Gold Oil Dollar Relationship Vaze Assignment

8/8/2019 Gold Oil Dollar Relationship Vaze Assignment

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Background: Establishing a Relationship between Gold,Oil and the US $

Congress created the Federal Reserve System in 1913. Between then and 1971 the principle of

sound money was systematically undermined. Between 1913 and 1971, the Federal Reserve

found it much easier to expand the money supply at will for financing war or manipulating the

economy with little resistance from Congress while benefiting the special interests that

influence government.

Dollar dominance got a huge boost after World War II. Printing money to pay the bills was a lot

more popular than taxing or restraining unnecessary spending. In spite of the short-term

benefits, imbalances were institutionalized for decades to come.

Dollar World Reserve Currency

The 1944 Bretton Woods agreement solidified the dollar as the preeminent world reserve

currency, replacing the British pound. Due to USAs political and military muscle, and because

USA had a huge amount of physical gold, the world readily accepted our dollar as the worlds

reserve currency. The dollar was said to be as good as gold, and convertible to all foreign

central banks at that rate. This was a gold-exchange standard that from inception was doomed

to fail.

The U.S. did exactly what many predicted she would do. She printed more dollars for which

there was no gold backing. But the world was content to accept those dollars for more than 25

years with little question until the French and others in the late 1960s demanded US to fulfill

its promise to pay one ounce of gold for each $35 they delivered to the U.S. Treasury. This

resulted in a huge gold drain that brought an end to a very poorly devised pseudo-gold

standard.

End of Dollar convertibility into Gold

It all ended on August 15, 1971, when Nixon closed the gold window and refused to pay out any

of our remaining 280 million ounces of gold. In essence, US declared its insolvency and the


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world recognized that some other monetary system had to be devised in order to bring stability

to the markets.

Amazingly, a new system was devised which allowed the U.S. to operate the printing presses

for the world reserve currency with no restraints placed on it not even a pretense of gold

convertibility, none whatsoever! Though the new policy was even more deeply flawed, it

nevertheless opened the door for dollar hegemony to spread.

OPEC -Pricing of Oil in Dollar

Realizing the world was embarking on something new and mind-boggling, elite money

managers, with especially strong support from U.S. authorities, struck an agreement with OPEC

to price oil in U.S. dollars exclusively for all worldwide transactions. This gave the dollar a

special place among world currencies and in essence backed the dollar with oil. In return, the

U.S. promised to protect the various oil-rich kingdoms in the Persian Gulf against threat of

invasion or domestic coup. This arrangement helped ignite the radical Islamic movement

among those who resented USAs influence in the region. The arrangement gave the dollar

artificial strength, with tremendous financial benefits for the United States. It allowed US to

export its monetary inflation by buying oil and other goods at a great discount as dollar

influence flourished.

This post-Bretton Woods system was much more fragile than the system that existed between

1945-1971.Though the dollar/oil arrangement was helpful, it was not nearly as stable as the

pseudogold standard under Bretton Woods. It certainly was less stable than the gold standard

of the late 19th century.

During the 1970s the dollar nearly collapsed, as oil prices surged and gold skyrocketed to $800

an ounce. By 1979 interest rates of 21% were required to rescue the system. The pressure on

the dollar in the 1970s, in spite of the benefits accrued to it, reflected reckless budget deficits

and monetary inflation during the 1960s. The markets were not fooled by LBJs claim that we

could afford both guns and butter.


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Once again the dollar was rescued, and this ushered in the age of true dollar hegemony lasting

from the early 1980s to the present. With tremendous cooperation coming from the central

banks and international commercial banks, the dollar was accepted as if it were gold.

Gold An Alternative Investment for Depreciating Dollar

In recent years central banks and various financial institutions, all with vested interests in

maintaining a workable fiat dollar standard, were not secretive about selling and loaning large

amounts of gold to the market even while decreasing gold prices raised serious questions about

the wisdom of such a policy. They never admitted to gold price fixing, but the evidence is

abundant that they believed if the gold price fell it would convey a sense of confidence to the

market, confidence that they indeed had achieved amazing success in turning paper into gold.

Increasing gold prices historically are viewed as an indicator of distrust in paper currency. This

recent effort was not a whole lot different than the U.S. Treasury selling gold at $35 an ounce in

the 1960s, in an attempt to convince the world the dollar was sound and as good as gold. Even

during the Depression, one of Roosevelts first acts was to remove free market gold pricing as

an indication of a flawed monetary system by making it illegal for American citizens to own

gold.

Economic law eventually limited that effort, as it did in the early 1970s when US Treasury and

the IMF tried to fix the price of gold by dumping tons into the market to dampen the

enthusiasm of those seeking a safe haven for a falling dollar after gold ownership was re-

legalized.

Once again the effort between 1980 and 2000 to fool the market as to the true value of the

dollar proved unsuccessful. In the past 5 years the dollar has been devalued in terms of gold by

more than 50%. You just cant fool all the people all the time, even with the power of the

mighty printing press and money creating system of the Federal Reserve.

Even with all the shortcomings of the fiat monetary system, dollar influence thrived. The results

seemed beneficial, but gross distortions built into the system remained. And true to form,


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Washington politicians are only too anxious to solve the problems cropping up with window

dressing, while failing to understand and deal with the underlying flawed policy. Protectionism,

fixing exchange rates, punitive tariffs, politically motivated sanctions, corporate subsidies,

international trade management, price controls, interest rate and wage controls, super-

nationalist sentiments, threats of force, and even war are resorted to all to solve the

problems artificially created by deeply flawed monetary and economic systems.

In the short run, the issuer of a fiat reserve currency can accrue great economic benefits. In the

long run, it poses a threat to the country issuing the world currency. In this case thats the

United States. As long as foreign countries take dollars in return for real goods, US come out

ahead. This is a benefit many in Congress fail to recognize, as they bash China for maintaining a

positive trade balance with US. But this leads to a loss of manufacturing jobs to overseas

markets, as US become more dependent on others and less self-sufficient. Foreign countries

accumulate dollars due to their high savings rates, and graciously loan them back to US at low

interest rates to finance our excessive consumption.

The agreement with OPEC in the 1970s to price oil in dollars has provided tremendous artificial

strength to the dollar as the preeminent reserve currency. This has created a universal demand

for the dollar, and soaks up the huge number of new dollars generated each year.

The artificial demand for USD, along with their military might, places them in the uniqueposition to rule the world without productive work or savings, and without limits on

consumer spending or deficits. The problem is, it cant last.

Price inflation is raising its ugly head, and the NASDAQ bubble generated by easy money has

burst. The housing bubble likewise created is deflating. Gold prices have doubled, and federal

spending is out of sight with zero political will to rein it in. The trade deficit last year was over

$728 billion. A $2 trillion war is raging, and plans are being laid to expand the war into Iran and

possibly Syria. The only restraining force will be the worlds rejection of the dollar. Its bound tocome and create conditions worse than 19791980, which required 21% interest rates to

correct. But everything possible will be done to protect the dollar in the meantime. The US has

a shared interest with those who hold their dollars to keep the whole charade going.


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Greenspan, in his first speech after leaving the Fed, said that gold prices were up because of

concern about terrorism, and not because of monetary concerns or because he created too

many dollars during his tenure. Gold has to be discredited and the dollar propped up. Even

when the dollar comes under serious attack by market forces, the central banks and the IMF

surely will do everything conceivable to soak up the dollars in hope of restoring stability.

Eventually they will fail.

Most importantly, the dollar/oil relationship has to be maintained to keep the dollar as a

preeminent currency. Any attack on this relationship will be forcefully challenged as it already

has been.

Targeting Iraq

In November 2000 Saddam Hussein demanded Euros for his oil. His arrogance was a threat to

the dollar; his lack of any military might was never a threat. At the first cabinet meeting with

the new administration in 2001, as reported by Treasury Secretary Paul ONeill, the major topic

was how to get rid of Saddam Hussein though there was no evidence whatsoever he posed a

threat to US. This deep concern for Saddam Hussein surprised and shocked ONeill.

It now is common knowledge that the immediate reaction of the administration after 9/11

revolved around how they could connect Saddam Hussein to the attacks, to justify an invasion

and overthrow of his government. Even with no evidence of any connection to 9/11, or

evidence of weapons of mass destruction, public and congressional support was generated

through distortions and flat out misrepresentation of the facts to justify overthrowing Saddam

Hussein.

There was no public talk of removing Saddam Hussein because of his attack on the integrity of

the dollar as a reserve currency by selling oil in Euros. Within a very short period after the

military victory, all Iraqi oil sales were carried out in dollars. The Euro was abandoned.


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Relationship between Gold and Oil (commodities traded in dollar)

If you spend (waste) a lot of time reading or listening to the explanations in the mainstream financial

press for why the gold market did what it did on a particular day you will probably come away with the

impression that the oil market drives the gold market. For example, whenever gold and oil prices fall onthe same day you'll almost certainly see headlines such as "gold follows oil lower"; and whenever both

markets rise together there will usually be headlines such as "gold bounces in response to higher oil

price".

The idea that the oil price is an important driver of the gold price has also been given weight by the

commentaries of the many gold bugs who, over recent years, have often cited the rising oil price as a

reason to expect a higher gold price. Some gold bugs even claim, in one breath, that a higher oil price is

bullish for gold and then, in the next breath, that gold is money. It seems not to have occurred to them

that there's no reason for the demand for money and the demand for industrial commodities to move in

the same direction.

On a side note, gold is unfortunately not money right now, but in many respects it still trades as if it

were. For example, it typically turns in its best performances when real economic growth and

confidence are falling.

When a particular viewpoint becomes entrenched it will often be self-fulfilling in the short-term. For

instance, the idea that the widening US trade deficit all but guaranteed a continuing decline in the dollar

gripped the markets during the final quarter of 2004 and encouraged a lot of speculative 'shorting' of

the dollar. Even though it was based on a false premise this speculative 'shorting' had the effect of

pushing the dollar down at the same time as interest rate differentials were setting the scene for a US$

recovery. In a similar way, the mistaken view that the oil market is an important driver of the gold

market is causing a stronger correlation between the two markets than there should be, which, in turn,

reinforces the faulty analysis.

But just as the "dollar is going to plunge due to the widening trade deficit" idea that was so popular at

the end of 2004 was eventually overwhelmed by real interest rate differentials (the true fundamental

drivers of intermediate-term exchange-rate trends), we suspect that the "oil price drives the gold price"

idea that is currently quite popular will, before much longer, be overwhelmed by genuine fundamentals.

In our opinion, changes in the oil price are neither here nor there as far as the price of gold bullion is

concerned. Under the current monetary system the directions of the long-term price trends in oil andgold will tend to be the same because inflation is a primary driver of both markets, but it is what's

happening on the monetary front, not what's happening with oil supply/demand, that matters to the

gold market.

Changes in the oil price do, however, have an important effect on gold mining shares, but it's not the

effect that most people would expect. To be specific, as far as gold mining equities are concerned a rise


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in the oil price is BEARISH and a fall in the oil price is BULLISH. The reason, of course, is that gold miners

are major CONSUMERS of oil (a large chunk of a gold miner's costs are energy-related).

In theory, therefore, a comparison of longer-term charts of oil and the AMEX Gold BUGS Index (HUI)

should reveal a slight inverse correlation. Fortunately, this is what the following chart comparison of the

oil price and the HUI actually does reveal (we say "fortunately" because it's nice when market trendsmake sense). In particular, the chart shows that:

a) The start of the long-term bull market in gold shares in Q4-2000 coincided, almost to the day, with an

intermediate-term PEAK in the oil price

b) The largest percentage gains made by gold shares occurred between Q4-2000 and Q4-2003, a period

during which the oil price was basing

c) Oil's upside breakout from its base coincided with the start of a major downward correction in the

gold shares

d) Between November of last year and May of this year the oil price and the HUI both surged upward. In

light of what happened over the preceding 7 years this action was anomalous, although it simply

reflected the fact that the gold price was rising at a faster rate than the oil price during this period (gold

was strong enough relative to oil to offset the adverse effects, on the profit margins of gold miners, of

higher energy prices)

Of interest, but not shown on the below chart, is the fact that ALL the gains in the major gold shares

relative to the gold price were made while the oil price was below $35.


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Bottom Line

In summary, the oil price does not drive the gold price and the only reason the two markets have similar

long-term trends is that they have one important long-term driver in common: monetary inflation.

There is, however, an inverse relationship between the oil price and the prices of gold shares, but this

relationship only comes to the fore during periods when the oil price is moving sharply lower or sharply

higher relative to the gold price.


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Relationships between Dollar and OilWhile it is difficult to establish statistical evidence of causality, we believe that the USD and oil will likely

remain negatively correlated, for various reasons. Oil prices, therefore, will remain an important

though not the only consideration for the dollar. Specifically, lower and stable oil prices should be

positive for the USD, while rising oil prices should be negative for the USD.

The Oil-Dollar Link

The circle of rising oil prices and a falling dollar was vicious. In contrast, the recent reversal of these

trends is virtuous and, all else equal, positive for the world. Not only will lower oil prices help to support

global demand, they should also permit greater monetary flexibility to deal with lower economic

growth. (There are two aspects of the nexus between oil and the dollar: their correlation and the

direction of causality. We have conducted Granger Causality tests, and found that, in practice, and for

the most recent period (1992-2008), the dollar tends to lead oil, rather than the other way around.)

Until around 2003, higher oil prices were correlated with a stronger dollar. This was primarily because

petrodollars were not only recycled back in to the US through trade but also because of financial flows:

the US was dominant in every way back then, in terms of the attractiveness of its exports and assets.

However, since 2004, this correlation has evaporated, and since 2006, the correlation has turned

intensely negative.

There are several possible explanations for this negative correlation between oil prices and the dollar,

especially the EUR/USD bilateral cross. We have, in previous work, touched on some of these reasons

(see The USD and Oil Prices: Some Conceptual Issues, August 9, 2007). We list them here, paying

particular attention to the direction of causality.

There are primarily three channels through which oil prices could affect the dollar:

Link 1. Petrodollar recycling less dollar-friendly. The economic reliance of oil exporters on the US has

declined over the years. Specifically, petrodollar owners now have a higher marginal propensity to

consume European-made products than before. (Back in the 1970s, around 18% of OPECs imports were

from the US. Now, this ratio has fallen to 9%, and OPEC sources 26% of its imports from the EU.) Also,

they are likely to have a lower marginal propensity to invest in USD assets, simply because the array of

assets in the world available to the petrodollar investors is now much wider than before. This is also

related to the issue of reserve diversification by oil exporters. The establishment of the EMU has

enhanced the liquidity of EUR-denominated assets, and intra-Eurozone divergence has preserved the

diversification benefits of investing in EUR assets. Petrodollar owners have responded to these changingglobal financial markets. Thus, the higher the oil price, the more diversification takes place, and the

weaker the dollar is.

Link 2. Different central bank responses to oil shocks. Investors have different opinions about how the

Fed and the ECB may react to rising oil prices, one opinion being that the latter might act more

aggressively than the former, because of their different mandates. Thus, higher oil prices tend to lead to

general expectations of a more hawkish reaction from the ECB an inflation targeter than from the


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Fed, which has a dual mandate on growth and inflation. In other words, rate hikes in response to oil

price rises appear more automatic for the ECB than for the Fed. This may help to explain why EUR/USD

and oil are correlated on a real-time basis a trend that cannot be satisfactorily explained by the

diversification argument mentioned above. Thus, in general, a higher USD price of oil may have

conveyed to the world the impression that there was more global inflation than there really was.

Monetary tightening in response to this positive inflation shock had further depressed the dollar,

thereby perpetuating the circle.

Link 3. High oil prices hurt the US C/A deficit. The US C/A deficit has shrunk rapidly since 4Q05,

especially the non-oil portion of the C/A. (The US C/A deficit reached a peak of 6.8% of GDP in 4Q05,

and has just breached the 5.0% GDP mark in 4Q07. It is likely to decline to around 4.5% by end-2008.)

Indeed, trends in non-oil and oil trade balances have diverged substantially since 2005. While the

former improved from U$40 billion to around U$30 billion a month, the oil trade balance reflecting the

sharp move in the US terms of trade deteriorated from around U$20 billion to U$30 billion a month.

In short, high oil prices have offset the tremendous improvement in the US external imbalance that has

and continues to take place, and have prevented the dollar from being rewarded for this improvingtrend.

And there are three links through which the dollar drives oil quotes, in addition to the numeraire effect:

Link 4. Feedback through the de facto dollar zone. The de facto dollar zone could also help to explain

the link between the dollar and oil, and the causality running from the former to the latter. While the

de facto dollar zone is looser now than two years ago, many Asian and other EM currencies are still

quite sticky vis--vis the dollar. Dollar depreciation effectively makes Asian exporters even more

competitive, and economic buoyancy in these dollar zone countries (i.e., Asia) has led to high

consumption of energy products. Therefore, a weak dollar may, on balance, increase the worlds

demand for energy products.

Link 5. Financial investment in commodities. There are anecdotal signs that institutional funds may be

starting to treat commodities as a separate asset class. To the extent that real commodities are treated

as anti-dollars, there could be a negative relationship between these two variables. Similarly, if

commodities are seen as a hedge against inflation, expectations of higher US inflation will drive the

dollar down and oil prices up.

Link 6. Weak dollar and the lack of oil demand destruction. Many countries have tried to let their

currencies appreciate in the past quarters so as to offset the impact of oil price increases in USD. But

what may make sense from an individual countrys perspective has in fact been inflationary from theworlds collective perspective. Essentially, strong currencies provided an implicit subsidy on oil, and

rising oil prices have not caused the level of demand destruction they should have done. As a result, oil

prices continue to march higher, the longer this strong currency policy is maintained.

These are some explanations for why oil and the dollar have been so negatively linked since 2006.

However, a further theory we have is that oil and the dollar could appear correlated only because they

are driven by the same factor. We see this thesis as particularly relevant for the recent episode of oil


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price correction and the rise in the dollar. The dollar could have risen in the past month due to the

Dollar Smile effect. At the same time, a broad-based deceleration in global growth, on top of the oil

demand-destruction that had already begun in many developed countries, should driver oil prices lower.

As a result, the dollar rose at the same time as oil prices fell, not because one caused the other, but

because they were both driven by the same factor: a deteriorating global economic outlook.

The Outlook for the Dollar, Conditional on Oil Price

There are two thoughts:

A strong dollar helps the world to rationalise on oil consumption. The vicious circle between a weak

dollar and high oil prices was bad for the global economy. The contraction in Germanys GDP was due to

weak domestic demand, rather than exports. This raises the whole concept of de-coupling and re-

coupling, that Germany has not weakened because of a weak US or a weak world. Rather, it has

weakened due, possibly, to the sharp energy shock and the credit crunch. As we argued under Link 6, a

stronger dollar would force the rest of the world to rationalise energy consumption. A currency-based

policy reaction to the oil price rise such as the strong EUR policy adopted by the ECB never made

sense from a global perspective, in our view. This was a negative-sum solution, due to the lack of oil

demand-destruction. We believe that a virtuous circle of a stronger dollar and lower oil prices is what

the world needs now.

Inflation-targeting central banks to become more dovish. Calmer commodity prices make sense if the

global economy is decelerating. This should help anchor inflation expectations and permit inflation-

targeting central banks to ensure that two-year forward inflation does not fall below their targets. The

speed with which the RBA may make a U-turn (it last tightened in March, and may ease on September 2)

on its policy and the markets positive reaction to the RBAs flexibility are a good example of what other

inflation-targeting central banks (ECB, BoE, Swedens Riksbank, RBI, BoK, SARB and RBNZ) could do though such a policy reversal may not come as soon as the case of the RBA, further supporting the

dollar.

Viewpoint: Oil isnt expensive instead dollars have become cheap

In his classic book, The Theory of Money and Credit, Austrian School economist Ludwig Von Mises

plainly observed that "Whenever money is valued by anybody it is because he supposes it to have a

certain purchasing power." Von Mises's views on money loom large considering the nosebleed price of

oil that American consumers continue to suffer.

Though it's well down from highs of $147/barrel that it reached in the summer of 2008, that the price ofa barrel of oil still trades in the $79 range is a certain signal that something is amiss.

Perhaps unaware of the dollar's undefined, floating nature, commentators continue to point to the oil

price to support their suggestions of foul play on the part OPEC, too much global demand for what is

allegedly a limited commodity, or greedy "speculators" keeping the price of the world's fuel at


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abnormally high prices. Influential newsman Bill O'Reilly frequently fingers speculators when attempting

to explain the price of oil to his viewers.

In each instance commentators mistake the symptom of expensive oil for its true cause. Von Mises

frequently touched on money values in his brilliant expositions on markets, and it's because the dollar

has no true value or fixed definition that oil is presently expensive. In short, oil is dear because the dollarin which it's priced is cheap.

For background, it's worth mentioning that not long after he was inaugurated as our 40th president,

Ronald Reagan predicted a fall in the price of a barrel of oil. What made Reagan so confident?

Aware of the historical relationship between gold and oil, Reagan deduced that oil was due for a

correction based on a 20% drop in the price of an ounce of gold since his election. Sure enough, by

December of 1981 the price of a barrel of oil was nearly 20% lower than it had been one year before.

Looked at over a longer timeframe, from 1970 to 1981 the price of gold rose 1,219 percent, versus a rise

in the price of oil 1,291 percent. This wasn't coincidental. With gold and oil both priced in dollars, andwith gold serving as the best proxy for the latter's value, a jump in the gold price neatly foretold the oil

"shocks" of the 1970s that were merely dollar shocks.

Given the strong price correlation between the two commodities, many economics writers took to

explaining the gold/oil relationship in terms of a 15/1 ounce/barrel ratio. As the late Warren Brookes

wrote in his 1982 book, The Economy In Mind, "In 1970 an ounce of gold ($35) would buy 15 barrels

OPEC oil ($2.30/bbl). In May 1981 an ounce of gold ($480) still bought 15 barrels of Saudi oil ($32/bbl).

More modernly, in March of 1999 The Economist predicted $5/bbl oil in the future because "the world is

awash with the stuff, and it is likely to remain so." Instead, with the gold/oil ratio of roughly 25/1

historically out of whack, crude proceeded to rally beyond the 15/1 ratio; reaching $24/bbl by

September of 2001.

Considering oil's aforementioned spike to $147/barrel in 2008, an ounce of gold then only bought 6.8

barrels of oil. What this meant at the time was that oil was due for a major correction as its price fell

back to historical ratios. In that sense, oil's collapse from nearly two years ago was less a function of

reduced global demand and allegedly "benevolent" speculators, and largely a function of it returning to

its normal relationship with the gold price.

Right now gold trades in the $1176 range, and the price of oil is roughly $79 per barrel. That an ounce of

gold buys 15 barrels of oil signals yet again that the real price of oil has hardly changed at all over thelast 10 years of allegedly costly crude. Still, $79 oil ensures $3/gallon gasoline as far as the eye can see,

and it's a fair bet that the price will stay there so long as gold continues to test all-time highs.

The good news, however, is that this can be fixed. As evidenced by the dollar's major decline versus gold

this decade, the dollar is very cheap. The dollar's debased nature explains expensive spot oil prices, high

prices at the pump, and most important of all, it helps explain a difficult job outlook. With so much


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soggy money flowing into commodities least vulnerable to dollar weakness, the entrepreneurial

economy where most jobs are created is losing out.

So the answer is really quite simple. If we want cheaper gasoline, we need the U.S. Treasury to target a

stronger dollar, and for it to even threaten intervention if markets unexpectedly fail to comply. If a $500

gold price is targeted as so many gold-watchers would prefer, the stronger dollar will sooner rather thanlater reveal itself in greatly reduced oil prices; roughly $33/barrel if historical gold/oil ratios once again

prevail.

For now though, it's a waste of time to bemoan what many deem "expensive oil." Time is wasted

because there's no such thing as expensive oil, and there never has been. Instead, we have a problem of

Americans supposing that the dollar is fixed in value, when in fact the dollar floats.

Oil hasn't become expensive this decade; rather the dollar has become very cheap. Strengthen the

dollar, and worries over nosebleed gasoline prices will quickly become a thing of the past. Absent that,

to hope that something will become inexpensive when the unit of account in which it's priced continues

to fall is to indulge in fantasy.

Linking Oil prices to increase in Gold Prices

The answer to that question begins with the historical desire of Arab producers to receive gold in

exchange for their oil. This dates back to 1933 when King Ibn Saud demanded payment in gold for the

original oil concession in Saudi Arabia. In addition, Islamic law forbids the use of a promise of payment,

such as the US dollar, as a medium of exchange. There is growing dissention among religious

fundamentalists in Saudi Arabia regarding the exchange of oil for US dollars.

Oil, gold and commodities have all been priced in US dollars since 1975 when OPEC officially agreed to

sell its oil exclusively for US dollars. From 1944 until 1971, US dollars were convertible into gold bycentral banks in order to adjust for any trade imbalances between countries. Up to that point, the price

of gold was fixed at US$35 per ounce, and the price of oil was relatively stable at about US$3.00 per

barrel. Once the US ceased gold convertibility in 1971, OPEC producers were forced to convert their

excess US dollars by purchasing gold in the marketplace. This resulted in price increases for both oil and

gold, until eventually oil reached US$40 per barrel and gold reached US$850 per ounce.

Today, apart from geopolitical threats in oil-producing regions, supply/demand imbalances from Peak

Oil and increasing demand from developing countries, the price of both gold and oil can be expected to

increase as the US dollar declines. With an ever-increasing US money supply, growing triple deficits and

mounting debt at all levels, the US dollar is likely to continue the decline that began in 2001. Since then,

foreign holders of US dollar assets have already lost 33 percent of their investment. How long will oil

exporters continue to accept declining US dollars? How long will they continue to hold US dollars as

their reserve currency?

At some point, they may decide to abandon the US dollar in favour of euros. Russian premier Vladimir

Putin and Venezuela's president Hugo Chavez have both publicly announced that they may begin to

price oil in euros in the near future. Even Saudi Arabia has stated that it is considering pricing its oil in


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euros, as well as in US dollars. There have even been discussions among Arab nations about pricing oil in

Islamic gold and silver dinars. If this happens, other producers may follow suit and opt out of accepting

US dollars for oil. Demand for the currency will plummet, sending the dollar into a freefall while demand

for euros, gold and silver soars.

In addition, Middle Eastern oil producers would be forced to diversify their vast US dollar holdings intoprecious metals and other currencies to protect themselves from further losses. As losses mount, other

large, non-oil producing, US dollar holders such as Japan, China, Korea, India and Taiwan would seek to

diversify out of US dollars. Eventually, this could result in a dollar sell-off and a corresponding increase in

oil and gold prices.

Over the last 50 years or so, gold and oil have generally moved together in terms of price, with a positive

price correlation of over 80 percent. During this time, the price of oil in gold ounces has averaged about

15 barrels per ounce. However, with recent soaring oil prices, the relationship has strayed far from this

average. While oil prices recently set an all-time high of $56 per barrel, gold prices have not kept pace

and the oil:gold ratio fell to an all-time low of 7.5:1. At US$56 per barrel oil, the gold price should be in

excess of US$840 per ounce. Some experts are suggesting that, in two or three years, US$100 per barrel

oil is very possible. At that price gold should be US$1500 per ounce.

The gold silver:ratio has varied from 16:1 to 100:1. Currently it is about 66:1. Gold Fields Mineral

Services expects this ratio to fall to between 40:1 and 50:1 in the near future. At a 50:1 ratio and a

$1,500 gold price the price of silver should be $30/ounce. At 16:1 it would be $94/ounce.

The size disparity between oil and gold markets must also be considered. While annual gold production

is approximately US$35 billion, annual oil production is US$1.5 trillion, by far the largest-trading world

commodity. As oil prices increase and demand for US dollar diversification increases, there will be an

ever-expanding number of petro dollars and other offshore dollar holders chasing a relatively smallamount of bullion ounces.

In conclusion, the price of oil is poised to rise steadily as the supply/demand imbalance increases and

the dollar declines, even if there are no supply disruptions, terrorist threats or geopolitical concerns to

consider. As this happens, the price of precious metals will climb until they eventually catch up to their

historic ratios. Should oil producers demand euros, dinars or precious metals in payment for their

product, the decline in the US dollar will accelerate while the price of precious metals explodes. If oil

producers and other foreign US dollar holders begin to sell the trillions they hold and diversify into

alternatives, then the price of both oil and precious metals will rise to levels that today are hard to

imagine.

Using Hubbert Predictive model to explain price movement in OilOf the various vulnerabilities traditional financial assets are exposed to, a rising oil price is of particular

concern. In 2004, oil hit an all-time high of $56 per barrel, up 366 percent from the $12 low of 1998, and

up 75 percent since January 2004.


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Generally speaking, an increasing oil price results in increasing inflation, negatively impacting the global

economy, particularly oil-dependent economies such as the US. Apart from increased transportation,

heating and utility costs, higher oil prices are eventually reflected in virtually every finished product, as

well as food and commodities in general. Furthermore, there is evidence that global oil production is

peaking and the flow will soon be in permanent decline.

The US has enjoyed inexpensive oil-based energy for nearly a century, and this is one of the prime

factors behind the unprecedented prosperity of its economy in the 20th century. While the US accounts

for only 5 percent of the world's population, it consumes 25 percent of the world's fossil fuel-based

energy. It imports about 75 percent of its oil, but owns only 2 percent of world reserves. Because of this

dependency on both oil and foreign suppliers, any increases in price or supply disruptions will negatively

impact the US economy to a greater degree than any other nation.

The majority of oil reserves are located in politically unstable regions, with tensions in the Middle East,

Venezuela and Nigeria likely to intensify rather than to abate. Because of frequent terrorist attacks, Iraqi

oil production is subject to disruption, while the risk of political problems in Saudi Arabia grows. The

timing for these risks is uncertain and hard to quantify, but the implications of Peak Oil are predictable

and quantifiable, and the effects will be more far-reaching than simply a rising oil price.

In the early 1950s, M. King Hubbert, one of the leading geophysicists of the time, developed a predictive

model showing that all oil reserves follow a pattern called Hubbert's Curve, which runs from discovery

through to depletion. In any given oil field, as more wells are drilled and as newer and better technology

is installed, production initially increases. Eventually, however, regardless of new wells and new

technology, a peak output is reached. After this peak is reached, oil production not only begins to

decline, but also becomes less cost effective. In fact, at some point in this decline, the energy it takes to

extract, transport and refine a barrel of oil exceeds the energy contained in that barrel of oil. When that

point is reached, extraction of oil is no longer feasible and the reserve is abandoned. In the early years of

the 20th century, in the largest oil fields, it was possible to recover 50 barrels of oil for each barrel used

in the extraction, transportation and refining process. Today that 50-to-1 ratio has declined to 5-to-1 or

less. And it continues to decline.

Hubbert's 1956 prediction that crude oil production in the US would peak in the early 1970s and then

decline was greeted with great skepticism. After all, production in the US was increasing and technology

was improving. However, there were no new major reserves being discovered, and his prediction proved

to be correct. Oil production in the US did peak in 1970, and has been declining ever since.

Using analytic techniques based on Hubbert's work, oil and gas experts now project that world oilproduction will peak sometime in the latter half of this decade. We are now depleting global reserves at

an annual rate of 6 percent, while demand is growing at an annual rate of 2 percent (and that growth

rate is expected to triple over the next 20 years). This means we must increase world reserves by 8

percent per annum simply to maintain the status quo, and we are nowhere near achieving that goal. In

fact, we are so far from it that, according to Dr. Colin Campbell, one of the world's leading geologists,

the world consumes four barrels of oil for every one it discovers.


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Once a supply shortfall materializes, the US will be in competition with China, India, Japan and other

importing countries for available oil. Many experts are now predicting US$100 per barrel within the next

two years. Some believe it will go even higher. Taking geopolitical factors and supply/demand

fundamentals into consideration, it is impossible to predict how high the price of oil will soar. One thing

seems certain - the age of cheap oil is over.

Figure 1: Historical Supply of Oil from Oil producing countries

Bottom Line

The USD and oil are likely to remain negatively correlated for some time; the performance of the USD

will in part be determined by the evolution of oil prices. For the global economy, a strong dollar/low oilprice combination is much better than a cheap dollar/high oil price combination. Calmer commodity

prices should also temper the hawkish bias that some inflation-targeting central banks have had.


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Scenario 1: OPEC insists on trading Oil for GoldOPEC had a problem. They were selling their oil and getting dollars in return. However, the Dollar was

losing value quickly. They worried that, in the future, the Dollar might not be worth very much at all.

They would have sold their irreplaceable natural resources for a paper promise from a country that

didnt keep its promises.

The year was 1971. On August 15 of that year, president Richard Nixon officially ended the Dollars link

to gold, which had been the policy of the U.S. government since 1789. At the time, the Dollar was worth

1/35th of an ounce of gold, as it had been for the previous 38 years. When OPEC sold its oil, it was, in a

sense, receiving gold in return. That was the idea, anyway.

In September of 1971, only a month after Nixon pulled the rug from under them, OPEC gathered to

decide what to do about the Dollars declining real value. In Resolution XXV.140, they decided that:

[OPEC] Member Countries shall take necessary action...to offset any adverse effects on the per barrel

real income of Member Countries resulting from the international monetary developments of 15 August

1971. Eventually, this took the form of higher prices, as it took more and more depreciating dollars tobuy a barrel of oil.

Today, OPEC is faced with a similar problem. They take dollars for their oil, and these dollars often end

up buying Treasury bonds. Also, their own domestic currencies are linked to the Dollar, which is causing

domestic inflation.

OPEC should go back to its original plan. Sell oil, and take gold in return or a hard currency linked to

gold. In practice, taking payment in metal is impractical, so a gold-linked currency like the Dollar was

is a more appropriate choice for todays financial world.

Gold-linked currency? There arent any more of those. So why not make one? Today, there arediscussions about depegging regional currencies like the United Arab Emirates dirham from the

unreliable dollar, and perhaps repegging to a currency basket. But is a currency basket, of many fiat

currencies, much better than a single fiat currency? Some [OPEC members] said producing countries

should designate a single hard currency aside from the U.S. dollar...to form the basis of our oil trade,

Iranian president Mahmoud Ahmadinejad said recently.

Ah, theres the rub. There are no hard currencies. Only varying degrees of softness. No central bank

today wants its currency to rise further against the Dollar. During the 1970s, all the fiat currencies in the

world got dragged down with the Dollar, because of the trade implications of allowing the Dollar to fall

too far against their currencies. The pound, deutschemark and Yen were no escape. Inflation roaredthroughout the world.

Instead of pegging to the Euro or Yen, both just as unreliable as the Dollar in the long run, the UAE could

peg the dirham to gold even if the government owns no gold at all. The important thing is not to

stockpile bullion, but to properly adjust the supply of dirhams to meet demand, the exact same process

now used by the existing currency board. The UAE would have, in effect, a currency board linked to gold.


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This would not be anything new for the dirham. The dirham coin used to be worth 3.207 grams of gold,

and circulated alongside another popular Islamic currency, the Dinar, which was worth 4.25 grams of

gold. The gold Dinar coin was reintroduced in 2006 by the Malaysian state of Kelantan.

Middle East oil traded on the Dubai Mercantile Exchange for example could then be priced in gold-

linked dirhams. The world would finally have a hard currency again, as the Dollar was before 1971. Thedirham would immediately become an international currency, because everyone would need it to buy

Middle East oil. The UAE would get into the currency business, which can be very lucrative. The Federal

Reserve makes a profit of about $40 billion a year on its roughly $800 billion of U.S. Treasury bond

holdings.

Eventually, if people wanted access to Middle East capital, they could issue bonds denominated in

dirhams. No more dollar bonds. This would be very attractive, because the interest rate on dirham

bonds would sink to very low levels. When the British pound was pegged to gold from 1823 to 1914, a

ninety-one year stretch, the average interest rate on Consols government bonds of infinite maturity

was 3.14%. It never rose above 4.0%. In the past century, no central bank has ever managed such a

record of success. After four decades of experimentation with floating currencies, nothing has ever

come close to the performance of a gold standard in action.

The world is transitioning to a new monetary order. Ideally, it will be better than what preceded. the

Dollar-centric monetary order arose in the 1930s and 1940s because the Dollar remained a hard

currency pegged to gold while all the currencies of Europe and Japan were devalued during the

Depression and two world wars.

Perhaps it is time for the oil-exporting countries to stop playing by the rules of the oil importers, and

start setting their own rules. The first rule is that they get paid for their oil in a hard currency, which,

over six thousand years, has only meant one thing: a currency linked to gold.


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Scenario 2: Dollar continues to be the currency of Choice (a Pro-

Greenback view)The U.S. dollar has become the whipping boy of world currencies and the price of oil has been the big

topic of discussion for some time now. Why is oil so expensive? Are we running out of it or is someone

disrupting the supply? Is there some sort of conspiracy against the United States? Some blame supplyand demand; others say speculation and politicians tell us it is oil company greed. Saudi Oil Minister Ali

al-Naimi has stated, "There is no justification for the current rise in prices."

When the U.S. dollar is losing value, it is believed to be a function of low interest rates, an expanding

budget and current account deficits. Oil price increases are viewed as a result of growing demand,

geopolitical tensions, supply issues, speculationAND a weak U.S. dollar.

Today, the two main reasons for the high price of oil are

1) the weak U.S. dollar and

2) the liquidity the Federal Reserve is pumping into the economy, which, in fact, helps to weaken the

dollar. Pessimism on the part of the citizenry towards the dollar (even if it is only psychological) can

cause the dollar to plummet even lower, which is where some experts believe the dollar is headed. And

yet, the dollar bulls believe the dollar is poised to go up.

Because the situation is so dismal at the moment, some suggest that the only direction for the U.S.

dollar is up. A few of the reasons for this belief include

y The dollar is undervalued. It was just before the dollar bull market in 1982 that the dollar wasthis undervalued compared to other world currencies.

y The last two major U.S. dollar bear markets each lasted exactly seven years and this is theseventh year of the present dollar bear market. Starting in 1971 when President Nixon nixed the

gold standard, those who believe the dollar is poised to ascend will propose the following three

major dollar bear markets as proof that this will be the last year for the present cycle.

1971 1978

y Fed Chairman Volcker squeezes inflation.y Gold rises

1985 1992

y Tech boom begins2001 2008

y Tech bubble popsy Credit crunch


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Stabilized interest rates would provide support for the greenback. Treasury Secretary Henry Paulson, Jr.

and Federal Reserve Chairman Bernanke have zeroed in on the dollar as a way to reduce oil prices.

Stabilized interest rates would lend support to the dollar. And, rising bond yields strengthen the dollars

position since they make bonds more attractive to investors. [Of course, rising bond yields will put

pressure on mortgage rates too, which is about the last thing the struggling housing market needs at the

moment.]


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Scenario 3: Dollar falters as a currency even more (Anti- Greenback

view)Unfortunately there are quite a few reasons why the dollar could weaken even more.

First, interest rates are still out of kilter. The yield differential for the dollar against the euro is negative.

In fact, when one compares the real interest rates of all the major currencies, the U.S. dollar comes in

last. While the Fed may not cut interest rates any further, that doesnt mean the interest rate

differentials that currently favor other major currencies will change right away.

Second, the credit crunch may not be over. Because of its position among the worlds currencies, the

U.S. dollar gets hit the hardest when risk increases in the global economy, so its too soon to say the U.S.

economy is safe from the effects of the credit crunch.

Third, theres the U.S. housing and mortgage crisis. U.S. Treasury Secretary Paulson stated in July that

1.5 million home foreclosures were initiated in 2007, and some economists estimate there will be about

2.5 million foreclosures initiated this year. Fannie Mae and Freddie Mac, the only two institutionsthought to be big enough to save the market from further collapse now need to be propped up at a cost

estimated as high as $25 billion.

Fourth, the United States is running a massive current account deficit funded by the rest of the world.

The U.S. has been able to borrow at low rates, but there is a limit. Increasing budget and trade deficits

have thrust the U.S. current account deficit to over $60 bill ion a month!

Fifth, and perhaps the most critical of all, there are big differences between previous oil crises and the

oil crisis we are now experiencing. In 1973, when OPEC placed an embargo on oil to the United States

for supporting Israel in the Yom Kippur War with Egypt, the reason was political. It had nothing to do

with supply and demand. Ironically, the embargo prompted conservation, so that when the supply of oilwas cut off a second time, it wasnt nearly as painful for the U.S. as the time. This time OPEC took it on

the jaw, because the U.S. didnt need as much and without American demand oil prices fell.

Between 1979 and 1981, when the oil industry in Iran collapsed in the wake of revolution and the loss in

output contributed to the worst worldwide recession, especially in the U.S., since the 1930s, new oil

sources such as Alaska, the North Sea, Mexico and Angola were about to kick in. By the mid-1980s, oil

was selling for less than $15 per barrel and because everyone believed the supply was plentiful, the

price remained relatively stable. This era of cheap oil, however, created the illusion that oil would be

cheap forever or at least for a long, long time.

Gold Oil Dollar Relationship Vaze Assignment

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