Forex Trading Library

Why Gold Traders Should Care About Crude Prices

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Elasticity of supply isn’t something that you hear much talk about when it comes to gold. In fact, one of the selling points of gold is that it is so rare that the amount in the world is kind of fixed. That means it holds its value better since it can’t be “inflated” like a typical fiat currency.

But, when it comes to the ups and downs that traders take advantage of, supply elasticity can potentially have enough of an impact to become relevant to gold traders. And this makes an unusual connection with the recent fluctuation in crude prices. Of course, petroleum is often called “black gold”, but that’s because it’s seen as valuable. Not because the price of crude can have an impact on gold. But, we live in strange times.

How does supply elasticity apply here?

Elasticity of supply is the economic term applied to how when something becomes scarce, people figure out a way to produce more of it. Scarcity is remedied by discovery, innovation, or conservation, and driven by market prices. When an asset’s price increases enough, it becomes worthwhile to spend more on figuring out ways to find more of it, or create more of it, or prevent it from being wasted.

But the phenomenon works in the opposite direction as well. As prices decline, then there is less interest in finding more of the resource, because it can be bought cheaply. In a way, this is what’s happened with energy in the last century. Fossil fuels were abundant, and therefore cheap. So finding other sources of energy were not really worthwhile. But when prices rise, then alternatives become more “economical”, and thus investment in solar, wind, and other alternative energy sources becomes viable.

The unusual price moves

Gold prices have been under pressure recently due primarily to monetary policy. With high inflation, gold should be shooting higher in relative price. But high-interest rates push the price of gold down. Higher interest rates make the dollar stronger, because it becomes more worthwhile to hold dollars.

Normally, that would mean that crude prices would go down. But, supply of crude to the world is being artificially restricted by the major producers in order to force up the price. Global crude consumption is expected to reach a record high this year, while Saudi Arabia and Russia are holding back production.

The gold crude connection

High inflation should have caused elasticity of supply to kick in, and gold miners to spend on finding new deposits to exploit. But the manipulation of prices by central bankers has kept demand artificially low, opening the chance for a “rebound” when interest rates normalize. The higher cost of crude has pushed gold production costs higher, squeezing margins for miners. Which makes the gold supply increasingly inelastic.

Major mining companies have turned to buying out smaller producers that already have discovered gold, instead of spending on exploration. That’s because the bigger company can take advantage of economies of scale. But it also means that gold production isn’t keeping up with “normal” demand, creating a supply hole. When prices normalize in the future, say, when central bankers move into a rate-cutting cycle, gold demand will likely “snap back”. It takes several years to develop new gold mines, so when demand returns, there could be a significant supply glut, leading to a price spike for the yellow metal.

As long as crude prices remain artificially elevated, this phenomenon could intensify. A sign that an unraveling of the situation could be if oil prices fall while the Fed is cutting rates. That could send people diving for the safety of gold only to find that there isn’t enough supply.

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