yet an ever growing pile of money chasing the same amount of goods and services being produced can only lead to rising prices, inflation, and even hyperinflation.
Velocity, oil and the rush towards hyperinflation
When people worry about the future of their finances, they typically cut back on spending.
As you’ve seen, fewer transactions results in a drop in velocity.
Initially, this drop has a deflationary effect on the economy.
This is important because central banks, like the Reserve Bank of Australia, have an inflation target of roughly 2%. These targets are designed in no small part to stave off deflation.
Governments and central banks will go to any length to preventing deflation. To do this they must give the appearance of a robust economy. They understand that public psychology plays an important role in keeping people spending.
But deflation isn’t the real problem.
If people cut back on spending, prices will actually rise in the long term.
That runs counter to what you’d think would happen.
But consider this:
During deflationary times, central banks inject money into the financial system to get people spending. If they succeed in convincing the public that an economy is in good shape, people that have kept money on the sidelines will start to spend again.
But all that does is leave even more currency chasing a similar amount of goods and services.
Prices have to rise as a result.
When velocity of money increases following a period of deflation, the net effect is usually out-of-control inflation.
While the endpoint of this can devastate economies through hyperinflation, it can also be a highly profitable time if you get the timing right once velocity begins to rise following a period of deflation and before it spirals into hyperinflation.
So here’s one way to take advantage of this scenario…
The future oil boon
There’s a lot of easy credit in the energy market right now. Among other reasons, cheap credit has played its part in keeping oil prices at current levels, hovering around US$70 a barrel.
Easy money is flowing into the oil market partly because there’s pressure to keep prices relatively subdued.
You’ll recall that oil was at almost US$140 a barrel prior to the 2008 financial crisis. And it traded above US$100 for much of this decade.
US shale supply has played its part in suppressing prices, but policymakers also want to ensure inflation doesn’t spiral out of control. In order to do this, they need stability in the oil price at a level which makes it very affordable.
After all, oil consumption underpins global growth, and lower prices help boost public confidence about personal finances and the economy.
So there is a concerted effort to suppress oil prices. That’s partly why we’ve seen so much credit flow into the sector.
Even then, oil prices have still doubled over the past 18 months, to around US$70 a barrel.
But as velocity picks up, oil prices could shoot much higher from where they are today.
We could see oil at $100–150 a barrel again.
That puts oil producers in line for a massive payday.
Like the tiny Aussie company Daily Reckoning editor Callum Newman recently unearthed.
This under-the-radar explorer operates in the Gulf of Mexico and is trading for less than 50 cents.
Callum’s research suggests it’s sitting on a potential 28 million barrels of oil.
At today’s prices, that’s $1.82 billion below-ground resources. Which is more than six times its market cap.
If this ASX-listed wildcatter strikes oil — and there’s a good chance of that as this discovery sits right next to a proven reserve — the potential returns on offer are enormous.
This article was originally published by The Daily Reckoning Australia