Monday, August 22, 2011

Gold/Oil Ratio - Where is it heading?

A few months back I looked at the historic ratios between Gold/Silver and Oil.

Gold/Oil and Silver/Oil Ratios - Then and Now

Given the recent rise in Gold and fall in Oil price I think it's worth revisiting this ratio as well as reviewing what current events might impact this ratio and their individual prices.

As per the last post the WTI Oil price data came from Economic Research section on the Federal Reserve Bank of ST. LOUIS website (Link) and the Gold price data came from the Perth Mint, I used the monthly London Fix (PM) (Link). For the month of August 2011 (top of current spike) I used spot prices so as to highlight the current ratio.

Here is a chart showing the past 40 years:


There is historical precedence for Gold to head higher versus oil, currently it's sitting at almost 23 ($1875 Gold/$82 Oil). To get to 25 which the ratio has spiked to on several occasions over the past 20 years we could see Gold head up to around $2050 (assuming no change in the price of oil).

However, the ratio has struggled to stay above 21 for long periods of time on past occasions and with each passing day there is increasing risk that the ratio falls back toward the longer term average rather than rising further. The long term average over the past 40 years sits at around 15.6 (15.6 barrels of oil per 1 ounce of Gold).

The price of oil has already fallen somewhat over the past several weeks, likely due to escalation of global growth concerns with awful figures coming out of the US (such as the Philadelphia Fed’s economic index which printed a shockingly low -30.7 in August, the lowest since March 2009)
and other economies. The market is starting to price in the likelihood of a global recession. A scenario of low global growth would see the demand for oil easing, reducing pressure on the price.

Further to this we have news today coming out of Libya that Gaddafi’s Son has been captured and I can’t help but wonder whether we might see the market reduce the risk premium that the situation in Libya has added to price of oil (as discussed in detail by Houses and Holes on Macro Business), that is assuming that Gaddafi doesn’t get the opportunity to cause any further major damage to Libya’s oil infrastructure. While this news is far from the end of conflict for the region, it’s certainly a step in the right direction and the risks to oil supply from Libya should reduce.

If we see oil fall further over the short term as growth concerns dominate and the Libyan situation settles and we saw a price of $75 per barrel, this would suggest that Gold could also moderate in price if historical ratios continue to have influence over the metal.

Oil at $75 (WTI) per barrel (around an 8% fall from the current price) at a ratio of 25 with Gold would present an $1875 price point which is around the current spot price of the metal. A fall in the ratio back to a sustainable level around 20 or lower suggests we could see the price of Gold retreat back to $1500 (and perhaps even lower).

Picking a top in Gold when it’s moving in a parabolic nature like we have seen recently is a dangerous game (as I found out when suggesting we might be close to a top at US$1630 a few weeks ago, LINK), but moves such as this often end up in tears, they tend to correct just as viciously as they’ve moved higher. Those riding Silver’s move to $50 earlier this year would be familiar just how painful the correction following can be.

There is no doubt in my mind that Gold can and will go higher than current spot prices in the future, but it is currently well overbought on a technical basis and the Gold:Oil ratio suggests that the price cannot go much higher in a sustainable manner.

I would struggle with a recommendation to buy Gold at these levels (even though I think it’s going to head higher in the medium term). Now that we’ve seen what Gold is capable of in my opinion the old saying “buy the dips” should be on the fore front of our minds and given the parabolic spike we’ve seen over the past few weeks it could be one heck of a dip that we are about to encounter.

Expectations are increasing that Bernanke may hint further or even announce QE3 at the upcoming symposium in Jackson Hole. A decreasing oil price does make such an option more palatable (increasing commodity/food/oil prices caused by earlier QE programs are in part what triggered revolution in the Middle East), but it is my opinion that we will not have much more clarification on QE3 than was presented in the last FOMC statement (we have the tools and are prepared to use them as needed). My expectation is that the market will be unimpressed with this result and it could lead to the next leg down in the stock market (and it may also have a negative bearing on Gold/Silver prices). Of course I could be wrong.

I have eased back my positions in Gold stocks to around 30% of my capital (after I increased my exposure to 50% as per this post made a almost 2 weeks ago: Gold Stocks – Cheapest since early 2009) as they have lacked direction even with the price of Gold soaring. Should the market tumble again along with Gold then there is still the potential for the topping pattern to play out that I suggested a few days ago (HUI Forming Head & Shoulders Pattern?). The 20% of stocks that were sold was only at a slight profit. I still have positions in the companies that I think are fundamentally sound to ride out a correction in Gold and the markets if it comes.

It's important to remember that the properties that cause physical Gold to rise in price during these turbulent times (no credit risk/no one's liability) aren't necessarily shared by the Gold miner who pulls the metal of the ground. So while Gold miners are set to profit handsomely from a sustained increase in the price of Gold, there is no guarantee that they will rise in tandem with the metal itself and during turbulent times such as these are best held with caution.

The relationship of the Gold price with the miners is clearly reflected in the Barron's Gold Mining Index which continued to rise even after the price of Gold peaked (and fell significantly following) in January 1980. In fact some of the largest moves in Gold stocks occurred after the price peak in the spot price of Gold. Something to consider...


While the miners continue to trade at depressed levels and look cheap at these prices, there are just too many risks present to be "all in" at this time. I will be looking for opportunities to increase my positions again in Gold stocks once the volatility present in the market subsides or if Gold shows that it can sustain current prices and the stocks start to follow it up (a close on the HUI above 610 would be a good start).


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  1. Going of the chart posted one can see ratio of 35. That is GOLD @ 3000USD.
    Keeping in mind unprecedented moment we are in, ratio can be tracked far outside it's historical min/max markers say by factor of 2, is that reasonable?:)
    All above is pure fantasy, but so is history for measuring the limits of the current state of affairs while we live thru "one in the life time" event.

    I know nothing, do not take me seriously!
    simple @ simplesustainable :)

  2. @Val, it's true there is historical precedent for a ratio higher than 25, however I think a repeat of that is only likely to occur in the final parabolic finish to the current bull market (if it gets that high at all). We can dream!

    @Anon, I've tried looking for Brent oil data in the past and been unsuccessful finding an appropriate source. If you know of one (that goes back 40+ years) then please share!

  3. In examining ratios such as Gold/Oil (R1); or Pt/Au(R2); or Pt/Oil/Au(R3), I also examine rate of change of these ratios with respect to time----dR/dt as well as the second derivatives and, in addition, the products of these derivatives over a period of five or six years.

  4. I think the Gold / Oil ratio is now complicated by the spread between WTI and Brent. (this spread never used to be more than a few dollars, and WTI used to trade at a premium to Brent).

    Brent is now trading for a premium of approximately $22 over WTI (and has been for some time). Other than the U.S, Brent is a better benchmark for the price the world is paying for oil.

    If you use Brent as the figure you'll find the Gold Oil ratio is high, although not too bad. (as I write this Gold is $1879 and Brent is $108.65, making a ratio of 17.29).

    Even if you were to average WTI and Brent to take a middle ground, the ratio is 19.37, which again is higher than the long term average of 15, but not too bad.

  5. hungry_jono, you raise a reasonable point (re the spreads altering the ratio outcome dramatically between the two oil prices) and if I was able to source Brent data I would post that as well. However, the Gold price I am measuring oil against is in USD, so while Brent may be a better benchmark for global comparisons, I think the WTI/US$ Gold is probably the most appropriate in this situation (both US centric).

  6. Respectfully I disagree with you BB. Firstly because the price for Brent is denominated in USD in the same manner as WTI, and secondly because global demand for gold is now predominantly non-US centric.

    The reason this was never an issue in the past is that there was only really "one" gold to oil ratio that could be devised (because Brent and WTI, give or take one or two dollars, traded together). The spread between them is now dramatic (and has never existed to such a degree before).

    Hence, I think there is little predictive value in looking at the Gold / WTI ratio in isolation.

  7. Global demand for Gold is only part of the US price though. The price in US$ is also reflective of a devaluing US Dollar.

    Probably the fairest way to get an accurate Gold/Oil ratio would be to create an index of Gold priced in multiple major currencies (averaged) and then compare it to Brent/WTI averaged as well.

    Maybe next time :)