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No one agrees what is the “fundamental” price of gold.

What’s indisputable is that the price went up by 400% over the past ten years; thus the “Gold Bugs” are purring like fat-cats full-up with fresh milk. Their indisputable logic is that the price went up, they got it right, and that proves their logic was correct; it’s hard to argue the other side of that debate.

One point of common ground is that most people agree that the price of gold ought to have something to do with oil prices. Indeed the general trajectory of the price of gold has pretty much tracked the trajectory of the price of oil since it was released from the shackles of central bank control in 1970 (more or less – some people say the prices of both gold and oil have been manipulated).

The argument there is that the price of gold (as the ultimate measure of value) ought to reflect the price of oil as the ultimate driver of economic utility in the world as we know it. Of course in Roman times things were different, but that was long time ago, and if you use other benchmarks (the price of a top-of-the-line toga compared with a Saville Row suit, the argument holds water).

The difference of opinion starts when you have to decide at which point to start. Or in other words, if the fundamental for gold can be found from the price of oil, at what point in time was there égalité?

Recently the argument for “gold is under-valued” was put up by Michael Fitzsimmons. The core of the argument referenced an analysis done by Barry Ritholtz who observed that since 1970 the price of oil went up 700% yet the price of gold only went up 400%.

It follows that if oil is more or less priced correctly today (which in my opinion it is, more or less, then gold is under-priced, by about 25%. And if oil prices go up to $150 (which they might), then looking forward, gold is massively under-priced at $1,400.

That argument is perfectly logical; but why choose 1970? There are some people (for example me, but also the Shah of Iran), who have argued that in 1970 before the Arab Oil Embargo, oil was under-valued due to manipulation of the market by the “Seven Sisters”, and also that it took time for gold to find its feet in the market. That is always the problem with picking one point in history as a reference, you get into a debate about which is the right point?

Another line of thinking is that the fundamental of the relationship between oil and gold since say 1970 can be determined with a reasonable degree of accuracy simply by plotting the oil price against the gold price (or the other way around); and looking at the best fit.

That approach has the advantage of being slightly more “scientific”, and gets you away from a debate about which point to pick as a reference. Although the answer you get depends on the cut-off, plot the points from 1970 to today, and you will get a different answer from what you get if you plot the points from 1970 to say 2007, which is the point at which a cycle of under/over valuation finished (reference the fundamental), according to me.

Either way, that regression analysis can explain 75% of the changes in the price of gold year-on-year since 1970 (i.e. the R-Squared is 75%), which is a lot better than the explanation that starts with the assumption 1970 was égalité.

According to that line of reasoning, if oil is priced correctly today, then gold is priced 50% too high.

A third line of reasoning is that whatever it is that determines the correct price of oil, also determines the correct price of gold, thus the price of each is independent of each other but is driven by the same fundamental.

A line of reasoning for working out the fundamental value of oil was put forward by me over the past few years, which says that so long as supply of oil is not limiting (there is an argument to say that is no longer the case, as in “Peak oil”), then the fundamental price of oil is a linear function of Nominal World GDP.

Plot that line against the price of gold since 1970, and although you don’t get a better R-Squared, it fits with the “General Theory of BubbleOmics”, which says (a) that any departure above the fundamental must be followed by an equally severed departure below the fundamental and (b) the period of time above the fundamental is reflected in the period of time below, following the “popping of the bubble”.

Those three arguments are summarised in this chart:



(Click to enlarge)

If you buy that 1970 was the start-point then gold is heading up to $2,000 and if oil prices go up by 50% (which they might), then $3,000 is a good target.

If you buy the argument of the "best-fit" BubbleOmics, then at some point, probably in 2011 or early 2012, the price of gold might plummet by as much as 50%.

Source: Is Gold 50% Overpriced or 25% Underpriced?