Monday, February 28, 2011

How to Use the Gold-Crude Oil Ratio

oil_pump_energy_productsBefore we kick things off today, Smart Investing Daily reader J.N.M. wrote in about last Friday's article, "Are Pink Sheet Listings Appropriate for Your Investment Portfolio?" I'd like to share the comment with you:
You should add to your discussion of "Pink Sheet" stocks that they usually have a very large spread between bid and asked prices. A good way for the amateur to get ripped off when either buying or selling.
Another reason to have a care when delving into this area of the market.
Now, let's get down to business. The geopolitical upheaval in the Middle East has levied crude oil prices back up to nearly $100 a barrel, and gold prices above $1,412 an ounce.
We know the psychological reasons for this: Unrest has split Libya in two -- and Libya is a major crude oil-producing country... and a member of OPEC. Economic questions of stability in the Middle East have also sent investors back to the relative safety of gold.
But these two commodities have a relationship -- and one that investors might be able to exploit, if they know what tools to use.
Back in 2005, I stumbled across an article by Adam Hamilton, written in 2004 for ZEAL, LLC, titled, "Gold/Oil Ratio Extremes." It was part of a series that tried to explain some of the big moves in both gold and oil, but more importantly, it found an important relationship between the two.
You should read the article for all the intricate details, but for simplicity's sake, Hamilton shows that historically -- on average -- one ounce of gold buys 15.4 barrels of crude oil.
This is the Gold-Oil ratio.
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What Does the Gold-Crude Oil Ratio Mean?

What this ratio infers is that when the current ratio is below 15.4, gold is either too cheap, or oil is too expensive. When the ratio is greater than 15.4, oil is either too cheap or gold is too expensive, as noted in this chart.
Let me give you an example. Back in the beginning of 2009, crude oil prices were at $34.57 a barrel. Gold prices were at $874.50 per ounce. This means that back in 2009, one ounce of gold bought about 25 barrels of crude oil. That's not on the chart above...
Since then oil prices have nearly tripled, while gold has gained 61%.
Now, 61% is not a paltry gain, but compared to the behavior of oil prices, you can tell which commodity was out of balance within the ratio. The Gold-Oil ratio sits just under 15 as of yesterday.
That's pretty close to the ratio's average... but some investors thing the sharp drop from 2009 could mean gold has room to move higher.
Let's see if this line of thinking makes sense.
Will Gold Prices Push Higher?
Credit Suisse reports, as per Bloomberg:
"We see potential for gold to outperform oil over the coming months," Stefan Graber, Zurich-based analyst with Credit Suisse, said in an e-mailed interview yesterday. "We think an ounce of gold could potentially buy a few additional barrels of oil. This assessment is based on our positive view on gold versus a neutral view on the oil market."
But something's not quite right with his assessment.
Crude oil prices have climbed nearly $12 in the past five days, or 13.6%. Gold prices have climbed $27, or 1.95%. Credit Suisse says that OPEC has spare capacity of more than 5 million barrels a day. And the U.S. has seen its crude inventory climb by 11.4 million barrels over the past year.
It's clear that speculation of supply disruptions has caused oil prices to climb back to $100 a barrel, not actual disruptions.
This could mean -- should no actual disruption occur -- that crude oil prices could drop. So let's try something. Let's take out the oil price rise over the past five days, and see what the Gold-Oil ratio looks like then.
At $1,412 an ounce, and $88 a barrel, the Gold-Oil ratio is 16.04, meaning that crude oil is cheap, or gold is expensive. Slightly...
In other words, the only way gold could climb significantly against oil is if oil prices fall.
Believe me, I'm all for holding gold as an inflation hedge -- even at these high levels, but for gold to close even half the gap in the Gold-Oil ratio difference between 2009 and today, gold prices would have to climb to more than $1,900 an ounce.
For gold to trade for just "a few additional barrels of oil," as Credit Suisse suggests might happen in the coming months, gold would have to climb to $1,700 an ounce.
I don't see that happening in such a short time frame, particularly if oil prices stay at around $100 a barrel.

Using the Gold-Crude Oil Ratio

As I've done here, you can use the Gold-Oil ratio as a "reality check" to some predictions. But you can also use it to see if gold or crude oil is overpriced or underpriced. But it's only the first step in your analysis.
Clearly, when oil prices were trading at $34 a barrel, crude was hugely underpriced. Just as oil was massively overpriced at the peak in 2008. Right? In hindsight we know this to be true.
Once you determine the relationship between the two, you have to look at fundamentals to decide which commodity you think is going to move. For example, when oil prices peaked in 2008, and the ratio was an anemic 6, one of three things could have happened to bring the ratio back to 15.4.
  • Oil could have stayed at $147 a barrel, and gold could have climbed to $2,264 an ounce.
  • Gold could have stayed at about $885 an ounce, and oil could have fallen to $57.50 a barrel.
  • Oil could have fallen as gold climbed.
Each of these three scenarios would mean very different investments.
That's why the Gold-Oil ratio is a tool, a barometer of sorts.
With the ratio at just about 15, fundamentals are more important for direction in each commodity, and I'm thinking that if oil supply is not disrupted by the uprisings in the Middle East and North Africa, then we could likely see prices fall back below $90 a barrel.
That said, investors will look to gold during this time as a place of safety for their money -- but perhaps not to the tune of "a few additional barrels of oil."
In other words, we could see gold climb, but not in a significant manner in the immediate future... And we could see oil prices fall, but not so far as to make oil seem underpriced.

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