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Gold/Oil Ratio Extremes 3

Adam Hamilton
August 20th, 2005

Crude oil has been soaring this year, as irate commuters all over America are lamenting. Since January it has blasted from $42 to $67 per barrel for a massive 60% year-to-date gain. 2005 has already proven to be the most fascinating episode in the oil markets in a quarter century, truly remarkable.

While I understand why rising gasoline prices irritate folks, as an investor I remain in awe of the wondrous opportunities presented by this secular commodities bull. Oil is just one facet, albeit extraordinarily important, of a broader long-term march higher by all kinds of essential commodities.

Some of the most amazing opportunities of this Great Commodities Bull exist because some of these commodities are interrelated. Interrelationships are well understood in the stock markets, such as the tendency of one sector to move in correlation with another sector. If sector A and B are highly correlated historically, and A is up but B is not, then savvy investors buy stocks in B and wait for the relationship to revert to its usual tendency to run parallel. Eventually B will catch up with A’s advance.

Unfortunately though since it has been a few decades since the last great commodities bull, today’s investors have largely forgotten its lessons. Interestingly there are all kinds of very strong historical interrelationships among commodities, glued together via similar supply/demand profiles, responsiveness to similar economic conditions, and other fundamental factors including monetary expansion and geopolitics.

One of the most powerful historical commodities interrelationships exists between oil and gold. This is fitting. Oil is the most important commodity on earth since almost everything tangible that we physically move burns oil in the process. And gold has been the ultimate form of money through six millennia of human history, utterly immune to the inevitable debasement and inflation that all paper currencies eventually suffer.

This key relationship is easiest to understand when expressed as a ratio, the Gold/Oil Ratio or GOR. It simply takes the market price of gold divided by the market price of oil and the result is charted across the seas of time. The really fascinating part is this ratio has traded within a well-defined range since just after World War 2, nearly 60 years. Any trend persisting for this long must be taken seriously by investors.

The GOR research presented today is the latest in a long thread of analysis that I started back in June 2000. Back then gold was running at $292 and crude oil only cost $32 per barrel. At that time the GOR was low but still well above historical extremes. But in just the past few months the GOR has dived to new all-time record lows that likely represent dazzling opportunities for investors who position themselves to ride the GOR back up into normal territory.

Before we delve into the mathematical abstraction of the Gold/Oil Ratio, it is important to gain a strategic perspective on its components. The following chart shows monthly oil and gold prices since 1965, adjusted for inflation using the US Consumer Price Index. Visually the interrelationship between these two elite commodities is quite stunning. Generally as goes one so goes the other.

With the notable exceptions of 1975 to 1976, 1998 to 2001, and 2004 to today, oil and gold tend to move in undeniable symmetry. While there can certainly be temporary spikes higher or lower in either commodity, over a long strategic time frame their secular trends synchronize incredibly well. Temporary anomalies in one not mirrored by the other are eventually erased as their high correlation reasserts itself.

Back in 1975 oil in today’s dollars was holding steady near $40 a barrel but gold was falling rapidly from around $700 real to just under $375 real. This anomaly caused the first great Gold/Oil Ratio extreme low, all of which are numbered in red on each chart in this essay for reference. At that low there were only three possible events that could happen to the GOR. Oil could plunge to match gold, gold could soar to match oil, or the ratio could be broken with oil and gold heading their separate ways.

How was it resolved? The chart speaks for itself. Gold rocketed from $375 in today’s dollars to nearly $1700 on a monthly basis in the greatest gold bull in modern history. Gold not only caught up with oil to preserve the GOR, but it easily blew past crude as a speculative mania seduced mainstream investors to buy more gold. Gold ultimately ran up over 1800% in nominal terms in the 1970s while oil pushed 1100%, both on monthly bases. Naturally vast fortunes were won by commodities investors of the time.

This 1970s Great Commodities Bull pushed both elite commodities up to their all-time inflation-adjusted highs as well. In today’s dollars, oil exceeded $95 per barrel in April 1980. Gold ended January 1980 at $1690 in today’s dollars, truly impressive. And while this chart is composed of monthly data, if gold’s all-time daily closing high on January 21st, 1980 is considered in 2005 dollars, it now runs about $2140 per ounce!

These all-time highs are important to consider as we ponder the GOR extremes evident today. At $67 today oil is already three-quarters of the way to hitting new all-time real highs. But gold, at $440 today, is only one-quarter of the way to achieving new record highs. Bull to date crude oil is up nearly 500% in recent years while gold is pushing just 70%. Just as in 1976 we are presented with three scenarios … gold soars, oil collapses, or the GOR relationship implodes. Which will it be?

Back in 1998 to 2001 a somewhat similar scenario unfolded. Oil was driven down to absurd all-time real lows that were unsustainable, below the cost of production for most of the world outside of the Middle East. After falling under $14 in today’s dollars, oil then started rallying and ultimately hit $38 real in late 2000. But during most of this time period gold was languishing, grinding lower from $330 to under $290 in 2005 dollars.

In 2000 and 2001 investors faced the same dilemma we face today. Oil and gold have a very high historical correlation, as goes one so goes the other ultimately. Since the GOR was hitting its fifth major extreme low ever, an all-time record at the time, investors had to decide if the venerable ratio trading range was still valid. Either oil could plummet, gold could rally, or the ratio could be broken. The ratio ended up holding solid and gold embarked on a new secular bull.

With gold essentially flat in real terms over the last 18 months or so and oil more than doubled, today we are once again facing the same question investors faced in 1976 and 2001. Is the GOR even valid anymore in our modern world? If it is, then is oil destined to collapse or is gold destined to soar to bring the ratio back in line with its long history?

The six-decade old GOR relationship could certainly end at anytime, anything is possible in the markets. But odds are it won’t. Gold and oil are both tangible and finite assets, they can’t just be wished into existence but instead vast amounts of capital must be expended to recover them. Since they are both real, they tend to feel the effects of inflation similarly. As the US Federal Reserve continues its dangerous course of printing perpetually spiraling amounts of paper money, more paper will bid on gold and oil driving up both prices at the same time.

In an inflationary fiat-paper regime such as the ones that exist in every country on the planet today, money supplies are guaranteed to grow faster than commodities supplies. As relatively more money bids for relatively less commodities, higher commodities prices are the inevitable result. To bet that the GOR is going to suddenly fail is not only to bet against six decades of history, but to somehow assert that fiat-paper inflation will miraculously cease so monetary pressures don’t push up gold and oil simultaneously.

If you don’t think central banks are going to dissolve and return to intrinsic money that can’t be inflated, then there is little sense in betting that the long GOR trading range will shatter. All throughout history gold and all tangible commodities have risen in concert during inflationary times, and today will not be an exception. As long as central banks exist, increasing money supplies will lift all commodities including gold and oil and probably help preserve the longstanding GOR trading range.

If the GOR is unlikely to break, then we are faced with either oil falling or gold soaring to restore the ratio. Oil is overbought today and should indeed correct sooner or later here as all bull markets do periodically, but when it corrects it is likely to bounce near its 200-day moving average. Once it gets under 95% of its 200dma it will be oversold and another strong buy signal will trigger. With oil’s core 200dma now running above $52, a major correction to 95% of this would yield a high-probability technical downside target near $50.

But even if oil manages to correct back to $50 or under temporarily, strong fundamentals are still driving its underlying bull. On the demand side half the world’s population is rapidly industrializing in Asia and its oil consumption will continue to skyrocket. Even if Asia never reaches American per-capita oil-burning levels, its growth will constrain global oil supplies for decades.

And on the supply side, despite the countless billions of dollars spent searching for more oil, no new major oilfields have been discovered worldwide in decades. Existing fields are depleting rapidly and it is becoming more and more costly to extract the oil since the low-hanging fruit was picked in the last half century. Even the biggest of the world’s elite major oil companies cannot find enough new oil to replenish their reserves annually.

With oil unlikely to go much below $50 technically in a typical correction and its supply and demand fundamentals so unbelievably bullish, I think it is a silly bet to assume oil will plunge and its bull market will end. This oil bull will probably last another decade or more along with the general commodities bull. If the GOR is unlikely to break and the oil bull is unlikely to lay down and die, that only leaves gold soaring to fix today’s extreme GOR ratio.

What would it take for gold to soar? Virtually nothing compared to oil. Gold is the safest investment in world history, the ultimate hedge against inflation and government meddling in monetary affairs. Since so few people in the First World own gold these days, all it would take for gold to skyrocket would be some modest fraction of investors, say a quarter, deciding to diversify a few percent of their portfolios into physical gold. The resulting explosion of gold investment demand would be stunning and higher prices would beget even more demand.

So today’s extreme GOR lows must be resolved in one of three ways. The GOR could break forever, but such an event is extraordinarily unlikely as long as central banks inflate paper money supplies. The oil bull market could end, but how could that happen with soaring demand and dwindling supplies worldwide? And gold could soar, which would only take more investors around the world deciding to diversify a small portion of their capital into gold. I believe this latter gold scenario is the most likely outcome.

With the probabilities clearly in favor of a gold rally to resolve the current GOR extreme low, just how extreme is it? Believe it or not, today the Gold/Oil Ratio is at its lowest level in history by far. Prior to this summer the average GOR extreme low, of which there had only been five in three decades, was 9.3. Today the GOR is at 6.6, a whopping 30% below previous historical average extreme levels!

Today’s incredibly anomalous GOR extreme means that an ounce of gold costs just 6.6x a barrel of crude oil. Digesting this four-decade chart should give you an idea of just how rare any GOR extreme lows are, let alone one shattering all-time records. Note also in each previous GOR extreme low case that the ratio didn’t linger at extremes for long, but promptly shot back higher at least up to the long-term average of 15.2.

To better understand the probabilities of where the GOR tends to trade within its long range, standard deviation bands are overlaid on this chart. 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 99.7% of the time. Today the GOR is nearing the -2 SD line for the first time in history, truly a remarkable event.

Now after past extreme lows, the GOR has mean-reverted dramatically every time. One extreme rocketed all the way up to +3 SD, one extreme blasted up to +2 SD, one rallied to +1 SD, and two returned to average. So while we have plenty of precedent for mean reversions overshooting dramatically to the upside, we can be really conservative by just anticipating a mean reversion of the GOR to merely average this time around. So far this event has had a 100% chance of happening after each prior GOR extreme low.

Rather than assuming oil will stay high, let’s add even more conservatism to this analysis by assuming it will correct back down under its 200dma, as it has already done periodically several times in this bull to date. A probable target under oil’s 200dma is around $50, which has the added benefit of being a nice round number for easy calculations.

So if oil corrects to $50 before its next major upleg erupts, and the GOR simply reverts back to its mean and doesn’t even overshoot to the upside as it is prone to do, how high will gold have to go to restore balance to this ratio? At a 15.2 average GOR and $50 oil, gold would have to trade to $760 per ounce! And obviously if you believe the GOR will once again overshoot to standard deviations above its mean, the resulting target gold price to restore the ratio would be far higher.

If the GOR is not broken, and if oil corrects dramatically, and if the ratio merely reverts back to its mean and doesn’t overshoot, which are all conservative assumptions, gold would have to rally 73% from here to bring the GOR back in line! Savvy investors can ride this probable move easily by deploying capital in gold and gold-related investments like gold stocks. Today’s all-time record GOR extreme low is extraordinarily bullish for gold.

A related but inverted way to measure the strong historical relationship between gold and oil is via the Gold Cost of Crude Oil, or GCCO. It states how many ounces of gold it has taken throughout modern history to buy 100 barrels of crude oil. This key metric has also shattered all records and hit a dazzling new all-time extreme, but to the upside. In standard deviation terms this is so rare, nearing +4 SD, that it is certainly unsustainable and likely to start falling fast soon.

Last time I wrote on this crucial gold and oil interrelationship in early April the GCCO was running 12.9, its highest levels ever but still within +3 standard deviations. Nearly 20% higher now, 15.2 ounces of gold per 100 barrels of crude, these levels are mindboggling. Oil has never been more expensive in gold terms, oil producers have never been able to trade oil for as much gold as is being offered today. This has to be an anomaly.

Once again oil prices aren’t the problem, as rampant demand growth and dwindling supplies fully explain the secular bull market in crude oil. But gold is way, way undervalued compared to oil. It has lagged behind in its own bull market for so long that it has just become extraordinarily cheap relative to other commodities. While oil will probably correct sooner or later here, most of the work in restoring the GCCO will have to be done by a major gold upleg.

Of the five previous extreme GCCO highs numbered above, all collapsed right after the spike high was achieved. One collapsed all the way back down to -2 SDs, two mean reverted and overshot to -1 SD, and another two returned to below the average. Since all five fell below the GCCO average though, it is the most conservative point at which to project the coming mean reversion.

If oil corrects to $50, 100 barrels of it will be worth $5000. At the four-decade average Gold Cost of Crude Oil of 7.2 ounces per barrel, this yields a target gold price of $694 per ounce. Thus if the GCCO mean reverts back to its average as history strongly suggests it ought to, the gold price would have to rally 58% from here to make it so. Once again this is extremely bullish for gold.

Gold and oil, since they are both finite and scarce tangible commodities, are forever bound together since they exist in a rampantly inflationary world. The more paper currency that the world’s central banks decide to inject into their economies, the more paper will compete for finite gold and oil supplies. As relatively more paper bids on relatively less gold and oil, their prices have no choice but to rise. A rising inflationary sea of paper currency lifts all tangible boats.

While oil can and should correct, its underlying supply and demand fundamentals remain extremely bullish. Global consumption of oil is climbing around the world yet the oil pumped each year is not being replenished. And if the world is really passing peak oil production as many energy geologists believe, then the supply situation is unlikely to ever improve materially. This oil bull isn’t even close to being over.

This leaves gold. During inflationary times, which these undoubtedly are despite the watered-down government statistics, gold shines the brightest. By diversifying into gold investors can preserve their purchasing power from the ravages of inflation as well as weather the ugly secular bear market in the general stock markets in style. It will only take a modest fraction of investors diversifying a small percentage of their portfolios into physical gold for investment demand to overwhelm tight gold supplies and cause its price to soar.

In addition to gold, gold-related investments should also thrive. One of my favorites is gold stocks, which leverage the underlying gains in gold tremendously. In anticipation of the next major gold upleg driven by the GOR extreme as well as other macro factors, this year we have been extensively researching and deploying into the most promising of the world’s gold miners. Once gold starts moving in earnest, elite unhedged gold stocks will soon rocket higher.

The current August issue of our acclaimed Zeal Intelligence monthly newsletter outlines our favorite gold stocks to ride this highly probable gold upleg. As the GOR mean reverts and gold powers higher, all these companies ought to soar. Please join us today while these stocks are still relatively inexpensive!

The bottom line is the venerable Gold/Oil Ratio has traded in a well-defined range for six decades, which is far longer than most of us have even been investing. And gold has never been this cheap before relative to oil, we are so far into all-time record territory here it is just silly. With markets hating anomalies and having overwhelming tendencies to mean revert, odds are these extremes will not last.

Until governments can conjure up oil and gold as magically as they print paper money now, odds are oil and gold will rise together on a relentless inflationary tide. Physical commodities supplies will never grow as rapidly as paper money. This common monetary ground between oil and gold suggests that the GOR is unlikely to suddenly forever leap out of its long trading range.

And if the GOR trading range remains intact and mean reverts, the lion’s share of this reversion must be driven by a major gold upleg. Oil fundamentals are far too tight for it to fall much beyond a correction and it really won’t take much investment capital in the grand scheme of things to catapult gold higher.

Adam Hamilton, CPA

August 20, 2005

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