Is Crude Oil More Precious Than Gold?

April 11, 2005 – Crude oil expert Matt Simmons is becoming a familiar name to many, particularly as the price of crude oil climbs higher. He has been featured in numerous financial publications and has appeared on CNBC.

As proprietor of Houston-based Simmons & Co., he is widely respected for his views about crude oil, one key aspect of which is that there is a lot less oil in underground reserves than most people believe. Saudi Arabia in particular, he believes, has reached, or is at least very close to, the maximum production possible from its fields, and consequently, its production of crude oil should soon start to decline. In other words, Saudi reserves are being depleted faster than most people expect. He has challenged the Saudis and anyone else for that matter to prove him wrong, but so far no one has risen to the challenge.

The issues surrounding crude oil reserves have been very important to me since the announcement by Royal Dutch Shell just over one year ago that they had overstated their reported reserves. I noted this point in my interview in Barron’s last fall. I identified the Shell restatement as a “wake-up call” that there is not an infinite amount of crude oil available at under $50 per barrel.

As a consequence, the rise in crude oil prices to over $50 has not been a surprise to me or to the readers of these letters. It was predictable, but what else can be predicted about the future of crude oil? Perhaps more than we might think.

In the 1940’s a geologist named M. King Hubbert made some startling – and accurate – predictions. While working for the Shell Oil Company in the 1940’s, he noticed that the production of crude oil from individual oil fields reflected a normal bell- shaped curve, and that about half of the oil from the field had been exhausted when the bell curve reached its peak.

Following accepted mathematical principles, he then surmised that the oil production for any group of oil fields would also follow a bell-curve. Therefore, in the 1950’s, he predicted that the cumulative group of oil fields within the United States would reach their peak production in the 1970’s, and thereafter decline.

Interestingly, his prediction for 20 years into the future proved accurate. The US reached what is called ‘peak oil’ in the 1970’s pretty much on target as predicted by Hubbert’s bell-shaped curve. Therefore, carrying this concept one step further, is it possible to predict when the group of oil fields existing cumulatively throughout the world will reach ‘peak oil’?

This is a question that I have been pondering and as a result, have read Simmons work with great interest. Is it possible that the great oil fields of Saudi Arabia are at or near their peak of production, and if so, are they about to decline? Does that mean that the world’s production of oil has reached Hubbert’s peak?

I’ll leave it to geologists to answer this question whether we are at so-called ‘peak oil’. But given the record high price above $58 per barrel recently recorded, it may seem to many that peak oil has indeed been reached. However, like so many things in finance, a closer examination reveals some interesting results. We can predict when peak oil arrives by using a methodology other than bell-shaped curves. We can look at the price of crude oil in terms of gold.

This past week crude oil climbed over $58 per barrel, a record high price in terms of dollars. Interestingly, it also hit a record high in terms of goldgrams. So it would appear at first blush that crude oil is becoming dear. But I would like to more fully explore the price of crude oil to answer the following two questions. Is crude oil really becoming more expensive? Or is gold just very undervalued? Take a look at the following chart.

This chart presents the price of crude oil from 1945 to the present in terms of goldgrams (one gram of gold and the unit of account used in the company I founded, GoldMoney.com). The average price of crude oil during this near 60-year period is 2.2gg per barrel, which was fairly close to the prevailing price while the dollar was still defined in terms of gold.

After the Nixon administration broke the dollar’s link to gold in August 1971, the price of crude oil has fluctuated between roughly 0.9gg to 4.0gg per barrel. But most importantly, notwithstanding these fluctuations in price, gold has for the most part held its purchasing power over the nearly 60-years presented in this chart.

Presently, as we can see on the chart, crude oil is at a record high goldgram price, just as we know it is also at a record high in dollar terms. Therefore, because oil is becoming more expensive, it appears that maybe peak oil is indeed being reached. In other words, the price is rising because supply is limited and demand has not yet abated. But before we conclude that peak oil has been reached, there are a couple of things to consider.

First, is oil really that expensive, or is gold just too cheap? Clearly, given the ongoing intervention in the gold market by central banks, I believe that gold is very undervalued. In my view, its natural market price at the moment is north of $500 per ounce. In fact, if we use Friday’s closing price of crude oil at $53.32, gold should be over $750 per ounce if its historical 2.2gg per barrel price prevailed, which brings me to the second point that needs to be considered to determine whether peak oil has been reached.

The above chart shows that there is a consistent relationship in the price of oil when measured in terms of gold. We can therefore conclude that peak oil will be reached when oil prices break out of this chart to the upside, assuming of course that central banks are no longer keeping a lid on gold so that gold eventually reaches its real market level. Is that moment near?

The answer of course is that there is no certainty about the future. But my expectation is that once central bank intervention in the gold market ceases, the price of crude oil will return to its historical average around 2.2gg per barrel. The interesting question is where the dollar price of crude oil will be at that time?

The weakness of the dollar and the ongoing supply/demand equation for crude oil suggests that much higher dollar prices are likely. The $50 level appears to be the new price floor, and $60 looks ready to be breached at any time. So for the sake of argument, let’s assume that crude oil is headed for $80 per barrel.

If crude oil reaches that level, and the goldgram price drops to its historical average of 2.2gg per barrel, then gold will be $36.36 per goldgram, which is $1,130 per ounce. Therefore, to answer the question posed in the title of this article, when left unfettered by central bank intervention, gold will remain more precious than crude oil.