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January 8, 2015

This week the price of gold peeked back above $1200 per ounce, while the price of light crude oil ducked below $50 per barrel, its worst price in five years. The result, as this Reuters graphic shows, is that an ounce of gold is selling for the equivalent of 24 barrels of oil–the first time this ratio has hit such heights since 1998, when Russia defaulted on its debt, roiling the oil market while making gold a safe play.

During the latter part of the Clinton years, the price for a barrel of West Texas Intermediate oil was barely in the double digits and gold checked in at a touch under $300 per ounce, both of which seem like misprints by current standards. But it’s the ratio that tells a story. Historically, gold has cost about 15 barrels of oil per ounce, and while an increase in this number can sometimes be seen as a sign of deflation, this time analysts believe that oil’s free fall is due to oversupply and obstinate attitudes.

Gold, meanwhile, remains a popular bet for investors skittish about the euro zone’s stability and general global instability. ”Investors remain more interested in gold because of issues other than the oil price, specifically, financial market stability, economic stability, international tensions between the United States and pretty much the rest of the world,” Jeffrey Christian, managing partner of the CPM Group commodities research firm,  told Reuters on Wednesday. So while the gold to oil ratio can be a warning, it seems this version isn’t necessarily bad news.





Either crude or gold has to give, or has the world changed?

If historical norms are anything to go by, then something is definitely off-kilter with oil and gold markets. Historically, it has taken about 15 barrels of crude oil to buy an ounce of gold. Today that ratio is more like 22:1, due to oil prices touching five-year lows on Monday, while gold, in contrast, has stayed stubbornly high and, perversely, managed to fly in the face of just about everything else by staging an $18/oz rally on Monday.

There are many analysts that believe the greater risk to gold prices is to the downside than to the upside. Barclays’ Suki Cooper is one of them and reiterated the downside view on Monday in a research note. Cooper belongs to the camp of those believing a rise in US interest rates will happen sooner, rather than later, despite the Federal Reserve continuing to make no such indication in its policy statements to date. But a rise in interest rates is likely to serve only to strengthen the dollar further.

Conversely, the gold bugs would have us believe that, while the short-term prospects for gold prices point to weakness, the US’s inability to tackle its deficit and debt, and the implications for the broader economy, should support gold prices. The gold bugs keep talking about gold being the great store or preserver of wealth. But anyone that bought gold in the January 21, 1980 peak of $850/oz never made a profit, if allowing for inflation. They may have gotten close to achieving a profit if they had sold at the peak of August 2011, when gold prices rose briefly above $1,950/oz, but to really make a profit, allowing for inflation, they would have had to sell for about $2,200/oz.

Given the strength of the dollar, which has pushed most dollar-denominated commodities’ prices lower, including crude oil, gold ought to be under some downward pressure, but a looming Greek general election — the outcome of which is not entirely clear — has triggered a renaissance for the “Greece has no future in the eurozone” theory. Greece is roiling from a period of unprecedented austerity and one of the political forces in the country — the far-left Syriza Party — is campaigning on a promise of cancelling, renegotiating, or reneging on Greece’s sovereign debt, which could potentially give rise to a eurozone sovereign debt crisis that will make the previous one seem like a relative walk in the park.

Blog post continues below…

Gold usually has an inverse relationship to the dollar, especially when it comes to the euro/dollar exchange rate. The previous eurozone sovereign debt crisis weakened the euro against the dollar. Yet, on several occasions, gold prices went up when the dollar rose against the euro, because gold was seen as a safe haven from the euro. The same thing pushed gold prices higher on Monday.

To prove history right on the oil/gold ratio, the logical conclusion might be that something has to give: either crude oil prices have to rise, or gold prices have to fall, or a bit of both, to restore the historical 15:1 ratio. So far, gold seems to be finding solid support at the $1,200/oz level, while crude oil, basis front-month NYMEX, dipped below $50/barrel on Monday, and only just about managed to settle above the $50 mark. All the talk seems to be of crude remaining under downward pressure.

Has the world changed in the last couple of months to the point that the old 15:1 ratio is no longer relevant? Perhaps only an historian will be able to answer that in a couple of decades’ time. But consider this: Russia is exporting more crude than at any time since before the collapse of the Soviet Union — desperate for petrodollars — even though in doing so, it is contributing to lower crude oil prices and adding to its enormous economic woes caused by sanctions from the EU and the US. Additionally, the US is becoming less reliant on crude oil imports, probably the main reason why OPEC chose not to cut production at its last meeting, in the hope of pushing oil prices lower in an attempt to render as many US shale plays as possible uneconomic, so that OPEC members can ultimately reap the long-term rewards.

It was not so long ago that President George W. Bush told us that the US was addicted to oil, leading to a widely held view that the US would forever be dependent on imports for most of its energy needs. From that perspective, the world does seem to have changed. The US may still be addicted to oil, but it is, at least, producing more of its own vice.

Periods of sustained low oil prices, result in widespread, sustainable economic growth; at least, they have in the past. So if we are in for a sustained period of low oil prices and history repeats itself, then maybe the widespread economic growth that the low oil prices generate will put the necessary pressures on gold and oil prices to restore the historical 15:1 ratio.


Will Collapse in Oil Price Cause a Stock Market Crash?


The Black Monday stock market crash of October 19th, 1987 was the largest one-day percentage decline in the Dow Jones Industrial Average. The crash was a genuinely perplexing event. To informed observers it seemed to have little basis in economic fundamentals. There were various ”hand-waving” theories, including that the introduction of automated trading on the Dow had injected instability into the market. However, at the time, Black Monday appeared to come out of nowhere.


In an analysis published in 2009, Therramus pointed out that Black Monday fell into a broader pattern in which nearly every stock market crash and recession of the preceding 50 years had occurred shortly after a large and abrupt change in the price of oil. In the case of the 1987 Dow crash, it was foreshadowed by a tumble in oil price that ensued in the wake of disputes within OPEC – which had come to a head in the previous year.


During the mid-1980s Saudi Arabia grew increasingly frustrated with cheating on agreed oil production quotas by other members of OPEC. In 1986 the Saudis gave up honoring their own quota commitments to the cartel and the price of oil plummeted.

Current Falls

Between July 2014 and January 2015 the price of oil plunged over 55%. One of the steepest legs of this decline was a 10% drop that occurred on Black Friday November the 28th following a meeting of OPEC. The ostensible reason for this fall was that the Saudis had refused to agree to production decreases being pushed by some OPEC members, instead choosing to let the market play out for the time being.


Given this article’s brash headline and its tenor so far you might be led to believe that we foresee a large fall in stock prices in the next year or the year after. Perhaps the 2014 Black Friday plummet in oil prices could spark a Black Monday-like stock market crash in 2015?

This is the 4th in a series of related articles written for Oil-Price.net (2009, 2011 and 2013). The last of these written in late 2013 had the prescient title ”Oil Price Volatility on the Way”. In this series, the theory is developed that since the year 2000 we have seen the emergence of an oscillatory pattern in oil price volatility. Moreover, it has been suggested that the mechanism driving this oscillation is a teetering imbalance between oil supply and demand that was set in motion when global production reached a plateau in the mid-2000s.


One of the tools that have been used to identify this oscillating signal is a mathematical technique called fast Fourier transformation. This algorithm indicates that since the year 2000 oil prices have adopted a cycle in which volatility spikes tend to occur every 32 to 34 months. As shown on the figure, the last of these crescendos in price variance happened in 2011 and before that there were surges in volatility in 2008/9 and 2005/6.

Further analysis of the figure is that the 2014 Black Friday ”crash” in oil price is occurring ”as near as dammit” on cue within this cycle. Thus, the current drop in oil prices provides the fourth confirmation that a long-term oscillation in oil price volatility has been established.

historical oil price volatility

Figure 1 – Cyclical Oil Price Volatility


We have addressed previously how the fall in the price of oil originates from a power play by the Saudi Arabian elite and the US government. The Saudis want to squeeze out new production in the world as OPEC crumbles. Also one of the major new streams of oil flooding the market comes from the American shale oil revolution.

Market analysis shows that the new price levels of oil are caused by the simple mechanism of supply and demand. Globally, the 2014 slower economic growth in Europe and China took capacity planners and market makers by surprise; the developed world’s drive to decrease carbon emissions is finally having an impact on the oil market through greater energy efficiency. Demand for oil declined unexpectedly in 2014.

An end to conflict and years of reconstruction brought major oil and gas suppliers in Libya, Algeria, Iran and Iraq back to the market in 2014. The rapid expansion of tar sands supplies from Canada and shale oil in the USA squeezed suppliers such as Nigeria and Venezuela out of the US market. The world’s largest producers of oil – the USA, Russia and Saudi Arabia each had financial needs that prevented them from reducing production. Thus, there was no cut in production to match a fall in demand and the market became over supplied, causing a fall in prices.


The simplest explanation for the slump in oil prices is it falls in line with an established multi-year pattern that is being driven by supply and demand. The oil crash of 2014 was the most recent manifestation of a tidal ebb and flow in oil price volatility that has occurred every three years or so since at least the mid 2000s.

If one accepts that we are seeing the fourth confirmatory spike in a long-term pattern of oil price volatility, what is causing it and what can be expected next?


The mechanism of the oscillation is a natural occurrence, like the tides, which is anticipated to occur at the summit of a resource-depletion curve, such as at peak oil. Other mechanisms might include a direct role for human agency. Perhaps there are behind-the-scene players who have the means and persistence to rhythmically seesaw oil price over extended periods of time.

The simplest prognosis would be to anticipate that a fifth spike should occur sometime in 2017-2018. History teaches about the fall-out from surges in oil price variance – instability in various economic indices might be expected to occur in the next 6 to 12 months. When oil markets go crazy, in an upward or downward direction, bad things happen to the economy. The trajectories of changes that accompany volatility spikes, shown in the top chart, indicate that sudden drops may be worse augurs than abrupt upticks in oil price.

Possible Scenario

The mechanism by which a fall in the price of oil could trigger a collapse in the stock market lies in the financial devices used to fund oil exploration and exploitation throughout the world, and particularly in the United States. Modern oil exploration is financed through a range of methods including issuance of shares to increase capital, and raising debt through bonds and bank loans.

A shale oil well operating through hydraulic fracturing can cost $9 million to get into production. When oil was hovering close to $100 per barrel, banks were more than willing to finance billions of dollars worth of oil exploration projects. As far as banks were concerned these loans were backed by tangible assets and considered low-risk. It was (almost) like printing money. A price of $80 per barrel was seen as a floor in the profitability of shale oil. This took an average break-even price of $70 per barrel, plus a $10 margin for financing costs.

Today with oil under $50, many producers lose $20 for every barrel produced and will likely default on these loans, as outlined in last month’s Falling Oil Price Slows US Fracking article. This loss will be passed to the banks that made the loans, as it happened with the housing sector in 2008.

A telltale sign of this is the recent 20% fall of high yield corporate bonds since this summer which follow very closely the fall in crude oil prices. Many investors are afraid of defaults in the high-yield market due to over-lending to the energy sector and are indiscriminately selling off ”junk bonds.” The downside of this corporate bond selloff across the board is that less favorable financing options will be available for other sectors, which in turn will spread the slowdown to the rest of the economy.

Simple mathematics reduces a credit-worthy company to bankruptcy – for example a company with a market capitalization of $50 million owing $9 million suddenly becomes a bad risk when its total value dives to $10 million thanks to the sudden switch from profit to loss caused by the fall in the price of oil. A loss of profitability causes a loss of share value – pension funds and investment houses have seen billions wiped off the value of their investments in a matter of a few months. The knock on effect of loss of value then permeates to the banking and insurance sectors, causing the value of stock in those companies to fall.

Not all shale oil exploitation was financed by loans and bonds. Derivatives have played a part, too and many of the main players in the fracking business have their prices set in futures contracts all the way into 2016. The holders of these obligations to buy will be in serious trouble if the oil price does not turn around by mid-2015 when many of these contracts fall due. The major Wall Street banks hold a total of $3.9 trillion worth of commodities contract, the bulk of which are based on oil and were written when oil seemed to be destined to remain above $80 per barrel. If the price of oil stays below $80, America’s biggest financial institutions will have to beg – once again – the Fed (and the taxpayer) for help.

In addition to those companies that drill for oil and those that finance them, there is a large industrial sector supplying tools, chemicals and equipment to the oil industry and the value of shares in those companies will tank as oil production winds down. Major index component companies, such as GE and Halliburton will see a loss of business and an inability to cover investments and loans in their oil industry divisions. These financial shortfalls will affect dividend payments or force them to sell otherwise profitable divisions to cover their losses. When the value of index component companies falls, all index-linked investment funds fall into losses. Managers of these funds usually sell off profitable assets to meet their obligations. A sudden shortfall of cash caused by an unexpected fall in the oil price could then trigger a sell off on Wall Street in which case the price of all shares would drop under an urgent rush to sell.

Should energy loans start to default, we may be looking at a snowballing effect in the order of the 2008 banking crisis with a caveat: low oil prices do help reduce the cost of transportation and services and may be a blessing in disguise for the economy. However this plays out, our FFT analysis illustrates that volatility is on the cards. Fasten your seatbelts for a bumpy ride, and keep an eye open for opportunities. As Warren Buffett once said: ”Be fearful when others are greedy and greedy when others are fearful.”


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