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Gold Signals, Yellow and Black
What they're telling us about inflation, wealth, and geopolitical fears.


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For months, gold has been giving a false inflation signal. Oil’s steep price rise is part of the reason, but other important factors include growing anxiety over Iran’s nuclear intentions, increased personal wealth in countries like India, and international asset reallocation by OPEC members.

Prospectively, Iran looks to be the single most important issue on which the prices of yellow gold and black gold (i.e., oil) will pivot. Tehran’s nuclear ambitions are certainly a nettlesome problem. But are they intractable? Maybe. Point is, concern over Iran’s desire for a nuclear device could put intense upward pressure on petroleum and gold, especially if a trade embargo is imposed. The biggest danger would be if monetary authorities were to monetize the oil price rise (as happened after the 1973 oil embargo).

Thankfully, there’s no indication that the Federal Reserve or other major central banks would make such a foolish mistake. The U.S. Fed and the European Central Bank, for instance, haven’t shown any inclination to add liquidity in response to more expensive energy. However, forced to buy more dollars to pay for more expensive petroleum imports, oil-importing countries helped to drive up the dollar exchange rate last year. Oil-exporting countries in turn used their increased dollar revenues to buy more gold. This two-step process explains the seemingly contradictory action of gold and the dollar.

Normally, of course, an escalating gold price would coincide with U.S. currency weakness. Late last year, though, the opposite happened: The greenback rose against other major currencies even as it sank against gold. In the period between mid-November and early December 2005, the dollar actually reached two-year highs against the euro, yen, and sterling. At the very same time, gold broke through $500 a Troy ounce, ultimately reaching its highest levels since 1981, when U.S. consumer price inflation was in double digits.

Gold’s appreciation thus didn’t reflect rising U.S. inflation expectations or excess dollar liquidity. More petrodollars simply were being invested in gold than had been before. Matter of fact, the second half of last year saw a marked reduction in net purchases of long-term securities from U.S. residents by OPEC members.

The world is currently awash in a sea of petrodollars, generated by the steep run-up in dollar-denominated oil prices that reached its zenith last September, capping a 250 percent price rise since the end of 2001. In the past four years, in fact, the OPEC 10 (i.e., Algeria, Indonesia, Iran, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela), plus Iraq, raked in a whopping $1.44 trillion in oil income.

Last year alone, OPEC’s receipts, plus those of Iraq, totaled an estimated $555 billion, representing a 44.4 percent improvement on 2004’s results, which were not too shabby, either. In 2004, the OPEC 10 and Iraq had oil revenues of $384.4 billion, a 39.3 percent increase from the year before. OPEC oil production, in contrast, was flat. For most of 2005, monthly output ranged between 900 million and 936 million barrels. On a year-to-year basis, December’s production was just 1.4 percent above year-earlier levels — but revenues were up 48.5 percent.

In terms of asset allocation, OPEC members on the whole shied away from U.S. financial instruments in the second half of last year, with their total holdings of long-securities purchased from U.S. residents rising by a mere $2.7 billion, or 3.1 percent, during the five months from July to November, according to the latest data from the U.S. Treasury International Capital System Office. The investment slowdown extended to both U.S. government and corporate securities.

So where did all the petrodollars go? A portion obviously found safe haven in gold. In fact, tax-free gold trading just began on the new, fully automated Dubai Gold and Commodities Exchange (DGCX), the Middle East’s first derivatives exchange. OPEC receipts also went into Persian Gulf real estate and equity markets. Over the past year, for instance, the Saudi Stock Exchange General Index gained about 115 percent, Qatar’s Doha Securities Market General Index rose around 60 percent, and Kuwait’s Stock Exchange Index added about 75 percent. (The U.S. Standard & Poor’s 500 Index, in contrast, is up a mere 7 percent over the same period.) The Persian Gulf investment craze even prompted the region’s new pan-Arab television network al-Arabiya to devote two-fifths of its programming to business and financial news.

Oil exporters aren’t the only ones bidding for gold. India’s burgeoning middle class of more than 300 million people, many of whom are reluctant to entrust their hard-earned savings to banks and other financial institutions, also sought safe haven in the yellow metal — particularly, in the form of gold jewelry. India, the world’s largest gold importer, accounts for a quarter of all gold jewelry sales worldwide.

Gold ranked as India’s second-largest commodity import (after oil), totaling $6.5 billion in the seven-month period from April to October in the 2005-06 fiscal year. It was also the fourth-fastest-growing commodity import, increasing 33.6 percent from a year earlier and representing 8.1 percent of all Indian commodity imports. An estimated 13,000 tons of gold, or around 8.4 percent of the total global supply, is believed to reside in India.

Other bullish bullion news included rumors suggesting some central banks, in what would be a policy reversal, may opt to add to their gold reserves. President Vladimir Putin, for one, favors adding more precious metals to Russia’s foreign reserves. Gold currently comprises about 5 percent of Russia’s official international reserves, and one central bank official said the percentage could double. Russia produces around 183 metric tons of gold annually. Official gold reserves now total around 500 tons.

New gold-oriented hedge funds also are sprouting, and Japanese investors are said to be particularly keen on these exchange-traded funds. Scarcity, too, is a consideration. If all the gold produced throughout history (i.e., an estimated 155,000 metric tons) were neatly stacked on the site of New York’s Empire State Building, the pile would stand less than 2 feet 3 inches high (or 67.9 centimeters).

Finally, the specter of an Iranian nuclear bomb will continue to animate the gold market for the foreseeable future. Gold indeed started its recent climb shortly after Tehran’s August decision to resume large-scale conversion of yellowcake, a preliminary step in the uranium enrichment process. Anxiety over Iran’s nuclear intentions and weapons capabilities escalated after it broke UN seals on its uranium enrichment facility on January 10. With no easy solution in sight, continued international capital flight into bullion is more than likely, and petroleum prices too could rise if global supply is cut.

– William P. Kucewicz is editor of GeoInvestor.com and a former editorial board member of the Wall Street Journal.



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