China's Gold-Backed Oil Futures: A Threat To The U.S. Dollar, A Boon For Gold

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Includes: GDX, GDXJ, GLD, IAU, PHYS
by: Al Moghadam

Summary

China is introducing a new gold-backed, yuan-based oil benchmark.

The new oil futures contract in the yuan will reduce demand for the USD, dropping its value.

China will need to increase its gold reserves to back the yuan-denominated futures contract sufficiently.

A combination of increased demand for gold in china and a weaker USD will lead to higher gold prices in the short to medium term.

China has recently announced a new crude oil benchmark that's similar to Brent and West Texas Intermediate (WTI) and based in Shanghai. This has the potential to become an important oil benchmark since China is the world's top oil importer. The new oil futures contract will be in yuan as opposed to the U.S. dollar (USD). Since some oil exporters might hesitate to accept yuan as payment, China is making yuan convertible to gold. This could potentially have a significant impact on currency, bonds, oil, and gold markets.

Currently, almost all the oil trade in the world is being conducted in USD. The exceptions are countries under some form of U.S. sanctions (Iran, Russia, Venezuela, etc.). In this article, I will try to estimate the volume of oil futures that could potentially be traded on the Shanghai International Energy Exchange in the short/medium term. This estimate can help us understand potential implications for the currency and gold markets.

What does it mean for USD?

Total oil imports in the world currently amount to 45 million barrels per day. China is responsible for 8 million barrels per day of oil imports. However, the futures volume of oil traded far surpasses the actual oil imports. Currently, WTI brings in roughly 1 million contracts per day, and Brent's futures trade amounts to half of that. Each contract is equivalent to 1,000 barrels of oil. Therefore, a rough estimate for the current oil futures traded in the world amounts to 1.5 million contracts, or 1,500 million oil barrels per day. This volume is roughly 30x the physical oil demand for imports. All this volume is currently traded in USD, which contributes to the high demand for the currency -- hence the name "petrodollar."

If China eventually procures its oil imports of 8 million barrels per day through the yuan-based contracts and we use the same multiplier (30) for the futures volume, the total trade volume in yuan amounts to 240 million barrels of oil per day (or 0.2 million contracts per day). Producers such as Russia, Iran, and Venezuela will potentially welcome using gold-backed yuan as a trading currency.

240 million barrels of oil per day at $50 per barrel amounts to $4 trillion in annual trade. This means roughly $4 trillion will eventually be sold and converted to yuan. This will have a significant negative impact on the value of the USD, all else being equal. Lower dollar value with respect to other currencies could lead to an increase in U.S. inflation, at a time when the economy is facing the end of a cycle or a recession (in the next one to three years, in my opinion).

It should be noted that the transition of this volume of oil trade to yuan won't happen overnight. It could take a few years, depending on the willingness of oil exporters.

How does gold benefit?

The benefit of the new oil futures contract for gold price is twofold. For one, a drop in USD value leads to an increase in the gold price. Gold is mainly priced in USD, so it tends to move in the opposite direction. This is apparent in the recent gold price vs. dollar index values presented in the chart below.

Two, China is backing yuan with gold for the new oil futures contract. We can say with certainty that not all of the $4 trillion trade volume will be redeemed in gold. If we assume China will at least have enough gold reserves to immediately back 10% of the trade volume, that means $400 billion worth of gold would be needed. China's official gold reserves have been increasing in the past few years at an increasing pace (now we know at least one of the reasons).

The current gold reserves in China stand at 1,800 metric tons. At $1,300 per ounce, it adds up to $74 billion. In order for China to sufficiently back the yuan with gold, current reserves need to increase fivefold to around 8,000-10,000 metric tons (leading to a $400 billion equivalent gold reserve). Current gold production in the world is around 2,500 metric tons, half of which is used for jewelry.

In order for China to increase its gold reserves to meet the requirements for the gold-backed, yuan-based oil futures, a significant amount of gold needs to be purchased. The increase in demand will inevitably increase the gold price. Additionally, the higher the gold price, the less of it China will need to meet its obligations. Therefore, China will potentially have an interest in keeping gold prices up in the future.

Recommendations

I believe the new gold-backed, yuan-based oil futures contract reduces the demand for USD considerably. That will lead to a decline in USD in the short to medium term (one to five years), all else being equal. On top of that, since the new oil futures contract is redeemable in gold, China needs to bolster its gold reserves in the near future. I believe the combination of a weak USD and a strong demand for gold to increase China's reserves will drive gold prices much higher. If the current business cycle ends within that time frame (which is very likely), another set of rate cuts and QE coupled with economic uncertainty will be additional fuel for gold prices. The stars seem to be finally aligned for a new gold bull market.

I recommend at least a 10% allocation to physical gold ETFs such as SPDR Gold Trust ETF (GLD), and gold miners such as VanEck Vectors Gold Miners ETF (GDX) and VanEck Vectors Junior Gold Miners ETF (GDXJ).

There are several assumptions in the calculations I've provided above, and by no means are they perfect. The main assumption is that enough oil exporters agree to accept the yuan as payment to cover China's 8 million barrels per day of imports. Please feel free to comment if you think some of these assumptions can be refined further.

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Disclosure: I am/we are long GLD, GDX, GDXJ.

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.