Revisit of the Tight-bound Relationship Between Gold and Oil

By: John Lee | Fri, Dec 19, 2008
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As I toured around the world to talk about the merits of gold during the last several years, the same question was posed to me over and over again

"John, oil is $80, $100, $150 a barrel, why hasn't gold lived up to its reputation as a hedge against inflation?"

Oil's triumph over gold from 2001 - mid 2008

While gold investors faired well as gold went from $250/oz in 2001 to $1,000/oz in early 2008, oil investors reaped stupendous profits as oil price topped $145/barrel in July 2008, up from $22/barrel in 2002.

Ten year charts of gold and oil

People have attributed oil's superior rise, and the relative underperformance of gold to

1. Peak oil theory
2. Emerging market needing oil, not gold
3. Oil is consumed and gone, while there are lots of gold
4. Jewelry market favoring platinum, not gold anymore
5. Central banks having lots of gold to sell

And my answers have always been

  1. Oil production has been rising yearly from 60million barrels a day in 1980 to now over 80 million barrels a day
  2. Gold is about preservation of global wealth, which is ever increasing.
  3. Gold is money, which is to be saved, not consumed
  4. Jewelry demand represents a tiny fraction of gold's trading or gold's total volume, most of it in bullion form.
  5. True, but central banks today have also inordinately large amount of US dollars (over $8 trillion), yet to be diversified.

So why was gold lagging until recently? My single most plausible answer was

"People are buying the growth story. Speculators like oil, not gold at the moment."

Financial deleveraging and gold's resurgence in 2008

The fortunes of gold and oil have reversed 180 since July, when we witnessed the most speculator fall in oil's history in the last 100 years. Oil price plunged over $110, or 75% from $147 to $37 a barrel. You can't possibly explain away such dramatic correction by fundamentals. So what if super tankers are storing oil and world oil inventory now can sustain 59 days instead of 54 days of global consumption. Would you see the price of milk go down 75% because people are cutting back consumption?

In my view, the freefall of oil price has more to do with the collapse of Lehman Brothers, US banking, and US hedge fund industries. Many of those outfits are leveraged up to 30 times, bankrupt, and had to close out entire line of positions (including oil) in a hurry at any cost.

We can also see the rapid and all-out deleveraging through the reversal of yen carry trade. The yen has gone up 24% since August not because Japan all of a sudden became a star investment destination.

12month yen chart

Where is gold headed?

Adjusted for inflation/CPI/money supply growth, various analysts have pegged a fair gold price of between $700/oz and $1,200/oz. Gold authority James Turk will show you how gold has exchanged more or less the same units of oil through hundreds of years.

20 year chart of gold to oil ratio

The lower and upper horizontal bands in the chart above show an oz of gold has exchanged between 22 and 10 barrels of oil since 1989. The ratio dipped to as low as 7 and right now it trades at 20. One shouldn't buck against the trend and I expect the ratio to exceed 20 to reach perhaps 30 or more.

You can play with two of the three variables (oil, gold, and ratio) and come up with the third. For example, at ratio of 30 and oil price of $50/barrel, the formula produces a gold price of $1,500/oz. I honestly have no idea what future lies, except

  1. Oil is oversold and cheap
  2. Gold is not expensive by historic means
  3. The gold-to-oil ratio will keep rising until it comes down.

Fundamentally gold is attractive as investment of last resort. It's no good to leave money at the banks earning zero interest, or buy real estate that is faltering, or invest in equity market during recession.

While gold's blow-off phase is yet to come, I like to offer a word of caution. Given how quickly things can change, it might soon be a good idea to hedge gold position by longing oil.

Enjoy the ride and happy holidays from all of us at Mau Capital.

 


 

John Lee

Author: John Lee

John Lee, CFA
Executive Chairman,
Prophecy Development Corp.

JohnLee, CFA is an accredited investor with over 2 decades of investing experience in metals and mining equities. Mr. Lee joined Prophecy Development Corp (www.prophecydev.com) in 2009 as the Company's Chairman. Under John Lee's leadership, Prophecy raised over $100 million through Toronto Stock Exchange and acquired a portfolio of silver assets in Bolivia, coal assets in Mongolia, and a Titanium project in Canada. John Lee is a Rice University graduate with degrees in economics and engineering.

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