The Oil-Gold Connection.

(Originally published on December 10, 2016 at goldtradingmastery.wordpress.com)

Last week, I promised to say more about the connection between gold and oil. So today, I’m going to do what I promised.

The Reason Why Gold And Oil Are Correlated.

It is well known that the price of gold and oil are correlated. However, the usual explanation for this is that they are both used as inflation hedges. When inflation gets high, investors buy gold and oil in order to protect themselves from inflation…or so we are led to believe.

However, I think this explanation is not complete. There is actually another, more fundamental reason why the two tend to be correlated. In order to mine gold, energy must be used, and this energy generally takes the form of diesel fuel. But diesel fuel is derived from oil.

If, therefore, the oil price rises rapidly while the price of gold stays the same, gold miners can only afford to mine gold-ore that is closest to the surface and that is the very highest grade. Lower grade ore and ore that is buried further down into the earth must be abandoned and left for future miners to dig up.

As a result, a rise in the oil price will cause the supply of new gold to fall, slowing down the growth of the aboveground gold-stock. Unless this fall in the growth-rate of supply is matched by a slowing of demand growth, the price will rise automatically.

It is not necessary for investors to buy more gold as an “inflation hedge” in order for a correlation between gold and oil prices to appear. If they do buy gold to protect themselves from rising oil prices, it will just make the correlation even stronger. But the price will be somewhat correlated even without this happening.

Oil And Inflation.

One other thing to keep in mind is that it’s a bit strange to talk about people buying oil in order to avoid inflation. In a sense, a rising oil price simply¬†is inflation. Since there is nothing to give the dollar its value except petrodollar recycling, consumer prices rise when the supply of dollars grows faster than the supply of oil. When this happens, people sell their dollars for the thing that is backing the dollars. They get rid of dollars and buy oil.

So while it is true that a rising oil price causes consumer price inflation, and this causes people to sell dollars for oil, it’s confusing to talk about oil as an “inflation hedge”. It makes it sound as if a rising oil price is one thing and rising consumer prices are something completely different, whereas really they are intimately connected.

Using The Oil Price to Predict The price of Gold.

So…knowing this information, how can we use the price of oil to make predictions about the price of gold?

Let’s take a look at a chart and see what we can determine.

gold-oil-dollar-12-10-16-with-notes

Click to enlarge.

Stage 1: Oil Rises Faster Than Gold.

When the gold bull market began in 2001, the gold/oil ratio had just hit a peak at 30 barrels of oil per ounce of gold. This meant that gold was extremely expensive relative to oil. So when the bull market began, oil outperformed gold for many years.

I’ve labeled this time period “stage 1” on the chart.

This outperformance caused the ratio to decrease until it hit a low of about 6 barrels per ounce in 2008. At this rate, the price of oil rose so rapidly that it outstripped the ability of consumers to earn enough money to pay for it. As a result, there was a dramatic reduction in economic activity as consumers reduced their purchases elsewhere so that they could pay for gasoline. This was one of the main causes of the financial crash of 2008.

When the financial crash occurred, this pushed up the gold/oil ratio to its equilibrium level of around 14-17b/oz. This appears on the bottom chart as if the price of oil fell into and was “caught” by the price of gold.

This was the end of stage 1 and the beginning of stage 2.

Stage 2: Oil Rises at The Same Rate as Gold.

In stage 2, the Federal Reserve instituted Quantitative Easing to reflate the global economy. This caused gold and oil to rise at the same rate.

QE 1 was ended in 2010, but quickly replaced with QE2. QE2 ended in the second quarter of 2011. After the end of QE2, gold and oil stopped climbing and began to fall. I refer to this as the end of stage 2 and beginning of stage 3.

QE 3 was instituted in 2012, but was much smaller and therefore failed to stop the fall in oil and gold prices.

Stage 3: Oil Falls Slower Than Gold, Then Speeds Up Its Descent and Crashes Past It.

In stage 3, oil at first started to break away from gold and went sideways as gold fell. This is because OPEC was restricting output in order to keep the oil price artificially high. This attracted U.S. shale oil producers into the business, increasing the supply of oil. At the same time, QE was reduced and eventually eliminated, leaving less dollars for oil companies to earn. As a result, shale oil producers began to seize market share from OPEC, causing reductions in revenue.

OPEC responded by eliminating their restrictions on output, flooding the world with oil and causing a crash in oil prices. This put most of the shale oil producers out of business. It also pushed the gold/oil ratio to the highest level it has ever been, at 40b/oz.

So was this the end of stage 3?

Stage 4: Oil Rises Faster Than Gold Again?

From the looks of it, it appears that oil reached a bottom of below $30/barrel early this year. If this is the case, then a new “stage 4” has developed, in which oil climbs faster than gold once again. If this continues, the price of oil will eventually catch gold and push it higher, while the gold/oil ratio will fall until it stabilizes once again at around 14-17b/oz.

However, we have to keep in mind that this may just be a temporary uptrend before deflation resumes, causing gold to fall faster than oil instead of rising slower than it.

It really depends on what the Federal Reserve does. Oil and gold have now reached the point to where their prices can continue to rise without QE. But the Fed has still kept interest rates very low. If it increases them, this may leave less dollars chasing the same amount of gold and oil, driving down their dollar price.

Does The Dollar Price of Gold and Oil Matter?

One could easily argue that this doesn’t matter…because what we really want gold for is not to trade it later for more dollars, but to trade it later for consumer goods.

So this brings me to the subject of consumer price inflation.

Here’s a chart showing the price of oil as it relates to the Consumer Price Index. The original can be found here.

oil-cpi-chart

As you can see, the CPI is less volatile than the oil price itself but also lags it in time.

During QE1, oil was rising just as quickly as it had before the financial crash. But when QE 1 ended in 2010, a long slide in the rate of growth of the oil price commenced, with growth turning negative a year later and continuing to go more deeply negative until 2015. Meanwhile, the CPI growth-rate peaked in 2011, just as the rate of growth in the oil price hit zero.

After the CPI growth-rate peaked, consumer prices continued to rise – but at a slower rate with each passing year. If this trend had continued, the growth in consumer prices would have eventually gone to zero and then turned negative. Everything we buy would have started falling in price: rent, food, electricity, water, designer clothes, diamond jewelry, all the necessities and luxuries of human life would have gotten cheaper and cheaper as time went on.

Luckily for our deeply indebted U.S. government, this did not happen. Instead, oil prices bottomed early this year and started going up again. If this continues, it will pull up the growth rate in the consumer price index and make everything around us more expensive. As a result, it will make it much easier for the U.S. Government to make monthly payments on its debt.

Given this circumstance, I seriously doubt the Fed is going to raise interest rates enough to push the price of oil (and gold) back down again. The most likely scenario is that they keep interest rates low for a very long time, and this results in a new bull market for gold and oil prices (and a rise in the cost of living).

What Happens if The Fed Raises Rates.

But let’s consider what happens if I’m wrong. What if the Fed does engage in a series of aggressive interest-rate increases?

If so, we can expect that the oil price will crash, dragging down the gold price with it. Meanwhile, consumer prices will fall more slowly. So the purchasing power of gold will fall.

However, this will only continue so long as the gold/oil ratio stays above its equilibrium level of 14-17b/oz. Once it gets significantly below this level, gold mining will become less profitable and mining output will fall. When this happens, the growth in the aboveground gold stock will slow down. In addition, consumers may have more money to spend because of the fall in the cost of living (assuming they don’t use the money to pay off debts). So there may be more demand as well.

So even in that case, the fall in the purchasing power of gold will only be temporary. It will resume its upward trend once most of the gold miners are put out of business by the terrible economy.

In such a case, people who hold a dollar-centric view of the world will not realize this is happening. They will say that “gold is falling” when in actuality gold will be rising, just not as fast as the dollar.

I hope this adequately explains the relationship between the price of oil and gold. If you have a question, please leave it as a comment.