Oil, gold, and the coronavirus economy

March 22, 2020

New York (Mar 22)  Since the U.S.-led shale oil revolution got rolling around 2008, OPEC's strong-but-never-absolute power to set world crude oil prices has been threatened. Today, we are seeing another OPEC-inspired struggle in this vital market.

OPEC shakiness has intensified as U.S. petroleum exports expanded from 40 billion barrels in 2010 to 200 billion barrels this year. Meanwhile, by opening and closing the largest petroleum supply in the Arab world, Saudi Arabia attempted to steady the price of oil. At one point, around 2014 and in conjunction with Russia, the Saudis put a squeeze on U.S. shale producers by pushing prices below what they believed to be shale oil production costs. U.S. shale producers sat tight and kept on pumping. Oil prices seemed stuck at a relatively low level, and U.S. drivers enjoyed a gallon of gasoline for $2.50.

As with everything else, the coronavirus’s tumultuous January entry changed petroleum markets. When China (the world’s second-largest economy and largest petroleum importer) faltered, crude oil prices fell, OPEC trembled, and Russia decided this would be the time to teach a final lesson to U.S. shale oil producers.

In a matter of weeks, crude oil, which had been fetching $59 per barrel in December, fell to $50 in February. Gasoline in my town fell to $2 a gallon. In an effort to stabilize prices, the Saudis gathered OPEC and Russian oil czars and called for orchestrated output reductions. All but Russia seemed to be in agreement. The Russians, now riding with a huge sovereign rainy-day fund, said, “Nyet.”

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Instead of cutting production, the Russians opened their valves further. Then, the Saudis called the Russians’ hand and raised them. The price of crude oil fell fast to $40 a barrel and touched on $30 in mid-March. Gas at my local station hit $1.78 a gallon.

The combination of coronavirus and OPEC-Russian sandbox antics put some real pressure on U.S. shale producers. They started turning off drills, began worrying about paying off debt, and started organizing a White House appeal for help. At the moment, crude oil prices are cheap, but that is destined to change.

The story just told can be seen in the below chart. Using Federal Reserve data for monthly gold and crude oil prices from late 1990 through March 2020 (which I estimate using the prices for Tuesday), I have built a series that shows the number of barrels of oil that can be purchased with an ounce of gold. Doing this enables one to avoid currency value changes and to see the world as an oil trader might.

The question: How much will an ounce of gold fetch? Historically, the answer has been cycled around a value of 20 barrels, which is shown in the chart. When oil becomes dear, as in the period following Sept. 11, 2001, and until the 2007-2008 recession, an ounce of gold doesn’t go very far. Recently, of course, an ounce of gold has bought a lot of oil, most recently 53.9 barrels.

Cheap oil and related energy, such as natural gas, feeds into lower prices throughout the economy, and lower price expectations lead to lower long-term interest rates. When economic life recovers in a post-coronavirus world and Russia and OPEC end their price war, we will see higher inflation and higher interest rates. But with coronavirus woes behind us, we will also see higher real GDP growth.

Until then, I am of the opinion that crude oil is gradually losing its grip on the energy economy and that, combined with lower-cost shale production, we’ll see a new normal where an ounce of gold will buy 30 barrels of oil. Even so, there’s a lot of distance between 53.9 barrels now and 30 barrels then. All of this also suggests that once we are beyond the effects of the coronavirus and the related recession, we will see higher-priced oil, and I will see $2.50 gasoline at my local station.


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