Gold and oil resume their dance

The bull market in gold has been in full swing since 2001, and one of its more intriguing aspects has been the return of an enduring and special price relationship between the two kings of the commodities world: gold and crude oil.

For decades, from the end of the Second World War to 1994, gold and oil prices had a strong, positive correlation on the order of 0.9.

Strangely, during the period 1995-2000, as the gold price slipped into a coma, this special relationship completely fell apart, and the correlation reverted to around minus 0.1. This period coincided with the equities bubble in the U.S., the “strong-dollar” policy advanced by the Clinton administration, and various central-bank interventions designed to suppress the gold price and mask inflationary pressures baked into U.S. monetary policy.

However, in 2001, the old relationship picked up right where it left off, with gold and oil prices returning to a familiar, positive correlation of about 0.7.

Crude oil hit the front-page headlines again this May as prices reached all-time highs in the low-US$40-per-barrel range, surpassing those last seen during the commodity bubble of 1979-80.

What the alarmist headlines, the mind-numbing interviews with motorists grumbling at the pumps, and the empty promises of the politicians vowing to get to the bottom of the supposed gouging all failed to take into account was that only the nominal price of oil hit new highs; on an inflation-adjusted basis, the real price of oil is nowhere close to those highs of 1979-80, when inflation was running rampant, Jimmy Carter was stumbling badly in the White House, and the army of the “evil empire” was rolling into Afghanistan.

During 1979-80, the real price of oil (in present-day dollars) was above US$90 per barrel; then it gradually declined over the next six years to around US$50. After that, the real price (again in present-day dollars) mostly oscillated between US$20 and US$30 per barrel for the next 15 years, with the notable exception of a spike above US$50 when Iraq invaded Kuwait in 1990.

Interestingly, while oil prices are now scoring all-time highs in nominal terms, gold prices have so far reached only half way towards their nominal peak above US$800 per oz. in the key 1979-80 bubble period.

Another way of looking at the gold-oil relationship is to examine the price ratio over the past few decades: it has been fairly stable and averaged about 15.4 since the early 1960s, and currently is a low 9.9.

In past decades, any prolonged positive or negative deviation from the ratio of 15.4 has resulted in a rapid reversion to the mean, often with an overshoot. So the question is, Which do you think is the more likely route for the ratio of 15.4 to be restored? Oil prices plummeting to US$26 per barrel, or gold prices exploding to US$616 per ounce?

Oil is in a bull market today because of fundamental shifts in demand and supply. On the demand side, the rapid and still nascent industrialization of China and India is an earth-shaking event unique in human history that will drive oil demand for decades to come.

On the supply side, we’re all too familiar with the turmoil in the Middle East, where insurgents have relentlessly attacked Iraqi oil infrastructure and al-Qaeda members have targeted the Western ex-pats who run Saudi Arabia’s oil industry.

Little-appreciated outside the Arab and Islamic world, America had its worst day since the 9-11 attacks during the week of April 24 in Iraq. No, it wasn’t the Abu Ghraib prison scandal, as bad as that was in demoralizing the American public and losing any remaining goodwill left in Iraqis’ hearts toward the Coalition forces; the terrible new development for America was the withdrawal of the U.S. Marines, arguably America’s top combat troops, from the streets of Falluja after they besieged the city for almost a month.

It’s the first battle lost by the Marine Corps since the early months of the Korean War, when the 1st Marine Division was forced by eight Chinese divisions into a 4-week retreat from the mountainous Chosin Reservoir area, inland from Wonsan.

Situated 35 miles west of Baghdad, Falluja is called the “city of mosques” and is the most religiously conservative city in the “Sunni triangle,” with numerous adherents to the famously intolerant Wahabi sect. While Falluja saw little looting and mayhem immediately following the fall of Saddam Hussein’s regime, the city has since become an epicentre of violent crowd-control incidents, murders and bombings.

The First Marine Expeditionary Force launched the siege, named “Operation Vigilant Resolve,” in early April in response to the killings of five U.S. soldiers and the murder on March 31 of four American employees of North Carolina-based security firm Blackwater USA. The latter were killed in their SUVs at a red light of Falluja’s main thoroughfare (earlier renamed Sheikh Ahmed Yassin Street, to honour the recently assassinated co-founder of the Palestinian terror organization Hamas), following which their bodies were mutilated, burned and strung up on a bridge.

The men who desecrated the contractors were never arrested — even though they were filmed in the act — and few insurgents’ weapons were turned in, but the Americans agreed to withdraw from the city nonetheless. Local militiamen and foreign jihadists have since imposed an ultra-orthodox, Taliban-like rule over Falluja.

The defeat of the Marines in Falluja has exposed, for all to see, the Achilles’ heel of American military might: it can’t win a guerilla war in a foreign land. (Wait a minute, didn’t they already learn this in Vietnam?)

Veterans will tell you there are only two ways to win a war against guerillas when they are supported by the local populace: one is to kill everybody, which is not an option given our present moral make-up, and the second is to terrorize the locals into giving up information on the guerillas — a technique that is now out of the question after the Abu Ghraib revelations.

Moreover, there has been a confluence between the local Sunni participants in the siege of Falluja and the Shiite uprisings in Najaf, Karbala and Baghdad, which were led by the young martial cleric Moqtada al-Sadr and his al-Mahdi army.

Al-Sadr had been on the Coalition forces’ “Wanted: Dead or Alive” list just a few months ago but is now the most likely candidate to become Iraq’s new leader once the tragically weak Iraqi interim government, led by Prime Minister Iyad Allawi, inevitably falls. Al-Sadr, in turn, is very much under the influence of the pro-Iranian and anti-U.S. Grand Ayatollah Ali al-Sistani, the most-revered Shiite cleric in Iraq.

In short, it looks like the winner of the Iraq War will be . . . Iran. Yes, the same “Axis of Evil” country that is now gunning for nuclear capability and supporting Islamic terrorist groups.

Needless to say, these unsettling developments are not conducive to a stable and growing global supply of oil in the coming years — and we’ve barely mentioned Saudi Arabia’s troubles. All this will most likely translate into slower global economic growth, a weakening U.S. dollar, and higher gold and oil prices.

Another positive observation for gold and oil bulls is that the price rises in both commodities have been slow and strong since 2001, quite unlike the panic in 1979, when gold and oil shot up almost vertically to unsustainably high levels. What this indicates is that today’s rising gold and oil prices have solid technical foundations, marked by higher highs and higher lows, on which can be built truly superb generational bull markets — a situation that, though sometimes painful from a geopolitical perspective, will financially benefit all of us working or investing in the North American gold and oil sectors.

(For an in-depth look at the gold/oil price relationship, visit Adam Hamilton’s website at www.zealLLC.com, from which the above figures were derived.)