The Price of Oil

July 11, 2005 – Last August I wrote an alert entitled “The End of Cheap Hydrocarbons” that was published on the GoldMoney website. The article is still posted there at the following link:  http://goldmoney.com

Crude oil had just cracked the $40 level, and pundits were quick to claim that oil would soon be retreating back to $30 per barrel or less. I took an opposing point of view.

After looking at several factors affecting the price of crude oil and particularly the position of vulnerability in which the US dollar has been placed, my conclusion was simple and straightforward: “The dollar price of crude oil will continue to rise.” That conclusion was controversial, and looked outlandish to some, given that I was one of only a handful of people projecting higher oil prices. But with the benefit of nearly a year’s worth of hindsight, my conclusion was spot-on accurate.

However, I also went on to conclude: “The price of crude oil in goldgram terms will remain basically unchanged, fluctuating [over the long-term] around 2.2gg per barrel…As the dollar price of crude oil rises, it will also take more and more dollars to purchase gold, i.e., the dollar price of gold will rise.”

I would like to take another look at this second conclusion because so far at least, it hasn’t worked out that way. The price of crude oil is also rising in goldgram terms (a ‘goldgram’ is gram of gold and the unit of account of my company, GoldMoney). The reason is that while the dollar price of crude oil is climbing ever higher, gold remains stuck in the same range against the dollar that has confined it for several months.

Last August a barrel of crude oil cost about 3.4gg. That price was high based on historical experience, as we can see on the accompanying chart that presents the month-end goldgram price of crude oil since 1945. Note the two horizontal lines. When the price of crude oil is at 3.7gg per barrel, it’s relatively expensive. When the price is only 1.0gg, crude oil is relatively cheap.

The crude oil price was 4.0gg per barrel at the end of June 2005 on this monthly chart. Since then, crude oil has climbed even higher into new record territory. It closed Friday at 4.4gg per barrel, down slightly from the new record of 4.5gg it reached earlier in the week.

Clearly, the goldgram price of crude oil is out of whack, based on historical experience. So the question I have been pondering is, are we now seeing a restructuring of the oil market that will cause the goldgram price of crude oil to trade in a new higher range than it has historically?

While pondering this question I have just read “Twilight in the Desert” by Matt Simmons, which is an excellent book and one that I highly recommend reading. It provides a detailed and thorough analysis of Saudi Arabian oil reserves, and offers an alarming conclusion – namely, that Saudi Arabia may be near, or may have already reached, the peak in its oil production. In other words, oil fields eventually dry up, and the body of evidence researched by Simmons and meticulously presented in his book suggests that Saudi production is approaching the down-slope.

We can see from the chart that crude oil’s price has ranged roughly from 1.0gg to 4.0gg per barrel. What I’m thinking about now is whether the implications of Simmon’s analysis in the long-term might mean this price range may shift upward from say, 2.0gg to 5.0gg per barrel, or even higher.

The implication of Simmons’ analysis is that the world has benefited since the end of World War II from oil that is cheap to produce because it is relatively easy to get at. We consumers of oil are not going to run out of it anytime soon, but the important question is, if Saudi Arabia has indeed reached the peak of production, what price is needed to keep the world’s growing demand for oil and its constrained supply in balance as we move forward from here?

Consequently, if Simmons is right, might we already be seeing the market adjusting to the reality that oil prices are going to move inevitably higher? And importantly in regard to the chart above, are crude oil prices in terms of gold therefore going to continue moving higher and clearly breakout from its 60-year historical range?

These are two different questions that therefore need to be answered separately. First, in dollar terms crude oil will continue to move higher because the dollar will continue to lose purchasing power from inflation and other forms of monetary debasement. It may also continue to rise because of oil’s supply/demand equation, if Simmons is right.

Second, the rise of crude oil in terms of gold is an anomaly that is the direct result of central bank efforts to suppress the gold price. Gold and oil will in time resume their historical relationship, regardless whether Simmons is right or not.

This conclusion about the goldgram price of crude oil is based on one principal tenet. The aboveground stock of gold continues to grow by less than 2% per annum, which is a rate of growth approximately equal to the world’s new wealth creation each year. Therefore, over long periods of time (like the sixty years on the above chart), the goldgram price of goods tends to be relatively stable. In the case of crude oil, its historical average price is around 2.2gg per barrel. So the 4.4gg present price is an anomaly that will disappear when the central banks lose their ongoing battle to keep the gold price suppressed.

Actions have consequences, and sometimes they are unintended or not foreseen. The rising goldgram price of crude oil – and indeed, the rising price of most commodities and other asset classes in terms of gold – is a direct consequence of central bank efforts to keep a lid on the gold price.