It wasn’t that long ago that we were buying record amounts of Russian oil and petroleum products in exchange for dollars, until earlier this year.  Today an increasing number of nations are discussing trading oil for gold, such as in Ghana recently.  But there is an interesting dynamic at play that could ramp up this trend in ways that US policy makers might not be ready for.  The United States is trying to simultaneously cap the price of Russian oil at $60, while also sanctioning Russian gold reserves to prevent others from accepting Russian gold as payment for goods and services.  This plan is spelled out in the National Defense Authorization bill for 2023, but Credit Suisse financial analyst Zoltan Pozsar believes the plan could backfire, sending gold higher and the dollar lower.

Pozsar explains that limiting the price of Russian oil to $60/barrel pegs gold to oil at the rate of 1 gram of gold per barrel of oil, at current gold prices.  But the sanctions do not prevent Russia from importing gold, only from using their own gold to purchase other goods and services.  Russia could easily exchange a barrel of oil for a gram of gold, thereby increasing their gold reserves.  But they could also offer to trade 2 barrels of oil for 1 gram of gold, thereby doubling the price of gold in dollar terms.  This would allow Russia to continue to profit from the oil trade, while vastly increasing the value of their gold reserves.  For those of us who live in the dollar-centric world of the United States, it would also increase the value of our gold holdings and vaulted reserves.

At 2 barrels of oil per gram of gold, there would be overwhelming demand for the oil.  The oil would be purchased in the East by a nation such as India, who would in turn sell oil to Europe.  Unless the sanctions package is expanded to prevent indirect purchases of Russian oil by proxy, Europe’s energy woes could largely be over by purchasing “Indian” oil.  Russia could sell oil for gold at this rate without having to increase or slow production.  This would also increase gold production around the world,  double it’s price in dollar terms, and weaken the demand for dollars needed for global trade.  It would also make oil more expensive in dollar terms, with cheap Russian oil only available to non-sanctioning partners in the Far East, Africa, and South America (and by proxy from India to Europe, for example).

The banking industry could also feel the impact of gold for oil, as higher gold prices would produce a liquidity shortfall for those active in the paper gold markets.  Basel III rules were put in place to help ensure banks couldn’t harm one another in the gold space, by limiting the bets that can be made with unbacked paper gold derivatives.  But the underlying assumption of Basel III was that physical gold would not be allowed to become an international trading mechanism once again.  “Gold for oil” upends that assumption, and negatively impacts the balance sheets of those banks on the wrong side of the “higher gold” trade.  What banks trusted one another not to do, could have little impact on what various state actors do in terms of gold usage and prices.  They would then be competing to purchase gold to cover positions while the rest of the world sought gold to buy oil.

Part of the issue for the United States has to do with the current supply of oil available in the Strategic Petroleum Reserve (SPR).  Oil supplies on hand in the SPR have reached the lowest levels in 36 years, at the same time oil-producing nations have begun to accept and seek non-dollar arrangements for purchasing oil.  The gold-for-oil trade would reduce the amount of oil available for dollar purchase, just when we need to restock the SPR.  Ironically, it is perhaps the overuse of sanctions restricting dollar usage that has led to the world finding alternative trading mechanisms, furthering the demise of the dollar in world trade.  

Some are asking why the expected price of oil for gold wouldn’t go the other way, with Russia demanding 2 grams of gold per barrel, for example.  Obviously it would be better to trade oil for more gold, rather than less.  But this way of thinking misses the issue of what is really happening right now in world trade, and in the economic conflict that continues to unfold.  Pricing oil too high in gold terms would make it less attractive to those paying in gold, and thereby make more oil available to those paying for oil in dollar terms.  This would lower the price of oil in dollar terms, thereby strengthening the dollar, and increasing demand for dollars worldwide.  It would be much cheaper to pay for oil in dollars, than in gold.

With recession looming large on the economic horizon and inflation lingering longer than previously thought, the last thing American consumers need is higher oil prices in dollar terms.  But as gold for oil increasingly becomes an issue with the lowest SPR levels in a generation, higher oil prices in dollar terms seems fairly certain going forward.  One of the best ways we can protect ourselves from the ravages of oil inflation, is by owning physical precious metals.  Unlike dollars that depreciate against real goods and services over time, physical precious metals tend to maintain purchasing power over time.  With the highest COLA increases to retiree pensions in over 40 years, many bemoan the fact that the effects of inflation minimize the impact of COLA over time.  History has proven that owning physical gold and silver offers more inflation protection than COLA increases.  Expanded gold for oil transactions will highlight this fact.