NEW YORK, July 17, 2012 – Does the gold price dictate the price of a barrel of oil? A few months ago, a “Reality Check” report by Fox 19 Cincinnati reporter Ben Swann made the case that the price of a barrel of oil is indirectly set by the price of gold.
Could he be right? For years we’ve been told by the mainstream media that Middle East unrest, supply/demand, transportation hiccups, market conditions or trading activity are what causes major increases. High oil prices are a major sore spot among Americans, and many people lose sleep at night as they try to figure out how to make ends meet in their households. Rarely are we told that a weak Dollar is the culprit. Could Ben be right, in that there is another variable in the equation that has been left out and rarely if ever talked about: the value of the U.S. Dollar?
The cost of gasoline is a big concern in today’s society, as is the rising cost of food. But what drives the increased cost in those products? We’re told that the rising cost of food is due to the rising cost of energy to produce and transport the food. After all, in the U.S., there’s no overall shortage of food that is upsetting the supply/demand balance. So, it’s easy to make the leap that increased energy costs drive the rising prices of food and it can be left at that.
Now let’s look at gasoline. The production cost of gasoline is primarily broken up into the cost of the oil, refinement, transportation and profit. Since the bulk of the price of gasoline is derived from the price of oil, it’s natural that one seeks to understand what drives the price of oil.
In 1971, the U.S. decoupled the Dollar from gold and silver, making the Dollar essentially a promise of value and nothing more. At that time, recognizing the dangers of taking paper promises in exchange for real oil, Middle East suppliers decided that they would fix the oil they produced per barrel to a certain quantity of gold and according to Ben Swann’s report, this quantity happens to be, on average since 1971, .0602 ounces of gold per barrel. Paper money is easier to transact than gold or silver, after all. In this method, they could be paid in the proper quantity of U.S. Dollars in order to the go out and purchase the required amount of gold, divesting themselves of the Dollar. This assured that the producers could always get a tangible asset for their production, removing themselves from the risk of accumulating piles of paper promises.
Most Americans have little to no interest in monetary policy. Many do not even know what makes paper money valuable, or what money is. Does the value of the U.S. Dollar really matter? Can the actions of monetary policy makers have any impact of commodities or our daily necessities? If so, how does one prove that monetary policy can affect commodity prices? The answer to that begins with finding the linkages, if any. In this case it’s easy: both gold and oil are traded in U.S. Dollars around the world as Ben mentioned.
With that background provided, a statistical hypothesis can be formulated. Could the price of gold dictate the price of oil? Stated differently (statistically), can we say with 99 percent confidence that the price of .0602 ounces of gold will translate into the price of a single barrel of oil? Let’s find out.
Downloading daily gold and West Texas oil price data from readily available sources, one can perform a calculation to estimate the price of oil based on the price of gold. For example, if the price of gold for the given day is $326.30, multiply that number by .0602 ounces of gold to get a value of $19.643 per barrel. Perform that calculation for every daily interval downloaded, and for each interval, compare the calculated value to the actual price for oil by subtracting the calculated oil price from the market clearing price for oil. Rather simple actually.
On a sample of daily interval data from January 2, 1986 to March 3, 2012 (6,457 matching intervals), using basic statistics, a 2-sample t test was performed and the results are eye-opening. We can say that .0602 ounces of gold times the price of gold produces the price of a barrel of oil, with an standard error of just .421%, or an average difference of just $6.10 dollars between the calculated price and the actual price since 1986. For the last 26 years, the price of gold dictated the price of oil with 99.579 percent accuracy.
What does this mean? As Ben Swann stated, it means the strength of the dollar, more than anything else, determines the value of a barrel of oil in the marketplace. Sure, supply/demand, fear in the Middle East, trading activity all impact the daily price of oil, as seen in the daily fluctuations present in the data. Sometimes the prices differed substantially, for example the greatest daily difference was $89.08. But in the long run, the analysis proves that the calculated price matches the market clearing price for oil with an average difference of only $6. It means the policies of the U.S. central bank (the Federal Reserve) have a direct impact on our daily lives.
On the contrary, a higher valued, deflated dollar means less dollars required to buy .0602 ounces of gold. As we have recently seen, the price of oil is dropping, and hence the price of gasoline has been receding as well. This activity rails against all of the early spring forecasts of five dollar gasoline this summer, because Euro-zone problems made the U.S. Dollar seem strong. Most importantly, the drop in oil prices is only temporary since the Germans came to Euro’s rescue.
Americans should brace themselves for surging oil prices in the future because in reality, the U.S. economy is in no better shape than the worse offending country in the Euro zone. Soon the U.S. dollar will begin to fade in value once again and oil prices will begin to creep back up to former levels, and we will be told supply/demand or Middle East unrest will be the cause, not a weak dollar.
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