Gold/Oil Ratio Extremes 2

By: Adam Hamilton | Fri, Apr 1, 2005
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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

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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