Oil and gold are two of the top tradable commodities in the world. As mentioned here on Market Calls, gold is viewed as a safe haven asset by investors and is turned to during times of economic uncertainty. In contrast, oil is undoubtedly the king of commodities, with investors paying close attention to its volatile prices and production levels. It is also the most important commodity in the world economy. In this article we examine the correlation between gold and oil, and look at its relationship today and in the future.
Inverse correlation: low oil, high gold?
Like gold’s relationship with the dollar, its value increases when oil is under pressure from falling prices and vice versa. For example, in December 2017, gold’s value dropped due to a stronger dollar and high demand for cryptocurrency investments. In the same month CNBC reported that oil prices rose to above $60 per barrel. Oil investments are usually in the form of paper stocks because not a lot of investors store oil as a commodity. This is the reason why oil prices fall when investors run for gold.
FXCM reveal that when it comes to the relationship between oil and stock pricing, conventional wisdom suggests that the two have an inverse correlation. This means that when oil prices rise, equity valuations go down and vice versa. The underlying hypothesis of this view is that when the price of oil rises, energy prices rise as a whole.
However, unlike gold and the dollar that has an absolute inverse correlation, gold and oil has another variable involved that affects both commodities. Sometimes, gold struggles to gain any ground despite oil’s fall, and the reason for this is inflation. In order for gold to become the commodity of choice, it needs to outshine other conservative assets such as bonds. If it can’t, then the correlation coefficient between gold and oil won’t be wide when the dollar declines.
Positive correlation: peak oil also means peak gold
Peak oil is a theory by M. King Hubbert that states that the production rate of petroleum will enter a terminal decline once the maximum rate of extraction has been reached. If that theory becomes a reality, the value of oil stocks and other paper-based investments will go down. This is because the growth and development of the economy is strongly based on the energy sector.
Peak oil will have a huge affect on the world economy and this includes the gold mining sector in India. India has a relatively small mining industry, and peak oil could potentially wipe out the entire sector. Looking at the gold mining industry’s performance over previous years in finding new gold deposits, it would seem that mining production will not increase over the next 10 years. Mining firms and precious metals experts agree that most of the gold that can be easily extracted has already been mined, and that getting to the deposits that are still hidden will require a machine with a higher level of technology. Research and development facilities will need oil to produce this technology, and when the technology has been successfully produced, it will also need to run on oil. Therefore any new gold found would not decrease the price of oil, but rather increase its demand.
The question is, how fast can technology catch up to the declining oil reserves? Check out the graph below to see how much Bakken, one of the most important sources of oil in the U.S., has declined steadily since 2015.
The mining of gold will be affected if oil production declines sharply. If news comes out that peak oil has indeed become a reality, investors will likely turn to gold and its prices will go higher than its current value.
The correlation between oil and gold is constantly being monitored by investors in order to give themselves an idea of where the prices are going. If oil is down, gold is usually up and vice versa. There are, however, other variables at play to this correlation. The first is inflation, which pulls the prices of gold down even if the prices of oil are also down. The other is peak oil, which, if it becomes a reality, will also pull down gold’s spot prices.