By Adya Behera

Edited by Namrata Caleb, Senior Editor, The Indian Economist

Have you ever wondered how U.S Dollar, Gold and Crude oil prices have managed to rule over the world?

There’s no doubt in the fact that black oil is a significant input of each and every economy and with it comes inflation negatively impacting the global economy. Starting from transportation, heating and other amenities, higher oil prices are eventually reflected in all finished products as sellers try to put the burden of higher input prices on their consumers. The US economy was able to enjoy unprecedented prosperity in the 20th century. Inexpensive oil based energy was the main reason behind its success story. With only 5 percent of the world’s population US enjoys 25 percent of the world’s fossil fuel and imports about 75 percent of its requirements and has 2 percent of the reserves. Because of this high dependency any disruption in supply will affect US economy drastically. Hubbert Curve’s, a predictive model which runs from discovery through to depletion of a resource,  which predicted that crude oil production in US would peak in 1970’s and then eventually decline was treated with great scepticism because production in US was increasing and technology was improving . Gradually with no new reserves being discovered the predictions were proved correct.

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According to Hubbert Curve, in any oil field as more wells are drilled and newer and better technology is installed production initially increases but after a peak output is reached oil production not only declines but also becomes less cost effective. Oil and gas experts are predicting that world oil production will peak sometime in the latter half of this decade. Now four barrels of oil are consumed for every one barrel discovered. Once a supply shortfall materializes, the US will be in competition with China, Japan, India and other importing countries and the cost of per barrel of oil will skyrocket.

But how is oil prices linked to gold?

The answer is backed by the historical desire of Arab producers to receive gold in exchange of their oil. In 1933 King Ibn Saud demanded payment in gold for oil. In addition to this, Islamic Law also forbids the use of a promise of payment such as the US dollar. As a result gold was fixed at US $35 per ounce and the price of oil was relatively stable at US $3 per barrel. From 1944 until 1971, US dollars were convertible into gold by Central banks in order to adjust for any trade imbalance but later the OPEC officially agreed to sell its oil exclusively for US Dollars. Once US ceased gold convertibility in 1971, OPEC producers were forced to convert their excess US dollars by purchasing gold in the open market.  This resulted in price increase of both oil and gold. Supply/demand imbalances and increasing demand from developing countries have increased the price of gold and oil along with US dollar decline. With an ever increasing US money supply, growing triple deficit and mounting debt at all level how long will oil exporters continue to accept US dollars? At some point of time the oil exporting countries may decide to abandon US dollar in favour of Euros. Eventually, this could result in dollar set-off and a corresponding increase in oil and gold prices. Over the last 50 years gold and oil have generally moved together in terms of price with a positive correlation of over 80 percent.

The size disparity between the gold and black gold should be taken into consideration. While annual gold production is approximately US$35 billion, annual oil production is US$1.5 trillion and as a result these ever-expanding number of petro dollars have led to a chase after a comparatively small amount of billion ounces.

In conclusion it can be stated that price of oil is poised to rise, the moment there is a supply or demand imbalance or when the dollar declines. Even if there is no disruption, terrorist attacks and geopolitical factors will contribute to the rise in price. If this happens then gold price will climb up instantly. Then what is the solution? Should oil producers demand Euros, dinars or other precious metals for their payment?  If oil producers and other foreign countries begin to sell off their trillions of US dollars and diversify into other areas then price of both the precious metal as well as oil will skyrocket. Hence, it can be concluded that if the US dollar continues to decline then prices of precious metals will explode.

Adya Behera is a 19 year old and a privileged economics Hons student of LSR, Delhi, she has been connected with the economics since last 3 years. With a will to serve the nation it shall be the endeavor of the incumbent  to put light on the current topics and put forth the view of the columnist.

Posted by The Indian Economist | For the Curious Mind