Is Gold a Better Hedge than Oil?

By Brad Zigler

We've groused before about gold's much-vaunted role as an inflation hedge. When we looked at gold's long-term performance last year (see our January 2008 rant, "A Picture's Worth A Thousand Words (Or Dollars)"), we wondered if, indeed, the yellow metal would match its 1980 highs on an inflation-adjusted basis. As it turned out, gold didn't. But crude oil did.

We figured gold would have to average $1,563 an ounce in 2008 to equal its 1980 record when rises in the U.S. Consumer Price Index [CPI] were factored. Gold, loco London, managed to run up to $1,023 in March, but only averaged $872 for the year. West Texas Intermediate [WTI] crude, by contrast, needed a CPI-adjusted mean price of $95 a barrel in 2008 to equal its 1980 performance. Spot oil delivered to Cushing, Okla., averaged $100 last year.

Traditionally, gold's risen in tandem with oil. That's still the case - more or less, though it's been "less" than "more" recently. The relative strength of the two commodities is readily observed in the gold/oil ratio. Gold's purchasing power is waning now owing to a resurgence in oil prices. An ounce of gold currently buys 17 barrels of oil. Back in February, though, when oil prices cratered, the gold/oil ratio approached 28-to-1. At oil's zenith in 2008, the ratio neared its record low of 6-to-1. Over the long run, gold's multiple averages a shade under 16x, though the metal's leverage has been slipping recently. Over the past five years, an ounce of gold has been worth about nine barrels of oil.

Gold/Oil Ratio

De-leveraging had a lot to do with the run-up in the gold/oil ratio. You'd have a hard time making a fundamental case for the eight-month swoon in oil prices from $145 a barrel to $34. Slackening demand certainly contributed to oil's downtrend, but the fire sale of assets in the wake of the Lehman Brothers collapse, led by hedge fund selling, really pitched oil prices into the abyss, making gold look relatively strong.

Oil, in large part, fell upon its own sword. After all, it was oil's price rise preceding the banks' collapse that was the source of much of the inflation measured by CPI. Since 1986, the year the U.S. Energy Information Administration began collecting spot price data, the WTI price compounded at an average annual rate of 8.6%. CPI's contemporaneous growth rate was 3.0%.

And gold? Gold ended up appreciating at a 3.8% annual rate over the 23-year period.

Asset Performance 1986-2008 (Yearly Average Prices)

Keep in mind, though, that we're looking at raw asset values here. The picture looks a bit different when the effects of inflation are considered.

Inflation-Adjusted Asset Performance 1986-2008 (Yearly Average Prices)

Net of CPI inflation, gold's appreciation rate falls to 0.8% per annum. Crude oil's rate declines, too, but remains above CPI's at 5.4%.

Take note, however, of the price trajectory of large-cap U.S. stocks represented by the S&P 500 index. On both a raw basis (at 7.4% per annum) and adjusted for inflation (at 4.2% per annum), stocks pretty much stayed ahead of inflation each and every year while commodity appreciation was, until recently, sub-par. Oil's price velocity, in fact, languished below the inflation rate from 1991 until 2005. Gold's rate of rise is still playing catch-up to CPI's

Therein, though, lies the rub. While oil appreciated at a rate better than gold and CPI over the long run, it may not be the better hedge. At least, not a better hedge for a stock portfolio. Sure, one can hedge against inflation, but there are other adversities for investors to consider. In the strictest definition of the word, a hedge is an instrument that moves in opposition to a target asset. The object of hedging is to smooth out portfolio volatility until such time as assets can be liquidated.

Consider this: the 23-year correlation between the S&P 500 and WTI crude is 4.2%. Not a high correlation certainly, but a positive one nonetheless. Gold, however, is negatively correlated, at -38.6%, to stocks.

In a hedge, you want the hedge vehicle to zag when your primary asset zigs. Simply put, there just may be more zag in gold than there is in oil for long-term stock investors.

Comments

[Socialism c...:]

We're just STARTING to print money. Give it a couple years, and we'll see how gold and oil compare.

Apr 06 01:13 PM

[GMiki1:]

I like both. Oil fundamentals look good. Nat gas fundamentals very good.

Apr 06 01:14 PM

[auto credit:]

Isn't ZERO correlation the Holy Grail of portfolio theory?

Apr 06 01:54 PM

[Mad Hedge F...:]

Daniel Yergin of Cambridge Energy Partners says that crude prices will stay in a $40 to $60 range for the foreseeable future. The author of the Pulitzer Prize winning “The Prize”, the best business book I have ever read, believes the recent 26% rally in the stock market is what dragged crude up from $35 to $54. Another downdraft in stocks, or a realization that the recession will be longer than expected, could take crude back to $40 in a heartbeat. Inventories are at a 16 year high, with possibly 80 million barrels at sea, as demand has shrunk from 86 to 83.5 million barrels a day over the last two years. Spare capacity is now huge. Don’t expect to break out of this range until a recovering economy eats into these supplies, and inflation makes its inevitable return. Then all commodities will roar, not just crude.

Apr 06 02:03 PM

[johnnysize:]

Oh no here come the gold bugs.... ammo and gold, THAT's whats in my portfolio.

Apr 06 03:52 PM

[Mutual Fund...:]

I believe you are correct on all counts....What about the U.S. dollar?

Doug T.....Ttshe mutual fund guy
www.mutualfundwealth.com/


On Apr 06 02:03 PM Mad Hedge Fund Trader wrote:

> Daniel Yergin of Cambridge Energy Partners says that crude prices
> will stay in a $40 to $60 range for the foreseeable future. The author
> of the Pulitzer Prize winning “The Prize”, the best business book
> I have ever read, believes the recent 26% rally in the stock market
> is what dragged crude up from $35 to $54. Another downdraft in stocks,
> or a realization that the recession will be longer than expected,
> could take crude back to $40 in a heartbeat. Inventories are at a
> 16 year high, with possibly 80 million barrels at sea, as demand
> has shrunk from 86 to 83.5 million barrels a day over the last two
> years. Spare capacity is now huge. Don’t expect to break out of this
> range until a recovering economy eats into these supplies, and inflation
> makes its inevitable return. Then all commodities will roar, not
> just crude.

Apr 06 04:21 PM

[Mark Bern:]

I suspect that the crude/stocks corelation is positive while crude prices are relatively tame (low enough to not create a drag on the global economy). That is likely to continue for a while, at least until either one of two events occur: 1) the U.S. dollar drops significantly relative to other major currencies (crude being denominated in US$, therefore creating an upward pressure on crude when the US$ drops) or 2) when global economic activity increases sufficiently to support higher levels of demand. Until then, gold makes more sense as a hedge against stock declines.

But when demand returns and excess capacity evaporates, crude prices will soar and above some level the corelation will be shattered. At that point, crude may be the better hedge vehicle. My point is that external variables may play a role in determining the better hedge vehicle at different points in time.

Apr 06 05:11 PM

[Brad Zigler:]

The actual speed of those printing presses can be clocked by watching the real-time monetary inflation updates that head up Hard Assets Investors daily "Brad's Desktop" column.


On Apr 06 01:13 PM Socialism cannot compete! wrote:

> We're just STARTING to print money. Give it a couple years, and we'll
> see how gold and oil compare.

Apr 06 06:53 PM

[Brad Zigler:]

A perfect HEDGE provides -100% correlation to a target asset. The combination of the target asset's and the hedge instrument's beta would then be zero. That would result in the PORTFOLIO's present value being locked in.

Residual beta resulting from imperfect correlation leaves the portfolio exposed to market risk.


On Apr 06 01:54 PM auto credit wrote:

> Isn't ZERO correlation the Holy Grail of portfolio theory?

Apr 06 06:59 PM

[Mistrofan:]

He he he: Exactly for the very reasons you described in your article, the gold will do much better than stocks and even oil over the next decade: because has room to grow and is playing ketch-up. Stocks are overvalued, energy is a good play, but risky in a constrained environment. It the 90's belonged to stocks and the last 5 years to oil, than the next five year will be the gold.

Apr 06 09:00 PM

[Speedspirit:]

And if the problems in the world happen to spark a conflict what then happens to the price of oil. Or a natural disaster?

Apr 06 09:02 PM

[scotty1560:]

Hard to fight oil prices long term, humans keep populating the planet
and the stuff is getting costlier to extract.

Gold should do well down the road as well.

Mad Hedge Fund Trader makes nice points and Brad as well.

Apr 06 09:10 PM

[Fighting Yoda:]

Gold has underperformed everything last 20/30 years- Treasuries, inflation and the S&P. We are in a deflationary spiral - all assets will go down - they have already gone down - homes, oil, autos, commodities, and the rest. Gold has held up relatively OK, it is going to go down - my target is 600. The key is the dollar - as dollar strengthens against currencies - especially emerging currencies - like Indian Rupee etc- gold becomes prohibitively expensive to buy, and actually become profitable to sell.
India the largest importer of gold - has been exporting gold in 2009. Indian imports - '07- 850 Tons, '08 - 450 Tons, '09 - 1st QTR: export 70 tons (forecast only 100-200 tons import for '09). The demand for gold is falling from consumers - they are 60% of all gold purchases.

All the theories about money printing, inflation, on and on - but at the end of the day it is demand and supply - as price rises - demand falls. Investment demand has not been able to offset the consumer fall in demand. These are the facts. So do not make a one way bet on gold.

Oil – as recession deepens – investors will be convinced and give up the trade. OPEC will not cut production to offset fall in demand. And if your only hope for oil price rise is OPEC price cuts – that is not a smart trade.

Apr 06 11:10 PM

[Chris Uhlir:]

adding comment so I can refer back to this awesome article thanks.

Apr 07 01:08 AM

[mac.barron:]

Shocking as it might be to some people, the conditions that we are under one day may shift the next. Oil is seemingly low in price today as we compare it to its recent high. If the markets downshift again, oil will also drop for a time. Until something else happens, like a terrorist attack on the Saudi pipelines, or a Category 5 hurricane wipes out a big refinery in the Gulf.

Everything is very predictable until a violent unexpected outside force blows your logical scenario away. Think about LTCM and the Russian economy collapsing. Given that things often seem to go from bad to worse, and given that the world is already in a rough patch I'm quite comfortable with the notion that something else is going to go awry and that gold will be a safe harbor.

From my point of view the best thing that could happen would be a wonderful recovery global and a thirty per cent drop in that part of my portfolio because it would mean that there would be a lot of easy ways to more than make up for that damage and also that the U.S. Dollar had, by some miracle, kept its value. Just like Hard Assets Investor pointed out, plenty of zag in gold. Would be nice and all, but I can't actually see things going that way.

Apr 07 01:53 AM

[wildfirexx:]

Once the economy starts to recovery, hopefully oil will stabilize between $50 & $75 a barrel...any more than that could slow down the recovery, because of the extra financial burden it would put on the american people; like it did last summer.
Gold on the other hand should be relative to the strength of the American dollar...If people feel confident enough in the American Dollar in Bad Times why would they hedge against it in Good times? Does America's huge debt always give way to inflation down the road?

Apr 07 02:58 AM

[rinse cycle:]

I would like to see real estate vs. inflation also on the charts for comparison to stocks oil and gold.

Apr 07 10:22 PM