THE GOLD, OIL AND US DOLLAR RELATIONSHIP Nick BarisheffOf the various vulnerabilities traditional financial assets are exposed to, arising oil price is of particular concern. In 2004, oil hit an all-time high of $56per barrel, up 366 percent from the $12 low of 1998, and up 75 percent sinceJanuary 2004.Generally speaking, an increasing oil price results in increasing inflation,negatively impacting the global economy, particularly oil-dependenteconomies such as the US. Apart from increased transportation, heating andutility costs, higher oil prices are eventually reflected in virtually every finishedproduct, as well as food and commodities in general. Furthermore, there isevidence that global oil production is peaking and the flow will soon be inpermanent decline.The US has enjoyed inexpensive oil-based energy for nearly a century, andthis is one of the prime factors behind the unprecedented prosperity of itseconomy in the 20th century. While the US accounts for only 5 percent of theworlds population, it consumes 25 percent of the worlds fossil fuel-basedenergy. It imports about 75 percent of its oil, but owns only 2 percent of worldreserves. Because of this dependency on both oil and foreign suppliers, anyincreases in price or supply disruptions will negatively impact the US economyto a greater degree than any other nation.The majority of oil reserves are located in politically unstable regions, withtensions in the Middle East, Venezuela and Nigeria likely to intensify ratherthan to abate. Because of frequent terrorist attacks, Iraqi oil production issubject to disruption, while the risk of political problems in Saudi Arabia grows.The timing for these risks is uncertain and hard to quantify, but theimplications of Peak Oil are predictable and quantifiable, and the effects willbe more far-reaching than simply a rising oil price.In the early 1950s, M. King Hubbert, one of the leading geophysicists of thetime, developed a predictive model showing that all oil reserves follow apattern called Hubberts Curve, which runs from discovery through todepletion. In any given oil field, as more wells are drilled and as newer andbetter technology is installed, production initially increases. Eventually,however, regardless of new wells and new technology, a peak output is
reached. After this peak is reached, oil production not only begins to decline,but also becomes less cost effective. In fact, at some point in this decline, theenergy it takes to extract, transport and refine a barrel of oil exceeds theenergy contained in that barrel of oil. When that point is reached, extraction ofoil is no longer feasible and the reserve is abandoned. In the early years ofthe 20th century, in the largest oil fields, it was possible to recover 50 barrelsof oil for each barrel used in the extraction, transportation and refiningprocess. Today that 50-to-1 ratio has declined to 5-to-1 or less. And itcontinues to decline.Hubberts 1956 prediction that crude oil production in the US would peak inthe early 1970s and then decline was greeted with great skepticism. After all,production in the US was increasing and technology was improving. However,there were no new major reserves being discovered, and his predictionproved to be correct. Oil production in the US did peak in 1970, and has beendeclining ever since.Using analytic techniques based on Hubberts work, oil and gas experts nowproject that world oil production will peak sometime in the latter half of thisdecade. We are now depleting global reserves at an annual rate of 6 percent,while demand is growing at an annual rate of 2 percent (and that growth rateis expected to triple over the next 20 years). This means we must increaseworld reserves by 8 percent per annum simply to maintain the status quo, andwe are nowhere near achieving that goal. In fact, we are so far from it that,according to Dr. Colin Campbell, one of the worlds leading geologists, theworld consumes four barrels of oil for every one it discovers.
Once a supply shortfall materializes, the US will be in competition with China,India, Japan and other importing countries for available oil. Many experts arenow predicting US$100 per barrel within the next two years. Some believe itwill go even higher. Taking geopolitical factors and supply/demandfundamentals into consideration, it is impossible to predict how high the priceof oil will soar. One thing seems certain - the age of cheap oil is over.There are numerous social, economic and political implications related toworld oil production peaking in the next few years, but our concern here is toexamine how a rising oil price is linked to precious metals. The answer to thatquestion begins with the historical desire of Arab producers to receive gold inexchange for their oil. This dates back to 1933 when King Ibn Sauddemanded payment in gold for the original oil concession in Saudi Arabia. Inaddition, Islamic law forbids the use of a promise of payment, such as the USdollar, as a medium of exchange. There is growing dissention among religiousfundamentalists in Saudi Arabia regarding the exchange of oil for US dollars.Oil, gold and commodities have all been priced in US dollars since 1975 whenOPEC officially agreed to sell its oil exclusively for US dollars. From 1944 until1971, US dollars were convertible into gold by central banks in order to adjustfor any trade imbalances between countries. Up to that point, the price of goldwas fixed at US$35 per ounce, and the price of oil was relatively stable atabout US$3.00 per barrel. Once the US ceased gold convertibility in 1971,OPEC producers were forced to convert their excess US dollars bypurchasing gold in the marketplace. This resulted in price increases for bothoil and gold, until eventually oil reached US$40 per barrel and gold reachedUS$850 per ounce.Today, apart from geopolitical threats in oil-producing regions, supply/demandimbalances from Peak Oil and increasing demand from developing countries,the price of both gold and oil can be expected to increase as the US dollardeclines. With an ever-increasing US money supply, growing triple deficitsand mounting debt at all levels, the US dollar is likely to continue the declinethat began in 2001. Since then, foreign holders of US dollar assets havealready lost 33 percent of their investment. How long will oil exporterscontinue to accept declining US dollars? How long will they continue to holdUS dollars as their reserve currency?At some point, they may decide to abandon the US dollar in favour of euros.Russian premier Vladimir Putin and Venezuelas president Hugo Chavez haveboth publicly announced that they may begin to price oil in euros in the nearfuture. Even Saudi Arabia has stated that it is considering pricing its oil in
euros, as well as in US dollars. There have even been discussions amongArab nations about pricing oil in Islamic gold and silver dinars. If this happens,other producers may follow suit and opt out of accepting US dollars for oil.Demand for the currency will plummet, sending the dollar into a freefall whiledemand for euros, gold and silver soars.In addition, Middle Eastern oil producers would be forced to diversify their vastUS dollar holdings into precious metals and other currencies to protectthemselves from further losses. As losses mount, other large, non-oilproducing, US dollar holders such as Japan, China, Korea, India and Taiwanwould seek to diversify out of US dollars. Eventually, this could result in adollar sell-off and a corresponding increase in oil and gold prices.Over the last 50 years or so, gold and oil have generally moved together interms of price, with a positive price correlation of over 80 percent. During thistime, the price of oil in gold ounces has averaged about 15 barrels per ounce.However, with recent soaring oil prices, the relationship has strayed far fromthis average. While oil prices recently set an all-time high of $56 per barrel,gold prices have not kept pace and the oil:gold ratio fell to an all-time low of7.5:1. At US$56 per barrel oil, the gold price should be in excess of US$840per ounce. Some experts are suggesting that, in two or three years, US$100per barrel oil is very possible. At that price gold should be US$1500 perounce.The gold silver:ratio has varied from 16:1 to 100:1. Currently it is about 66:1.Gold Fields Mineral Services expects this ratio to fall to between 40:1 and50:1 in the near future. At a 50:1 ratio and a $1,500 gold price the price ofsilver should be $30/ounce. At 16:1 it would be $94/ounce.The size disparity between oil and gold markets must also be considered.While annual gold production is approximately US$35 billion, annual oilproduction is US$1.5 trillion, by far the largest-trading world commodity. As oilprices increase and demand for US dollar diversification increases, there willbe an ever-expanding number of petro dollars and other offshore dollarholders chasing a relatively small amount of bullion ounces.In conclusion, the price of oil is poised to rise steadily as the supply/demandimbalance increases and the dollar declines, even if there are no supplydisruptions, terrorist threats or geopolitical concerns to consider. As thishappens, the price of precious metals will climb until they eventually catch upto their historic ratios. Should oil producers demand euros, dinars or preciousmetals in payment for their product, the decline in the US dollar will accelerate
while the price of precious metals explodes. If oil producers and other foreignUS dollar holders begin to sell the trillions they hold and diversify intoalternatives, then the price of both oil and precious metals will rise to levelsthat today are hard to imagine.22 April 2005Nick Barisheff is the co-founder and President of Bullion Management Services Inc., which wasestablished to create and manage The Millennium BullionFund. The fund is Canadas first and only RRSPeligible open-end Mutual Fund Trust that holds physical Gold, Silver and Platinum bullion.www.bmsinc.caThe opinions, estimates and projections ("information") contained herein are solely those of BullionManagement Services Inc (BMS) and are subject to change without notice. BMS is the investmentmanager of The Millennium BullionFund (MBF). BMS makes every effort to ensure that the informationhas been derived from sources believed to be reliable and accurate. However, BMS assumes noresponsibility for any losses or damages, whether direct or indirect which arise out of the use of thisinformation. BMS is not under any obligation to update or keep current the information contained herein.The information should not be regarded by recipients as a substitute for the exercise of their ownjudgment. Commissions, trailing commissions management fees and expenses all may be associatedwith an investment in MBF. Please read the prospectus before investing. MBF is not guaranteed, its unitvalue fluctuates and past performance may not be repeated.
Could the US Dollar be Replaced as theWorld’s Reserve Currency? What it WouldMeanby DarwinCould a basket of currencies and gold replace the US Dollar as the primaryreserve currency globally? That’s a question that’s been batted around for a while,usually amongst fringe naysayers and ranting leaders of Venezuela and middle eastregions. However, I read with interest this article from the Independent UK that rivalcountries were looking to supplant the US Dollar as the currency for oil trading,which would have obvious implications for the standing of the American currency asthe reserve currency of choice worldwide. How goes oil currency, so goes the globalreserve currency is the thinking. According to the article, there was a secret meetingbetween the central banks of Brazil, France, China, Russia, Japan and several OPECstates where they were plotting to replace the denomination of US dollars with abasket of other currencies and gold. While there was speculation that the recent risein gold was correlated with the meeting, it may not be prudent to jump on the goldbandwagon just yet (see other metals ETFs that may benefit from a weakening dollarmore so than gold).As unlikely as it seems, never say never. Recall that the British Pound was the globalreserve currency for quite some time until the US dollar finally replaced it followingWorld War II. Note however, that the US was surpassing Great Britain as the world’sfinancial and military superpower well before that. Seeing a switch from one reservecurrency to another doesn’t happen overnight – but it does happen. It’s evident thatthe US is losing is dominance in everything from military might to trade, but expertssay even if a switch is under way, this is a decades-long process, not something we’dsee occur within a matter of mere years.Why are Countries Fed up with the US Dollar?There are some rather complex implications of an ever-weakening dollar, such as, oil-rich countries are seeing rampant inflation because while they get paid in US dollarsfor oil, they tend to import much of their goods and services from the EU region.Since the US Dollar has been tanking against the Euro and other currencies, these USdollars tend to be worth less and hence, have much less buying power, stokinginflation. (see full list of allcurrency ETFs to exploit this weak dollar trend). Similar
effects are felt elsewhere, namely China and other large exporters to the US. As theyare paid in dollars, an ever-declining currency, their income is artificially decreasingover time as well as the Treasuries they’re buying to satiate our debt. How long thesecountries will continue to see their investments plummet while sitting idly by isanyone’s guess. But, with the US taking on unprecedented debt with bailouts andstimulus plans while mulling over another massive entitlement in “health care reform”– another Trillion dollar boondoggle, things aren’t looking good for the dollar.What Would Happen if the US Dollar were Replaced as the Reserve Currency?Without US dollars serving as the reserve currency, that mandates an unwinding ofcurrent holdings and gradual transition into the new currency/gold standard. Thiscould result in a complete collapse of the US dollar versus virtually all othercurrencies. While US multinationals may rejoice temporarily since overseas sales inforeign currencies get a boost from a weakening dollar each earnings cycle,eventually, US consumption would suffer; we wouldn’t be able to afford imports tothe same degree. As foreign economies that have been servicing our debt realize thatthe music has stopped playing and they don’t want to be left without a seat, they stopfunding our debt. Interest rates would rise as demand for Treasuries sends yieldsskyrocketing. You think we’d ever see mortgage rates at less than 5% in our lifetimeagain?How Would we Explain this to Future Generations?Someday, we may very well tell our children that when we were their age, the USDollar was the most important currency in the world – the most trusted reservecurrency. We were the sole military and financial superpower in the world. We haddefeated the Nazis, Socialism, Communism, Fascism and Terrorists. Our generationthen squandered the best potential any generation in the history of the world has beenafforded. In spite of the culmination of all these accouterments, we squandered ouropportunity and left them with generational debt they will not be able to repay. Let’shope it doesn’t come to that, but with the elected officials calling the shots now (bothsides of the aisle), it’s evident that this is our destiny.The RealityThis article may seem overly gloomy and may not play out at all or nearly to thedegree feared. However, we need to at least be thinking about the consequences ofour indifference to our crumbling world standing. There aren’t really any goodalternatives to the US Dollar at the moment. It’s unlikely Asia and the middle eastwould agree solely to the Euro as a new reserve currency without trying to interjecttheir currencies into the mix, and keeping a basket of currencies in line involving
those various regions would be next to impossible, especially given differences intheir monetary policies, internal fiscal strength and lack of alliances politically.Throw gold in there and the prospects become even less plausible. “oil-rich countries are seeing rampant inflation because while they get paid in US dollars for oil, they tend to import much of their goods and services from the EU region.” This is exactly it. I would say that the above reason is one of the best reasons for this talk about moving away from the dollar and instead moving to a basket of currencies. Now, if the US was more of an exporter of the very same goods that these Arab nations needed to import then this would not be nearly as much of an issue but that is not the case. What are Your Thoughts? Does it Even Matter? Will the Average American even Know What Happened? [Reply] 2 Financial Samurai October 13, 2009 at 10:35 pm It actually doesn’t matter at all whether the USD depreciates further. Nobody in America stays overseas long enough for it to matter! [Reply] 3 Kevin October 14, 2009 at 2:03 pm It definitely matters if our currency continues to depreciate. It makes things more expensive. You think the economy sucks now? Wait til average Americans who are broke have to pay $5 and up for a gallon of gas. Inflation will slaughter average Americans… The future is ugly I’m afraid.
[Reply] 4 Jim Gill November 4, 2009 at 9:46 am Remember that the pound is still very strong against US dollars after US dollars become the reserve currency. I suspect it will the same. US dollars will become a high yielding currency as US rise interest rates in the not so distant future. [Reply]Don’t get carried away by the gold rally(10/oct/2011)Though gold has caught investors’ fancy for its steep rally over the past quarter, thevolatility it has shown during the same period seems to have gone out of the frameVolatile times | HirenDhakanGold has been, for decades, bought as a medium to diversify and reduce portfolio risk and volatility.Gold is crowned with the status of a “safe haven” due to its ability to preserve investment value inturbulent times and hedge it against inflation. While the equity and debt markets have much to worryabout before they see a takeoff, the global gold demand in the second quarter (April-June 2011) wasthe second highest quarterly value on record with India and China being the big contributors. Notsurprising enough though with gold rewarding markets for 11 consecutive quarters.The festive season is just around the corner and the yellow metal is back in the limelight; this timemaybe for an unnoticed but worrying reason. Though gold has caught investors’ fancy for its steeprally over the past quarter, the volatility it has shown during the same period seems to have gone outof the frame. No prizes for guessing the reasons for missing it: our love for the metal as well as gold’sbrand as a “saviour in jittery waters”.Changing prices
To give you a gist of what I’m pointing to: The average daily price change of gold in India hasincreased more than six times between 2001-2011. At the same time, the percentage spread betweenthe highest and lowest price of the year has more than doubled. The standard deviation, whichsignifies the volatility in daily returns over a period, has increased more than 85 times whencomparing periods of 1981-85 with 2006-10.Difficult to digest, isn’t it? However, KusumVaya, one of our astute investors from Gujarat, witnessedit first-hand when she was planning to purchase some gold jewellery for her son’s marriage scheduledthis November. Vaya was of the view that gold prices would shoot up as the festive season is close tothe marriage dates. She was thus planning to purchase the required jewellery beforehand in August.On 11 August, she approached her family jeweller and informed her about her plans to buy goldat Rs. 26,200 levels. The jeweller, in turn, informed her that the gold was down at least Rs. 600 in theday and is expected to fall further in days to come. Vaya considered his advice and decided to wait fora week. The advise worked somewhat as gold corrected Rs. 300 more in the next few days. Vaya gottempted to hold on for a few days more to seek some more correction. To her despair, prices shot upin a matter of days and breached Rs. 28,200 levels; a rise of almost 10% in a matter of week. Shefound herself helpless and finally bought at Rs. 27,800 levels only to see the prices drop to Rs. 25,512three days later—a fall of 8.2%.What should you do?Well, there would be many such investors who have been regretting for betting on gold’s “expecteddirection or volatility”. With such increased volatility, the big question remains: should you hold/buy itnow?Gold still is and will remain a hedge against uncertainties and inflation. What has changed is our needand ways for buying the same. Gold has been increasingly bought in the form of gold bars and coinsand it has started to increase its pie in the portfolio of most investors owing to lucrative returns in thepast one year. The emergence of exchange-traded funds has also led to increased speculative buyingof gold. There are investors who buy gold for hedging their equity positions for a week or two. In suchcases, one loses out on the basic premise for which gold is usually bought.Gold has very low correlation with most asset classes and thus plays an important role in a portfolioby reducing volatility. Gold is also immune to economic shocks and preserves portfolio during badtimes. Thus, gold should be bought as a long-term asset to hedge against inflation and uncertainties.Ideally, an allocation of 6-10% of one’s portfolio should suffice. But if you are betting more, it’s timeyou reassess why you did so.