Oil For Gold

On January 18, 2004, Reuters reported that former Malaysian Prime Minister, Mahatir Mohamed, advised Saudi Arabia to demand gold for its oil. For a couple of days, the Internet was all abuzz about the statement, but nothing was written to analyze in depth the possible ramifications of the Saudis actually making that move.

That's probably because nobody thinks for a second that the Saudis might actually do such a thing. But just imagine for a moment that Saudi Islamists stage a coup and gain control of the Saudi's oil empire. Demanding that the US pay gold for oil could indeed be their much-desired "weapon of mass destruction." It would be the economic equivalent to setting off a neutron bomb in downtown Manhattan.

In simple, straightforward economic terms, not even taking into account the financial and political ripple-effect of such an action, it would eventually force the world into either a quasi gold-standard, or a situation where only specie is accepted in international trade.

It is, of course, no secret that Mahatir wants exactly that for his gold dinar. The impact on the United States alone would be nothing short of devastating - and that is without doubt is his intended result.

So, what's the immediate effect if OPEC "goes gold"?

The Effect:

For simplicity's sake, let's for the moment disregard the enormous upward-pressure on gold prices such an action would set off. Let's take a look at the situation in terms of how long US gold supplies would last if neither the gold nor oil prices were to change over the period in question.

According to the New York Fed, the US national gold stock is nearly 262 million ounces (overlooking for the moment the possibility that the US no longer owns much of its former gold). At the current market price near $405/oz, these ounces represent slightly over $106 billion worth of gold buying-power.

It is hard to conceive a situation where, if the world's largest oil exporter and holder of proven oil reserves should start demanding gold for its oil, the other OPEC countries will not immediately follow suit. Other members would not sit idly by and watch Saudi Arabia alone drain the world central banks' gold reserves. They would most certainly want in on the action (and so would Russia, Canada, and Mexico, as a matter of fact). We therefore look at the total US import figures from all of OPEC together (but excluding the other major producers) in figuring out the immediate effect.

In 2003, daily US oil imports from OPEC countries averaged slightly in excess of 5 million barrels a day, which amounts to 1.8 billion barrels per year. At current market prices for crude oil (near $31/bbl at the time of this writing), OPEC imports cost the US about $56 billion per year.

If the US had to pay for its OPEC oil in gold, it would have to ship about 138 million ounces of gold per year at current prices ($405 gold, and $31 per barrel of oil). Since there are only 262 million ounces of gold (at best), that means the entire US gold stock would be gone in a little under two years!

(As an aside, it is worth noting that the EU could outlast the US almost ten times in that situation. EU imports just under one million barrels a day from OPEC [one-fifth of US imports], and it roughly has a cumulative 384 million ounces of gold reserves compared to the US' 262 million. That would give it about twelve years of OPEC oil imports.)

Another US Invasion?

This kind of scenario will almost certainly cause the US to use its conveniently positioned military to "intervene" in additional countries of the Middle East, most likely Saudi Arabia and Iran, the number one and number three countries in terms of proven reserves. (We’ve already got number two.)

But then again, the political capital may not be there to be spent on another invasion. What would be the official excuse? "Just shut up, we need the oil?" I don’t think so.

If the need for immediate action is felt, however, just imagine that a small suitcase nuke may go off in downtown LA, for example, and that such could be publicly blamed on Iranian or Saudi terrorists. US public support for s full-scale invasion of either country would be there in seconds.

If for whatever reason an invasion was not forthcoming, OPEC leaders will have to do some really hard thinking on how to set the most effective price levels of oil in terms of gold.

At current market prices, one ounce of gold (at $405 an ounce) buys 11.57 barrels of crude oil (at $35 per barrel), or 0.086 ounces of gold per barrel of oil. Let’s just say its close to a tenth of an ounce per barrel. In order to make the transition a bit more palatable to the US and thereby avoid another outright invasion, OPEC might set the gold price of crude at far lower levels, say at 0.01 ounces per barrel. That way, the US could "live" on its gold stock for almost 15 years or so. If OPEC were to single-mindedly and inflexibly pursued an oil-for-gold policy, it would on the one hand certainly end up with all of US gold stock in a very short time while, on the other hand, it would lose its biggest customer. After the US spent all of its gold, there would be no one left to fill the void.

At current market prices, one ounce of gold (at $405 an ounce) buys 11.57 barrels of crude oil (at $35 per barrel), or 0.086 ounces of gold per barrel of oil. Let's just say its close to a tenth of an ounce per barrel. In order to make the transition a bit more palatable to the US and thereby avoid another outright invasion, OPEC might set the gold price of crude at far lower levels, say at 0.01 ounces per barrel. That way, the US could "live" on its gold stock for almost 15 years or so. If OPEC were to single-mindedly and inflexibly pursued an oil-for-gold policy, it would on the one hand certainly end up with all of US gold stock in a very short time while, on the other hand, it would lose its biggest customer. After the US spent all of its gold, there would be no one left to fill the void.

Claiming Iraqi Oil

The US, of course, doesn't have to go the invasion route. It currently occupies Iraq, which has the world's second largest proven oil reserves. If OPEC made this policy change, the US could easily reverse its present course of turning over government authority to the Iraqis, and could actually start behaving like a full-fledged conqueror.

Iraq has 115 billion barrels of proven reserves. At a rate of 1.8 billion barrels per year of oil imports from OPEC, the US can satisfy its entire current OPEC import demand from Iraq alone for more than 50 years - once it brings sufficient production capacity online. There are of course terrorist attacks on pipelines, facilities, etc. to take into account. Nevertheless, it's better than having to spend all of its gold on oil.

For the US, this would constitute the least expensive solution from a purely economic cost/benefit standpoint. But this is where we need to consider the inevitability of a gold price explosion that will result from the enormous added demand from OPEC demanding gold for its oil. That price explosion alone would immediately doom the dollar, and therefore the entire US economic machinery.

So, even if the US can avoid paying for oil with gold, which is not entirely certain, (consider the political fallout from totally claiming Iraq) gold would shoot so high that the dollar, due to existing trade deficit/debt load problems, would be pulverized - ahead of all the other fiats. Think, "US of A" as in "United States of Argentina"

Universal Gold-Settlement?

Whatever the complexities and strategic contingencies of such a move by OPEC, one thing is immediately clear: If the oil consuming countries of the world don't want to end up with dwindling buying power and disappearing public stocks of gold, they'll be forced to demand gold settlement for all of their exports to OPEC countries. That, in turn would eventually cause the entire world economy to get back to gold settlement, at the very least for international trade purposes.

The question arises: once most international trade is settled in gold (and maybe silver, especially after its imminent price-adjustment) can individual transactions within countries remain far behind?

What is "trade" between countries, really? Trade is not primarily something the governments of different countries do with each other. Trade is mostly conducted between different countries' private corporations and individuals.

So, if corporation "A" sells a shipment of Mercedes to a wholesaler in Saudi Arabia, it can demand gold in payment. What will "A" do with that gold in its home country? It may sell it for cash and use the cash to pay expenses, save, invest, or buy whatever it needs. But in an economic environment where gold is demanded by OPEC for oil payments, all paper currencies will rapidly depreciate against gold due to an unbelievable increase in gold demand world wide.

Under that scenario, "A" would be worse than stupid to sell its ultimate value-retainer - gold - for an ultimate value-loser - cash. So it will keep its gold. Corporation B, which does business with "A" at home, sees its own "stash of cash" losing purchasing power by the minute, so it wants gold, too. It will demand payment in gold from "A" for its services.

In turn, A's and B's employees (at least upper management with enough clout) may demand their pay in gold as well ... and so on, and so on. Maybe in the US, legal tender laws and the abrogation of gold clauses will prevent such a scenario, but there is probably little in other countries that would prevent this from happening.

The more instances of this process take place, the more fiat would lose value, in turn accelerating the entire process. Very soon, nobody will take cash for anything except at tremendously discounted values, and everyone and their brother will demand gold for literally everything. We will have a pure-specie currency system in no time.

And that, dear reader, is Mahatir's plan. Could this actually happen?

Just ask yourself if the Wahabis could overthrow the Saudi dynasty, and you have the answer staring you right in the face..

The "seeds" have been planted in the minds of OPEC leaders. If they grow, their harvest will be in gold - and cash will be trash.

Got gold?