Why high oil prices are good for gold

The world is a more hostile place than it was ten years ago, and there is one underlying reason why - the high price of oil. That may be bad news for peace and personal freedoms, but it's definitely good news for those who hold gold.

As a general rule when the price of crude oil rallies, the price of gold tends to follow suit. The link is straightforward. Gold is seen by some investors as the ultimate hedge against inflation. So as energy prices rise, industry and transport costs rise, inflation goes up and so does demand for gold bullion. But there is another link, which is less well known. Gold is often regarded as a 'safe haven' asset in times of global political uncertainty. Meanwhile there is a very persuasive link between high oil prices and political instability in the world. It follows that a rise in crude oil prices increases the demand for gold as a safe haven asset. Let me explain.

There is no denying that the world is a much more dangerous and hostile place than it was ten years ago. The euphoria following the collapse of the Berlin Wall, talk of a 'peace dividend' and the irresistible tide of free markets and democratisation have been dissipated. As we speak there are four theatres of war in the Middle East; in Lebanon, Gaza, Iraq and Afghanistan while genocide is being carried out in the Darfur region of Sudan. At the same time personal freedoms are being eroded in places like Russia, Iran and Nigeria.

High oil prices: bad for peace

So what has caused this turn for the worse? This deterioration in the prospects for peace and freedom around the world. The usual suspects are the rise of 'Islamofascism' (to use the neo-cons preferred term) or America's wrong headed foreign policy. These factors have a part to play but there has been one enduring and underlying influence that has shaped the cause of peace and freedom over the last thirty years. It's the oil price.

Believe it or not, high oil prices are bad news for peace and personal freedoms. Oil-rich countries that have weak state institutions become nastier regimes as the oil price goes up. There are a number of mechanisms at work.

First, a rise in oil revenues enables autocratic governments to relieve social pressures that otherwise lead to demands for greater accountability from the government. Nationalism is easier on a full stomach. Because of the swelling coffers of petro-dollars, this year the Iranian government has promised to build 300,000 new housing units and maintain energy subsidies that amount to 10% of GDP. At the same time oil revenues allow Iran to be more isolationist because they can turn their back on foreign investors. Here's an example: Turkcell (TCELL), a Turkish mobile-phone operator, had signed a deal with Tehran to build the country's first privately owned mobile network. The company would invest $2.25bn, pay Tehran £0.3bn for the licence and create 20,000 Iranian jobs. But the mullahs have suspended the contract claiming it might help foreigners spy on Iran. With oil prices high, the Iranian government don't need to do anything to reform the economy.

Second, oil wealth leads to greater patronage spending. This in turn leads to cronyism and a web of corruption. Let's look at Nigeria. In 1999 when oil prices were around $25 a barrel President Obasanjo came to office after a period of military rule. He made headlines for tackling abuses in the military and releasing political prisoners. The term of presidency would be limited to 2 four year terms. Oil accounts for 90% of Nigeria's exports. Now with oil at over $70 a barrel it is alleged that the legislature is being bribed to extend President Obasanjo's tenure and at the same time there is a crack down on political opponents.

High oil prices: increased military spending

Autocratic governments also use their cash windfall to consolidate their position by spending lavishly on police, internal security and military hardware. Hugo Chavez signed a $1bn arms deal with Russia last week, purchasing 30 fighter jets and 30 military helicopters. Chavez and Putin also discussed plans to build two Kalashnikov factories in Venezuela. The oil-rich South American state supports the insurgency in Iraq and has close ties with North Korea and Iran.

Bumper oil revenues also encourage military adventurism. Saddam Hussein's attacks on Iran and Kuwait are well known but oil wealth also underpins terrorist groups like Hezbollah, Hamas and al-Q'eada. Iran is bankrolling Hezbollah. With oil at $75 a barrel, Iran earns oil revenues of $300m a day, when the oil price was $20 a barrel this daily income was only $80m.

In the world of militiamen, money rather than ideology talks. Take Afghanistan as an example. The Taliban are paying recruits up to $12 a day to fight locally, while the fledgling Afghan National Army pays soldiers $4 a day to risk their lives far away from home. The pay difference risks defections from the 38,000 strong ANA which has faced a much better and equipped insurgency since January. Afghan defence ministry officials believe that funds for insurgency are flowing over the border from Pakistan and possibly from oil rich Arab countries.

Finally, oil wealth gives countries the confidence to cock a snook at the world and engage in repression within its borders knowing full well that the international community covets its resources. So Mahmoud Ahmadinejad can declare that Israel should be wiped off the map and Venezuela's President Chavez tells his supporters that free trade can go to hell. You can't help thinking that if oil were at $20 a barrel these countries would have to empower their entrepreneurs rather than just sink new oil wells, while their grandstanding leaders would be out on their ears.

Indeed the boom in oil prices has given Sudan a staunch ally on the UN Security Council. China has invested more than $8bn in Sudan's oil industry including a 1500km pipeline. Last year, China was purchasing between 50% to 60% of Sudan's crude oil production. In return, arms, including tanks, planes and helicopters have been supplied to a country, which is orchestrating genocide against African tribes in the eastern Darfur region. At the same time China have slowed efforts at the UN Security Council to use sanctions against Khartoum and deploy a UN peacekeeping force in the area.

High oil prices: the Soviet example

If you are still not yet convinced by this oil thesis consider the recent history of the Soviet Union and Russia. The collapse in oil prices in the second half of the 1980's was a key factor bringing down the Soviet Union. Energy exports were the major source of foreign exchange, without the bunce from high energy prices the Soviet Empire crumbled. When the Soviet Union officially dissolved on Christmas Day 1991, the oil price was just $17 a barrel.

With oil prices low, post communist Russia was desperate for foreign investment. So the Yeltsin government became more open to the outside world and more sensitive to legal structures demanded by global investors. At international summits Boris Yeltsin used to kow-tow to western leaders. Even when Putin came to power the West and Russia had a sympathetic dialogue. But when the oil price rose, Putin requisitioned the huge Russian oil company Gazprom, swallowed up previously independent newspapers and TV networks, while his influential rivals either went into exile or were imprisoned.

High oil prices: creeping nationalisation

The creeping nationalisation of energy resources is still continuing. The oil giant Shell (RDSB) has invested $20bn in the Sakhalin II project. Sakhalin, an island due north of Japan, is one of Russia's richest petroleum provinces with as much oil and gas as the North Sea. But it is almost one of the harshest environments in which to drill oil. Profit sharing and tax agreements for the project were signed in 1994 when the oil price was low and Russia was desperate for foreign investment. Now oil prices have tripled, Russia is moving the goalposts and demanding a larger stake in the project.

Putin knows the West needs Russia's gas. He is holding the trump cards. At last month's G8 summit in St Petersburg, the host was on a roll. After President Bush made an oblique reference in a press conference to Russia's slide towards autocracy, Putin prompted laughter by saying that 'we certainly would not want the same kind of democracy as they have in Iraq!' This is a commentary on our times.

Back in 1989 the Berlin Wall was torn down and the nations of Eastern Europe could enjoy greater prosperity and freedom. At about the same time the Venezuelan oil industry reopened to foreign investment. President Clinton, with the help of the peace dividend, brought US public finances back into good shape. Freedom and democracy were flourishing. It was no coincidence that oil prices were low then.

High oil prices: demand for gold

Then as oil prices crept higher, what Thomas Friedman calls the 'First Law of Petropolitics' came into play. Higher crude prices gave some of the worst regimes in the world extra money to consolidate their position and corrode world stability. This may be good news for holders of gold and arms manufacturers, but in terms of peace freedom and democracy, the world is an uglier place than it was ten years ago.

By Brian Durrant for The Fleet Street Letter.

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