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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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What Oil Investors Can Learn From Gold

What Oil Investors Can Learn From Gold

 Commodities investors had been riding on momentum for years and with a diminishing supply of the product coming from producers, prices seemed destined to keep rising for the foreseeable future.

Then in the span of a few months, the commodity’s price crashed and billions upon billions in investment value and producer company market capitalization was wiped out. For many energy investors, this story might sound familiar. But it’s not the story they are thinking of.

In 2013, after a price run-up that had lasted for a decade, investors in gold found out that the precious metal was not as safe as many had assumed. Gold is supposed to be the ultimate safe-haven asset. Like land, as Mark Twain once said, they’ve stopped making it. Unlike stocks or bonds or even green pieces of paper, gold is tangible and has been traded for centuries. It also has a global demand base that is largely built in and reasonably consistent. Yet, after prices neared $2000 an ounce, gold’s price fell by hundreds of dollars an ounce in the span of a few weeks Related: With Shell’s Failure, U.S. Arctic Drilling Is Dead

The price has not come close to recovering. In fact over the last year, it has mostly continued to fall albeit at a much more subdued rate. It wasn’t supposed to be like this.

The worldwide printing of virtual money through quantitative easing was supposed to keep inflating gold’s price. Even after the commodity collapsed in value, numerous commentators and groups predicted that it was temporary, and many said that, with the fall in price, demand would surge leading to a sharp rebound within a few months. There was even talk about various industry organizations failing to properly report supply and demand numbers thus keeping the markets misinformed and prices low. Now though, more than two years on from that drop, nothing close to those predictions has materialized, and investors are still licking their wounds. Related: How Much Longer Can Venezuela Keep The Wolves At Bay?

This is not a story about gold though. It’s a story about oil. The truth of the matter is that gold is largely an irrelevant commodity compared with oil. Oil is the basis for dozens of countries’ economies around the world and for thousands of major companies’ existence. None of that matters though. The other truth, and the less pleasant one, is that there are stark parallels between what happened to gold a few years ago and what is happening to oil today.

In the cases of both gold and oil, frothy price levels led to large increases in production over the course of a decade and unorthodox sources of supply started to be exploited. Despite the rising supply and only slow growth in demand, prices continued to rise. After a while, both gold and oil stabilized and spent time consolidating and then, just as gold fell, oil too collapsed in price.

Now roughly a year after the first big shocks started to hit the oil market, suppliers have responded in earnest. But just as with gold, simply cutting supplies a bit and having a few weak producers go bankrupt will not lead to a rapid price rebound. Instead it is increasingly beginning to look like oil prices will remain subdued at well less than a $100 a barrel for years to come. Related: Exxon CEO: Alaska Is Its Own Worst Enemy

Perhaps oil prices will come back and the parallels with gold will end here, but that’s probably too optimistic. Most of the same basic economic forces that impact gold are equally valid with oil. Investors need to be prepared for the reality that it may take a decade or more for oil to return to $100 a barrel. That does not mean that oil companies will all go out of business or that investing in energy stocks cannot be profitable.

But it does mean that the industry is changing and evolving. Some firms that once commanded lofty prices, probably never will again. Other firms that are faster to adapt will probably be able to take new market share. Regardless, investors need to recognize and adapt to the new realities of the market, and that holds true for both gold and oil investments. It may be painful, but it is the only way forward.

By Michael McDonald of Oilprice.com

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Leave a comment
  • adec on September 29 2015 said:
    Same bear, same agenda. The author is always bearish on oil. This article is just another attempt to spread bearish sentiment on oil. Just wonder how he is related to the shorts...
  • Rob N on September 29 2015 said:
    "Gold is supposed to be the ultimate safe-haven asset. Like land, as Mark Twain once said, they’ve stopped making it."

    As the author says, a whole lot of people believe this, but I'm not one of them. The big problem, of course, is that they are indeed still making it, in the form of mining.
    The second problem is that something like 40% of gold that is mined is hoarded, another large percentage goes into jewelry and only a small amount is actually used - electronics and such. You can't eat it, run your car with it, heat your house with it. It doesn't degrade or rust. So when prices go up, there's a huge amount of it just sitting around that people will eventually be willing to unload. It's only worth what people will pay for it - another fiat currency.

    Oil, on the other hand, is used, and it's used for everything in modern society - transportation, machinery to make products, asphalt for the roads, even fertilizer for the fields (from natural gas that tends to come with oil drilling). And the American dollar is backed by petroleum (the petro-dollar), which is better than being backed by gold - as long as you get rid of people like Saddam Hussein who wanted to sell oil in Euros instead of dollars.

    So in that regard, oil and gold are different. But they do have boom and bust periods that are tied to the economy, so there are similarities as far as that goes.

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