Oil And Gold Still Joined At The Hip: Be Wary

 |  Includes: GLD, OIL
by: Andrew Butter

I saw this in Money Morning: Apparently gold is still "The Greatest Trade Ever" and that's because (NYSE:A) the same old reasons (NYSE:B) central banks are still buying (NYSE:C) John Paulson is buying and he made a fortune betting the housing bubble was going to bust.

OK, but central banks don't always get it right and the fact John Paulson saw there was a housing bubble and put money on the bubble popping, does not prove that when he says gold is not a bubble...he will be right two times in a row.

This is a chart of the price of oil and the price of gold, superimposed for the past 10 years:

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Do a straight-line regression on those numbers and you get an R-Squared of 69%, which means over that time 69% of the changes in the price of oil can be explained by the changes in the price of oil over that period, or the other way around.

Take those lines back to 1971 when gold was pretty much allowed to find its own level, leaving aside the accusations (so far not proven) that central banks manipulated markets to keep the price of gold down…there is an 84% R-Squared.

Of course that doesn't mean that's going to happen in the future and also that information does not tell you whether (in the past) the price of oil drove the price of gold or the other way around, or even if the price of both of them was driven by something else.

Personally, about three years ago, I thought that the price of gold (in dollars) was driven by the price of oil (in dollars), the logic there was that oil is the indispensable and irreplaceable driver of modern economy's, so its price in gold...real money...had to be constant over time.

Now I think it's a bit more complicated.

Take the price of gold in dollars (or if you are an Austrian, the value of dollars expressed in real money), over the past few years when the price of gold sky-rocketed, there has been a very good correlation between gold, and how much money the U.S. Government owes:

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What happened in 2010 was that the appetite of foreigners for U.S. Treasuries went down relative to the total need, and so the central bank started buying.

So there is support for the idea that the driver of the price of gold is how much money the Fed prints to buy U.S. Treasuries. That's what Marc Faber is talking about when he says, "So long as Ben keeps printing money, I'm buying gold."

But perhaps that's not right, or at least only partially right? It's hard to tell, certainly from the chart.

My intuition is nagging away telling me that's too neat; there has to be a reason and I don't buy the idea that when the Fed prints that will automatically create inflation...velocity is an issue too, and the current price inflation in the U.S. can be just as easily explained by the drought, the subsidies on corn-to-ethanol, and the price of oil. In which case perhaps the black line is the right one?

Oh, and I know the U.S. Government debt is not just U.S. Treasuries, but recently the trend has been to stop raiding the pension funds, and although it's hard to get the numbers in a timeline, the total exposure pretty much follows the black line.

America needs to sell Treasuries to foreigners to finance its current account deficit. In the run up to the credit crunch that need was mitigated because the shadow banking system was selling "other than Treasury securities" to foreigners. In some way those sales can be considered to have been "exports" since the debt was non-recourse, and much of it won't get paid back.

But those days are gone, as of now securitization is dead and the only credit-worthy provider of securities in any bulk in the U.S. is the Federal Government.

A big driver of the current account deficit, is what America spends buying oil.

So perhaps that's it? The money America borrows to pay for importing oil causes the price of gold to go up via the requirement to sell Treasuries to foreigners to pay for the oil.

So what's happening now? For almost a year the price of gold went no-where, also the price of oil pretty much flat-lined.

One thing that happened was that America's oil dependency went down, first because it started producing (a little) more and second because it started consuming (a little) less; this is a chart of the production:

(click to enlargeClick to enlarge


The other thing is that the discovery of new ways to get natural gas out of the ground, has led to an over-supply. Prices are rock-bottom.

There are ways to use natural gas to replace oil. All the buses in Korea run on natural gas, trucks and trains can run on natural gas also, and in fact so can automobiles.

Right now, the infrastructure isn't there, also because there is practically no tax on gasoline, and no tax breaks for doing conversions, no one is switching.

But it is possible that once the U.S. government gets its act together and works out the cost-benefit of Americans not being dependent on foreigners' largess so they can drive to work in the morning, there may be a change of heart, including a challenge on the immutable right to have cheap gasoline.

Perhaps there is an expectation in the market that America might one of these days do something about the current account deficit, particularly in relation to the amount of money it has to borrow from foreigners, in order to pay for importing oil.

And that expectation might be what is cooling down the price of gold?

One other thing, according to me, oil is in a bit of a bubble now (not a lot of people agree with me).

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OK I've being saying that for a year, and although that analysis did call the inflections correctly, the price never went down to what I call a true-pop price.

I suspect that might have something to do with the Bomb-Bomb-Bomb-Bomb-Iran brigade, who apparently didn't work out yet that the "unintended-consequence" of that would likely be a huge spike in the oil price, which would not be good for the economy of a nation that is as dependent of the largesse of foreigners to buy oil, to keep running.

Sorry to sound like a broken-clock, but for me oil prices are going to need a "pop" before they can get back to their current other than market value (some people call that the fundamental fair value; personally I don't like the word "fair" in that expression because there is nothing "fair" about value). Either way, I think that's about $90 (Brent) right now.

And I wouldn't be surprised to see gold under $1,000 in the next two years, and yes I know that's a real minority view.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.