What Do Gold-to-Oil and Gold-to-Silver Ratios Say?

 |  Includes: GLD, OIL, SLV, USO
by: Justice Litle

The gold-to-oil ratio is at ten-year highs – a single ounce of gold can now purchase 22+ barrels of WTIC crude. But what does it mean?

For individuals, gold remains the best insurance against future shocks and the best store of value.
– William Rees-Mogg, Times Online

There has been a lot of talk lately about the gold-to-oil and gold-to-silver ratios. This is understandable, as both ratios are further out of whack than they have been for a long time.

The gold-to-oil ratio, for one, is now at ten-year highs.

View Gold-to-Oil Ratio Chart

The gold-to-silver ratio is similarly extended, though not by nearly as much as gold-to-oil.

For gold-to-silver, the 200-month moving average is 57 and the current value (as of this writing) is a touch above 69 – meaning a single ounce of gold is worth 69 ounces of silver.

The 200-month simple moving average tells us that 57 is closer to the norm. So that puts a better than 20% premium on the price of gold versus silver (based on U.S. exchange-traded futures contracts).

Analysts have looked at these relationships and come to some interesting conclusions. Some feel strongly that it’s time to buy oil (or silver). Others feel – quite foolishly in my opinion – that it’s time to short gold.

Let me expand on a few key points here so you can come to your own conclusions.

First of all, many investors and traders have gotten into the habit of throwing gold, oil and silver all into the same bucket – the “inflation expectations” bucket. Reason being, when inflation comes roaring back, all this stuff should come roaring back too (as the value of paper currencies plunges).

That’s the basic theory. But it’s also a bit simplistic. We need to remember that all three of these commodities lead “double lives,” so to speak. There is more to the equation than just inflation expectations.

Oil’s Industrial Role

Oil, remember, is an industrial good. We use it to power nearly everything that moves (and a lot of stuff that sits still).

During oil’s run-up to $147 a barrel, the world was barreling ahead (no pun intended) at full steam. A global economic boom was under way, and the supply/demand balance for oil was very tight.

When the global economy fell into recession, though, global oil demand fell too. That slip in demand at the margins was enough to send oil prices crashing through the floor.

Remember that the demand for commodities (and most everything come to think of it) is determined at the margins. The price is set by the most desperate buyer (or anxious seller).

So when there was very little daylight between supply and demand, the price of crude just kept marching higher. But it didn’t take much of a drop-off in demand before, suddenly, the world had excess oil on its hands, as we were no longer burning up every last drop of the 86.4 million barrels being pumped out each day.

When the price of oil went into freefall, sharp-eyed traders saw a chance to store the stuff in tankers and wait for higher prices to return. But eventually most of the storage facilities filled up, and the stuff just kept coming. And so crude continued to fall.

Peak oil is still in effect, mind you. It’s just a long-term type phenomenon that needs a rising global demand trend to really have effect.

When the global economy gets back on track, oil demand will relentlessly tick back up. Think of long-term oil demand as the needle on a dial: At some point growth will take us back to 86 million barrels per day... 86.5 million... 87 million and beyond...

When those days come back, oil will be expensive again as we run headlong into a production ceiling. For now, though, oil is cheap.

The Golden Thermometer

Gold has a “double life” too. Or maybe two double lives, if you count jewelry and ceremonial demand. The double life we’re going to talk about here is gold’s role as a general anxiety barometer – a sort of thermometer for how the world is doing.

Gold is the ultimate safe haven asset. It’s the thing you buy when nothing else can be trusted.

Furthermore, gold has earned its safe haven reputation over a history of thousands of years, whereas the present-day fiat currency experiment is less than 40 years old (dating back to Nixon’s shutting of the gold window in 1971). Four decades versus multiple millennia... hmm, is there any wonder people are flocking to gold in this time of great upheaval?

The other wild thing about gold is the supply/demand picture. We just talked about the ugly supply picture for crude oil right now – how the stuff is overflowing because the world isn’t burning it.

With gold the opposite is true. There just isn’t enough gold in the world to even begin to satisfy total demand right now.

Consider that the total dollar value of all the gold ever mined, at present prices, is something like 4 trillion to 4.5 trillion dollars.

Four trillion bucks is a drop in the bucket. Foreign central banks already hold at least $3 trillion worth of U.S. Treasury securities, with trillions more set to be issued in 2009. The Federal Reserve alone has nearly 2 trillion dollars on its balance sheet – one entity with paper assets and obligations totaling close to half the worth of all the gold in the world!

Central banks around the globe would probably love to own lots more gold. But they know that they can’t buy it in size, because if they tried to they would run the price into the stratosphere.

That’s why, even now, countries like China, India, Russia and Japan have 3% or less of their total reserve holdings in gold. If they made a concerted effort to ditch dollar-denominated assets and up that total, the price of gold would explode.

Supply, Demand and Anxiety

In light of this information, the extreme highs of the gold-to-oil ratio make perfect sense.

Oil is in a deep funk right now due to the supply/demand situation and the prospect for a continued slump in global economic activity. While there is reason to be long-term bullish crude, there is little reason to expect a higher oil price until global demand trends show signs of returning to form.

Gold, on the other hand, is in high demand right now as a safety blanket – a salve for the general anxieties brought on by flailing governments, out-of-control printing presses, and mass “stimulus” schemes that get bigger by the day. There is not enough gold to go around right now. Hunger for the yellow metal is waxing, not waning.

As for the gold-to-silver ratio, gold’s 20% premium isn’t hard to understand there either. While silver is a bona fide “precious” metal, it is also an industrial metal... and silver has less psychological traction as an anxiety barometer.

There will come a day when the price of silver could explode, and perhaps even rocket past gold like it was standing still in percentage performance terms. But we will need to enter a mania phase for that to happen, and we are far from seeing that just yet. People are buying precious metals more out of a safety motive than a speculative one at this point, and so silver waits.

A Word on Economic Revival

There is another point that is important to address. Some pundits in the “sell” camp argue that gold will be ripe for a fall when economic recovery starts to take hold. When the sun begins to shine again, they reason, investors will come back to traditional equities and hoary old gold will go back in the closet.

I don’t think so, and here is why – the U.S. Fed and Treasury would consider the return of serious inflation a “win” at this point. Right now, Ben Bernanke and his global counterparts are doing everything they can to fight a deflationary death spiral. Inflation is a mosquito bite in comparison.

And so, in a dangerously deflationary world – the one we inhabit at this present moment – noticeable and persistent inflation pressures must take hold in order for us to have clear assurance that the Fed and Treasury’s rescue policies have worked.

And because mass stimulation is a highly inexact science, we won’t get to choose the amount of inflation we get. When you dynamite the deflationary dam, so to speak, you don’t get a say in whether it’s a trickle or a flood that results. The same goes for the Fed’s reflation efforts.

This leads to the odd conclusion that, in the event we see signs of recovery accompanied by signs of inflation, gold’s upside movement could actually accelerate.

But it’s really not so odd, when you think about it, because the price of gold is anticipating a future outburst of inflation here. Either that, or the debasement of all paper currencies into oblivion. One’s as good as the other as far as gold bulls are concerned.

Runaway Train?

In conclusion, I would argue that the extraordinary nature of the gold-to-oil ratio at this point is merely a reflection of extraordinary times.

We have seen a global deflationary bust knock down the price of oil, even as general anxiety and currency debasement fears have sent the price of gold rocketing higher. We are also seeing a marked divergence in the supply/demand picture, with plenty of oil to go round but not nearly enough of the yellow stuff.

I am chomping at the bit to go long oil and gas at some point in the coming year, but not as a currency debasement play. I’ll wait for global demand to show signs of life before getting on that train.

As for the gold train... if the $900 level holds, we could see another blast of upside movement soon as all the “wait for a pullback” folks get nervous and pile in.

And silver, which is still very much playing second fiddle at this point, will likely start going nuts once we hit the true “mania” phase – which we are nowhere near as of yet.