Over the last half-century, oil prices have seemingly paralleled fluctuations in the price of gold. Gold prices rose along with oil prices in the 1970s and 2000s. A similar direct relationship between gold prices and oil prices occurred in the 1980s and 1990s when both dropped. But what affects the price of oil and the price of gold? Some suggest oil prices drive gold’s price while others discount the relationship. By taking a closer look at these two presumed commodities, some clarity about what affects oil prices and the price of gold can help.
The Argument for Inflation
Most market analysts believe that inflation classically drives oil prices and the price of gold in the same direction…upwards. However, why this occurs is subject to debate. For those who argue that oil prices determine gold prices, the process starts with an increase in oil prices. The higher oil prices drive aggregate prices to increase (due to higher costs of production of many goods). This inflationary trend then raises the price of gold in the process. In this scenario, oil prices are the primary driver of higher gold prices.
While aggregate price effects sound appealing in linking oil and gold prices, this argument deserves a closer look. Inflation causes both oil prices and gold price to increase, but oil prices are not the main trigger. Instead, what affects the increases in oil prices and gold prices is a weaker dollar. With less buying power, more dollars (higher prices) are required to buy the same amount of oil and gold. Inflation itself rather than oil prices are what drives higher gold prices in this situation. Thus, the monetary policy in place is what affects oil prices and gold prices to a greater extent.
The Commodities Argument
From another point of view, oil prices are believed to be predictors of gold prices because they share similar traits. Both are often considered commodities because they are raw materials used to meet other fundamental needs. Oil prices and gold prices therefore move in similar directions because of supply and demand effects on commodities in general. As reserves diminish (supply), oil prices and gold prices then rise (demand). The belief is that both oil prices and gold prices move in sync because both are affected by commodity and industry trends.
Unfortunately, this argument for linking oil prices and gold prices is not very strong either. While oil prices do fluctuate based on its commodity nature, the same is not true of gold prices. Gold is used in some circumstances as a raw material to make goods (like jewelry). But gold prices are not married to supply and demand as much as oil prices are. Instead, gold prices tend to shift based on their monetary asset value, which distinguishes gold from oil. Therefore, the commodities argument fails to accurately predict what affects oil prices and gold prices overall.
Gold – Both Precious and Unique
So, what does affect gold prices? If oil prices do not drive gold prices through aggregate price changes, what does? If gold is not a pure commodity, what is it? While gold prices are affected by changes in commodity indices, these can only explain gold price changes partially. Interestingly, gold tends to behave more like a currency and money asset than a commodity. This is where oil prices and gold prices no longer move in parallel. This helps explain why oil prices tend to be more volatile while gold prices are often more stable.
Certainly, gold is not a modern-day currency like the dollar or yen. However, gold still serves as a material that retains long-term value. Because of this, predictions about gold prices are often more accurate when understanding gold is a monetary asset. What affects gold prices has more to do with its ability to store long-term value than its demand on the commodities market. While oil prices might be affected by inventories and long-term asset value as well, gold prices are much more so. This explains why gold prices tend to be more stable over time when compared to oil prices. It also explains why oil prices have many more short-term ups and downs.
Monetary Policy – What Primarily Affects Gold Prices
As a partial commodity, supply and demand factors can affect gold prices just as they do oil prices. Therefore, taking a look at commodity indices and gold inventories above ground is not a bad thing. But in identifying what affects gold prices, three key drivers are often the best predictors. These measures affecting gold prices include inflation, the value of the dollar, and real interest rates. Gold prices tend to change more in relation to monetary policies than they do with oil prices per se. Thus, expansionary monetary policies tend to affect gold prices in a more positive direction.
With expansion, inflation tends to develop, and the value of the dollar weakens. This requires more dollars to buy the same amount of gold (higher gold price). It also serves to encourage investors to buy gold as a long-term monetary asset since gold’s value relative to the dollar is higher. For these reasons, the price of gold will increase. Real interest rate effects are less obvious as predictors when it comes to gold prices. In theory, higher interest rates make investments in stocks and bonds more attractive (higher yields). This is believed to reduce gold demand and gold prices as a result. However, interest rates tend to affect gold prices less consistently when compared to other factors that affect the price of gold.
How Do Oil Prices and Gold Prices Relate?
Research examining the correlation between gold prices and oil prices show that both move together 85 percent of the time. It would appear, on the surface, that oil prices and gold prices react similarly to economic changes. This is partially true. During times of stability, oil prices and gold prices are more likely to change in the same way. This is because both oil prices and gold prices are influenced by the value of the dollar, inflation and interest rates. However, the differences between oil prices and gold prices tend to be more noticeable during financial crises. Despite still moving in similar directions, oil prices and gold prices may vary significantly in how much they change.
In general, oil prices tend to be much more volatile when compared to gold prices. Because oil prices respond more quickly to supply and demand changes as a commodity, oil is more volatile in nature. In part, this has to do with lower reserves of oil when compared to gold. This is not to say that gold does not change in relation to supply and demand issues. However, gold prices change much more slowly and steadily. This is due to larger inventory reserves and a larger trading market in many cases. Specifically, the large volume of Chinese buyers in recent years has stabilized gold prices significantly.
Using the Gold-to-Oil Price Ratio
One financial tool often used to examine gold prices and oil prices is the gold-to-oil ratio. This instrument compares gold to oil prices, which yields a value that can help investors determine comparative values. The price of one ounce of gold bullion is divided by the price of one barrel of oil. Traditionally, a gold-to-oil ratio above 16 suggests that the gold price is too high or oil prices are too low. If the ratio is below 16, the opposite is true. Depending on where the ratio falls, investors may choose one commodity over the other.
The ratio between gold prices and oil prices can help identify whether gold or oil prices are excessive or not. But, one major caveat exists. The ratio is a comparison between gold price and oil price. Therefore, if both are too high or too low, the ratio offers little advice. Because oil prices tend to be more volatile, the ratio can provide useful information in the short term. But over the long term, the ratio is less helpful in predicting gold prices and gold’s investment potential.
Are gold and oil prices excessive?
Oil Prices and Gold Prices – Putting It All Together
To answer whether oil prices affect gold prices, the answer is likely no. Indeed, both oil prices and gold prices move in similar directions most of the time. However, this does not mean oil prices cause gold prices to change. Increasing shoe size correlates with higher intelligence in children, but one doesn’t cause the other. It just so happens both change as children grow. The same applies to oil prices and gas prices. In many ways, they respond similarly to market dynamics…inflation, currency value, interest rates, and even commodity pressures. But when it comes down to it, oil prices are more affected by short-term pressures than gold prices are. Doing your due diligence in both “commodities” can help you better predict changes in oil prices and gold prices ahead.
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