Is Oil Keeping Gold From Hitting $800? (OIL, USO, GLD)

Conventional wisdom has it the the price of gold tracks the price of crude oil. As oil rises, so does gold, and vice-versa.  Probably the simplest explanation for the phenomenon is that the price of oil measures inflation threats, and as fear of inflation grips investors, they retreat to the safe haven of gold. That seems pretty straightforward.  But what about recessions? In a recession, inflation is rarely a significant issue. Deflation is by far the greater threat. And as prices, including oil prices, fall, gold offers no haven from deflationary effects.

During a recession, oil prices might be viewed as a proxy for the overall health of the economy because the price for oil is primarily driven by demand from industry and consumers. If businesses and ordinary folks are not using a lot of energy, the price of oil falls. Not until spending increases does the price of oil go up.

In the past year oil went dangerously close to $150/barrel, and just as rapidly went to well under $40/barrel until the recent rally took the price to right at $50/barrel yesterday.  The  iPath S&P GSCI Crude Oil Total Return Index ETN (NYSE: OIL) has dropped about 78% from 52-week highs. United States Oil ETF(NYSE:USO) has dropped 75%. Spot prices for crude have fallen by about 70%. SPDR Gold Shares (NYSE:GLD) has dropped about 9.5%.  That drop in gold is magnified because last year’s peak gold was over inflationary pressures.

Ironically, demand for gold has recently increased, even as the price was mostly flat and even fallen in recent days. The “GLD” ETF has purchased record amounts of gold, and every week seems to set a new record for its stock of bullion.  But this demand was not driven by industry nor by the sudden move for jewelry demand.  It has been a simple hedge against an economic implosion and as the ultimate flight to safety.

A couple weeks ago before the stocks stabilized and recovered, gold was flirting with $1,000/oz.  The gold price in London today is off more than $20 from yesterday’s close and is now handily back under the $900.00/oz. mark.  Oil prices have also fallen below $48/barrel today following the build in crude and gasoline inventories.

So, is the oil horse pulling the gold cart? Has the price of oil kept gold from falling to $800/ounce? Given what’s been happening, it’s hard to give an affirmative answer to that question. What seems to be holding up the price of gold is garden-variety fear of what could be inflation once all this new money starts hitting the system. And because there is little evidence of inflation, the price is not jumping but more or less holding steady.

The investment storyline seems to be buying some gold guards against a sharp run-up in inflation, even when there is virtually no evidence of such a run-up.  It also guards against fear.  Gold prices have set a floor well above $800/ounce, and unless oil suddenly jumps well up to the Pickens call price of $75/barrel, deflationary pressure outweighs inflation fears.

The link between oil and gold prices should remain weak until economic activity picks up and the recession begins to fade away.  Based upon the sudden move back into equities and based on the end of the world as we know it not happening, it seems that the higher oil prices have cushioned gold from what would have been a much larger drop.

Paul Ausick
March 18, 2009