Oil Is a Far Better Inflation Hedge than Gold or Bitcoin

By Justice Clark Litle

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Editor’s Note: Today we’re bringing you a guest editorial from TradeSmith Chief Research Officer and TradeSmith Decoder Editor Justice Clark Litle. We think you’ll appreciate his research and analysis. Keith will be back on Monday with more of his market insights.

Are you worried about inflation? Do you seek investments that protect against inflation?

If so, you should know that oil is a better inflation hedge than Bitcoin or gold.

It isn’t a close contest either. When it comes to inflation protection, oil (and oil-related investments) beats gold and Bitcoin by a mile.

There are multiple angles to consider here. Let’s look at gold first.

Gold’s Performance Has Been Terrible

Gold’s biggest problem is price performance, or rather a lack thereof. Bitcoin and crude oil were two of the best performers for 2021, with percentage gains in the 55% to 60% range.

And gold? It actually declined in price for 2021 by more than 3%.

Remember, too, that inflation fears came roaring back in 2021 as a result of broken supply chains coupled with the aftermath of trillions of dollars in fiscal stimulus.

The annualized inflation rate, as determined by the monthly Consumer Price Index (CPI), rose to 6.8% in November — its highest level since 1982.

And yet gold finished down on the year instead of up — even as Bitcoin and crude oil rose 55% to 60% each? There is something very wrong with that picture.

For whatever reason, investors seem to have abandoned precious metals. Silver had an even worse 2021 than gold, finishing down nearly 12% on the year. Juxtaposed against a CPI near four-decade highs, that is simply not acceptable if the goal is inflation protection.

Bitcoin Is a Ticking Time Bomb (Because All of Crypto Is)

Bitcoin has an entirely different problem.

To be sure, there are logical arguments for considering Bitcoin as an inflation hedge, and Bitcoin’s price performance has been stellar over the life of the asset.

(Bitcoin recently celebrated its 13th birthday, as marked by the creation date of the “genesis block” — the first-ever entry in the Bitcoin blockchain.)

But Bitcoin leads a double life, and in its second life Bitcoin is a wildly inflated speculative asset pumped up by crypto shenanigans and wildly unsustainable leverage.

To put it bluntly, the Bitcoin price is at risk of outright collapse — we’re talking catastrophic decline here, on the order of 50% to 70% — because of what could happen when the dangerous leverage buildup in crypto faces its inevitable violent unwinding.

There is more than a touch of irony here: Satoshi Nakamoto originally created Bitcoin as a kind of libertarian protest against the global financial crisis of 2008 and the reckless bank leverage that created it — and now the crypto space has not only recreated 2008-like leverage conditions, but arguably pushed them much further (as we will shortly explain).

What this means is that, when crypto on the whole blows up, we have no idea how far Bitcoin could fall, because of how intertwined Bitcoin is with the unsafe leverage built up in the heart of the system.

To put it simply, the Bitcoin price at the moment is composed of two separate things: Some of it is the implied value of Bitcoin as an inflation hedge (i.e., Bitcoin as digital gold), and some of it — a much larger chunk — is the speculation premium of a dangerously leveraged asset.

Without going too deep — we have gone plenty deep for TradeSmith Decoder subscribers elsewhere — we need to quickly recap what is happening in crypto to understand what is going on here.

Some will dispute this, but we have argued forcefully that the entire crypto space is caught in the grip of a mania — quite possibly the largest mania of all time.

This mania was driven by a once-in-a-lifetime combination of a tsunami of pandemic stimulus (trillions of dollars in fiscal spending capped off by checks sent directly to households); the “bored in lockdown” trading phenomenon of 2020 introducing two new generations (millennials and Gen Z) to trading; zero-commission trading apps encouraging addictive trading behavior through behavior-modification techniques; social media message boards enabling “memes” to spread like wildfire (with the largest of these message boards boasting millions of members); and last but not least, the techno-utopian promises of crypto catching on globally.

Put all that together, and you’ve got the recipe for the biggest mania in history.

But then, to make things even wilder, the crypto space remains almost entirely unregulated, which means crypto operators and promoters — including the crypto lenders of the decentralized finance (DeFi) space and the large offshore exchanges — are able to engage in wildly manipulative activities and blatantly deceptive financial practices not seen since the 1920s.

Bitcoin is at the heart of all this by way of multibillion-dollar Bitcoin loans backed by U.S. dollar stablecoin reserves that don’t actually exist.

The 1920s were a decade of knock-your-socks-off corruption and manipulation in U.S. equity markets.

The 1920s manipulation occurred because all of it was legal at the time; there weren’t any rules against most of what was happening. And so you had open manipulation of stock prices — to the point where the Wall Street Journal covered the action and the public openly participated — and rampant insider trading, to the point of bank CEOs pumping and dumping their own shares (and sometimes going short).

After the crash of 1929 and the Dow losing roughly 85% of its value, the U.S. government decided to look into all the crazy stuff that happened in the 1920s and set up some basic rules to try to restore public trust in markets. That effort led to the creation of the Securities and Exchange Commission (SEC) in the early 1930s.

The crypto space today, in its nonregulated state, is just like the stock market in the 1920s. The rank manipulation and accounting trickery going on is enough to make your head spin — and all of it is legal, because the government has not yet imposed any rules.

Take Tether, for example, the issuer of the largest dollar-backed stablecoin. Tether has the ability to “print” new Tethers (symbol USDT), which are supposedly backed by U.S. dollars, based on the amount of reserves on its balance sheet.

Except Tether can create fake reserves out of thin air without breaking the rules — because there aren’t any official rules. Tether can do what it wants, as long as it stays consistent with its own fine print. And according to the fine print, Tether can create reserves out of nothing.

Here is how it works: Based on Tether’s own rules (in the absence of anyone else’s), Tether can make a loan to anyone it wants, and then count that loan as a reserve asset at 100% of face value. Tether can also count future interest payments as a source of income.

In practice, this means that Tether could loan a billion dollars to my dog and count that billion dollars as a reserve asset against which to issue more stablecoins. Tether could also charge my dog 6% interest — or whatever interest rate it feels like — and then count the interest payments owed by my dog as future income.

That might sound crazy, but it isn’t against the law. There aren’t any laws! Congress is making noise about regulating stablecoins — and the entire crypto market — but they haven’t gotten to it yet.

How does this tie back to Bitcoin?

We know (because crypto CEOs have admitted this) that Tether has made billions of dollars in Bitcoin loans to various crypto lenders in the DeFi space.

We also know that the DeFi lenders, like Tether, can do whatever they choose with these loans, including using them to buy more Bitcoin, or pump up the value of their own tokens, or relend the Bitcoin out to crypto promoters, and then lend the same Bitcoin two or three times over when the promoters deposit it back into their accounts.

Are you starting to get the picture? In crypto, the mania mentality dominates. Everyone is getting while the getting is good, and the total absence of rules means the financial trickery going on is so ridiculous it makes Enron look like a lemonade stand. And again, all of this is legal because there aren’t any rules.

The problem is that all of this leverage is going to create a crypto equivalent of Chernobyl — a total meltdown — and when it does, Bitcoin will be at the center of it all because terrifying quantities of Bitcoin (we are talking tens of billions) are wrapped up in all this leverage, which in turn is sitting on a foundation of dollar-backed stablecoin reserves that don’t actually exist.

Meanwhile, Oil Is Awesome

To sum up the above, gold’s performance has been terrible, even with inflation fears surging, and Bitcoin is at serious risk of imploding when the whole crypto space goes into a full-on meltdown.

Oil, however, looks awesome right now. As we finish this note, Bitcoin and gold are both cratering below their 200-day moving averages, even as West Texas Intermediate crude surges toward $80 per barrel.

As we kick off 2022, the charts alone are telling us oil is a winner and gold and Bitcoin are not. There are plenty of reasons to think that dynamic could last the whole year.

In some ways, oil was always a better inflation hedge than gold — and Bitcoin has no track record as an inflation hedge at all. (The spectacular price rise of Bitcoin over the past 13 years is more about BTC as a game-changing technology and speculative asset.)

Just think about the price of oil in past inflationary and reflationary periods.

What happened in the 1970s? That was the decade gold bugs remember with fondness — but crude oil skyrocketed in the 1970s, too. On an inflation-adjusted basis, the oil price rose nearly 500% between 1973 and 1980.

And then think about the 2000s, when the oil price skyrocketed again due to the rise of China as a global industrial power. Oil finished the 1990s in the low teens, with gold falling as low as $250 per ounce in that same time frame; by 2008, the oil price had risen above $140 per barrel, for a more than 1,000% gain in less than a decade.

Oil also beats gold as an inflation hedge because the factors that drive inflation also tend to drive oil demand.

On a broad level, inflation can be described as “too much money chasing too few goods.”

That inflation description can go two different ways. You can have excess capital via credit creation (too much money), or you can have supply shortages and production constraints that limit supply relative to demand (too few goods).

Oil is poised to benefit from both sides of that equation. When governments print more currency, the oil price tends to benefit because oil is priced in dollars, and thus more dollars chasing the same quantity of oil can push the price higher.

And on the supply side, there just isn’t enough oil in the world to meet global demand! We got a vivid reminder of this via the recent meeting of the Organization of the Petroleum Exporting Countries and their allies (OPEC+).

Even though OPEC+ announced a planned increase in oil production, the oil price rose anyway — because the members of OPEC are having trouble producing enough oil to fill their quotas.

To produce oil consistently, you need an ongoing flow of capital expenditure — investment in oil and gas facilities and fields — in order to maintain your rate of production. If your oil-producing infrastructure is starved of investment, then your oil production will decline over time. That means less supply.

This is why multiple Wall Street investment houses are anticipating oil prices in the range of $100 to $150 per barrel over the next few years. Investors and governments got so prematurely excited about renewable energy projects, they forgot to maintain a proper flow of investment into global oil production.

Oil Is Also Fed-Proof (Gold and Bitcoin Aren’t)

Then, too, just look at the price action this week. The Federal Reserve minutes from December were released, and the picture was severely hawkish. Technology stocks — and gold and Bitcoin — got hammered by fears of a hawkish Fed.

Think about that: The threat of a Federal Reserve raising interest rates multiple times in 2022 hammered speculative assets, and it hammered precious metals too — and yet the oil price completely ignored it. The oil price actually went up as all this other stuff dropped!

Rising interest rates are a real problem for speculative assets, because tightening monetary conditions tend to deter speculators by making leverage more expensive via higher borrowing costs.

But oil and oil-related investments don’t care about rising interest rates so much. Why? Because the oil price is tied to global demand relative to supply — the actual need to burn the stuff in cars and trucks and ships and whatnot.

This is another big reason why oil is superior as an inflation hedge: In a truly inflationary environment, rising interest rates will be a part of that environment as central banks turn hawkish.

That rising rate dynamic has the potential to be seriously bad news for speculative assets and precious metals — and yet the oil price can basically ignore rising rates, because the factors driving it higher run much deeper.