Time to Exit Oil / Gold Pair Trade

When making recommendations in EPIC Insights, I always want to maximize my gains. This leads me on a quest to find mispriced securities that can be purchased at low levels and then sold at higher prices in the future. However, I am equally concerned with risk. We never know with certitude which direction the markets will travel. Therefore, we must consider what can go wrong as well as right with each investment.

Looking for low risk and steady gains, I often gravitate to pair trades. By being long of one instrument and short a related instrument, I can eliminate the market's general direction and focus on the basis between these instruments. If the trade is structured correctly, the basis will move in our favor and gains will come our way.

A recent example of this approach is a trade we entered on April 20-long oil and short gold. When I decided upon that trade, I examined the long-term relationship between oil and gold. On average, we should be able to purchase 13 to 15 barrels of oil for each ounce of gold. While this ratio holds over the 1-, 5-, 20-, and 25-year time periods, the volatility in the trend is extreme. By going long oil and short gold when the ratio is well above historical standards, we profit when the ratio reverts to more normal levels.

When we entered this trade, the ratio stood at 19.2 with gold fetching $885 per ounce and oil less than $46 per barrel. Since then, the ratio has dropped to 13.6 with gold rising 8% and oil increasing 53%. By remaining patient and allowing the trade to move in our favor, we did not need to speculate on the direction of each commodity, but instead gained by watching the basis change.

Having marked these prices in our portfolio each week, we have accounted for the gains. However, we must also worry about the risks. Since we have traded to the middle of the long-term range, I question how much upside remains. Despite oil's continued rise, I am concerned that the widening contango will push prices lower. Factor in my bearish view of crude given the widening contango and I easily foresee oil dropping to $57 to $60 per barrel. Were that to occur, we would need to see gold retreat to between $800 and $840 to maintain the current ratio and below that for us to realize additional gains. Considering the fear over fiat currencies, the push toward commodities, and the fact that gold has not consistently traded below $850 for a prolonged period since last fall, the likelihood of gold falling enough to either maintain or tighten this basis is unlikely.

Many investors do a nice job of determining which trades to enter. However, few of them are disciplined enough to decide the correct time to exit. In many of my newsletters, I have demonstrated the discipline to exit trades when the time is right and our performance has shown positive results. Now is one of those times we must head for the door. I recommend exiting the gold/oil pair trade as this week's fundamental trade.

Comments

[xxxx:]

except if the s&P is manipulated as many think if this isn't allowed to correct other commodities will not correct.

In a rational market you are right, we are not in a rational market and wall street banks on low volumes have pushed up valuations beyon where they should be.

"Europe’s Dow Jones Stoxx 600 Index advanced 2.1 percent. The gauge has rebounded 36 percent since March 9 on speculation that the $12.8 trillion pledged by the U.S. government and the Federal Reserve will help end the first global recession since World War II. The index is now valued at 24.9 times the earnings of its companies, the most expensive level since 2004, weekly data compiled by Bloomberg show."

logic does not work in a manipulated market!!!!

Jun 10 08:33 AM

[ScroogeMcduck:]

Not a bad strategy and a good article thanks sean

Jun 10 08:38 AM

[doubleguns:]

Cetin, did you stay up all night working on these pathetic mumblings that you are posting all over the place. They should have something to do with the article.

Its the same damn post on every blog.

I will not go to your site to give you additional hits, to increase your collections, to encourage you to come back her and do it again.


On Jun 10 08:45 AM amg wrote:

> Telling us the fines means nothing if you don't tell us how much
> they were convicted of
> paying in bribes. This could be peanuts, not prohibitive and in fact
> could encourage them to
> simply factor getting caught into their huge money pots. they have
> more money than
> governments at their disposal. they are "they" - the enemy of the
> lower and middle classes
> in this ongoing class war that little people have been losing forever.
>
>
> good reading: kl.am/tsc finance and econ articles

Jun 10 09:21 AM

[mbkelly75:]

I like pair trades also and agree that it is time to take some profits and get out of this one.

Jun 10 10:09 AM

[pslater:]

I was sooo hoping Cetin had left for good. It's disappointing to know he's back under a new name.....

Jun 10 10:24 AM

[Donald Ingram:]

Yes. Discretion being the better part of valour. A bird in the hand is much better than two in the bush! Preserving gains and then watching them grow, knowing when to harvest is the name of the game. Keep your shorts up!

Jun 10 11:39 AM

[Living4Divi...:]

The OIL fund holds only oil futures contracts. You can successfully win in oil speculation if you can predict a) the future level of the U.S. dollar, b) the pace of the global recovery (demand) and c) the actions of speculators and hoarders. Not an easy task.

Oil futures are highly speculative. Rather than repeat my arguments here, feel free to read my rationale in the article titled "How High Will the Price of Oil Go?"
Here is The Link: seekingalpha.com/artic...

Jun 10 11:49 AM

[Sheik Rattl...:]

I agree, time to exit oil. There's a good chance it has higher to run but compared to the easy gains from $35/brl to here it's a lot more risky now. On a major pullback or gold rise it might be time to buy again, but I'm expecting gold to pullback too...

Jun 10 12:08 PM

[sickofthehype:]

What concerns me is everyone claiming we're due for a correction. Kind of like the market overall. I would agree with this, but being manipulated the way it is, that correction might not happen until we gain another 30%.

Jun 10 12:27 PM

[long roh:]

Interesting article and data. Given that gold is essentially money and that oil keeps getting harder to come by (Peak Oil), I suspect that if one drew a moving average on that chart, it would show a irreversible long-term trend down, which is scary since there is really no cost-effective way to sensibly profit from it (too much volatility). Only a breakthrough alternative energy technology can save us from an eventual 1:1 gold to oil ratio.

Jun 10 12:32 PM

[Maxe Paul:]

Nice result on your trade, well done, congrats etc.

Jun 10 02:01 PM

[Anandakos:]

Long Roh,

I have been surprised that the Saudis and Kuwaitis haven't started demanding gold for their oil, or at least a portion of it. The logic would be: "We're selling you an irreplaceable resource. We want something that you can't inflate away from us."

On Jun 10 12:32 PM long roh wrote:

> Interesting article and data. Given that gold is essentially money
> and that oil keeps getting harder to come by (Peak Oil), I suspect
> that if one drew a moving average on that chart, it would show a
> irreversible long-term trend down, which is scary since there is
> really no cost-effective way to sensibly profit from it (too much
> volatility). Only a breakthrough alternative energy technology can
> save us from an eventual 1:1 gold to oil ratio.

Jun 10 03:20 PM

[Jon G:]

Sean -- why not take a look at Oil to Nat Gas from a ratio perspective. I can make a fundmental argument why the ratio is so out of whack but I took a position in UNG anyway based on it. Would love to hear your thoughts as well

Jun 10 04:21 PM

[long roh:]

Andankos: They probably have -- indirectly, by dumping dollars for other assets. Compare GLD, UUP and DBO for any period since Lehman went under and it tells the story.

Jun 10 04:45 PM

[Vandana Bharti:]

Well I am surprised, same stratgy I adopt on the same day 20th of aptil. We got good profit here. This is an uncertain time where personally I expect that both gold and oil should move in a tight band, hence this strategy wont be fruitfull as it was in the recent past. But what I feel that if we reversethe strategy and go for "buy gold and sell oil " in the fourth quarter , then it can work.

Jun 11 12:38 AM

[daniel3582:]

The FOREX. I'm sure they are hedging their dollar exposure.


On Jun 10 03:20 PM Anandakos wrote:

>
> Long Roh,
>
> I have been surprised that the Saudis and Kuwaitis haven't started
> demanding gold for their oil, or at least a portion of it. The logic
> would be: "We're selling you an irreplaceable resource. We want
> something that you can't inflate away from us."
>
> On Jun 10 12:32 PM long roh wrote:

Jun 11 05:40 PM

[BestInvestIdea:]

There is no justification for $70+ oil other than speculation. Just because we have had a bear market bounce doesn't mean we are off on a new bull run. With speculation running high, the low risk move today is to get defensive for a correction or more. This post is the correct move, but for more reasons than profit taking.

Jun 12 12:20 AM