The international economic panorama is agitated these days, in addition to the coronavirus epidemic, due to the sharp drop in the price of oil, a raw material that maintains an important relationship with gold . How can the fall in the price of oil benefit investment gold? How are the two commodities related? In this post we are going to explain where this relationship comes from.
During the week of April 20, the price of West Texas Intermediate futures contracts (one of the two types of crude oil traded in international markets, along with Brent) fell to $55.9 in a single day .placing itself in negative figures for the first time in its history.
As it is a contract with physical delivery, the lack of storage capacity at its delivery point, Cushing (Oklahoma, USA), caused a selling frenzy before the expiration date of the contracts.
As explained by the consultancy Metals Focus in its latest Precious Metals Weekly report , apart from this unusual situation, the truth is that the price of oil has experienced an unprecedented drop so far this year, which has important ramifications for the economy.
Indeed, the fall in oil not only negatively influences the economies of producing countries, but also inflation expectations, geopolitics and investor attitudes towards other raw materials that are also investment assets, such as oil.
First of all, it must be borne in mind that some of the world’s major economies, such as Russia and the United States, are highly dependent on oil exports. Given that the energy sector has a notable weight in the world capital markets, the fall in the price of crude oil may drag the stock markets down with it.
In addition, the price of oil is one of the variables taken into account when calculating inflation, which also influences the evolution of the price of gold.
As for the geopolitical component, it also suffers the consequences of the drop in oil: when there are long periods of falling prices, political instability in the Middle East increases.
This is already happening right now, with the confrontation between the world’s two largest producers, Russia and Saudi Arabia, and with tensions between Iran and the United States.
All these factors, combined, have a positive influence on precious metals, especially gold, which benefits the most from investors’ global risk aversion.
In fact, from Metals Focus they consider that the interest of institutional investors in gold as a safe haven asset is going to multiply, supported by a favorable environment of low interest rates and large stimuli from central banks.
Where does the close relationship between gold and oil come from? Why does crude oil play a fundamental role in the formation of the gold price?
Their main relationship stems from the fact that both are assets whose price is denominated in dollars . Therefore, the evolution of both is usually parallel at times when the US currency fluctuates up or down.
Another fundamental link is inflation . The price of oil is one of the variables used to calculate it, so when crude oil goes up, inflation does too. This is when gold comes into play, since it is considered one of the main elements of protection against inflation. And as it rises, so does the interest of investors in the precious metal and, therefore, its price.
According to experts, gold and oil maintain a direct relationship for approximately 60% of the time, as can be seen in the attached chart.
Another of the links between gold and oil is that when the price of crude oil rises, economic growth slows down, which in turn affects major industries. The immediate consequence of the moderation in economic growth is the fall in the stock markets, which triggers the demand for alternative assets, among which gold stands out.
Thus, if the economy goes into a recession phase, the price of precious metals and, therefore, of gold, skyrockets.
There is also another link between the two commodities through the mining companies that extract the gold . When the price of oil rises, the mining companies suffer a narrowing of their margins, since their activity requires a huge consumption of oil (machinery, transport trucks, excavators, generators, pumps…).
When these margins are reduced, the shares of mining companies react downward in the markets. We have already seen the effect that the fall in the stock markets produces on gold.
To what extent are the fluctuations between the price of gold and oil related? The truth is that the connection between the two is very close, although they cannot always be equated.
According to research published in 2017 in the Journal of Economic Research , when the price of oil rises, consumers see how the amount of money they can spend on consumer goods such as cars or electronic devices decreases.
This scenario may end up leading to inflation, which, as we have seen, is one of the factors behind the rise in the price of gold, since investors consider this precious metal as the best protection against inflation.
What Happens When The Dollar Falls?
Another factor that influences the correlation between the prices of both is the dollar. When it rises, the prices of gold and oil fall, since foreign investors find it more expensive to acquire these materials, the demand is reduced and the price is lowered.
Instead, when it is the dollar that falls, the opposite effect occurs, and both gold and oil rise.
In any case, this synchronized movement of the prices of both raw materials does not always exist, since each one has its peculiarities. Thus, while gold is considered a safe haven asset, oil is a higher risk asset, whose price fluctuations come exclusively from supply and demand conditions. For this reason, the volatility of the oil price is greater.