 Gold/Oil Ratio
Extremes 2
Adam Hamilton
Archives
April 4, 2005
The financial markets are endlessly fascinating to study, but
it is really not very often that we are blessed to witness extremes
never before seen in history. Given markets' well-documented
abhorrence of extremes and their ironclad tendencies to mean
revert, extremes usually mark stellar trading opportunities.
In late March the venerable
gold/oil ratio hit an all-time low, an abysmal 7.7. The
math behind this revelation is simple, it just means that an
ounce of gold now costs only 7.7x as much as a barrel of crude
oil, each priced in dollars. From a speculation perspective however,
this never-before-witnessed extreme has profound implications.
Oil and gold are arguably the
most important commodities on the planet today and the ratio
of their nominal prices is far from a trivial issue. The gold/oil
ratio expresses the interrelationship between the commodity that
forms the foundation of our entire global economy and the commodity
that has been the ultimate form of money for six millennia of
human history.
Oil, of course, forms the foundation
of the extensive global trade today and hence the world economy.
Virtually everything we consume in the first world is transported
via oil-powered ships, trains, airplanes, or trucks. Without
oil, the incredibly intricate global logistics network on which
we heavily rely today would grind to a halt. The world would
be thrust back into the Steam Age before flight and global trade
would implode. In this oil-powered young Information Age, oil
truly is the king of commodities.
And gold always has been and
always will be the ultimate monetary standard. Empires and nation
states rise and fall, and history is littered with once mighty
fiat currencies that became worthless as their sponsoring governments
slid out of favor. But gold is the standard by which all other
currencies are judged, the only real money of world history.
It is highly sought after universally, it is very scarce in the
natural world so its supply can't inflate rapidly, and it is
very valuable relative to the tiny volume it occupies ... the
perfect money.
The gold/oil ratio is such
a crucial measure because it expresses the entire complex interrelationship
between the king of commodities and the only timeless real money
in a single data series. This ratio allows us to discern when
gold or oil prices are probably out of whack and hence a mean
reversion is highly likely. If we can figure out which component
of this ratio is most likely to lead this mean reversion, gold
or oil, then we can position trades to ride the move.
I first wrote about this ratio
nearly five
years ago, before our secular
gold bull was born. The conclusion I reached back then was
that since the gold/oil ratio was so low (9.2) a mean reversion
was probable led by the gold side of the equation. Gold was trading
near $290 at the time and the gold/oil ratio proved correct in
calling gold undervalued.
By last summer the ratio was
again running 8.7, even lower, and gold was just clawing back
over $400 following a healthy
correction. In my original
essay in this series I concluded, "Whether oil soars
or slumps, a gold/oil ratio mean reversion is going to push gold
higher, probably a whole heck of a lot higher, in the years ahead."
Now, seven months later, the gold/oil ratio has grown even more
extreme at 7.7.
As a student of the markets
I have studied mean
reversions extensively, and one of their most intriguing
aspects is the peculiar psychology they generate. In the physical
world, the farther something is stretched the more likely it
will fail and everyone intuitively knows this. But in the investment
world, however, the popular perception is that the farther something
is stretched the more likely that it will continue stretching
even further, happily on into infinity.
If you stretch a rubber band
between your hands, and pull them apart from an inch to a foot,
does this successful initial stretch make it more or less likely
that the rubber band can continue stretching to three feet?
The obvious answer is less likely, as the greater an extreme
placed on a mechanical system the more likely it is going to
catastrophically fail and mean revert to relieve the excessive
energy.
Contrary to popular perception
the markets work the same way. The more extreme something
gets, like the NASDAQ bubble of early 2000, the more likely it
is to fail catastrophically as prices mean revert back to historical norms.
But investor psychology is based on inertia, not logic. People
perceive that the greater a market extreme grows the more likely
it is to persist forever. They foolishly believe that each new
extreme marks a brave "New Era" where historical laws
of finance no longer apply.
In the case of the gold/oil
ratio, similar inertia-based assumptions are gaining ground today.
They are usually directed at the gold side, since global gold
supply and demand is far more murky and difficult to analyze
than the global oil supply and demand. Lots of investors today,
for reasons running the gamut from government conspiracy theories
to deflation scares, are advancing the view that the gold bull
is over regardless of the state of the oil bull. In other
words, a permanent new era of extremely low gold/oil ratios is
miraculously upon us!
Is this time really different?
Can the oil bull continue migrating higher in the years ahead
while gold languishes driving the gold/oil ratio to new lows?
I doubt it. Rock-solid historical relationships established over
40 years between gold and oil will not be easily broken.
And market history is crystal clear in teaching that investors
would be better off believing in tooth fairies than the idea
of fanciful New Eras exempt from the venerable laws of finance.
Before we dive directly into
the gold/oil ratio analysis to investigate the probable mean
reversion, I would like to briefly discuss this chart of real
inflation-adjusted oil and gold prices. It is a fascinating chart
we have been watching for over five years now and is absolutely
crucial foundational background for understanding the gold/oil
ratio.
I find this chart endlessly
fascinating on multiple fronts. Perhaps the most obvious is the
fact that oil is just mid-priced and gold is very cheap when
the relentless erosion of the US dollar's purchasing power via
the Fed's endless fiat inflation is factored in. In order to
get to new all-time real highs, oil would have to catapult
north of $95 per barrel and gold would shoot well over $1600.
Neither oil nor gold should
be considered expensive today in light of history, regardless
of Wall Street's incessant anti-commodity propaganda. Oil is
just above its First Gulf War spike but still well below
its high real levels from 1980 to 1985 or so. Meanwhile gold
is so darned low in real terms that it hasn't even returned to
mid-1990s levels yet! The folks who claim gold is
expensive apparently don't understand inflation.
Second, note the incredible
correlation between gold and oil prices in the last four decades.
While they don't always move in lockstep over the short term,
they always seem to ultimately walk hand and hand over the long
term. And, since both the oil and gold axes are zeroed in this
monthly chart, the percentage moves in gold and oil are very
similar. This strong dance between oil and gold is what makes
the gold/oil ratio so valuable.
Now since their respective
real secular monthly bottoms, $13 for oil in December
1998 and $284 for gold in March 2001, there has been a massive
disconnect. The oil price has rocketed 312% higher in real terms
while gold is only up a fraction of this, 49% real. Gold's recent
lagging is very apparent visually as well, if you compare the
slope of gold and oil since 2000 or so. This anomaly has created
the new all-time lows in the gold/oil ratio.
By definition an anomaly is
a deviation from a normal condition, and it is usually temporary
in duration. Gold and oil do tend to disconnect on occasion.
For example, from 1975 to 1980 oil gradually meandered higher
while gold initially fell sharply, throwing the gold/oil ratio
out of whack to its third lowest level ever, 8.2. Yet, this temporary
anomaly did not herald the end of the gold/oil ratio. Soon gold
started rallying with oil and caught up with the black goo with
a vengeance by 1980.
Today we may very well witness
a repeat of history, of oil driven higher by strong global supply
and demand forces while the gold price initially languishes.
But once investors around the world start to perceive the stunning
opportunities for a mean reversion here, capital will flood into
gold and blast it higher to catch up with oil. Once this current
gold/oil ratio anomaly is resolved, I suspect gold investors
will be very happy campers.
Our next chart outlines the
fabled gold/oil ratio itself. The red numbers marking all of
the major interim lows in the ratio for the past four decades
correspond with the red numbers in the real oil and gold chart
above. They are included so it is easier to see what gold and
oil happened to be doing at each previous extreme similar to
today's. It is amazing to now see the gold/oil ratio at
its lowest levels ever.
With an ounce of gold trading
at only 7.7x the cost of a barrel of oil, we have never before
seen the gold/oil ratio this far out of whack. In each of the
five previous cases that major interim gold/oil ratio (GOR) lows
were carved, the ratio immediately mean reverted back away from
those extremes. At worst the GOR mean reverted back up near its
average, and at best it mean reverted far beyond and overshot
to extremes on the other side, like a giant pendulum.
To better define GOR extremes,
we overlaid this chart with the ratio's four-decade average of
15.3 as well as standard deviation bands. They help us visually
see exactly how rare a particular GOR happens to be. Statistically
the GOR should be within +/-1 standard deviation from its average
68.3% of the time, 2 SDs 95.4% of the time, and 3 SDs a whopping
99.7% of the time.
At roughly 1.5 SDs below its
mean today, the GOR has never been lower. Odds are it is due
to mean revert back up, probably in a fairly rapid fashion if
history is a valid guide. The ratio almost certainly will head
back up to its mean of 15.3, but it could move higher as well,
to 20.3 at the first standard deviation or even 25.3 at the second.
Regardless of how far this mean reversion runs, it will
happen sooner or later as it is extraordinarily unlikely that
today's extreme GOR low can persist indefinitely.
In order for the GOR to mean
revert, either the price of gold has to rise, the price of oil
has to fall, or both at once. The most conservative case for
the coming mean reversion is probably to assume both at once.
Our original real oil and gold chart above shows why. Oil's rise
has been nearly vertical as of late, so sooner or later a healthy correction
is inevitable in this secular oil bull. Meanwhile gold has only
reached real levels last seen in 1997 or so, thus it really ought
to get moving to catch up with oil.
As far as the oil-correcting
component of the GOR mean reversion, oil will probably bottom
somewhere between its linear
support line and its key 200-day moving average. Oil's 200dma
is currently just above $46 and its linear support is approaching
$38. We can split the difference and make a $42 target for the
next major interim low in crude oil.
Interestingly, fundamentals
back up this target as well. Last week the CEO of the massive
Kuwait Petroleum Corporation, Hani Hussein, told Gulf News out
of Abu Dhabi that, "Prices will never [again] go under the
$40 per barrel mark." The usual reasons were cited,
massive new crude-oil demand out of the rapidly industrializing
Asian giants including China and India. So even supply and demand
fundamentals as seen by elite OPEC insiders bear out a $40ish
worst-case scenario in the next oil correction.
So if $40 is indeed a floor
for oil going forward as OPEC suspects, this gives us a potential
idea of where gold would have to climb to in order for the GOR
to mean revert as it ought to. If crude oil fell to $40 and the
GOR merely mean reverted right back to its 15.3 four-decade average,
gold would need to rally up to $612 to make this happen. If the
GOR overshot its mean reversion as it often does and went to
the 20.3 +1 SD level, gold prices would rocket up to $812 or
so!
Thus, even if oil corrects
dramatically and stays near $40 for some time to come, gold prices
would have to rise far higher from here to even see a
modest mean reversion or a common overshoot to one standard deviation
above the long-term GOR mean. Obviously you can make these numbers
a lot more aggressive if you choose a higher oil price or a greater
mean reversion overshoot, but even in the most modest scenario
gold ought to absolutely thrive in the coming years.
Just as a rubber band stretched
near its breaking point can't continue stretching forever, neither
can the gold/oil ratio. Over the past 30 years the GOR ratio
has always mean reverted sharply, often due to a major
gold rally, shortly after it hit a major interim low. With today's
all-time low GOR extreme of 7.7, odds are we are in for another
major mean reversion in the GOR which could move rapidly as the
past ones have. If you want to game this possibility buy physical
gold, deploy long gold futures, or buy quality unhedged gold-producing
stocks.
Another way to measure the
relationship between gold and oil is to consider the gold cost
of crude oil, or GCCO. Expressed by the number of ounces of gold
it takes to buy 100 barrels of oil, it shows the relative value
of oil in terms of real money, gold. Considered in this alternative
light, oil is now the most expensive it has ever been
in gold terms! Like the extreme GOR low, this extreme GCCO
high is probably not sustainable either.
At 12.9 ounces per 100 barrels,
the gold cost of crude oil is now at its highest levels in
history. The four-decade average is only 7.2, and the GCCO
is now just shy of being three standard deviations above the
mean, truly extraordinary territory. Note above that in each
of the five previous cases that the GCCO hit extreme highs it
promptly fell like a rock and mean reverted with a vengeance.
If we assume that the $40 per
barrel minimum for oil will hold for technical and fundamental
reasons, we can also model just how high gold would have to climb
in order for the GCCO to mean revert in line with historical
precedent.
At $40, 100 barrels of oil
would cost $4000. If the GCCO mean reverts back down to its long-term
average of 7.2x as it has at least done after every other
extreme high in history, then gold would need to march up to
$556. If the GCCO overshoots down to one standard deviation below
its mean, like it often does, then the GCCO would hit 5.1. At
$40 oil gold would have to rally up to $784 to bring the gold
cost of crude oil back into line in this latter scenario.
Once again you can play with
the numbers if you like. If oil does correct down near $40, for
example, it is not likely to stay there for long given the rapidly
growing world demand and the incredible difficulties involved
in finding and bringing new supplies online. After a few months
of correcting, oil would probably bounce back strongly and trade
above $50. And $60 and beyond will certainly be seen in oil's
next major bull-market
upleg.
At $50 oil, a gold/oil ratio
merely hitting its four-decade mean of 15.3 would yield a gold
target of $765. In this same $50 scenario the gold cost of crude
oil gold target at its 7.2 mean would be $694. And of course
the higher oil ultimately goes in its powerful secular bull,
the higher the potential gold targets rise. Regardless of what
numbers you plug into these equations, gold looks tremendously
undervalued by every single measure.
The bottom line is the financial
markets abhor extremes. The more extreme that a long-term
historic relationship becomes, the higher the probability that
it will experience a sharp reversion back to or through its mean.
Ignoring this tendency in the gold/oil ratio is as silly as the
tech investors who foolishly thought that tech stocks could go
up forever in early 2000 regardless of earnings. The inevitable
mean reversions eviscerate those who scoff at history and believe
in New Eras.
In the past five years the
gold bull has lagged the oil bull dramatically. Oil demand is
growing rapidly around the world and especially in Asia as half
the planet industrializes and lusts after a first-world lifestyle.
Meanwhile no new major oilfields can be found and it is getting
more and more expensive to maintain production levels from existing
major fields. With relentlessly growing demand and hopelessly
tight supplies, oil's secular bull is almost certain to power
higher for years.
As oil marches higher, gold
will inevitably follow sooner or later as it always has. Indeed,
once investors "discover" the huge potential of gold
and vault it into Stage
Two of its secular bull, gold will surge and outperform oil
long enough to bring these key ratios back into line. Regardless
if oil corrects, flatlines, or continues higher, the target gold
levels necessary for these ratios to mean revert are far higher
than today's cheap gold prices.
If you want to ride this highly
probable gold/oil ratio mean reversion, the best way to do it
is to get long gold somehow. You can buy physical
gold coins if you are really conservative. You can buy gold
futures if you are a speculator trafficking in that world. You
can also leverage the gold surge indirectly by buying shares
of elite quality unhedged gold-mining
companies, a very profitable strategy we have been using
at Zeal for the entire gold bull now.
Our acclaimed Zeal
Intelligence monthly newsletter outlines our ongoing gold
bull strategy as well as actual real-world gold-stock trading
recommendations when appropriate. If the gold/oil ratio indeed
mean reverts as history suggests it ought to, we will be blessed
with some fantastic gains in our gold-stock portfolio. Please
join us today to capitalize on this dazzling and rare opportunity
to ride a gold/oil ratio mean reversion.
With the gold/oil ratio at
an all-time low and the gold cost of crude oil at an all-time
high, conditions have never been riper for a powerful mean
reversion. And as tight as global oil supply and demand fundamentals
are, the only practical way this mean reversion can be executed
is via a massive new gold upleg.
Adam Hamilton, CPA
April 1, 2005
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
Copyright©2000-2024 Zeal Research All Rights Reserved.
321gold Inc
|
