The Real Price of Oil:
Dollars, Gold, and the Price of Tea in China

Oil, it’s the lifeblood of our society. It’s given us the freedom and wealth we have today. It’s given us automobiles and machinery and greased the wheels of the industrial revolution. It made old Jed a millionaire. But oil’s in trouble, the price is up and everyone thinks they understand it. But what if the price of oil wasn’t really up? What if it were just an illusion?

“The price of oil is skyrocketing, and that means gas prices are up…”
That’s about the limit of what most Americans know and understand about the whole oil situation. But there are more complex issues at work, and they involve more than just Middle East politics and China.

The American Geological Institute (AGI) recently released a report looking at the price of crude oil in relation to the U.S. dollar and the price per ounce of gold. It highlights a fact that probably makes some folks at the Federal Reserve very nervous.

This graph makes it easier to understand:

The bottom purple line is the price of a barrel of crude oil per ounce of gold (if you wanted to use gold to pay for a barrel of oil). As you can see, that line is stable, and has been for the entirety of the graph through June 2008, which is about 7 years.

The top two lines are the price of oil in relation to currency (blue is the Dollar and the red is the Euro). Those lines show that the cost of oil has been going up in relation to currency only. What this chart makes obvious is that the value of oil has not been increasing in real terms, currency has just been decreasing in value.

The 20 year average number one ounce of gold buys is about 15 barrels of crude oil. Over the most recent 10 years, the average has dropped to 10 barrels. The previous peak of 26 barrels was over 10 years ago when crude oil was under $20/Barrel. At the end of 2008, one ounce of gold buys over 22 barrels of oil. One of two conditions exist. Either gold is overvalued (ie should be valued at about $400), or oil is undervalued (should be in the $80 range). Either way, as the above chart shows, this imbalance should not persist for long. The US dollar is a poor indicator of the real price of oil.

If the US Dollar were still based on gold (as it was until Nixon eliminated the Bretton Woods system in 1971), then the price of oil would be just as stable as that purple line in the chart is.

So oil is worth the same, and the US dollar is just worth less. Maybe we need to shift our focus away from war and drilling; and towards a better economic policy at home.

Here is the AGI data report

Whisperings of a New Gold-Backed Global Currency From the BRIC Countries Could Decimate Both the U.S. Dollar and the Euro

By: Vince Byfield, www.dailydose4u.ca

With the BRIC (Brazil, Russia, India, China) economies in much stronger shape domestically compared to the sickly U.S. and their respective markets already pricing in much of the coming collapse yet to really hit the U.S. stocks I wonder when these countries will band together to form a new currency of their own? They may as well, since many global financial instruments already treat them as an economic unit ( case in point).

And if these countries were to form a new global currency that’s 100% backed by gold (like the U.S. dollar was from 1792 to 1971) then I suspect we would witness a global stampede out of Euros and U.S. Federal Reserve Notes into this new golden currency backed by the strongest economies across the globe. Why not call the new currency a bric? In English, the name alludes to something concrete, sound, stable, and badly needed in these uncertain times. The gold-backing shouldn’t be B.S., though. Any Tom, Dick or Harry needs to know he can go to the bank with a Bric note and know he can walk out with gold.

From Brazil: Although its stock market is beaten up, its domestic economy is still very strong.
Brazil expects the odd sniffle, but nothing serious

• Brazil has not decoupled itself from the rest of the world: its stock market has fallen fairly much in line with other markets but, unlike in the past, the turmoil elsewhere has not been amplified.
• Brazil has been able to maintain foreign reserves in excess of $200bn to help it weather the storm.

From Russia: Now a major player in the world energy scene, Russia’s central bank has recently been stockpiling gold.
Time for a gold rouble?

• The decision by the US government to inject $700 billion into the financial system means that the already gigantic annual budget deficit of the American state (previously some $450 billion a year) will now rise by a factor of three. The total state debt of the USA will rise to well over $11 trillion. It is obvious that such a colossal debt can never be repaid.
• Russian leaders might also consider making their own currency, the rouble, convertible into gold.

From India: The World Gold Council says that Indian citizens possess the most personally-owned gold in the world. And that love for gold is now stronger than ever.
Indian customers lured by gold’s lower price

• UBS, one of the largest gold exporters to India, says it has seen a spike in sales. John Reade, UBS metals strategist, says that the near-absence of jewellery demand in India between August 2007 and July left the local market largely de-stocked, “hence the tremendous pickup in demand over the past five weeks.”

From China: Also big gold lovers, the Chinese government is now openly questioning the use of U.S. Dollars as the default world currency.
China paper urges new currency order after “financial tsunami”

• Threatened by a “financial tsunami,” the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.
• “The world urgently needs to create a diversified currency and financial system and fair and just financial order that is not dependent on the United States.”

Gold, Oil and the Middle East

The "bargain" price of oil at the end of 2008 is well below 50% of the 10 year average price of oil if you price oil in terms of what 1oz of gold will buy. The unusual drop in price from June 2008 through December 2008 has been blamed on "demand destruction". However, the latest reports from the IEA indicate demand has fallen by only 2% on a global basis (drop of 2mbd from 87mbd to 85mbd global demand). This should not trigger a 70% crash over 6 months in the global price of oil. A more reasonable explanation is that oil was a victim of forced deleveraging by very large hedge funds or possibly a victim of oil swaps from the Strategic Petroleum Reserve (SPR). .

Assuming gold is conservatively priced at current levels, expect to see the price of oil rise to the historical average of 12 barrels per ounce of gold. Expect Oil Exporting nations to continue to press for a gold backed currency to replace the US Dollar as the preferred currency for sale of Crude Oil. The (Arabian) Gulf Cooperation Council launched a 10 year plan in 2001 to replace the US Dollar as the medium of exchange for oil. The group met as recently as January 2009 still on track to launch a united (Arab) currency by the end of 2009. It may not be prudent to assume our oil exporting friends are encouraged by US and European plans to inflate their currencies (using quantitative easing) in order to stimulate jobs and the economy.

Another possible consequence of the artificially low oil price is more instability in the middle east. The large drop in oil revenues could be perceived by some oil exporting nations (Venezuela, Russia, Iran, Saudi Arabia, Mexico) as a financial attack by the US. Since the US is dependent upon most of these countries to purchase and retain US Treasury Debt, those countries may use their Treasury Bonds as financial weapons to restore the historical value of their oil in relation to the value of gold (not US Dollars).

The role of the US dollar as the medium of exchange for the purchase of oil in the world is not guaranteed. Gold should be a good tool to determine if oil is fairly priced in whatever currency is used.