Correlation between Oil and Gold Prices and the US Dollar

Correlation between Oil & Gold prices and US dollar The History The forex exchange market is one of the largest and most liquid securities exchanges in the world with over $3. 2 trillion in average daily turnover. This equates to 10 times the average daily turnover of global equity markets and 35 times the average daily turnover of the New York Stock Exchange. The forex market is open 24 hours a day, 6 days a week, with the EUR/USD accounting for 27% of total turnover. There is plenty of opportunity to make and lose money in currency exchange. The gold standard era in the U. S. officially began with the passing of the Gold Standard Act in 1900. But it was not until World War II that brought about the need for a worldwide standard for currency values and exchange rates. The Bretton Woods Agreement in 1944 established two very important international institutions: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (now the World Bank). What came from this agreement was that all the world’s currencies would be pegged against the value of gold, and with the U. S. dollar on the gold standard, the U. S. dollar effectively became the world’s reserve currency. The value of gold was fixed at $35 per ounce until the gold standard was effectively withdrawn in 1971 as President Nixon ordered an end to the out-dated system and the price of gold was allowed to â€Å"float†. Now, every major currency is no longer on the gold standard but rather is referred to as â€Å"fiat† currency. This basically means that a country’s own currency is intrinsically worthless because it is not backed by any type of reserve, such as gold. The value each currency is therefore based citizen’s perception of their economy, supply and demand for money in general, and how their currency is compared to other country’s currency. Something to think about though is 40 years ago, the world’s currencies used to be pegged against the price of gold and ultimately the Dollar. Now it would not be a stretch to say that global currency is on an Oil Standard. From 1944 until 1971, US dollars were convertible into gold by central banks in order to adjust for any trade imbalances between countries. Up to that point, the price of gold was fixed at US$35 per ounce, and the price of oil was relatively stable at about US$3. 00 per barrel. Once the US ceased gold convertibility in 1971, OPEC producers were forced to convert their excess US dollars by purchasing gold in the marketplace. This resulted in price increases for both oil and gold, until eventually oil reached US$40 per barrel and gold reached US$850 per ounce. In 1975 when the U. S. Government made a deal with Saudi Arabia and OPEC to only trade oil in U. S. Dollars, their â€Å"partnership† effectively gave the USD a monopoly over all other currencies when it comes to oil trading. The US has enjoyed inexpensive oil-based energy for nearly a century, and this is one of the prime factors behind the unprecedented prosperity of its economy in the 20th century. While the US accounts for only 5 percent of the world's population, it consumes 25 percent of the world's fossil fuel-based energy. It imports about 75 percent of its oil, but owns only 2 percent of world reserves. Because of this dependency on both oil and foreign suppliers, any increases in price or supply disruptions will negatively impact the US economy to a greater degree than any other nation. The majority of oil reserves are located in politically unstable regions, with tensions in the Middle East, Venezuela and Nigeria likely to intensify rather than to abate. Because of frequent terrorist attacks, Iraqi oil production is subject to disruption, while the risk of political problems in Saudi Arabia grows. The timing for these risks is uncertain and hard to quantify, but the implications of Peak Oil are predictable and quantifiable, and the effects will be more far-reaching than simply a rising oil price. In the early 1950s, M. King Hubbert, one of the leading geophysicists of the time, developed a predictive model showing that all oil reserves follow a pattern called Hubbert's Curve, which runs from discovery through to depletion. In any given oil field, as more wells are drilled and as newer and better 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, the energy it takes to extract, transport and refine barrel of oil exceeds the energy contained in that barrel of oil. When that point is reached, extraction of oil is no longer feasible and the reserve is abandoned. In the early years of the 20th century, in the largest oil fields, it was possible to recover 50 barrels of oil for each barrel used in the extraction, transportation and refining process. Today that 50 -to-1 ratio has declined to 5-to-1 or less. And it continues to decline. The Correlation between Oil & Gold Is there a strong correlation between the prices of gold and oil? It depends on which data are  used to measure. Many price movement studies suggest that the correlation between the two commodity prices over time is quite strong. Typically, these studies rely on data covering extensive periods of time and show that when oil increases in price, gold will inevitably follow. On the other hand, there are correlations calculated from data that show a weak relationship between the two prices. The data in these cases usually cover periods as short as years or months. â€Å"From 1965 to 1994, the monthly correlation between gold and oil weighed in at a  very  impressive +0. 879. From 1995 to 2000, however, this correlation seemingly vanished with a negative 0. 133 reading,† according to a May 2004 article by Zeal LLC. â€Å"Since 2000 though, the historical oil and gold correlation has been restored, now again running positive at +0. 715. †Ã‚  It would seem that gold may be well correlated with oil in the long term, but it is not necessarily so in the short term. While oil prices have exploded and gold prices have shown marked appreciation, protagonists of a tight long-term correlation between the two evoke previous historical price movements such as those in last half of the 1970s. From the mid-1970s to 1980, oil prices rose from around $20 USD per barrel to  more than  $100 USD per barrel in 2008 dollars. Gold followed along and roughly quadrupled in price during that same time period. [pic] The long-term chart above is also very valuable to help visualize just how closely gold and oil prices tend to correlate over strategic time frames. If one looks at major secular trends measured in years, gold and oil pretty much move in lockstep. Yes, they deviate tactically over shorter periods of time as their respective supply-and-demand influences dictate, but over the long run they travel the same path. Their prices tend to oscillate around each other and periodically cross on this chart. Over the entire four-decade span of time charted on this graph, these monthly gold and oil prices have a correlation coefficient of 0. 835 and an R-Square value of 69. 7%. These are very impressive numbers over such a long period of time and really drive home just how closely gold and oil are intertwined. If one focuses his attention on the far right side of this graph, however, a glaring anomaly becomes instantly apparent. Since oil bottomed near $11 in December 1998 ($13 in 2004 dollars) it has surged up dramatically in several subsequent uplegs achieving a mammoth 312% bull-to-date gain. But over the same period of time gold has lagged dramatically, only rallying by 39% or so in nominal terms. So far the gold price has not been able to even attempt to retain parity with oil in recent years. Now the only other similar time in history when oil was strong and gold lagged was in the late 1970s. As this chart reveals, for years gold lagged oil but when it finally did decide to catch up it powered higher with a vengeance. Gold, Oil and Dollar Relationship The answer to this question begins with the historical desire of Arab producers to receive gold in exchange for their oil. This dates back to 1933 when King Ibn Saud demanded payment in gold for the original oil concession in Saudi Arabia. In addition, Islamic law forbids the use of a promise of payment, such as the US dollar, as a medium of exchange. There is growing dissention among religious fundamentalists in Saudi Arabia regarding the exchange of oil for US dollars. Oil, gold and commodities have all been priced in US dollars since 1975 when OPEC officially agreed to sell its oil exclusively for US dollars. Today, apart from geopolitical threats in oil-producing regions, supply/demand imbalances from Peak Oil and increasing demand from developing countries, the price of both gold and oil can be expected to increase as the US dollar declines. With an ever-increasing US money supply, growing triple deficits and mounting debt at all levels, the US dollar is likely to continue the decline that began in 2001. Long term trend analysis shows negative correlation between gold prices and the value of dollar but gold price does not increase proportionately to the diminishing dollar. Market is not so simple that every down-day for the dollar corresponds to an up-day for gold and every up-day for dollar correspond to down day for gold. The effect may not be immediate and the lagging can sometime be attributed to the information gap and time lag which an individual wastes in doldrums not being able how to react to the changes. Daily and weekly fluctuations are not important at all as they don’t give analyst any idea of clear cut trend and interrelationship between them. Inflationary 1970’s saw soaring of gold above $800 while dollar fell. Dollar bounced back in 1980 and rallied before peaking in 1985, while concurrently gold peaked in 1980 and dropped all the way down to $300 during the same 5 years that dollar rallied. The Future of Gold, Oil and Dollar The word â€Å"recession† has been hurled around the biggest financial capitals in the world from New York to London to Tokyo, and no one really wants to be the one to drop the bomb. While all the experts and economists around the world want to debate who is or is not in a recession right now, it is pointless and frankly useless information. The incessant chaos and obvious current state of the global economy is clear cut enough that the world is facing major hurdles in moving forward with our economies. The fact of the matter is, all the major economies are hurting badly and answers are becoming more infrequent and costly as time continues. Amongst a multitude of important topics to discuss in relation to a worldwide recession, the currency markets are a great source of risk and sometimes guaranteed investing opportunities no matter how unpredictable the world’s stock markets are trading. It’s quite clear that over the past six months, the Euro was the place to be if one wanted to lose a lot of money. Sure it was trading at all-time highs versus the Dollar back in May, but with the U. S. slashing interest rates, the Euro has given all of those wonderful gains back and then some, to the tune of 2 year lows. It seemed that an even one-to-one exchange rate was the next stop for the EUR/USD, until the past 10 days when bad went to worse. As bellwether, blue-chip companies continue to fold across the U. S. the only solution the world can come up with is to give them all the money they need to stay alive and skip out on the much publicized Chapter 11. The average U. S. consumer simply cannot handle reality in times of massive financial distress and force the government to hold their hand through this horror movie that is the year 2008. With government money flooding the economy and interest rates on their way to 0% and beyond in the U. S. , inflation is on the brink of exploding and no one is going to want to be anywhere close to a U. S. Dollar. [pic] Oil Relief Rising crude oil prices over the last two years and the general rush to commodities has been a major roadblock for the U. S. Dollar. As discussed above, there has generally been a negative relationship between crude oil prices and the value of the U. S. Dollar. It is no coincidence that as oil prices peaked in May, the Dollar was at all-time lows versus the Euro, and conversely as oil prices have shed over 60% in value since then, the Dollar has rallied against most major currencies. Something that has been a very debatable topic is how crude oil prices have fluctuated so wildly in the past 12 months and the role of speculators in the commodities market. With oil prices falling this year primarily on falling consumption and increasing reserves, how countries like the U. S. and China react to the recent economic turmoil will determine the fate of crude oil prices going through 2009. The recession affecting all the major economies will remain dire without substantial relief in sight in the near future. Provided speculators do not drive the prices up and the recent terrorist attacks in India fail to spread panic in the Middle East, crude prices will remain modest and will not have a major effect on the U. S. Dollar. Nonetheless, if there happens to be a large run-up in oil prices back towards the $100 mark, the Dollar will be back on the defensive. As far as gold is concerned, with such a huge demand for gold coming from around the world, it is no wonder that the price is projected to reach an almost unbelievable $1000 per ounce. One of the biggest importers of gold is China, constituting a large chunk of the price hike. Most of the gold usage is jewellery related. Supply is also a factor. With such a high demand, gold is becoming scarcer. Miners are searching for new sources to combat the possible shortage. The Federal Reserve has a lot of control over the value of the dollar. When it raises interest rates, usually the value of the dollar goes up. Now, with the Fed lowering interest rates in hopes of promoting trade between banks, the value of the dollar is going down and so, the value of gold is going up.