Usually, the correlation between gold prices and oil prices is positive for two main reasons. First, both are denominated in the US dollar. Second, the price of crude oil is an important determinant of inflation. However, gold is known as an inflation hedge. Going by this logic, an increase in crude oil prices is usually positive for gold. The relationship between the two commodities isn’t that simple when there are myriad other variants working in the background.
Correlation between oil and gold
Right now, oil prices are in a freefall and gold is rising relentlessly. The current drop in oil prices signifies depressed economic activity. Since a large part of the global population is in lockdown, the need for oil has gone down drastically. The WTI crude oil futures went negative for the first time ever last week. Most of the unprecedented move has to do with the supply glut since demand remains subdued. More importantly in the short term, the supply has overwhelmed the storage capacity. Conversely, gold is gaining from increasing uncertainty, fear, and easy money.
Fed and gold’s price rally amid COVID-19
Oil prices, left on their own, would contribute to deflation. To prop up the demand hit by COVID-19, central banks, including the Federal Reserve, are printing money quickly. In the absence of a corresponding rise in output, this will lead to inflation. Along with zero interest rates and huge budget deficits, the situation is a perfect recipe for rising gold prices. The SPDR Gold Shares (NYSEARCA:GLD) has gained 17.8% since mid-March. The VanEck Gold Miners ETF (NYSEARCA:GDX) has multiplied the gains by returning 59.5% during the same period. Mega miners like Barrick Gold (NYSE:GOLD) and Newmont-Goldcorp (NYSE:NEM) have also been on a tear. They have gained 68.5% and 51.2%, respectively.
Double benefit for gold miners
Gold miners will likely benefit doubly from the rise in gold prices and lower costs. Energy costs are a significant input cost for miners, which will likely remain lower due to the supply-demand imbalance. Lower costs should help miners expand their margins and increase dividends. Incidentally, Newmont announced to increase its dividends by 79% in January.
A lot of upside in gold prices
While the US stock market has bounced back after its March lows, the rally doesn’t seem solid. Even after the recent spike in gold prices, there seems to be a lot of upside for gold due to uncertainty and fear. Investors with a preference for physical gold can go for GLD, while those with more risk appetite can flock to quality miners like Newmont-Goldcorp and Barrick Gold. Among medium gold miners, Agnico Eagle Mines (NYSE:AEM) also offers an attractive risk-reward profile. The stock has underperformed the gold miners’ index year-to-date and can offer an attractive entry point to investors.
Many high-profile investors and hedge fund managers are also recommending gold during the current environment. Bank of America expects gold prices to reach $3,000 per ounce in 18 months. The target implies an upside of 73% from the current levels. The rally for gold seems to have just started with a lot of steam left.