 Gold/Oil Ratio
Extremes
Adam Hamilton
Archives
Aug 21, 2004
With crude oil relentlessly marching towards $50 this summer,
market commentary is utterly dominated by the potential implications
of this major oil upleg. In fact it is rather amusing to see
practically every single negative development in every
major market blamed on oil, the new universal scapegoat for Wall
Street.
What a convenient excuse too!
While the stock markets remain overvalued
in a Great Bear following a supercycle bubble and therefore almost
certain to grind lower until their ultimate secular
undervalued bottom, conventional investors can continue to
blissfully ignore all these timeless truths thanks to oil. If
the markets were to plunge from here, I am certain that oil,
and not rampant overvaluations, would be assigned the blame.
But while conventional investors
blame oil for all of their bad trades rather than their own folly
in buying grossly overvalued stocks during a supercycle bust,
contrarians can celebrate this new
commodities bull. Indeed there are positive relationships
between oil and other commodities that forecast vast profits
ahead for those willing to heed them. The tight relationship
between oil and gold is the primary example.
It is fascinating to realize
that the Ancient Metal of Kings, gold, has a very strong positive
correlation with the King of Commodities, oil, throughout modern
history. When oil is strong, gold tends to be strong as well.
In fact, the prices of these two commodities are so intertwined
over the long term that they seem almost incapable of heading
in separate directions over longer strategic timeframes.
This week I would like to consider
the powerful gold and oil interrelationship over the past four
decades or so. The implications of our present major oil upleg
for gold investors and speculators are enormous and the coming
precious-metals profits will be vast if these commodities' rock-solid
historical relationship holds.
Instead of resigning to the
self-defeating Wall Street strategy of lamenting and whining
about oil rising on global demand growth outstripping global
supply growth, why not just accept this as the new reality?
And if the States, Asia, and Europe are unlikely to quit guzzling
oil soon, if ever, then why not deploy our capital so we can
ride these new strategic trends to great profits? Regardless
of if we personally like rising oil or not, we must adapt
to new market realities to be successful in multiplying our capital.
Understanding the gold/oil
ratio is one key way to realize why rising oil is not damaging
to all markets. While higher oil prices do tend to slow
down the economy as a whole and reduce disposable income for
most Americans, which certainly does eventually adversely
affect the stock markets, gold shines brilliantly during these
very times. The gold/oil ratio helps quantify this relationship
for analysis. It is simply computed by dividing the gold price
by the oil price.
Our trio of graphs this week
are updates from my earlier "Gold
Boiling in Oil" series of essays. This line of research
is battle tested over time and has already helped us lead our
subscribers
to huge profits in gold-related investments and speculations
in the past four years.
When my original
essay advancing these arguments was published over four years
ago in June 2000, oil was trading near $32 and gold around $292.
Since then gold has run up nearly 47% while unhedged gold stocks
(HUI index) have screamed 340% higher! It definitely leads to
big wins to pay attention to the gold/oil ratio and trade
accordingly rather than fretting about higher oil prices.
And, truly, in real inflation-adjusted
terms oil prices are not even that high yet in the grand scheme
of things. Our first chart uses the latest US CPI inflation numbers
just released this week to show the real prices of gold and oil
in today's 2004 dollars over the past four decades. All of this
talk of new record highs in oil in the news every night, while
technically true in nominal terms, is extremely misleading.
Comparing the prices of anything
over the long term without considering changes in purchasing
power due to the Fed's relentless printing-press inflation is
like comparing apples to oranges. $45 oil may seem high today
to an average American who hasn't studied market history, but
as this real chart shows it is really nothing to get excited
about. Oil was higher than today's levels for over half a
decade in the late 1970s and early 1980s and the world didn't
implode into the dark ages.
Want high oil prices? Try the
staggering $93 per barrel achieved in April 1980 at the top of
the last oil bubble! We are barely even halfway to those stellar
extremes today! As a matter of fact, the average real
oil price since 1980 has run nearly $37 in 2004 dollars. Thus
today we are not even that much higher than average yet around
$45. Perspective is everything in the markets, and ignoring inflation
in multi-decade price comparisons assures a dangerously skewed
view of reality.
Why is considering inflation
essential? Imagine having a $20k income in 1980 when a hamburger
cost $1. Assuming you really liked hamburgers, you had enough
buying power to consume up to 20,000 of them per year. Fast forward
to 2004 and assume you are earning $200k in today's dollars.
If you think back to 1980 and earning only 20k you probably feel
very blessed today. Your 10x gain in income does sound
good on paper, but if a decent hamburger runs $10 today then
you still only earn enough to purchase 20,000 hamburgers per
year. It's a monetary wash and you are no better or worse off!
Your nominal income
went up greatly, the nominal hamburger price also soared,
but in real terms of what your income can buy nothing
actually happened. In this simplified example, all that really
transpired is the Fed increased the money in circulation by 10x,
hence both incomes and prices went up by 10x while real purchasing
power remained constant.
The price of hamburgers, oil,
gold, or anything is only relevant over long spans of time in
inflation-adjusted constant-purchasing-power terms. Around $45
in today's dollars, oil is only half as expensive as it was to
Americans in 1980 based on our income levels then. True new all-time
oil highs will not be achieved until oil exceeds $93, and this
number is constantly rising as long as the Fed incessantly runs
its printing presses.
Based on this chart, oil doesn't
even start to get interesting until it breaks $50. And I would
probably not consider oil prices to be on the high end of things
personally unless it gets above $60. The next time some Wall
Street commentator moans about today's "all-time high oil
prices", realize he is either naïve and has not studied
market history, or he is trying to mislead you by intentionally
ignoring inflation, or he is outright lying to deflect your attention
away from the real issues plaguing today's stock markets like
excessive valuations.
The long-term chart above is
also very valuable to help visualize just how closely gold and
oil prices tend to correlate over strategic time frames.
If you look at major secular trends measured in years, gold and
oil pretty much move in lockstep. Yes, they deviate tactically
over shorter periods of time as their respective supply-and-demand
influences dictate, but over the long run they travel the same
path. Their prices tend to oscillate around each other and periodically
cross on this chart.
Over the entire four-decade
span of time charted on this graph, these monthly gold and oil
prices have a correlation coefficient of 0.835 and an R-Square
value of 69.7%. These are very impressive numbers over
such a long period of time and really drive home just how closely
gold and oil are intertwined.
If you focus your attention
on the far right side of this graph, however, a glaring anomaly
becomes instantly apparent. Since oil bottomed near $11 in December
1998 ($13 in 2004 dollars) it has surged up dramatically in several
subsequent uplegs achieving a mammoth 312% bull-to-date gain
as of this week. But over the same period of time gold has lagged
dramatically, only rallying by 39% or so in nominal terms. So
far the gold price has not been able to even attempt to retain
parity with oil in recent years.
Now the only other similar
time in history when oil was strong and gold lagged was in the
late 1970s. As this chart reveals, for years gold lagged oil
but when it finally did decide to catch up it powered higher
with a vengeance. I believe we are being set up for a similar
scenario today, where crude oil blasts higher while gold gets
off to a slow start initially. But eventually investors will
realize that gold is radically undervalued relative to crude
oil and they will bid up the gold price dramatically in the coming
years.
The gold/oil ratio is the perfect
tool to help precisely quantify the degree to which gold leads
or lags crude oil. As I discussed regarding the gold/silver ratio
in the current issue of our monthly Zeal
Intelligence newsletter for our subscribers,
any ratio ultimately describes the relative overvaluation or
undervaluation of one commodity as expressed in another.
When the gold/oil ratio is
high, it means that gold is overvalued relative to crude
oil, either that gold is getting too expensive or oil is getting
too cheap. When the gold/oil ratio is low, as today, it means
that gold is undervalued relative to crude oil. Either
oil is getting too expensive or gold is getting too cheap. For
a variety of reasons discussed below, I believe that the latter
statement is most true today, that gold is just too cheap.
As the latest graph of the
gold/oil ratio reveals, this key ratio is currently at its third
lowest extreme in history! The red numbers marking each low correspond
with the first graph above.
One of the most fascinating
attributes of long-term ratio analysis is the elegance with which
it integrates two foundational market principles. First, all
markets abhor extremes. Nothing stays chronically overvalued
or chronically undervalued for long. Just ask the NASDAQ refugees
from their 2000 crash! Second, a direct corollary to the first
principle, over time all valuations revert back to their means,
or averages.
When investors identify unsustainable
extremes and harness their capital to ride the inevitable mean
reversions, it is one of the surest-fire and least risky ways
possible to earn massive profits. My entire Long
Valuation Wave thesis on the general stock markets is based
on this very idea, as are many other successful investment and
speculation theories.
In terms of the gold/oil ratio,
today gold is the third cheapest that it has ever been
relative to oil in our modern age! At one ounce of gold only
being worth 8.7 barrels of oil today, only the 8.2 barrels in
September 1976 and 8.1 barrels in November 2000 have been lower.
In addition to these three all-time extremes, there have been
three other slightly lesser extremes in this gold/oil ratio which
are noted in the graph above.
Now if you examine all five
of the past four decades' extreme lows in the gold/oil ratio
(GOR), there are a couple rather striking attributes that they
all share. First, because the markets abhor extremes, the GOR
doesn't linger for long once it hits an extreme high or low.
Second, because markets always mean revert, each of these extremes
is always followed by a mean reversion. Either oil plunges or
gold soars or both to bring the GOR back into line.
This chart highlights the four-decade
GOR average line in white, which happens to be at the level where
an ounce of gold will buy 15.4 barrels of oil. In addition, we
drew in standard-deviation
lines to help judge the degree of extremes. By definition,
68.3% of the data points are within one standard deviation of
the mean, 95.4% are within two standard deviations, and a whopping
99.7% are within three standard deviations. The farther out that
a particular GOR extreme is from the mean, the rarer it is statistically.
Now please consider the past
five extreme GOR lows before today's. Using the standard-deviation
and average bars drawn in above we can roughly quantify the degree
of mean reversion, and often overshooting, after each extreme
low. For example, after September 1976's extreme GOR low of 8.2
the GOR ratio quickly mean reverted and overshot to +1 standard
deviation. Since it traveled from approximately -1 SD to +1 SD,
we can say it moved 2 standard deviations in rough eyeball terms.
The actual precise number from the raw data is 2.5 standard deviations.
The second GOR extreme, June
1982's 9.0, ended up mean reverting about 1.6 standard deviations
back up to its average. The third, November 1985's 10.6, blasted
from -1 to +3 or through an amazing 3.9 standard-deviation bands.
Four and five weighed in at 3.2 standard deviations and 1.3 standard
deviations respectively. If we average these mean reversions
we get a typical expected surge higher of 2.5 standard deviations
after an extreme GOR low.
The standard deviation of the
gold/oil ratio is running right at 5.0. If today's GOR follows
historical precedent and mean reverts back up 2.5 standard deviations,
we are talking about a 12.5 addition to today's extremely low
GOR. Thus, a potential target gold/oil ratio in the next inevitable
mean reversion is 8.7 plus 12.5, or 21.2. And as you can see
above, a 21.2 GOR is barely above +1 standard deviations so it
is not a rare event by any stretch of the imagination and is
actually quite probable.
What does all this mean? Don't
let the necessary statistical mumbo jumbo cause your mind to
zone out, because the implications to gold investors are profound
and potentially enormously profitable. If today's extreme GOR
low around 8.7 catapults up to 21.2 in the years ahead, which
is merely an average mean reversion, what will this portend for
the price of gold?
We should consider this in
three scenarios, oil rises, oil falls, or oil flatlines. I personally
believe oil is going to rise significantly over the long-term,
but in fairness all three scenarios should be considered.
While oil may be overbought
short-term, I believe it is in a long-term
bull market. On the supply side major new oil deposits are
getting harder and harder to find. Unfortunately it appears that
the world as a whole is reaching its Hubbert
Peak of production, the peak-production level at which existing
fields will never yield greater numbers of barrels per day and
will actually start declining as they are depleted. Some major
oil companies have been restating their reserves downwards and
none of the majors are succeeding in growing supplies fast. Even
the mighty OPEC claims it is running near capacity!
On the demand end as we Americans
know better than anyone else, once one experiences a first-world
oil-rich lifestyle it is almost impossible to go back. Billions
of people in China and India alone, let alone the rest of Asia
and former Soviet-block European countries, are finally getting
their first tastes of an oil-driven first-world civilization.
They are unlikely to suddenly stop driving cars, transporting
goods, or moving people. On the contrary, their per capita oil
demand should ramp up vastly and eventually start approaching
American levels.
With global demand growth far
outstripping global supply growth, oil could rise for a decade
or more until some wild new technology manages to displace it
as prices get too high. Let's be really conservative and assume
a $60 per barrel average price in the coming years if this scenario
plays out. A gold/oil ratio mean reversion to only 21.2, not
even extreme on the upside, would yield a target gold price of
$1272! That is up 215% from today's levels.
Now the Wall Street scenario
of choice today is that oil is chronically overvalued and falls
dramatically. Perhaps massive new Siberian deposits are found
and come online, or spectacular new deep-water drilling technology
is developed. And maybe the economies of China and India slow
down so oil demand growth in Asia abates. Let's assume oil falls
all the way down to $30 in this scenario, a price which I suspect
is ridiculously low given today's immensely bullish supply and
demand fundamentals for crude.
At $30 oil and a 21.2 gold/oil
ratio mean reversion, we are still looking at $636 gold.
This is 57% higher than today's levels. Thus, even in a near
doomsday scenario where oil prices plunge to $30, the current
GOR extreme is so obnoxious on the low side that gold will have
to surge higher anyway to bring this ratio back into line.
Talk about a good speculation!
A final scenario is oil flatlines
near $45 in the coming years, neither rocketing towards $60 and
beyond nor plummeting to $30. At a GOR of 21.2, $45 oil means
$954 gold, or a massive 136% gain from here.
Isn't this exciting from a
contrarian perspective friends? The gold/oil ratio is so extraordinarily
low today that gold prices will have to go much higher
when this ratio inevitably mean reverts even if oil falls dramatically.
And you can play with these numbers as much as you want, including
reducing the expected mean reversion, and it is still very bullish
for gold no matter what happens to oil prices in the years
ahead.
This is why betting with
a mean reversion near a historical extreme is such a high-probability-for-success
trade. By all historical standards gold is just far too undervalued
today relative to oil, but the markets abhor extremes and they
will mean revert to correct this one sooner or later here.
If you are long leveraged gold investments and speculations like
quality unhedged gold stocks when this happens, you will probably
earn a fortune.
Our final graph presents this
gold/oil ratio from a different perspective called the gold cost
of crude oil. It tells us how many ounces of gold it takes to
buy 100 barrels of oil at any given time in modern history. At
the four-decade average of 7.1, for example, it means that a
buyer would have to sell 7.1 ounces of gold to raise the cash
necessary to buy 100 barrels of crude. This alternative view
of the GOR offers additional insights.
Not surprisingly as a gold/oil
ratio derivative, the gold cost of crude oil is also at its third
most extreme level in modern history. At 11.5 ounces of gold
for 100 barrels today, only September 1976's 12.2 and November
2000's 12.4 are greater. And if you look at the five previous
extreme gold-cost-of-crude-oil spikes, they all reverted
rapidly back to or through the mean without exception. Odds are
today's extreme will follow suit.
So let's assume that today's
gold cost of crude oil (GCCO) mean reverts from 11.5 back merely
to its average of 7.1, a very conservative assumption since four
of the five previous GCCO extreme highs reverted well below the
mean. What would this portend for the price of gold in our three
different oil scenarios discussed above?
At secular-bull $60 oil, 100
barrels of crude would be worth $6000. If it takes 7.1 ounces
of gold to buy this shipment of oil, then the gold price would
be $845, or 109% higher than today's levels. At flatlined $45
oil, this 7.1 GCCO yields a gold price of $634, 57% higher than
current levels. And at doomsday $30 oil, we are looking at $423
gold which is still a modest 5% above today's status quo.
This third most outrageous
gold/oil ratio extreme in history that we see today is so fascinating
and so important because its inevitable mean reversion virtually
guarantees a major rise in the price of gold from current
levels. By modeling merely average to below average mean reversions
and oil prices ranging from 33% higher to 33% lower than today's,
we saw a range of potential gold gains running from 5% on the
extreme low end to 215% on the high end.
Since the current gold/oil
ratio extreme seems to be telling us that a continuing gold bull
is inevitable, it makes great sense to invest and speculate in
gold-related plays. My long-time favorite leveraged gold investments
and speculations are quality unhedged gold stocks, which greatly
leverage the underlying gains in gold.
For example, bull market to
date in gold, the HUI unhedged gold-stock index has leveraged
the Ancient Metal of Kings by 6.2x on average during each major
upleg. So if gold runs up 5% to 215% higher as the gold/oil ratio
mean reverts in the coming years, the best gold stocks could
see gains running from 31% in an oil doomsday scenario to 1333%
or higher during a continuing oil bull market. That's a heck
of a lot of potential upside in my book with very minimal downside
risk!
If you don't want to put in
the long years of research time necessary to uncover the great
gold opportunities yourself, please consider subscribing
to our acclaimed monthly Zeal
Intelligence newsletter. My partners and I analyze and monitor
these incredible gold and silver opportunities every month and
recommend new trades as appropriate. We are currently trading
elite gold and silver stocks, highly-leveraged gold-stock
options, and are always looking for new ways to profitably
ride this ongoing gold
bull.
The bottom line is today's
incredibly low gold/oil ratio extreme is absolutely unsustainable
in light of historic precedent. The markets abhor extremes and
always mean revert away from these extremes. Riding these
inevitable mean reversions is one of the most profitable and
least risky strategies possible for investors and speculators.
And since gold is so ridiculously
undervalued relative to oil today, it really doesn't matter where
oil goes. 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.
Rather than whining about the
oil upleg like the myopic Wall Street shills, why not ride this
coming gold/oil ratio mean reversion up to potentially legendary
profits in your own portfolio? Put the oil bull to work for
you!
August 20, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
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