How Much Oil Can Gold Buy?

By Brad Zigler

Real-time Monetary Inflation (per annum): 7.4%

Imagine going into a filling station and being asked to pay for your gasoline with gold instead of dollars. How many one-ouncers would you have to pull from your pockets to top off your tank?

That's the kind of equivalency described in the gold/oil ratio. The ratio - a closely watched metric of economic prospects - reflects the price of gold expressed in number of barrels an ounce of metal can purchase. The ratio is also a beacon to gold traders that indicates the degree of overexuberance or disdain for bullion. Historically, buying opportunities for gold are flashed when the ratio turns up from a bottom. Gold selling is indicated when the ratio turns down from a top.

Where you call tops and bottoms is largely a matter of personal preference based upon your time and risk horizons. From a broad perspective, the "bottom" was about six barrels per ounce, when crude's barrel price spiked over $140 in the summer of 2008. The most recent "top" came eight months later, at around 28 barrels per ounce. Presently, the ratio's at about 17-to-1 and is giving some indications it wants to go higher. Or lower, depending upon your point of view. One thing is fairly certain: The ratio's not likely to hang out at its current level very long.

Pretty much all of the recent vacillations in the ratio have had more to do with the dollar price of oil than with gold's value. Gold's price has been a virtual steady state compared to oil. Wobbles in the value of petroleum have been clearly disproportionate. Stasis in the ratio would have required a two-thirds reduction in gold's value and that, for sure, didn't happen.

Gold/Oil Ratio

Oil's the bellwether for an economic recovery. Demand for fuels rise when goods and people are on the move. We've seen some niggling indications of demand rising. Witness the widening gasoline crack spreads.

Still, there's a real tug-and-pull going on in the ratio. Note the recent rebound on the chart. Let's just, for the moment, paint a bleak scenario in which the ratio continues its rebound; in other words, where gold gains purchasing power relative to oil. How could you play it?

You'd first need to find a short exposure to oil. You can do that in one of several ways: futures, exchange-traded notes (ETNs) or exchange-traded funds (ETFs). We can obtain some of the leverage of futures together with tight index tracking by using the PowerShares DB Crude Oil Double Short ETN (NYSE Arca: DTO), which attempts to deliver twice the inverse monthly performance of the Deutsche Bank Liquid Commodity Index's oil split.

You can find an analogous long gold exposure with the PowerShares DB Gold Double Long ETN (NYSE Arca: DGP). You'd want the double-exposure ETNs because of their greater liquidity versus the single-exposure editions.

Now, you could just keep things nice and simple and buy the notes 1-for-1. But this year - no surprise here - the oil ETN's been more volatile than the gold ETN. More than twice as volatile, in fact. If you think history will repeat itself, you'll need to hedge that excess volatility by purchasing two gold notes for every oil chit bought. In actuality, the year-to-date hedge ratio is 2.3-to-1, so for every 100 DTO notes, you'd buy 230 DGPs.

Gold (DGP) Vs. Oil (DTO)

Year to date, the 1-to-1 version of the ETN spread's earned a 15.8% return. If you'd done the trade with a 2.3x volatility adjustment, the return would have been a percentage point lower, but you'd have cut your risk, or standard deviation, by about 13%.

And in a market like this, who couldn't afford to shave a little risk?

Comments

[UbaTuba:]

Interesting article, but how should one actually plan to exit these trades?

Apr 27 07:50 PM

[Know Nothin...:]

Similar cases happened before. In the 70's, when government produced no more pure silver dimes. Some gas stations were very happy to take the silver dimes as 90 cents when customers filled up the tank.
Similar title at that time should be "How much oil can silver buy?"
History is a revolution, whatever happened before will happen again in future.

Apr 27 08:32 PM

[huswest:]

I get your point, but a dime has never been "pure" silver. This from Wikpedia:
The composition (initially 89.24 percent silver and 10.76 percent copper) remained constant until 1837, when it was altered to 90 percent silver and 10 percent copper. Dimes with this composition were minted until 1966,


On Apr 27 08:32 PM Know Nothing and Do Nothing wrote:

> Similar cases happened before. In the 70's, when government produced
> no more pure silver dimes. Some gas stations were very happy to take
> the silver dimes as 90 cents when customers filled up the tank.<br/>Similar
> title at that time should be "How much oil can silver buy?"
> History is a revolution, whatever happened before will happen again
> in future.

Apr 27 10:36 PM

[DONE_SONZ:]

The whole gold/oil ratio means nothing.

Apr 28 08:55 AM

[BrunoT:]

This is pure speculation. When you go to vegas, who usually wins?

Apr 28 09:32 AM

[Edward, Lor...:]

We used to compare tulips to spars. Useful in the day...

Apr 28 10:09 AM

[Brad Zigler:]

No? Please explain your thinking. Gainsay is easy; argument requires thought.


On Apr 28 08:55 AM DONE_SONZ wrote:

> The whole gold/oil ratio means nothing.

Apr 28 11:45 AM

[Brad Zigler:]

The house wins in the casino game. But it's because of a small incremental advantage over a time horizon. The reason people often lose in Vegas, Atlantic City or Monte Carlo is that they succumb to the green table's lure. They don't LEAVE with their winnings or accept their losses. They continue to subject themselves to the house's edge.

My question to you: who's fault is THAT?


On Apr 28 09:32 AM BrunoT wrote:

> This is pure speculation. When you go to vegas, who usually wins?

Apr 28 11:52 AM

[Brad Zigler:]

One clue would be the crossover of the 20-day and 50-day moving average for the ratio. If the 20-day crosses below the 50-day, get out of the trade.


On Apr 27 07:50 PM UbaTuba wrote:

> Interesting article, but how should one actually plan to exit these
> trades?

Apr 28 11:54 AM

[petervankan:]

The gold-oil ratio only means something in retrospect. For predicting the future one may as well use the Belgian pedophiles - Chinese dirty socks ratio.

Apr 28 01:48 PM

[Brad Zigler:]

Actually, the ratio's bottoming at 6:1 was a pretty good predictor of the current deep recession

Apr 29 12:46 AM

[petervankan:]

Well, that again is retrospect. We might also say that the unusual high number of dirty Chinese socks in August was a pretty good indicator of the current crisis.
And then, who says the ratio has bottomed ? It might go to 4:1 while the economy picks up.
Mathematical proof exists that the predictive power of what happens on the market is strong in the beginning, but then diminishes quickly. And you kow how quickly ? It is completely gone after 15 ........ minutes.
So much for TA.

On Apr 29 12:46 AM Brad Zigler wrote:

> Actually, the ratio's bottoming at 6:1 was a pretty good predictor
> of the current deep recession

Apr 29 09:19 AM

[Brad Zigler:]

Not in retrospect. The call was made for the depth of the recession in an article BEFORE the meltdown reached its nadir.

The ratio, by the way, is NOT an example of technical analysis (TA); it's a fundamental indicator.

Apr 29 06:04 PM

[Freya:]

When Oil goes to $60 and Gold drops to $700, the ratio will be 12. The Gold/oil graph above suggests that a crack below 17 has a chance to go to its breakout. It can be accomplished in various ways.

Gold at $850 and oil at $70 will do it too.

From my perspective, which is very Paranoid right now, our Major Oil facilities are too close to the Mexican border and we are not mobilizing to shut that Border. Viruses Mutate very quickly. But our Border remains porous.

I expect the Best but prepare for the Worst.

Apr 28 12:35 AM