The Price of Energy Just Crashed: What it Means for Gold

The Price of Energy Just Crashed: What it Means for Gold

Oil dropped to zero overnight.

Wait. What?

Yep, you read that correctly.

The price of energy went to zero.

In fact, when I opened the news this morning, I couldn’t believe my bleary eyes either.

Not only did oil drop to zero, one particular futures contract went negative.

Yet gold barely budged overnight.

Surely if the oil price is negative then gold should be soaring?

Believe it or not, what happens in the oil market can affect the gold price…

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Oil turns negative

Of all the things I expected to see this morning, discovering an oil futures contract had ‘gone negative’ wasn’t it.

Another unprecedented event in a short year of unprecedented events.

Perhaps it’s time to expect the abnormal as the normal now.

Nonetheless, as I was shuffling around the kitchen, tripping over bored kids and a hungry dog while trying to make a morning coffee, there it was. With the Australian Financial Review writing:

They’re running out of space in Cushing, Oklahoma, one of the world’s biggest crude oil storage hubs — sending the benchmark West Texas Intermediate contract for May delivery below zero for the first time in history.

In less than half an hour of stunning trading early on Tuesday (AEST), traders crashed the May WTI to an unprecedented minus $US37.63 a barrel.

You read that right.

The West Texas Intermediate (WTI) May futures contract dived some 321% while we were sleeping. Dropping to a low of minus US$40.32 during US trade.

That’s two firsts in one night.

The first was a WTI futures contract going to zero…the second was it dipping deeply into negative price territory.

In theory, that means suppliers would have to pay customers to take the oil from them.

Of course it’s worth pointing out, what happens in the futures market and what happens in reality are two different things.

Price discovery in the futures markets is becoming increasingly broken.

Although I recently spoke with one expert who said we need to remember the majority of Wall Street is working from home. It could be less a case of price discovery and more a case of bored or anxious traders.

Itchy trigger fingers aside, the WTI price slide is just another example of the wild price action in the futures markets.

The thing is, it no longer seems to be doing that. Right now, the futures markets appears to be swinging wildly.

However, the WTI heading lower is further proof of crude demand collapsing in the US. With many parts of the US shuttered like the rest of the world, the need for energy is slipping.

It’s worth noting that while the US price for energy went negative, the Brent crude price didn’t suffer as much, dropping 9.5% to US$25.41.

And yet amongst all of this, gold barely budged. Jumping up US$13 overnight — barely 0.77%, to US$1,694.

Surely if the US energy market is going backwards, that means there is something wrong with the markets and gold should be rallying, right?

Well, yes I have no doubt markets are reacting to the uncertainty, but gold’s minimal rally really reflects what’s happening with oil.

The link between oil and gold

There are many factors that impact the price of gold.

One of the more puzzling pieces of understanding gold and its price moves comes from getting your head around the gold and oil relationship.

It’s not commonly talked about. And few investors outside Wall Street really understand it.

That’s partly because it’s not a neat correlation. But once you understand the relationship, you can see how the price of oil tells you why gold is doing what it’s doing. And perhaps use that knowledge to predict future behaviour.

For example, the price of Brent crude skyrocketed from 2007 all through up to 2008, but gold didn’t.

Then the prices diverged in late 2008, gold did a moonshot…and oil tanked.

Brent crude compared to the US dollar gold price


Dailyreckoning

Source: Trading View

[Click to open in a new window]

These divergences mean people tend to dismiss the link between the two commodities as nothing more than analysts looking for an explanation.

You can see this in the chart above where Brent crude (blue line) and the US dollar gold price (orange line) don’t really seem to have a lockstep move.

However, there is a link between the price of oil and what that means for gold.

For starters, you’ll notice that gold tends to rise with oil, but doesn’t seem to fall as harshly as oil does.

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In other words, there is a general movement in the same direction, but gold lacks the extreme swings oil has.

However, there is a valid reason to understand this relationship.

When the price of energy is capped, the price of gold is unable to extend its rally.

In simple terms, low oil prices mean we are seeing deflation in play, not inflation.

Meaning that deflationary forces — prices of goods and services are falling — are impacting the market right now.

Now gold can still rise in a deflationary environment, but the gains are limited.

Should oil start to move higher, that means that will give gold a little more room to stretch its legs.

Furthermore, the longer the value of energy (oil) stays low, the more likely it will stifle any gold rally.

Of course, how long the price of oil remains low for is anyone’s guess. I mean, I never expected it to be negative.

But when you see the oil price move higher, get ready for a bigger gold price rally ahead…

Until next time,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia