Oh. My GOD!!

The finger of GOD never leaves identical fingerprints. But the GOD I refer to – Gold, Oil and Dollar is not that capable yet it is trying to break its age old correlation.

Their intricate relationships have long been debated. They flirt, marry, divorce and again flirt when conditions are conducive confusing everyone. Gold and oil are the reigning kings of the commodity world. Both are extracted from earth. The similarity seems to end there. One is yellow in color and the other is black. The green dollar that broker between the two hurts all and hurts itself too.

Now that the whole nation and the world around us are under the siege of inflation, it is time to rekindle their correlation. The interconnection between inflation, dollar, gold and oil are indeed complex and way too beyond the grasp of ordinary people.

For a very long time the average gold to oil ratio was close to fifteen, denoting that an ounce of gold cost about fifteen times that of a barrel of oil in dollar terms. But does that hold good now? So what has inflation to do with price of oil and gold? What about the effect of a declining dollar on the price of these vital commodities?

Gold is considered to be the definitive standard of value and a universal store of wealth. Its role in the monetary history of the civilized world is unquestionable. The US dollar had the unique position as the sole reserve currency in the Bretton Woods international monetary system. It was the only currency to be pegged to gold and therefore fully convertible into gold. Other currencies were pegged to the dollar. It was President Nixon who snapped the connection and allowed dollar to be backed by just faith and confidence. Yet gold is regarded as a de facto currency.

Oil on the other hand lubricates the world economy. It is almost the lifeblood of modern day living. Be it the groceries, vegetables, dairy and many other necessities that we pick up from the stores, the wide variety of transportation that we use, the electric energy we are so dependent on and the lists goes on, there is always the oil without which nothing can be produced today

Geophysicist Dr. M. King Hubbert constructed a predictive model for the elusive and proverbially slippery commodity – the Oil. The Hubbert’s oil curve built a correlation between peaking oil production and its depletion. His model is both haunting and dangerously closer to truth. As more oil wells are drilled and newer technologies employed, production initially peaks and thereafter outputs begin to decline. The energy that will be spent to discover, extract, transport and refine a barrel of oil now far exceed the energy in that barrel of oil. Oil extraction is becoming more expensive. As this ratio continues to decline, oil prices will have to go up. It will go up even further as long it is priced in US Dollars, with the diminishing value of the dollar. According to Dr. Colin Campbell, one of the world’s leading geologists, the world consumes four barrels of oil for every one it discovers. So the demand is surging.

Between 1944 and 1971, the price of gold was fixed at US$35 per ounce. (1 troy ounce = 31.1034768 grams). The price of oil was relatively stable at about US$3.00 per barrel. Yes it was three dollars.

With the US dollar no more convertible into gold, the oil producing countries holding excess dollars sought to replace it with gold. With more petro dollars chasing gold, the price for both oil and gold soared. Now Gold is US$ 825 per ounce and oil is about US$ 120 per barrel. So going by the standard historical ratio, gold seems to be very much under priced and therefore likely to surge in its anxiety to keep a correlation. Gold prices can therefore go north when confidence levels fall and prospects of real economic growth are bleak.

Some of the old tranquility and predictability that existed in the relationship between gold and oil that was maintained for over 50 years has been lost. The old correlation that stood the test of time for a long time has been broken. The 15: 1 ratio (15 barrels per ounce of gold) that stood for long, was broken when oil touched $55 plus when this ratio fell down and was considered to be at its lowest at 7.5 :1. Now with the oil prices hovering at $125 per barrel, this ratio is at an all time low of about 6.6:1. Is there an opportunity?

When oil prices increase, the input costs for almost everything else rise. This swells inflation. With rise in inflation the purchasing power of money comes down, meaning that a single unit of the currency will now buy lesser gold, oil and less of everything else. We are all experiencing that now. To compound the problem, if supply of gold, oil, other metals and food grains also fall or are not commensurate with the fresh demands from the vigorous economies of the once loved BRIC countries (Brazil, Russia, India and China), it becomes a double whammy

Can Gold prices reach $ 1200 per ounce? Will Oil touch $200 a barrel? Even GOD Almighty may not know. Portfolio managers, personal wealth advisor’s and high net worth individuals should be careful not to fall into this “ratio trap” – when oil moves gold has to move in sympathy. While GOD Almighty is considered to be subtle and not malicious, this GOD (Gold, Oil & Gold) is anything but that!!

 

One thought on “Oh. My GOD!!

  1. In my view there is one more variable here – – The INR /USD currency parity – the strange behaviour of this currency pair over the years has aided enough protection for an average Indian investor (I mean for a rupee investor!)

    To site a case, when the gold was peaking at $950+ during last summer the INR was trading at ~ 42 to a dollar. That will translate the gold price as Rs. 40,000 to an ounze. At the current gold price of $ 850 (after almost a 12% fall in the price ) the value of gold in INR has not changed – It is still Rs. 40,000 (850*47.06) – No asset manager can find a better hedging instrument !!

    Can we infer gold a safe investment – even in the current economic slow down!!! – at least for a resident investor?

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