The world’s economy is powered by oil. Although coal produces most of the world’s electricity, there are alternatives in electric power generation: nuclear, solar, natural gas, and wind. But the cars and trucks that enable personal transportation, the transport of goods, and the mining of Earth’s raw materials, are all predominately fueled by derivatives of oil – gasoline and diesel.
This is a fundamental fact which investors should always remember. My opinion is that worldwide oil production will have much difficulty keeping up with worldwide demand and that, therefore, the world economy is on an economic yo-yo based on the rise/fall of oil prices. Stephen Leeb describes this in great detail in his wonderful must-read book The Oil Factor. Leeb has even developed a stock market indicator based on changes in oil prices.
In this article the case will be made that it is oil prices that drive gold prices. If my theory that oil prices are going much higher based on supply/demand fundamentals, and my theory is correct, this means gold will go much higher as well. Let’s take a look at history.
By now, most investors are familiar with the following historical gold price chart:
Now let’s take look at historical oil prices (click to enlarge images):
The charts show how oil prices drove gold higher after the oil embargo and Middle East turmoil of the 1970’s. In the 1980’s, we saw oil prices (and gold prices) decline as the embargo ended, Saudi Arabia pumped all-out to hurt competitors, and new supply from Alaska and the North Sea came online. In the new century, we once again saw oil prices drive gold higher on increasing oil demand, the Iraq war and decreased supply from Iraq, and a much tighter supply/demand equation. These events led to the 2008 oil price spike and subsequent blow-off we all remember all too well.
It is clear there is a direct relationship between oil prices and gold prices. Some would say the connection of gold is based more on inflation expectations. I would counter that it is oil that drives inflation and therefore ultimately oil that drives gold. Regardless, it doesn’t really matter who is right in that debate as the crust of the biscuit can be seen in this chart I found courtesy of Barry Ritholtz’s blog:
This excellent chart of the direct relationship between oil and gold prices clearly shows oil prices(black line) lead gold prices (yellow line). So, if one wants to know the direction of gold prices in the future, the question is simply: Where are oil prices headed?
We’ve seen oil prices hit $147/barrel in the recent past, and I would say that is why gold has run to $1400/oz. Today, oil is around $100/barrel (brent crude) while the world’s largest consumer of oil, the U.S. at ~25% of all world oil production, has a sputtering economy and high unemployment. While it is true the United States is the third largest oil producer (after Russia and Saudi Arabia), it is also the world’s largest importer of oil at roughly 60% of all consumption (at a cost of over $1billion a day).
Meanwhile, China has overtaken the U.S. as the largest car market in the world. But gasoline powered automobiles are also proliferating throughout emerging markets – including India, the Middle East, and southeast Asia. Clearly oil demand is going to rise. Can oil supply keep pace? That is the subject of another article and clearly there are two very different opinions on this matter (you all know where I stand).
On the policy front, we now know after two years of Obama there is essentially no meaningful difference in Republican and Democratic energy policy. The country is still an oil centric country. We still have no strategic long-term comprehensive energy policy as the one I have been suggesting for years now. American refuses to utilize its #1 economic advantage against all other countries (its extensive natural gas pipeline system combined with its huge natural gas reserves) by adopting natural gas transportation. This even as other countries have proven that natural gas transportation works – it’s clean and it’s half the price of gasoline derived from foreign oil. And it’s domestic!
While the myth of the “clean coal”/electric car architecture has been embraced so eagerly by Congress, the media, and so-called environmentalists over the past 4-5 years or so, the U.S. could have used its stimulus dollars to build a natural gas re-fueling infrastructure that would not only pay for itself in a very short timeframe ($1 billion/day leaving the country for oil would pay for a lot of natural gas refueling stations…), we would have in the meantime reduced foreign oil imports by 5,000,000 barrels a day by transitioning only half the cars and trucks in American to run on nat gas.
Meanwhile, China is building 20 LNG terminals on its southern coast and is snapping up natural gas assets around the globe – particularly in Australia and, as of yesterday, Canada, when the announcement of an over $5 billion deal with Encana. It is clear China “gets it” and will surely adopt natural gas transportation on a large scale as soon as the infrastructure is in place, leaving the U.S. far behind. This is because China’s energy policy is predominately crafted by engineers while in the U.S. lawyers in Congress develop our “policy”. China knows it needs to diversify away from oil while the U.S. is fighting oil wars so it can stay addicted to oil.
So, these wrong-headed policies are all tremendously bullish for oil prices and therefore gold prices. Additionally, we finally have an elected representative (Ron Paul) who understands the U.S. Constitution and realizes that the only form of money should be backed by gold and silver. He will hold Ben Bernanke’s feet to the fire on the Fed’s incompetent monetary and fiscal policies.
Perhaps even more bullish is the recent announcement by J.P. Morgan that the firm will accept gold bullion as collateral for stock transactions. Gold will be treated as the equivalent as U.S. Treasury bonds or other stock securities and can be used for leverage. This is way overdue - looking at the energy and fiscal policies of the U.S. and the inability of either political party to craft logical problem-solving solutions, it is clear gold (and silver) are superior “securities”. If these weren’t reasons enough to own gold, we also have hundreds of millions of Chinese and Indians who are acquiring wealth and are firm believers in the long-term value of gold and silver.
In summary: Oil is going higher. Much higher. And that means gold will follow it to new historic highs. The recommendation is to accumulate gold and never sell until you see natural gas transportation adopted and a meaningful reduction in oil consumption. But gold bullion and for your IRAs, buy the GLD and SLV ETFs. Of course the other play is energy and energy service stocks where I continue to like Conoco Phillips (COP), Chevron (CVX), Marathon (MRO), Exxon Mobil (XOM), and Petrobras (PBR). But as we saw in the market correction after the last oil price spike, these oil companies can suffer severe haircuts. It may well be that gold and silver are the least volatile of the two asset classes.
That said, both will continue to march higher in the years ahead.