The relationship between the oil and gold prices

THE RELATIONSHIP BETWEEN THE OIL AND GOLD PRICES

Following the recent invasion of Ukraine by Russia we have seen a dramatic spike in the price of oil, reaching eight-year highs. The primary reason for this is that Russia is the world’s third largest oil producing country and any sanctions against them will have an impact on the total global oil supply. An often-quoted theory in the commodity markets state that when oil prices rise, gold will follow. In this month’s Financial View, we look at the relationship between the two commodities laying out that they independently have an impact on world economies.

According to a recent article by Market Realist there is a 60% correlation between gold and crude oil, with an increase in one driving an increase in the other, and vice versa. A look at the respective performance for the two commodities since 2004 demonstrates that what may hold true for some of the time, certainly doesn’t hold true all the time.

If we look at the two commodities individually, we will see why the price of oil has a bigger influence on the price of gold as opposed to being the other way around.

Crude Oil

In this day and age, where we still rely on fossil fuels, oil remains a big thing. Everyday close to 100 million barrels worth of oil is pumped out of the earth to satisfy the energy needs of humans.

The crude oil, which is a sloppy yellowish-black liquid, undergoes a distillation process where at various boiling points materials are separated based on their hydrocarbons and volatility. After the distillation the residual is a gloopy mess that is what is used as the bitumen in road surfaces (known as tar in South Africa, asphalt in the US) and, as any handyman will tell you, it often used for waterproofing.

As one can see the bulk of the crude oil is converted to fuel in the forms of petrol (gasoline in the graphic), diesel, jet fuel and LPG. These are well known by-products of the refinement process but other products such as aspirin, toothpaste, shampoo, lipstick and chewing gum all have chemical ingredients that arise out of the distillation process.

In a short summary the entire barrel is used to power our movements, to create the road surface that we drive on and help keep our teeth clean for the smiles as we move around.

Inflationary effect of Oil

As the by-products of oil are so critical to everyday life any increase in cost of oil impacts the consumer. Cost is generally driven on a supply & demand basis – if supply is constrained then the price will increase as people will be prepared to pay more than their neighbour for the limited supply. We mentioned in our introduction that Russia is the third largest supplier of oil with a market share of around 11%. Concerns around the security of supply have sent the oil price significantly higher and thus each one of us sheds a tear every time we ask the attendant to fill our tanks.

Unfortunately, the fuel price feeds into almost every item within the basket of goods as transport and production becomes more expensive. A rise in the price of fuel leads to secondary increases in the prices of food and other goods. The increase in the fuel prices results in increased costs and it is inflationary.

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Gold

Gold is fortunately a lot cleaner than oil, easy enough to handle without getting your hands sticky. Humans have long treasured it for its shiny quality and the history of gold is intertwined with the history of mankind. Gold’s main “strength” is that it doesn’t corrode unlike other more common metals. This allowed it to be used as a store of wealth and a currency for trade as a coin minted from gold would remain the same through time unlike a coin made from iron.

With the perceived value of gold through its resilience and its scarcity gold formed the basis of international trade. In fact, many paper currencies have their roots in gold and for a long-time currencies of the world were linked to the price of gold through the gold standard. Countries could only issue equivalent value of currency to the value of gold that they had stored in vaults.

The problem with gold is that whilst it doesn’t corrode easily it doesn’t grow either. One bar of gold bullion in theory should retain its dimensions over a significantly long period of time. Thus, unlike other investable assets there is “no return or yield” for holding gold, despite its perceived value. Where gold does have a position though is as a storer of wealth or a retainer of value.

In the Bible it states that in 600BC, during the reign of King Nebuchadnezzar an ounce of gold could purchase 350 loafs of bread. Historians indicate that in those times a loaf of bread weighed about 1kg – far larger than the loaves on our supermarket shelves today. The ratio of bread is thus 1/350th of an ounce of gold per kg. When this article was written the gold price was R27 805.84 per ounce and that would equate to R79.45 per kg of bread. Bread prices do vary based on the grains it contains and where you buy the bread but using the Soft Rye Bread 500g available at Woolworths for R36.99 (thus R73.98 per kg) we see that gold hasn’t really delivered any real return above inflation. Going back in history one can see that the gold/bread ratio has held true over many periods, and this is comparing against a consumer staple that often has some form of government subsidisation in the price.

The investment case for gold

The cheeky answer here if keeping with the bread analogy is that gold doesn’t grow mould. But as the bread example does illustrate gold hasn’t lost any value despite a price of bread being far more expensive than it was 10 years ago, this is due to inflation. Gold remains a retainer of value. With relative consistency compared to currencies the price of gold offers protection against inflation that the other asset classes don’t.

At Magwitch we are not gold bulls by any stretch of the imagination, but we do believe that there is a place for gold in any diversified portfolio, especially if you are worried about inflation and the value of your currency. Increased interest rates may result in market volatility and downside risk. We would not allocate more than 10% of our portfolio to gold, however during time of uncertainty holding some gold will add a level of protection to your portfolio.

If we look back at the relationship between oil and gold. Oil can be a driver of inflation and gold is a protector against inflation and that is why we say that moves in the oil price can impact the gold price but seldom the other way around.