Why Oil Drives Gold Prices
Understanding the correlation between oil and gold means understanding dollar-denominated assets. Any asset priced in US dollars is a dollar-denominated asset. Both oil and gold are dollar-denominated assets. Therefore, when the value of the US dollar rises, dollar-denominated assets often drop in price. Because both assets share this characteristic, the general ebb and flow of price fluctuations of gold and oil often occur in lockstep. This connection, however, is only part of the picture.
As oil prices rise inflation also rises. Inflation is a scenario in which too much money chasing too few goods. Rising inflation means demand is outpacing supply thereby boosting prices. Oil causes this scenario to unfold because oil is a major economic driver. That is, the economy runs on oil in a literal way. Many products and services require oil. Therefore, as the price of production and transportation increases so to will the end prices of those goods and services. These mechanisms connect to gold because gold tends to increase in value as inflation increases. The result: “there is a clear co-movement between the prices of the two strategic commodities, both in nominal and real terms,” according to research. In fact, even shocks to oil prices can reverberate throughout the gold market. The same research continues, “he signs of instantaneous impact of oil price shocks on gold returns are all identically positive.”
While the data proves the correlation the connection between the two assets makes intuitive sense. In other words, rising oil prices often impede economic growth. Operations become more expensive and profitability drops. As the economy slows other investments, namely equities, tend to also exhibit slow growth. As a result, more investors shift their money into “safe haven” assets like gold.
Perhaps the clearest link between gold and oil is seen in mining operations. Mining for gold is extremely resource-intensive. Industrial machinery, all of which runs on oil, becomes more expensive to use as oil prices rise. In such a scenario, many mines may go off-line or shutdown entirely. Even exploration requires substantial oil resources. We see this relationship playout with other mined resources. Barron’s explains “the correlation between the daily iron ore price and oil price has been 72%.”
Interestingly, with so much of the economy tied to oil, it’s not surprising to learn that “oil is one of the main factors in causing variations in stock prices, exchange rate and gold prices” according to one academic publication. Countries experiencing the strongest economic growth are often the largest drives of immediate surges in oil demand. As a result, it can be argued that, in the short-term, emerging economies can have an outsized influence on near-term gold prices.
These links illustrate the increasingly global nature of investing. Portfolio diversification is becoming more difficult as the factors driving profitability exhibit increasingly equal weight on companies across different industries and sectors. A more connected world is a more complicated world. Consider, for example that “A rise in oil price leads to an augment in inflation rate and this leads to an increase in gold prices as well.” Reaching diversification means understanding the interconnectedness of these factors and holding gold.