Gold/Oil Ratio Extremes

By: Adam Hamilton | Fri, Aug 20, 2004
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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 naive 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!


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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