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Strong evidence that the price of gold tends to follow the price of oil was given in the Seeking Alpha article titled, "Oil Will Drive Gold Prices Even Higher". The relationship between oil and gold prices is primarily caused by two factors: higher oil prices cause increased inflation and also leads to expansion of the trade and fiscal deficits in the United States, the world's largest oil importer.

The International Energy Agency (IEA) has recently issued a report predicting the U.S. will become the world's largest oil producer, and may even begin exporting by the year 2030. The obvious question then becomes: will increased U.S. oil production kill the bull market in gold prices?

The chart above shows gold's rise as oil went from roughly $33/barrel in 2000 to $108/barrel today. Gold hit an intermediate high around $1000/oz in 2008 as oil spiked to nearly $150/barrel. It subsequently sold off during the financial crisis, which didn't make much sense to me, but massive de-leveraging proved me wrong on that. However, once the crisis "stabilized" (for lack of a better word), U.S. currency printing presses began working 24/7/365, and oil rebounded to current levels, gold continued its advance. For the last year or so, gold has been relatively range bound at and around current levels. Oil prices have also been relatively stable and range bound. The chart below shows how the price of gold has followed the price of oil.

(click to enlarge)

But the question remains: if the IEA's prediction of increased U.S. oil production is correct, will this kill the bull market in gold? Since the price of gold follows the price of oil, the real question is: will increased U.S. oil production lead to lower oil prices? This leads us directly to a discussion of worldwide supply/demand fundamentals. And this is a complicated and very dynamic situation. First, let's look at the world's largest oil consumer (the U.S.). Oil consumption is down in the U.S. This is primarily due to the economic contraction, but also due to increased mileage standards and growing use of natural gas in the transportation sector. This is shown in the following chart:

U.S. Oil Consumption

At the same time, oil demand in China has been growing at a steady rate:

It is clear from inspection that Chinese demand is growing faster than U.S. demand is declining. Declining U.S. demand is freeing up Middle Eastern oil for China, and that country is ready, willing, and able to buy and consume it. Other Asia Pac emerging markets (India, Korea, etc) are also growing oil consumption.

On the supply side, Venezuelan production is down, while Iraqi production is up. Iran's oil exports are bottled up by an embargo, but the promise of abundant Brazilian oil production has been hampered by governmental interference as well as the technical difficulties of safely producing deep water pre-salt reservoirs. Russian oil output has been relatively stable over the past few years. Obviously, worldwide oil supply/demand is very difficult to fully analyze because there are so many players and things are changing so quickly.

However, one thing we do know is that oil is the most widely traded commodity in the world. It is truly a worldwide market. Currently in the U.S., a surge in mid-continent production from the Bakken and short-term transportation infrastructure issues have led to a wide discount between WTI and Brent (currently $86.50 versus $108.75). But this too shall change. Companies like StatOil (STO) and Phillips 66 (PSX) are using railroads to transport Bakken oil, while many companies are busily building pipeline infrastructure to solve the long-term transportation issue. See my Seeking Alpha "Editor's Pick" article, "Investment Potential in Bakken Pipeline Takeaway Infrastructure", for a more detailed look at this issue. One thing I am sure of: long term, the wide discount between Bakken and Brent will narrow. U.S. oil prices will move toward the world oil price (Brent). As Bakken production continues to climb, there is simply too much money being left on the table by the wide discount. Entrepreneurs will jump in to profit (i.e., transport) on this discount and thus, it will narrow.

But the question remains: will increased oil production lead to lower oil prices? Besides supply and demand, we also need to look at the cost of supply. While Bakken crude production is growing by leaps and bounds, it is a very capital intensive industry. While tight-oil shale reserves are economical, and producing companies are making good money, it is a very capital intensive business. Depletion rates are much faster than conventional oil wells, and so the drilling must continue at a rapid pace to keep oil production growing. The fracking technology and propants, crews, lease, cost and environmental issues are other expenses. Similar to the U.S. natural gas market, if prices were to fall too much, producers would simply curtail future drilling (as opposed to shutting-in nat gas wells) until prices firmed enough to make it worthwhile to produce.

Meantime, on the conventional oil side of the equation, more and more production is coming from off-shore deep water wells, and expenses there are very high as well. This is true in the U.S. Gulf of Mexico, Brazil, Norway, and around the world. Additional environmental regulations in the aftermath of the BP disaster are also adding costs. Commodity prices for iron and steel for pipe and infrastructure are likely to increase as demand increases.

Recent rocket launches into Israel from the Gaza strip, and the resulting aerial bombardment in response shows us on TV everyday the geopolitical risks in the Middle East. Syria, Iran, Iraq -- it just seems to be a powder keg with a short fuse. Maybe the increase in U.S. oil production will lead to less trouble in the Middle East, but if the U.S. were to significantly reduce military spending, who picks up the slack to safeguard oil transport?

Overall, it is hard for me to make a case that increased U.S. oil production will lead to a significant decline in the worldwide price of oil. Perhaps the best we can hope for is a stabilization of oil prices around current levels. However, when infrastructure enables Bakken oil to narrow the spread with Brent, and U.S. oil is more-or-less based at world prices, we could even see oil prices begin to rise in spite of increased U.S. production if we assume worldwide economic growth and increased worldwide oil demand from China and other emerging markets.

But there is another big factor that can impact the price of gold: U.S. economic and fiscal policy dysfunction. The rise in fiscal debt since 2000 is simply phenomenal. The fiscal debt doubled in the eight years of the Bush administration, and has continued unabated under President Obama. Since the price of gold shown in the chart above was in terms of U.S. dollars, obviously the value of the U.S. dollar is a direct factor in determining its price. In my opinion, there are two reasons the U.S. dollar has maintained strength in the face of huge fiscal deficits:

  • It is the best house in a bad neighborhood
  • It is the world's reserve currency and can be printed at will

However, it is clear other countries are tiring of U.S. abuse of its currency status. Other countries are beginning to conduct trade in currencies other than the U.S. dollar and there are countries working behind the scenes to come up with a basket of currencies as an alternative to the U.S. dollar. Many foreign countries see the U.S. dollar and worrisome U.S. fiscal and Fed policymaking as a direct long-term threat to their economic well-being.

Bottom line is this: I don't see increasing U.S. oil production as a direct threat to the gold bull market, at least not yet. My opinion could change, and it is definitely something to keep an eye on. What would be more of a direct threat to the gold bull is if the U.S. would adopt natural gas transportation to significantly reduce foreign oil imports and to fix its trade and fiscal deficits.

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Meantime, I continue to like gold (GLD), but I like oil producers better -- companies like Conoco Phillips (COP) and Phillips 66. COP is growing lower-48 unconventional oil production by leaps and bounds. It is particularly leveraged to the prolific Eagle Ford shale, which not only has better economics than the Bakken, but is also close to the refining and shipping assets on the U.S. Gulf Coast. COP sports a very respectful 4.8% dividend. On the other hand, PSX continues to profit from its ability to capture the mid-Con/Brent spread by buying lower priced oil and selling gasoline tied to Brent. Phillips 66 currently pays a 2.2% dividend, but it is clear the management wants to increase the dividend on a yearly basis.

I also like Whiting Petroleum (WLL), the second biggest Bakken producer and the #1 operator in terms of Bakken well results. An executive at the company recently gave a presentation at the Bank of America Merrill Lynch Global Energy Conference. You can listen and watch a replay of this presentation here. The executive made a good case that WLL's assets could be worth in the neighborhood of $15 billion. Its current market value is under $5 billion. No wonder takeover talk continues to swirl around WLL. Meantime, it keeps growing production quarter after quarter after quarter.

It is companies like COP and WLL that will be at the heart of growing U.S. unconventional oil production for years to come.

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Source: Will Increased U.S. Energy Production Kill The Gold Bull?