Long Gold, Short Oil: Why and How

Gold and oil traditionally follow each other, based on confidence in the global economy and on strength in the U.S. dollar.

But since its August 24 close of $73.68, oil has trended downward. Gold, meanwhile, has been racing since about September 1. These opposing trends come amidst ongoing global recovery, weakening dollar, and diminishing retail expectations. The following chart runs from July 27 to September 11, 2009.

Why cheap oil? Let’s talk El Nino. Only three hurricanes have ever strengthened to category 4 and tracked through the Gulf of Mexico this late in an El Nino year – a 1929 storm, Lili (2002), and Ivan (2004). If nothing forms with a potential gulf track in the next week, oil platforms should be free of weather trouble until next year.

The weather has heating oil looking cheaper, too. The National Weather Service’s most recent 90-day outlook predicts a warm autumn (here). Another outlook will be issued next Thursday; because of El Nino, confidence in a warm outlook will likely increase.

Politics and petroleum are blending together with less risk lately. After Nigeria’s crackdown on Darul Islam in August (here), the country has been quiet. Scotland’s bombers-for-barrels scandal (here) has faded, thanks to the 24-hour news cycle. Iran’s playing the nuke card as strongly as it can to provoke tensions but still maintain trade with Russia and China (here). The latest headlines on seaborne piracy more resemble a plot from Alias than anything threatening oil shipments (here).

Several factors could be contributing to stronger gold, but no single reason seems any more compelling now than before. A “safe haven” play for swine flu (here)? A weaker dollar (here)? The need for a new global reserve currency (here)? Too many Treasuries up for auction in the future (here)?

So after looking at gold and oil, a long/short play looks appealing. Going double-short oil (PowerShares DB Crude Oil Double Short ETN: DTO) and double-long gold (PowerShares DB Gold Double Long ETN: DGP) gives you the possibility of juicy returns, should current trends continue. But if oil and gold correlate, then each position hedges the other.

It’s only a losing scenario if oil rebounds and gold drops. In any kind of major oil supply disruption, gold would likely increase as a safe haven. And in an economic recovery, gold also would likely rise with other commodities.

Disclosure: long DTO and physical gold

Comments

[Roger Knights:]

"Several factors could be contributing to stronger gold, but no single reason seems any more compelling now than before."

If there's been long-term hanky-panky in the gold market, as some allege, then Barrick's de-hedging may be a sign that the scheme is unwinding, or anyway becoming more fragile. Also, a statement by one of China's officials, quoted by Evans-Pritchard, that implied China would buy gold on dips has made gold a less risky investment for speculators.

Sep 13 10:11 AM

[AlphaKing:]

After rising to 73, oil dropped back down to as low as 68.8. October contract had plunged -4%, settling at 69.12 Friday, for a total gain of approx.1.2% for last week. Crude oils decline on Friday was accompanied by dollar weakness, and some relatively positive economic data. Last weeks moves in oil were in contrary to the usual inverse relationship it has with the dollar; suggesting it may be in for a period of consolidation or a pullback, and is trading more on fundamental factors.

Sep 14 01:06 AM

[iknow1:]

Ross,

Well written. I happen to agree with your El nino hurricane theory and assume that the seasonal tendencies will take crude below $50 by mid January. Gold appears in strong hands right now but could pull back $25 to $40 an oz over the next 2 weeks. For timing purposes i would put on the short crude at about $71/ barrel first and then somewhere over the next 10 days add the long gold at about $980 / oz.

ik1

Sep 14 07:51 AM

[jerrydd:]

Gold has topped out so see little reason to buy it. Oil while it might go down for a short while, as soon as the world economy recovers, it's going up to $150+/bbl. Then as the world goes back into recession from that, sell, take profits.

So the author has it exactly wrong. Buy oil this fall as it drops, then enjoy good returns by investing in companies that have the most reserves for the lowest cost.

Sep 14 12:21 PM

[mna:]

hmmm.... so your only reason for a drop in oil prices is the absence of oil supply interruptions from hurricanes and politics? It's a contributor, but considering that the affected regions only contributes a small supply of global oil... You're definitely missing the forest for the tree. Oil will drop a bit in the interim, but will shoot right back next year as the recovery takes hold.

Sep 14 04:21 PM