Why high oil prices are good for gold

published 18 October 2007

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

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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.

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.

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.

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.

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.

Brian has contributed to MoneyWeek with his expertise in investment strategy, for example how to quadruple your dividend income and how to navigate through the stock market in the 2008 financial crisis. He’s also touched on personal finance such as the housing market and the UK economy.