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Revisiting $600 GOLD

October 22, 2014 I explained the price correlation between gold and oil (see GOLD).  Then on December 8, 2014 I made the case for $40/barrel oil, when oil was trading at $63 (see $40 OIL).

Today oil is trading at $45.52.  I can’t be certain how low oil prices will fall and where they’ll eventually stabilize (and neither can anyone else).  But it does appear that oil prices will drop lower and perhaps trade below $45 for quite some time.

While this has many implications, I want to revisit the impact that prolonged low oil prices could have on gold.  With market volatility picking up in the past three weeks, gold has risen some 5%, giving hope to many gold proponents.  Short term dynamics may be favoring gold (and I wholly support trading short term trends) but I want to reiterate that long term consequences of lower oil prices will be commodity deflation.  That includes gold.

To bolster the argument that gold is overvalued, consider the origin of gold’s perceived value.  Gold has both a “use” value and a “trade” value.  Gold has intrinsic value because of its use in industry and medicine, that’s its “use” value.  Also, because gold has historically been used as a store of value, it has been used as a currency, and thus has a “trade” value.  People have used gold as an exchange medium to facilitate commerce.

The trade value of gold has two components, fear and inflation.  In times of currency devaluation or other modern day financial crisis, fear increases the value of gold.  Debasement of currency (inflation) also causes the value of gold to increase.

I believe the fear component of gold peaked in 2011 and is slowly unwinding.

During the euphoria of early 2000, the average price of gold was $279/oz (it probably should have been trading for around $400).  Then came the dotcom bubble, 911 terrorist attacks, Middle East wars, and finally the 2007 housing and financial crisis culminating in the Great Recession.  The fear index was high, gold peaked in 2011 at $1,924.

But take out the fear and consider ONLY the inflation component of gold:

  • In 1934 gold was $35, that was the year after President Roosevelt took the dollar off the gold standard.
    • Inflation adjusted over those 81 years, today gold would be valued at $617.
    • http://www.usinflationcalculator.com/

Recall from my previous article, the 15 times relationship between oil and gold.  That puts the price at:

  • $40 oil x 15 = $600 gold

…not far off the 81 year inflation adjusted price.

Factoring out fear, if oil stays in the low $40s for a considerable time, I believe we could see gold at $600/oz.


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