'We must away, ere break of day, to claim our long-forgotten gold," sang the dwarves of Erebor on the quest to reclaim their homeland. If those Middle Earthlings were alive today, they probably would not consider the journey worth the occupational hazard — being eaten by Orcs or scorched by Smaug. The reason? Gold has lost a lot of its charm.
Since its 2011 peak of US$1,921 an ounce, the price of gold has dropped by almost 40%. Factor in purchasing power eroded by inflation and the impact is even worse. At about $1,200 currently, the price is even below the all-in cost of producing an ounce of gold, estimated at $1,350 by Thomson Reuters.
Gold bulls say this is a good time to buy. But from what we see, things are not really looking up.
In fact, gold is not alone in this downswing. Platinum has fallen 7.7% since January, while silver is down by 14.1%. The broad Bloomberg Commodity Index is down 8%. Since commodities are usually traded via futures contracts — with prices agreed on today for future delivery — the negative trend is likely to persist. The recent rout in oil markets is a big reason why.
Gold and oil prices are closely linked. Data from 2009 to the present suggest an 80% correlation on a scale of zero to 100%. Their year-on-year price growth rates also show a strong positive correlation of about 60%. We saw a brief exception late last year, when the Ukraine crisis pushed up oil prices. As the risk subsided, we saw a significant correction in oil, with its declines markedly surpassing those of gold.
But why should gold and oil prices move in tandem? Economists are always telling us gold is a safe haven to which people flee during recession, while demand for oil usually rises in an expansion period. So their prices should move in opposite directions, right?
Well, theory is one thing and practice another. Gold and oil are actively traded in highly liquid spot and futures markets. Demand and supply, therefore, incorporate speculative motives that have little to do with economic fundamentals. Investors simply put them in a box of "commodities", all of which are supposed to exhibit similar risk-return characteristics.
Furthermore, both gold and oil are predominantly quoted in US dollars. When the dollar strengthens — as it has done for much of this year — gold and oil prices tend to go south.
That said, oil has a stronger tie to the real economy than gold does. After all, the main purpose of buying gold, apart from the hope for price inflation, is to store value. We don't usually talk about "gold consumption", but it's natural to say "oil consumption".
Lately the global oil story has been all about shale oil, now abundant because new technology has finally made its production, mostly in the US, financially viable. But conventional crude in Opec countries can still be produced for less.
When Opec decided last week not to cut production despite a global glut, it was seen as a bid to nip US shale oil production in the bud. This is a classic Stackelberg game (named for the German economist who first explained it) in which the market leader strategically moves first, taking into account a reaction by the other party, then the followers move sequentially. Opec is a perfect incumbent monopoly and US shale oil a new entrant.
US Energy Information Administration figures put the cost of oil production in the Middle East at $17 a barrel, about half the US average (offshore and inshore). Opec said it would maintain its ceiling of 30 million barrels per day, while US output was 9 million bpd last month. Obviously, Opec has advantages in price and quantity. The game goes like this: by deciding not to cut quantity, Opec lets prices plunge further to narrow the competitor's margin but also at the expense of its own profitability.
We won't bore you with the details, but in the current weak economy the Stackelberg equilibrium price for oil is $58 a barrel. In other words, if the current game persists, oil could fall another 17% by the end of next year. Had Opec maintained a pure monopoly position, the price should not have fallen below $74.
A benign oil price usually is good news for consumers and businesses but not always. Given its strong link with oil, there is some room for gold to slip further, but only by 5% since much of the correction has already taken place. The reduction in wealth might further weaken consumer spending next year.
Oil deflation will also hurt Thailand's commodity-dependent economy, mainly by making petroleum-based synthetic rubber more attractive than natural rubber, which is already in a four-year price trough. A TMB Analytics report last year showed oil prices explained 40% of the movements in rubber prices.
Indeed, the imminent global deflationary risks might do more harm than good to our economy. This has already been a challenging year for commodities. Gold is gone. Oil is likely to go for a while. And others such as rubber are likely to follow. Only a few in this asset class can escape basic investment realities. Will they ever come back? Yes. But the real question is how long they will be gone.
(Thanks to our colleague Kridsda Nimmanunta for the inspiration.)
TMB Analytics is the economic analysis unit of TMB Bank. Behind the Numbers is co-authored by Benjarong Suwankiri and Warapong Wongwachara. They can be reached at tmbanalytics@tmbbank.com