China's New Gold-Backed Oil Futures Contract Cuts Out U.S. Dollar

by: Michael Fitzsimmons

At the turn of the year, I wrote an article related to a possible Trump induced rally in gold.

Since then, we've had two additional bullish factors: the North Korea crisis and Hurricane Harvey.

Here's a new bullish factor flying under the radar: China has created an oil benchmark based on gold, effectively cutting out the U.S. dollar.

Amid an already very bullish environment for the appreciation of gold, a recent development could cause massive disruption in to today's global oil market: the imminent introduction by the Chinese of a yuan based - and gold backed - crude oil futures contract. But before discussing that in some depth, let's first summarize the already very bullish backdrop for gold.

After considerable gold liquidation following last year's presidential election, my last Seeking Alpha article of 2016 was a bullish call on gold and "The Possibility Of A Trump-Induced Bull Run." I expanded on that theme with Part II and Part III as the Trump administration began taking action. In addition, I noted the bullish impact on gold of a falling U.S. dollar in this Seeking Alpha article.

Recent events - like North Korea's nuclear detonations and missile tests, Hurricane Harvey, and the up-coming need for Congress to raise the U.S. debt ceiling again - are all singularly bullish for gold. In aggregate, these events are compelling reasons why investors should seriously consider increasing their gold positions.

Note I wrote an article back in 2012 on the possibility that global warming, and the storms it helps intensify, will support higher gold prices via increased and substantial U.S. deficit spending to fund storm recovery efforts (see "Global Warming Will Push Gold Higher"). It's taken awhile to see that thesis come to fruition, but note that CNN reported that Texas Governor Greg Abbot thinks Texas will need "far in excess" of $125 billion in federal relief dollars. Houston Rep. Sheila Jackson Lee called for a record-breaking $150 billion aid package.

Federal hurricane assistance has increased dramatically since Hurricane Katrina, with the federal government shelling out more than $200 billion. About half went to the Katrina recovery effort and a quarter of which went to Hurricane Sandy relief efforts.

In the meantime, Hurricane Irma, a Cat 5 storm, is heading toward the Gulf of Mexico and is currently projected to pass between the tip of Florida and Cuba.

Source: CNN

All the events mentioned above lend additional support to my bullish outlook on gold at the beginning of the year. In fact, I have never seen the outlook for gold looking better than it does right now.

A Potential Game Changer in the Global Oil Trade

Recently I read about a development - which is flying well below the radar screen of most U.S. investors - which may turn out to be an even bigger long-term support factor for gold than anything previously mentioned in this article. The Nikkei Asian Review recently reported that China is expected to launch a crude oil futures contract which will be priced in yuan and convertible into gold. Given that China is now the world's biggest oil importer, this futures contract - which is designed to let oil exporters circumvent the U.S. "petro-dollar" - could become the most important Asia-based crude oil benchmark.

Crude oil is usually priced relative to Brent or West Texas Intermediate (WTI) futures contracts, both of which are denominated in U.S. dollars. China's new yuan-based, gold-backed crude oil futures contract is likely to appeal to oil producers that might prefer to avoid using U.S. dollars, but are not yet ready to accept being paid in yuan for oil sales to China. That is because the yuan is not yet a globally traded and highly liquid currency as compared to the U.S. dollar or even the euro. But the gold backing of this new crude oil futures contract solves that concern of the oil exporters. It would also make it much easier for buyers and sellers to elude any potential U.S. crude oil trade sanctions that may exist or arise from time to time.

China's crude imports averaged around 7.6 million barrels a day in 2016. At $50/bbl, that equates to trading of an estimated $138 billion on an annual basis. For comparison, note the total market cap of the SPDR Gold Trust ETF (GLD) is around $35 billion. I mention that just as a comparison metric for investors to judge the potential impact if only 25% of China's oil imports were to trade based on this new futures contract.

Source: Nikkei Asian Review

But what are the chances such a oil futures contract will be actually be adopted by oil exporters? In the Nikkei Asian Review linked to above, Luke Gromen, the founder of U.S.-based macroeconomic research company FFTT, said that the "rules of the global oil game may begin to change enormously." That opinion seemed to be seconded by Alan Bannister, Asia director of S&P Global Platts, in the same article. Bannister said that active involvement of Chinese independent refiners over the last few years "has created a more diverse marketplace of participants domestically in China, creating an environment in which a crude futures contract is more likely to succeed."

According to Wikipedia's webpage on Reserve Currency, China policymakers have previously said "we don't want to make any more foreign exchange reserve of any paper currency, because all the paper currencies are government debt currencies." That comment was obviously directed squarely at U.S. policymakers and the Federal debt they have piled on over the years.

Countries like China, Russia, India, Turkey, Brazil, and Venezuela have proposed using IMF "special drawing rights," or SDRs - which would be calculated daily from a basket of various currencies: the U.S. dollar, euro, Japanese yen, British pounds, and Chinese yuan - for international payments. Some have also advocated that precious metals like gold and silver also be components of any globally agreed upon SDR "basket."

Note that Russia, Brazil, and Venezuela alone accounted for around 25% of China's total oil imports (see graphic above). If Middle Eastern exporters like Saudi Arabia, Iraq, and Iran also began using the new yuan/gold crude oil futures contract, more than 50% of China's imports could potentially be non-U.S. dollar denominated transactions. If so, the impact could be huge. Over time it could erode the U.S. "petro-dollar's" role as the world's reserve currency of choice - and this would have a dramatic affect on the U.S.:

  1. The value of the U.S. dollar would likely fall significantly; imports would be more expensive, but it would also help U.S. manufacturing and exports.
  2. The U.S. Congress would very likely no longer be able raise the U.S. debt limit (i.e., print more U.S. dollars) indefinitely because global demand for the U.S. dollars will likely fall - perhaps dramatically.
  3. As a result, the value of gold, globally priced in U.S. dollars, would likely rise.

The good news here is that the U.S. is producing more oil these days and has reduced its oil imports from some of the same countries that are likely to adopt the new Chinese yuan/gold backed crude oil futures contract.

I have never seen the future of gold look as bullish as it does right now. While the precious yellow metal has been moving higher of late, I think it is just starting a major move which will take it much higher - certainly through the old high of ~$1900/ounce set way back in 2011. If oil exporters adopt the new Chinese yuan/gold backed crude oil futures contract for deliveries to the world's largest oil importer - China - it will lend further support and accelerate an already very bullish environment for gold investors.

Disclaimer: I am an engineer, not a CFA. The information and data presented in this article were obtained from company documents and/or sources believed to be reliable, but have not been independently verified. Therefore, the author cannot guarantee their accuracy. Please do your own research and contact a qualified investment advisor. I am not responsible for investment decisions you make.

Disclosure: I am/we are long GOLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.