We’ve heard a lot about oil prices flirting with new highs of $55/barrel, and seen prices correspondingly rise at the gas pump. We hear that the dollar is weakening, perhaps making a European trip more expensive. But we hear relatively less about the precious metal that used to be the only real currency: gold. As such, many people don’t realize that these three investments are in fact intertwined. To understand one, you need to know the others. Here, I analyze the relative situations of oil and gold.

(A good background on gold history is provided on this site by Morgan Poliquin.)

These two commodities have a special position with respect to the dollar. For most of our history, the value of the dollar has been defined by the government’s willingness to buy gold at a fixed price. Most investors with an interest in resources know that the dollar was backed with physical gold holdings up until 1971. Gold’s price stayed relatively controlled during that time – a period known as the Gold Standard. Once gold was removed as backing for the dollar, however, it rose for a decade, spiking to a bubble high in 1980 of $800 per oz.

A few more facts about gold: about 2500 tonnes of the metal were mined in 2004, with a market value of only $35B. Unlike oil, which is physically depleted when it is consumed, most of the gold ever mined is still around in one form or another – an inventory of 120,000 tonnes, with a value of $1.6 trillion today (using 32,150 Troy oz/tonne). Today’s incremental additions to the total base cause little fluctuation in the overall amount of gold in existence, making the metal a good standard for value.

Oil has a similar important history in defining the value of the dollar; so much so that it is sometimes called “Black Gold”. Because oil is universally exchanged for dollars, it could be argued that oil is one of the definers of the value of the dollar. Oil is, after all, the biggest-trading world commodity at an annual usage of 30 billion barrels, costing about $50 each for an annual market of $1.5 trillion. The war in Iraq has affected the price, and new concerns about the limits of supply are being discussed.

The US imports 75% of its petroleum; but owns only 2% of world reserves, while using 25% of world output. The growth of Asian demand has spurred overall world consumption, even as existing fields are being depleted. China’s oil imports grew 35% last year. The Middle East owns 65% of the world’s reserves, and the political difficulties in this area, and in other oil producing regions like Nigeria and Venezuela, are as serious as they have ever been. All the fundamentals have combined to drive oil price to record highs. The chart below shows the price of oil, which has now broken above the old record high in 1980 to $55 / bbl.

The pre-1973 stable price reflects a time when price was set by long-term contracts — somewhat like gold. A squint at the stair-step prices through the 1970s indicates that this was not a freely-traded price that fluctuated with short-term forces, even after the dollar went off the gold standard. I have overlaid another calculation showing the historical oil price in today’s dollars — the Real Price of Oil. I applied the change in PPI finished goods to the price and calculated backward. We would be paying $70 in today’s dollars to equal the price of crude at $40 in 1980. When we look at the price of oil in real terms, after inflation is removed, it is surprising that oil today is well below record price when inflation of the dollar is factored in. My interpretation is that the price is not as high as it could become judging from the fundamentals, which look more serious to me than they were in 1980. I think oil could be headed higher in the decade ahead.

So, which is a better long-term investment: oil or gold? To get an opinion on this, I have overlaid the price of each in the chart below. The scale for crude oil is on the right and gold on the left. We immediately see that oil has jumped ahead of gold in the last 4 years even as gold has risen. There are some interesting points along the way. Overall, we see similar patterns for the two prices. This is not particularly surprising; the movement was probably driven not so much by the changing fundamentals of oil and gold, but by the change in the base valuation of the dollar. There were of course, isolated events that affected the individual commodities – the most prominent for oil being the short-term spike for Desert Storm in 1990 – but overall these have been less of a long-term price factor. Gold has moved off its low of $256/oz in 2001 to $430 in early 2005, but the price of oil has moved more.

To look more closely at oil compared to gold, I calculate the ratio of gold to oil in the chart below. I’ve drawn a straight line for the average ratio, which is about 15. There are a few minor points to recognize here. Firstly, when gold was first de-linked from the dollar, gold got ahead of oil. In fact, one could say that the link to oil kept the dollar at a high valuation.

Even as gold has risen, oil has gained more. The important conclusion is that gold is at a relative price that matches historical all-time lows. My interpretation is that gold could rise more than oil to return to the more typical ratio of 15. If that happened, gold would rise to15 times the recent oil price of $54, equating to $800/oz.

There are many drivers of both these items, political and financial, so I caution that the ratio data alone is only part of the story. The historical data presented here does suggest, however, that gold could be an even better investment than oil going forward. Although, as you can see in my commentary, I also believe oil still has plenty of opportunity for price rises in dollars. The driver behind both of these could be the growing inflationary pressures on the dollar. As Doug Casey has said, the dollar will eventually reach its intrinsic value, and both gold and oil will measure the milestones along the way to that end. It is really up to all of us to make our own decisions and to incorporate a lot more than this simple ratio, but I hope the revelation that gold is close to record lows compared to oil is one more point of light that helps to understand our financial situation.