Crude Oil... Has Everything to Do With the Price of Gold

Submitted by SadInAmerica on Tue, 08/05/2008 - 6:01pm.

Crude oil prices in recent times threatened to breach the $150 per barrel mark, and later fell to $123 levels, clocking an appreciation of almost 30% in the year. In fact, higher oil prices have been sending shivers down the stock markets worldwide, as if the recent global financial crisis was not enough to unnerve them.

Back home, Indian stocks are down by around 30% in the current year. Inflation has already reached double digits at 11.98% and is showing no signs of respite, adding fuel to the fire.

I would start with an interesting conversation I heard recently. I happened to be at an oil trader’s dealing room. I asked the chief dealer, “What’s happening to oil? It is down 20% from its peak. Will you buy now?” He answered: “Oil’s down due to speculative unwinding of long positions and a growth scare in developed countries, which might result in lower demand for the scarce commodity.”

He then called someone in Iran, a member of OPEC, an association which controls around 40% of the global oil output. I heard him saying, “So the skirmishes between Israel and Iran continue? And the usual problems in Iraq, Nigeria, etc, also continue with supplies remaining vulnerable to serious disruptions. US stockpiles are down, no new oil discoveries.” He hung up the line. I was sure that his next reaction would be to buy more crude oil, since according to him, supply remained vulnerable.

Surprisingly, his next call was to someone in South Africa: “How’s the mining industry doing? Any increase in the output in gold? Will the gold mines continue to face power disruptions from Eskom?” The response from the other side was “no” for the first question and “maybe” for the second one.

He said: “Ok, buy gold worth $5 million.” I was shocked, and was compelled to ask: “Hey, after your last phone call, I was convinced that you would immediately place orders to buy more crude oil. Where does gold come into the picture? He was grinning from ear to ear and proceeded to show me a chart.

He asked me: “What do higher crude oil prices do to the general price levels in the world?” I said: “Of course, higher crude oil prices fuel inflation, since most of the demand for oil is inelastic.” He further probed: “Is gold a kind of proxy currency?” I said: “Yes. In fact, in the 1900s, many countries in the world had gold standards — gold was used as a medium of exchange.”

Let’s presume that gold was the currency now. How much gold would be required to buy a barrel of crude oil? Or how many barrels of crude oil will be required to buy an ounce of gold? The answer is around 7.3 barrels of crude oil would fetch one ounce of gold. This ratio is known as the ‘gold-oil ratio’.

He continued his questions: “Paper currencies like US dollar tend to lose their purchasing power over the years, why?” I replied: “Simple — due to inflation.” As time passes, paper currencies can’t buy the same amount of oil which you could have bought years ago. And the final words of wisdom came from him: “But gold is different.

It preserves value — better known as a store of value — and that’s the reason why gold is used to hedge inflation.”
He said: “Look at the very long term chart, the average number of barrels required to buy one ounce of gold is around 14.5, which is now at 7.3.”

I nodded in affirmation and said: “That’s because crude oil has moved up sharply from $38 in 1980s to $123 (high of $144), whereas gold has not moved in tandem. It is still trading near $910 per ounce, a little more than the 1980s high of $850 per ounce.” He jumped up and said: “Bingo, now for the gold-oil ratio to reach its long-term average of 14.50, at current prices, either the crude oil price has to move down to $63 or the gold price has to move up to $1,700.”

As I was leaving his office enlightened, I thought with the current uncertain geo-political situation in oil-rich countries such as Iran, Iraq and Nigeria, and with no new discoveries, crude oil seems unlikely to move down to say $63 levels for the gold-oil ratio to reach its long-term average of 14.50. In that case where would gold go?

With the US on the brink of a recession, financial crisis still not over, inflation not abating on higher food and commodity prices and the US dollar depreciating, all the positive factors for a gold price rise are in place.

And by sheer coincidence, I got a call from my stock broker, lamenting the fact that the equity markets were heading south and trading volumes had crashed. He was keen that I buy stocks. I told him: “Sorry, I am now only keen on buying gold.” He was happy.

“I can help you in buying gold at attractive prices,” he said and then explained: “The most appropriate way to buy gold is to buy a gold exchange traded fund (ETF) on the NSE. It is as easy as buying any other stock. The units are held in demat form in your account, thus eliminating the need to hold gold in the physical form.”

Acquiring gold via ETFs ensures no hassles of storage, security, quality, insurance, transportation, making charges and others. The fund house stores all the gold backing — each unit in secured vaults — and also has it completely insured. The price of gold ETFs reflect the domestic gold prices, less expenses. There is also a Gold Exchange Traded Fund which charges very low expenses. Moreover, easy liquidity and price transparency is ensured as they are listed on the NSE.

Later in the evening, I reflected on how much the relationship between crude, inflation and gold is important for investment decisions. And, how easy and convenient it is to buy gold and hold it without any worries — especially in times like these, with high crude oil prices, high inflation and falling equity markets.


Devendra Nevgi - August 3, 2008 - source EconomicTimes

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Submitted by SadInAmerica on Tue, 08/05/2008 - 6:01pm.