When the world last saw oil prices at $40/barrel the economy was just beginning to show some signs of life after the 2008 meltdown. With the price of this essential commodity now hovering around that price and possibly going lower, many analysts are trying to evaluate what this means for the world economy over the coming months.

Likewise, this dramatic and continuing decline raises a number of questions about its impact on the price of gold and other precious metals. To understand differences of opinion about what low oil prices could mean for gold going forward, it is important to have more insight into the reasons behind this sharp drop in oil prices and why it has happened.

How Oil Prices Generally Affect Gold

There has long been a correlation between oil and gold prices, largely because they both reflect the impact of anticipated inflation and the state of the world economy. Additionally, crude oil is now a significant direct and indirect factor in the cost of gold production. Thus, over the long-term, any major drop in the cost of oil should benefit gold producers.

However, if long-term decline is an indication of lower world production figures and demand, then it creates a downward pressure on gold pricing. Compounding this pressure is the reality that more producers of gold will enter the market when the cost of production falls, affecting the price from a supply perspective.

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Evaluating the Causes and Timing

It is the issue of supply and demand that seems to be the biggest factor in the current decline in the oil futures market. While the issue is complicated, the oil and gas industry has surprised itself and the world with a virtual glut of new production. With new technology creating unanticipated sources of crude, increased pumping in the Middle East, and other factors such as Japanese nuclear plants coming back on stream, the supply is simply exceeding the demand.

In addition to this increased production, the strong dollar is also putting downward pressure on both oil and gold prices. Since the price of oil is set in U.S. dollars, the strength of that dollar determines its real cost to other markets. In fact, the correlation of this factor is one reason China is working so hard to increase the value of the yuan.

These two factors—the dollar and the yuan—seem to be at the core of the current oil pricing trend, and the issue of the world economy is only a secondary factor. This is meaningful to gold investors at several levels. First, if a major world economic collapse is not the prime driver in the oil price decline, it means the lower prices could actually spur economic growth. Secondly, the intermediate to long-term impact of lower oil prices is probably not as serious a negative impact on gold prices if it is more a result of oversupply than economic conditions.