Gold Or Oil: How Far Up?
Oil recently hit an all-time record of $50/barrel, up dramatically from the $10/barrel hit just a few years ago. This is a dubious milestone for most consumers but sweet music for oil and oil stock investors. Many factors have come together to lift the price of oil to these lofty levels. These include increased demand from China and India, geopolitical concerns, weather, wars, and also the ever-present specter of resource depletion. Gold has also been on a pretty good run the last few years, recently settling into the $400 range from the low of $250 set in 2001.
Both gold and oil are natural resources that are extracted from the ground. Each has a limited global supply determined by the formation and evolution of the Earth's geology. But this is where the similarity ends. Gold has been mined by humans since time immemorial and has been coveted as the ultimate form of wealth in cultures all around the world. The curious thing about man's love affair with gold is that the yellow metal has performed no essential function that is required for life. Its primary use has been as a form of money, a function that can be easily substituted by another material. Oil does not have the deep history of gold. It has been in common use for less than 100 years as the dominant form of energy. But within that time, oil has become an absolutely essential substance for which there is no effective substitute.
Gold and oil differ in many ways, but for investors the only factor of interest is price. Either commodity can be traded for a profit. Investors choose to trade an asset with the best reward for the risks undertaken. One way to evaluate the risk/reward ratio is to determine maximum and minimum price points. How far up or down can the price of each asset reasonably be expected to move?
Looking at oil, we can determine that this is an essential material required for all modern societies. Oil is plentiful but limited in both production capacity and absolute supply, but demand continues to grow. Because of this, the long-term price of oil is most probably going to continue higher; at least until a substitute form of energy is developed. But higher oil prices have consequences. High oil prices divert limited wealth from other purchases into oil. Past oil price shocks have almost always caused recessions. These recessions encourage conservation which limits oil demand and therefore limits oil price increases. The essential nature of oil places limits on how high the price can go.
Looking at gold, we can determine that it is a very rare material that is limited in both production capacity and supply. But gold is not used for any economically sensitive purpose. A very high gold price will make a few investors very happy, cause problems for a few in the jewelry business, and maybe make some central bankers look foolish, but it won't materially affect the lives of most people. Gold therefore has no implicit price limitations and can absorb immense amounts of speculation with negligible macroeconomic consequences.
Just imagine the consequences of oil quadrupling to $200/barrel. Such a massive oil price shock would certainly put most economies into deep recession. But companies and consumers would also react aggressively to reduce consumption and increase efficiency. Eventually, economies would find ways to grow with less dependence upon expensive oil. Out of necessity, reduced demand would ultimately halt price increases.
Now imagine the price of gold quadrupling to $1600/ounce. Would there be any economic dislocations as a result? Even the jewelry business would be able to absorb the increase by raising prices and substituting other metals. Clearly, gold trading at any arbitrarily high price would cause few people any real discomfort. Instead, massive gold price increases would probably ignite further speculation and result in even higher prices.
This reveals a great investment paradox: Oil is arguably one of the most essential of all commodities and gold arguably the least, yet gold offers the greatest appreciation potential while oil is limited by its own essential nature. However, just because gold has the potential for great price appreciation does not mean that it will. The future price of gold will depend primarily on investment demand and the action of other investment markets.
Both gold and oil are likely to be worth more in absolute value over the long term. The economics of demand and depletion are clear in both cases. As such, investors should be exposed to both asset classes. But as an investor and as a consumer, I would much rather see gold at $1600 than oil at $200.
George
J. Paulos is Editor/Publisher of Freebuck.com, a website devoted to
wealth preservation and enhancement using alternative investing approaches including
precious metals. He is also Associate Editor of The Gold Letter, a newsletter covering junior mining and natural
resource stocks.
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Copyright 2004 George J. Paulos, All rights reserved.
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