“Saudi Arabia killed OPEC and buried it,” a senior OPEC source from a non-Gulf producer was quoted as saying to the press. This statement identifies the key to the havoc we’ve witnessed in oil markets during the last couple of years. WTI crude oil was trading close to USD120 per barrel five years ago (and maintained an average close to USD100), when it plummeted to USD49 by end of 2014, and has not moved much since. Meanwhile, in this unstable market, observers noticed another commodity that appeared rather resilient: gold. In the past two years, we have seen currency devaluations and low to no growth economies, increasingly shaking the public´s faith in the financial system. In the chart below we can see the fluctuations in the oil price compared to the performance of gold. According to commodity expert and President of the Gold Standard Institute Europe, Thomas Bachheimer, the purchasing power of gold has been steadily rising in the past year.
Chart: Gold vs. Oil Monthly Oil Prices since Jan 2011 in USD
This is a manifestation of the role of gold extending beyond the boundaries of an ordinary traded commodity and into the territory of a monetary currency. Historically, the gold price has provided a reliable yardstick for the state of the economy and offered insights into its undercurrents, while indicators for the oil market have also been used as a diagnostic tool of similar analytical value. Bachheimer is not only an expert on gold, but also a renowned oil analyst, who draws particular attention to the relationship between gold and oil. This relationship, represented by the gold-oil ratio, not only reflects the overall performance of our economy, but also serves as an indicator to where we are heading. As Bachheimer explains, when it comes to oil, we should look beyond supply and demand.
The Gold-Oil Ratio
The gold-oil ratio identifies the number of barrels of oil that a single ounce of gold can buy. Bachheimer, based on his expertise in the relationship between gold and energy markets, views the gold-oil ratio as a solid basis for appraising goods and for rating fiat currencies, such as the Dollar. On average, the ratio has historically orbited around 17. What this means, is that for over fifty years, one ounce of gold bought on average 17 barrels of oil. In other words, the higher the ratio, the cheaper the oil, and the greater the value and purchasing power of gold. The benchmark is considered to be 15; when the ratio falls below this threshold, oil is regarded as expensive (and vice versa).
We know the importance of oil as a commodity strategically, politically and economically today. According to Ronald-Peter Stöferle from Incrementum AG, the average inflation-adjusted oil price was around USD6.1/barrel while the Bretton Woods agreement was in place and it skyrocketed with the abolition of the gold standard. Since then, the oil price has been volatile and unstable.
Source: Incrementum AG, Bloomberg, Erste Group Research
The gold-oil ratio fluctuated quite a lot in recent months. Today it stands at around 27, but it reached a record peak a few months ago: As can be seen in the chart below, for the past year the ratio was more or less constantly above 20, and on 19/1/2016, it climbed to 40. This means that one ounce of gold was worth 40 barrels of oil! In terms of gold, oil was never this cheap.
This is not the first time that we find ourselves in a cheap oil period. According to Bachheimer, we’ve previously had 3 phases of cheap oil:
- 2008-today (with a brief interlude)
The gold-oil ratio has been widely regarded as an indicator of significant political and economic changes and events. Bachheimer illustrates this point with a few historical examples.
In the late 1980s, the gold-oil ratio reached peak levels at around 30, while it hovered above the average of 15, with only a short interruption, for over ten years, making this also the longest phase of cheap oil. 1989 marks the event that changed the global power balance – the fall of the Berlin wall, and with it, the shift from a bipolar system to a unipolar one due to the demise of the Soviet Union. Conversely, we witnessed a very low gold-oil ratio in June 2008, when oil prices rose sky high at USD140 and the gold-oil ratio dropped to 7: This marked the onset of the global financial crisis. Since 2008, however, we find ourselves again in the cheap oil phase.
Low oil prices, high stakes power games
According to OPEC’s mission statement, it was founded to secure the interests of oil producers, exporters and consumers with the objective “to ensure the stabilization of oil markets and to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry.” But, according to Bachheimer, this could not be further from the truth. He explains that “the current low prices deter investors, exploration projects are delayed or cancelled which is massively interfering with the 6 – 7 year oil cycle. This will be sorely felt in 3 or 4 years’ time when oil prices are bound to surge.”
OPEC is an international organization of member states and can therefore not act in a neutral manner; it is and cannot be anything but a political organization. And so, it comes as no surprise that OPEC´s internal politics and resulting decisions are susceptible to its largest and most influential member, Saudi Arabia. Saudi Arabia is the de facto leader of OPEC – it is the world’s largest oil exporter and controls the largest proven oil reserves. Over the past two years, Riyadh has demonstrated the clear intention and capability to fight persistently and tenaciously to maintain its status in the oil market. Saudi Arabia would seemingly be the first to gain from an oil price recovery – and yet, its strategy implies that it has a lot to lose as well. Counterintuitive as this might sound, it confirms that we cannot rely on market fundamentals to fully understand the oil market. Instead, we have to look at the politics behind it; at its core, we find the power struggle triangle between Saudi Arabia, Iran and Russia.
Saudi Arabia and Iran have been bitter rivals for decades, but especially so since the Iranian revolution of 1979. Both being members of OPEC, they have repeatedly clashed in the past on the long-term strategy of this organization, but Saudi Arabia now feels particularly threatened after Iran has resumed oil production, since the lifting of nuclear sanctions earlier this year, thereby preparing to claim a bigger piece of the pie. But it is not that simple: Iran’s regional power is backed by another international player: Russia. Russia has been supporting Iran in its proxy wars in the region, particularly Syria, which by definition goes against Saudi political interests. Russia is a mega player in the oil market. It is not a member of OPEC, although it is one of largest producers of petroleum worldwide, with quantities of a scale that rival Saudi Arabia´s. Unlike Saudi Arabia, known as a low cost producer, Russia suffered from the drop in the oil price. Oil accounts for 60% of the country´s export revenue and a considerable amount of its federal budget. Its economy is in shambles and is in dire need for those oil prices to pick up again.
It is worth mentioning that the last time OPEC decided to change output levels, was in December 2008, when it cut supply amid slowing demand due to the global financial crisis. Saudi Arabia, however, now prioritizes market share over prices, while Iran refuses to control supply until it reaches its pre-sanction production levels, and Russia is pressured between the two. Therefore, the direction of the oil price (and gold) depends on whether this relationship goes north or south.
Are we on the verge of a crisis?
As described in the press: “While the gold-oil ratio above 20 may be an arbitrary indicator, it has accurately predicted 4 “crises” over the past 25 years.” To observers, the gold-oil ratio also reflects investor sentiment. When we also consider the global debt situation, no growth in the real economy, as well as the staggering growth of money supply (data on the U.S. economy shows that M2 has expanded from USD 6.8 trillion to about USD12.7 trillion in the last ten years!), which inevitably weakens the purchasing power of the currency. In such an environment, this surge in the gold-oil ratio certainly implies that investors prefer safety to growth. When it comes to oil, we should look beyond supply and demand. Bachheimer argues it is more about the monetary system (or rather the petrodollar system that emerged in 1971, after Nixon dropped the Dollar-Gold peg) and the risk entailed in exporting inflation when oil prices start to pick up again.
This year, we saw the gold-oil ratio fall from its peak 40 levels to close to 27 in a matter of months. Is this an indication that the phase of oversupply is over? Or are we on the verge of a crisis? Despite the drop, the ratio is still quite high, and so it would appear that the state of our economy will get worse before it gets better. However, nothing is certain. What we do know, is that we are experiencing history-defining developments in the geopolitical and economic spheres: The geopolitical pressures of the oil market are tied to the stability of the Middle East region, a part of the world that is currently being torn asunder by a prolonged and seemingly unending war, further crippled by internal, local conflicts and massive refugee waves, and thereby rendered economically unpredictable and politically unstable. Meanwhile, OPEC politics also reflect the volatility and vulnerability of the region and the uncertainty of its future, which is to a great extent dependent on the outcome of the triangular power struggle between Saudi Arabia-Iran-and Russia.