Gold Still Boiling in Oil

Adam Hamilton     April 5, 2002     4343 Words


In what seems like a century ago in terms of all the incredible financial market and geopolitical developments of recent years, I penned an essay on gold and oil way back in June 2000. 


In my earlier essay, titled “Gold Boiling in Oil”, we took a look at gold and oil in their historical price context and examined their very strong relationship over time.  I arrived at the conclusion that the relatively high oil prices at the time were exerting substantial upward pressure on gold prices, that ice-cold gold was heating up as it was trapped in the bottom of a great cauldron of boiling oil.


Gold and oil are my two favorite commodities and I don’t think many people would dispute that they are the reigning kings of the commodity world!

Gold is the ultimate standard of value, resolutely standing fast in a fickle world.  For six millennia of human history gold has almost always been the most-highly-sought-after universal store of wealth.  The seemingly magical yellow metal is the de facto standard by which every other form of money and wealth in history has been measured.  Gold is indestructible and omnipotent in the monetary world, having withstood countless bloodthirsty assaults by governments throughout history vainly attempting to render impotent its iron-fisted discipline on currency growth.  Empires and currencies rise and fall, but gold stands strong, monolithic and proud, casting an enormous shadow over all of monetary history.


While nowhere near as ancient as gold, crude oil is the very lifeblood of our incredibly intricate modern civilization.  Without oil, global trade would grind to a screeching halt.  Our great cities, towering above the surrounding lands like magnificent concrete and glass castles, could not survive long without the cornucopia of goods that oil brings to them.  Virtually every physical good that enters a city, or travels anywhere for that matter, from food to building materials to computers, is hauled in via vehicles powered by oil-guzzling internal-combustion engines.  I don’t believe there is another single commodity on earth that even comes close to the central importance of oil in shaping the very civilization that we humans call home in this peculiar era of history.


Here at Zeal, in the last couple years we have mainly focused on stocks of primary gold-producing and oil-producing companies in our equity investments.  Our Zeal Intelligence private newsletter clients as well as ourselves have been blessed with some fantastic gains in recent years in these exciting commodities arenas.  While the mainstream equity markets burn down around us as the world relearns the hard lessons of seven decades ago regarding the inevitable hyper-painful consequences of great equity bubbles, gold and oil speculators and investors are enjoying a wondrously profitable run.


When my natural affinity for fascinating physical commodities like gold and oil is coupled with the wonderful blessings of tremendous profits from speculating and investing in these dynamic market sectors, my already strong lifelong interest in gold and oil waxes even larger.  Along these lines, I have been very pleasantly surprised to periodically receive e-mails about my old “Gold Boiling in Oil” essay.  Even today, almost two years after I penned those words and blasted them into cyberspace, folks still generously write me encouraging notes saying that they loved the oil and gold comparisons and would be thrilled to see an update.  Me too!


So, during this seemingly fitting time after a geopolitically-breathtaking couple of weeks, we decided to update our key gold and oil comparison graphs to see if the intricate dance between the gold and oil markets is ready to yield any more secrets now than it was way back in June 2000.


Before we begin, a few notes from the research department are in order.  All the data used in this essay is monthly closing data, except for the last data point in April 2002 taken from daily market closes on April 2nd, the day before these graphs were created.  For a strategic half-century plus comparison, monthly data is plenty adequate and produces much cleaner graphs than the far more volatile daily closing data.  The only caveat is that the monthly closing data does not reflect the full intra-month daily extreme price movements such as in early 1980 in gold and oil.


In addition, in a slight change from “Gold Boiling in Oil”, we decided to start our comparison in 1950 this time around rather than in 1946 again.  The reason for this change is that 1950 is a half-century mark and seems like a more logical embarkation point than the arbitrary 1946 that defines the beginning of our gold and oil dataset.  To make sure that this decision didn’t skew our analysis, we did compute the latest figures from 1946 as well, and as expected the differences in ratio averages were immaterial, far below 1%.  1950 just feels better than 1946 as a year to begin our journey.


Our first graph is a simple comparison of gold and oil prices.  These are nominal dollars, not adjusted for inflation.  Even without the benefit of fancy spreadsheets and fast computers the intimate dance between gold and oil prices throughout the recent decades is very apparent to the naked eye.



The yellow gold and black oil price threads winding through history match remarkably well.  The most striking attribute of this graph, as always, is the gargantuan break with the past that occurred in late 1971, marked by the red arrow above.  Before 1971, both the oil and gold prices were stable and predictable.  After 1971, it was as if a giant titan had suddenly shaken the world and price volatility and unpredictability literally exploded in a violent fury.  The Age of Volatility was born!


While some market historians attempt to lay the birth of this volatility explosion at the feet of the Arab Oil Embargo of 1973, the last time the Islamic countries attempted to destroy Israel in their surprise October 1973 Yom Kippur invasion of the tiny Jewish state, that was not the culprit.  Notice above how the gold price started running higher well before oil prices exploded, much earlier than late 1973.


On August 15th, 1971, US President Richard Nixon officially defaulted on the United States of America’s promise to pay foreign holders of US dollars with gold on demand.  This fateful day will live forever in infamy in American history.  The last vestiges of the proud Gold Standard, which had prevented the US from printing too much fiat paper currency too rapidly, were shattered.  The relative price stability we witnessed before 1971 will never again be seen in the United States without a new gold standard, a highly unlikely possibility as long as the private Federal Reserve still exists. 


This volatile gold and oil graph is a perfect example of the raw magnitude of the Pandora’s nightmares that were unleashed into the unsuspecting financial world when the US politicians tried to launch the first fully fiat world reserve currency in history.


The huge inflationary maelstrom spawned when the Federal Reserve was finally freed from gold’s iron-fisted discipline and could print as many dollars as it wanted is vividly illustrated in the graph.  Each time you pay the princely sum of $5 for a simple hamburger or $30 for a haircut and long for the far lower prices of the 1960s you can thank Richard Nixon and the Fed for lacking the courage and honor to maintain monetary discipline, instead deciding on the perilous course of totally jettisoning gold.  The full consequences of this grave and ominous decision for Americans and the world are not yet completely apparent as its shockwaves still reverberate loudly throughout the increasingly fragile global financial system.


Future economic historians will divide US financial history into periods before 1971 and after 1971, eras with and without a solid foundation of gold.


Transcending the great 1971 divide, in the entire graph span from 1950 to April 2002, the gold prices and oil prices had a high 0.902 positive correlation, usually moving in strategic lockstep with each other.  Provocatively, this very strong five-plus decade historical correlation suddenly broke down for no apparent reason in 1995, marked by the white arrow above.


From 1950-1994, gold and oil had an even higher 0.920 positive correlation.  From 1995 to today, however, gold and oil’s mutual affinity drifted apart as the correlation actually surprisingly fell negative, to -0.237!  This anomaly has now even festered far more severely than when I wrote my original “Gold Boiling in Oil” essay, as back in June 2000 the post-1994 correlation was approaching neutral but was still slightly positive at 0.067. 


The date of 1995 marking this sudden enormous rift between the decades old gold and oil relationship is especially interesting because this is when Wall Street’s Robert Rubin became Bill Clinton’s second Treasury Secretary and launched his infamous Strong Dollar Policy.  Rubin, a respected financial markets player, loved the strong dollar because it would attract more foreign capital to invest in US financial markets, greatly boosting the financial business at the expense of American industry.


Rubin’s strong dollar policy did indeed suck in a lot of capital that deluged into the US equity and debt markets and helped spawn the great stock-market bubbles of the late 1990s, but it also flooded the US with cheap imports that decimated US industry, rendering US exports uncompetitive in global markets and leaving many US companies unable to compete domestically on price terms with cheap foreign-made goods purchased with the strong dollars.


Today many investors believe, largely because of the tireless work of GATA in digging up evidence, that Rubin’s strong dollar policy was not only rhetoric and jawboning but also included stealthy attacks on gold, its price relentlessly driven down by concerted central bank selling of large portions of their vast centuries-old gold hoards.  I have discussed the anomalous gold activity since 1995 in many past essays and the topic is beyond the scope of this particular essay, but please keep the pivotal 1995 date in mind as you study these gold and oil charts because that is indeed the year when the immensely strong past relationship between gold and oil suddenly parted ways.  Coincidence?


Even with the US default on its gold dollar obligations by Nixon and Rubin’s war on gold, the average monthly-closing gold price since 1950 has only been $198.56.  The average crude oil price over the same period is only $13.05.  These prices may seem low, and they are, but it is impossible to fully comprehend the intricate dance between gold and oil without taking inflation into account.  It costs many more dollars to buy goods and services today as compared to two or three decades ago because of inflation, the increase in the fiat currency supply.


Unfortunately today, in one of the major persistent financial deceptions plaguing our era, Wall Street and the US government continually try to convince investors that inflation is simply “rising prices”.  This assertion is not true of course, as the historical definition of inflation and even the current dictionary definition is an increase in the money supply that leads to rising prices.  Printing money is the cause of inflation, and rising prices are only the visible results of such central bank actions. 


In order to perpetuate the fraud that inflation is divorced from money-supply growth in our Brave New Era, the horribly flawed US Consumer Price Index is almost universally used as a market proxy for “inflation” today.  While the CPI grossly understates true fiat currency inflation in the United States, we begrudgingly use it to represent inflation in this essay because it is the only popularly-accepted definition of inflation.


Our next graph shows real gold and oil prices, what gold and oil cost in the past in today’s 2002 dollars using the US CPI, the far understated but commonly-accepted definition of inflation, as our inflator.  Real gold and oil prices are very illuminating and reveal many additional insights that the non-inflation adjusted nominal chart above cannot.



While current $27 per barrel oil may seem high to us today in nominal terms, in real inflation-adjusted terms it is actually just below the average real oil price since 1950 of $27.48 of our 2002 dollars per barrel.  Today’s gold price around $300, while definitely exciting for long-suffering gold investors, is still quite low in real historical terms, with the average real price of gold since 1950 weighing in at $396.35.


Because of the Federal Reserve running the literal and figurative printing presses relentlessly since 1980, one dollar today will buy a lot less than it would have twenty years ago.  There are relatively more fiat dollars chasing relatively fewer goods and services, so inflation is the result as increasing amounts of dollars compete for a much more slowly expanding pool of goods and services on which to spend them.  Just like everywhere else in the economy, the enormous distortions of fiat currency inflation also have great effects on the tangible physical commodities of gold and oil.


In real 2002 dollar terms, the late 1970s/early 1980s gold and oil spikes rocketed to phenomenal heights.  Real gold approached $1600 per ounce on a monthly basis!  Real oil cost more than $85 per barrel in the early months of 1980 in today’s weakened 2002 dollars!


This real gold and oil chart is very important because it helps keep current gold and oil prices in proper perspective. 


If oil ran to $40 per barrel tomorrow if the Islamic Jihad against Israel boiled over yet again, there would inevitably be widespread comparisons to the early 1980s, when oil also approached $40 in nominal dollar terms.  But, comparing 2002’s inflation-ravaged dollars with the much stronger 1980 dollars is like comparing apples to oranges, totally inappropriate.  In real terms, oil would have to rocket over $85 per barrel in order to be comparable with the early 1980 price action!  For people who think that $40 per barrel oil is high today, $85 oil would probably seem like Armageddon!


The very same inflation adjustment applies to gold of course.  I often hear gold investors reminiscing back to January 1980 when gold briefly exceeded $850 per ounce, wishing that it would happen again.  Because of the great cyclical nature of the markets throughout history, another gold bubble in the future is a virtual certainty, but in today’s weakened 2002 dollars gold would have to run to about $1950 per ounce to approach 1980’s real price high!  Now wouldn’t that be exciting! 


Because of gold’s incredibly bullish commodity supply and demand fundamentals and the fact that suppressed prices often explode far above equilibrium after the temporary price ceiling chaining them down fails, gold could easily soar to thousands of dollars an ounce in a new gold bull market ending in another spectacular gold bubble, an echo of January 1980.


As you watch gold and oil prices in the coming months and years, it is crucial to keep in mind that nominal dollars are not comparable across decades.  We will need to see absolutely enormous jumps from today’s 2002 oil and gold prices if the real inflation-adjusted 1980s highs are to be challenged sometime in the coming decade.


The gold oil ratio is also quite interesting, a mathematical construct created by simply dividing the gold price (dollars per ounce) by the crude oil price (dollars per barrel).  It can offer additional insights on the fascinating historical relationship between gold and oil.



When I penned my first “Gold Boiling in Oil” essay in June 2000, the gold to oil ratio was near a historical extreme low of 9.  At the time I rightly said that the anomalous situation probably couldn’t last, as in history the spikes to extremes of this ratio always proved to be temporary as this graph illustrates.  Either gold had to rise or oil had to fall, bringing up the gold oil ratio.  At the time I thought there was a higher probability of gold rising to bring the ratio into line, but I was wrong then, a bit early by about nine months before the great gold strategic trend change and bottom of April 2001.


Since June 2000, the gold and oil prices briefly conspired to push the ratio back up to 14.52 in January 2002, very close to the historical average of 14.68 since 1950.  It has since fallen back below the mean again, however, currently running at about 11, on the low side.  Like all kinds of financial markets throughout history, even the gold oil ratio has tendencies of mean reversion, preferring to bounce around in historical central territory rather than loitering nonchalantly near historical extremes.


Interestingly, after Nixon severed the dollar’s relationship with gold and let it float freely backed by nothing but confidence and faith in late 1971, the gold oil ratio has been vastly more volatile and the average has even been significantly higher than in the whole period of time since 1950.  Between 1972 and today, the gold oil ratio has averaged 16.49, meaning an ounce of gold cost about 16.49 times as many US dollars as a barrel of oil, on average.


Now of course there is no reason why the gold oil ratio has to be 16.49, but based on historical precedent there is sure a large probability it will continue to oscillate around this number in the future.  The gold oil ratio already appears to be migrating back towards its post-1971 mean and will eventually almost certainly trade even higher than that.  While not necessarily tactically predictive, the gold oil ratio can be useful to give us a strategic historical idea of the approximate relationship between gold and oil prices.


At a gold price of $300, the 16.49 gold oil ratio implies that, on average over three decades, we would expect oil to be trading at $18 per barrel ($300 / 16.49).  How likely is $18 oil when the Islamic world still controls much of the world’s oil supply and Iran, Iraq, and even Saudi Arabia are already again publicly talking about using a new oil embargo as a weapon to bludgeon the American people into accepting the old Islamic goal of slaughtering the Jews and driving Israel into the Mediterranean Sea?  As recent decades have tragically shown, ancient enmities and oil prices make for a volatile mix.


At an oil price of $27, the 16.49 gold oil ratio implies that, on average over three decades, we would expect gold to be trading at $445 per ounce ($27 x 16.49).  I still believe, primarily because at least 60% more gold is demanded globally each year than is carved out of the earth’s belly by all the gold mines in the world annually, that far higher gold prices are much more likely than way lower oil prices to bring the gold oil ratio back into line.


Our final graph this week offers yet another perspective on the relationship between gold and oil, the gold cost of crude oil.  It is simply the number of ounces of gold it takes to buy 100 barrels of crude oil.  At today’s gold cost of crude of 9.03 ounces, it would take 9 ounces of gold (worth about $2700) to buy 100 barrels of light sweet crude oil (also worth about $2700).   The formula for calculating the gold cost of crude oil is the oil price times 100 barrels then divided by the price of gold.


As you examine this graph, imagine that you are a hereditary despot ruling an oil-rich Gulf kingdom plagued by rampant unemployment, Islamic extremism, and a very discontented populace, and that you well know that your oil reserves will probably only last another 50 years or so.



Since 1950, on average an oil producer could expect the cash equivalent to 7.33 ounces of gold for 100 barrels of its valuable crude oil, the very lifeblood of modern civilization.  Since 1972, this average has dropped about 9% to 6.67 ounces of gold per 100 barrels of oil.  Today the ratio runs around 9 ounces, on the high side of the historical average.


Your perception of this graph totally depends on whether you are an oil consumer or oil producer.


If you are an oil consumer, like the United States, you want to buy crude oil as cheap as possible, paying the equivalent fiat US dollars to as few ounces of gold as you can get away with.  Indeed, since the mid-1980s, it generally hasn’t taken many ounces of gold to buy 100 barrels of oil compared to historical precedent.  This is great for oil consumers and bad for oil producers. 


Provocatively, this whole era of low gold costs of crude oil from roughly 1986 to 1998 reflects a period of time when pro-Western factions ruled the crucial Arabian Peninsula, which was blessed with enormous oceans of oil camouflaged under parched desert wastelands.  I don’t know how to quantify it, but I suspect that if there was some way to measure the radicalness of the ruling Saudi regime over time that it would have a high positive correlation with the gold price of crude oil.  Perhaps the more radical and anti-US that the ruling House of Sa’ud becomes in a given period of time, the higher the average gold cost of crude oil will run.


If you are an oil producer like a Saudi Arabian king, you know full well that your finite oil reserves are a wasting asset, less and less is available every day you pump it.  You want to trade this wasting asset for as much real wealth as possible.  The higher the gold cost of crude, the happier oil producers will be.  It is much more fun to sell 100 barrels of oil for the dollars equivalent to 12 ounces of gold, like during October and November of 2000, than for the dollars equivalent to 3.9 ounces of gold as in December 1998, when oil plunged to $11 per barrel. 


Since the proverbial giant oil tanks under the shifting sands of Saudi Arabia do contain a limited amount of the black gold, the more yellow gold of enduring value for which the scarce oil can be traded the better for the Saudis and all oil producing nations.  I don’t think they really care about how many paper dollars they get for their oil exclusively, but more for what the actual real purchasing power of those nominal petro-dollars is in terms of hard assets like gold.  If the gold price rises significantly in coming years for supply and demand reasons, I suspect that the oil price will rise as well, lest oil gets too cheap relative to gold.  Oil will probably follow gold up again just as it did in the 1970s.


While the gold cost of crude at 10.86 was approaching a historical extreme when I wrote my original “Gold Boiling in Oil” essay, it has since bounced down and off its mean and is traveling in more normal territory today.  This indicator is most interesting to watch whenever it hits extreme highs or lows as something always gives to bring the gold cost of crude back in line.  Either the gold price moves, or the crude oil price, or both, and the historical extreme is left in the dust as the gold cost of crude screams back towards its average in a dazzling mean reversion.


While gold and oil are the undisputed kings of the commodities world and fascinating to watch and trade, they are complex to analyze. 


The gold market is crucially important to Western central banks, especially the US Federal Reserve, because a rising gold price signals to the world that the Western paper fiat currencies based on nothing but confidence and faith are weakening.  The central banks have a huge vested interest in capping gold in a vain attempt to stop it from vetoing their enormous money supply inflations we have witnessed in the last few decades. 


As gold is a political metal, more than pure supply and demand must be considered when analyzing it.  The gold market is manipulated, there is little doubt with all the evidence accumulated since 1995.  All market manipulations in history end the same way, badly.  Gold will rocket when the central banks run out of gold, lose their political will to dump it, or gold investment demand dwarfs their gold sales.


The oil market is critically important to not only the great consuming nations of the West, but the primarily Islamic producing nations of the East.  Rather than trading solely on commodity supply and demand, the oil markets are often tainted with the Islamic prophet Mohammed’s ancient hatred of the Jews because they wouldn’t accept his new religion when they passed through early seventh-century Arabia on their trading routes. 


Since those days of antiquity fourteen centuries ago, the Muslims have hated Jews because their prophet Mohammed told them to.  As oil is a commodity largely trapped in a region willing to wage a merciless holy war to destroy the only small refuge of freedom and democracy in the Middle East, Israel, oil analysis must take this into account.  How can there be any diplomatic solution to a fourteen-centuries old institutionalized Islamic Jihad against the Jewish people?


Complications aside, the oil and gold markets have had a strong intimate relationship in the past and they almost certainly will in the future as well. 


Just as in June 2000 when I penned my original “Gold Boiling in Oil” essay, I still believe that investors have a far higher probability of success in the coming years in betting for higher gold and oil prices rather than betting for lower ones.  We live in a complex and struggling age when religious, geopolitical, financial, and political stresses are running high and investors may certainly seek refuge in important and unchanging commodities like gold and oil in the ‘00s.


Gold is still sitting coolly in the bottom of a great cauldron of boiling oil and has yet scarcely begun to heat up, still defying physics and fundamentals.  This situation won’t last forever.  The days are numbered for this odd historical anomaly.


Adam Hamilton, CPA     April 5, 2002     Subscribe