Which Is Headed Higher: Gold or Oil?

By Brad Zigler

Instead of being tossed over the transom, Friday's mail was slipped under the door: a single letter from Hard Assets Investor reader Bob.

Apparently, Bob's been watching the gold/oil ratio and hopes for a shorting opportunity after the next upward spike. In other words, he expects gold's price to ultimately weaken relative to crude.

Bob writes: "If the gold/oil ratio rises again, to say, 23-to-1 or higher, I'd bet gold's multiple would retreat toward its mean. How could I play this hunch using exchange-traded funds (ETFs)?"

The gold/oil ratio measures the value of gold in terms of how much oil it will buy. When Bob's letter arrived, an ounce of gold could buy about 21 barrels of crude. The ratio's long been used as a bellwether of economic health as well as a means to identify gold buying and selling opportunities.

No doubt, with the recent collapse of oil prices, the ratio's raced to levels not seen since the turn of the century (uh, that'd be the turn into the 21st century). Over the past three decades, the ratio's found support at a gold multiple of eight or 10 barrels. Occasionally, excursions above 20, or even 30, barrels have been made, but these levels seldom hold for any length of time. In fact, the mean level for the ratio over the past two years charted below is 9.7-to-1.

Gold/Oil Ratio

Back in November, as the ratio was rising, we looked at buying the ratio ("Trading the Gold/Oil Ratio With ETNs"). We paired long positions in the PowerShares DB Double Long Gold ETN (NYSE Arca: DGP) and the PowerShares DB Double Short Oil ETN (NYSE Arca: DTO) and, after a month, the ratio peaked at 24.8-to-1. The volatility-adjusted ETN pairing gained an aggregate 18.8% as a result.

For ratio bears like you, Bob, a reverse position can be established by purchasing the mirror-image notes, namely the PowerShares DB Double Short Gold ETN (NYSE Arca: DZZ) and the PowerShares DB Double Long Oil ETN (NYSE Arca: DXO). To make the trade track the ratio effectively, though, you'll need to balance the combination for the respective ETNs' price and volatility.

At last look, the DZZ note was worth $26.26 and DXO was priced at $2.98. Let's call those Price 1 (P₁) and Price 2 (P₂), respectively. Balancing the dollars at risk in each position means you should buy nine DXO notes for every DZZ purchased (P_{1 ÷} P₂ = 8.8, but we'll round it to 9).

Since the notes' volatilities, or daily price variances, differ, you'll need another adjustment. Using the techniques laid out in the November column, you'd see DXO's volatility was a whopping 132.2%. DZZ's comes in at 74.6%. Without compensating for DXO's higher volatility, your combination's value would skew in short order.

If we make DZZ Volatility 1 (V₁) and assign Volatility 2 (V₂) to DXO, we can write the total adjustment factor as:

V₁P₁ ÷ V₂P₂ = (26.26 x .746) ÷ (2.98 x 1.322) = 6.2

So, if you buy six DXO notes for each DZZ, you'd be good to go, Bob.

Oh, by the way ...

I know you asked about exchange-traded funds, not notes. There are more short and levered products on the note side, though. You also rid yourself of index tracking error with ETNs. The trade-off is the exposure to credit risk. You've got to feel comfortable about the continued solvency of the ETN issuer which, in the case of the notes described above, is Deutsche Bank's London branch.

Comments

[rber:]

Neither.

Jan 12 11:53 PM

[wlc:]

"So, if you buy six DZZ notes for each DXO, you're good to go, Bob."

No Bob, I don't believe that 6 DZZ : 1 DSO is the correct ratio.

Jan 13 04:31 AM

[Conan the B...:]

Am in both DZZ and DXO: DZZ at $25 looking for $44, DXO at $3 looking forward to adding more below $2.

DXO will pop tommorow as Oil drawdown far exceeds estimates. IMO

Jan 13 09:59 AM

[User 320210:]

Analysts are predicting gold at $1200 . an ounce by June 2009 . What

does that do for the price of oil ? Does that give us a 4 month investment

window for oil/ gold from Jan. 1 ?

Jan 13 11:29 AM

[gjvoor1:]

I think he probably meant 6 DXO to 1 DZZ.

Jan 13 02:03 PM

[Conan the B...:]

Blew the Oil inventory call but the increase was much lower than expected. What really hurt was the unexpected extremely large rise in refined products, esp. heating oil.

The spread between WTI and Brent is now around $8+.
Even the Heavier grades basket in the Gulf States costs more.

Is Demand Destruction really that bad here or is oil overseas higher because of the Russia/Ukraine dispute?

any ideas?

Jan 15 02:02 AM

[Brad Zigler:]

Much of the WTI-Brent arbitrage is related to the time value of money. WTI is a true spot market where oil is immediately deliverable; Dated Brent is actually a short-term forward contract in which oil is subject to a load-in schedule.Because of this, the current US glut and widening contango market exacerbates the Brent time differential.

There's also shipping rates to be taken into account. Delivery of WTI is by pipeline. Brent's FOB shipboard,

Jan 15 09:02 AM

[CLH:]

For a short term trade I agree with the author. Gold down and oil up.

Jan 28 03:08 PM

[User 377734:]

In the near term oil up and gold down but long term oil will stagnate and gold will out preform. In fact now wouldn't be a bad time to short gold and leverage long on oil. The ETF is soon to dump gold on the market and gold is slightly overvalued to all other commodity classes at the moment. So i know what Im going to do lets just see if anyone else has the gonads to short gold and go double long on oil like me. LOL.

Mar 17 07:11 AM