Long-Term, Oil Will Put Gold Back In Its Place

Includes: GLD, OIL
by: Jeffrey Dow Jones

One of the games we economists and analysts love to play is called "Let's Price One Thing In Terms of Another."

Go ahead, laugh. I know the rest of the world makes fun of us for playing geeky games like that. But this stuff can make you some serious money.

Check this out:

That, my friends, is a chart of how many barrels of oil that one ounce of gold will buy. As you can clearly see, something distinctly abnormal is happening right now.

I'll wager that even those of you who are too cool for school have stopped laughing. You're paying attention now because you know that historically aberrant conditions like this very frequently lead to outsized profits. At least for those with the cojones to do something about it.

In a minute, I'll get to the details on the ways you can specifically execute this trade. There are ways to play it that are easy and ways that are more complex. But before we get to all that, we need to point out a few important things about that chart.

You'll notice a pronounced downtrend. Since the 1970s this ratio has slowly been trending downward. I started the chart in the 70s for two reasons: First, because that was when we got off the gold standard, and that was when the price of these two assets were allowed to trade freely and naturally about one another. Prior to the 1970s, the price of gold was fixed, and this ratio, as you might guess, was as useless as pricing oil in regular old dollars.

The second reason why the 1970s are a good place to start a chart like this is because that's when the world really starting changing fundamentally. Since then, oil has steadily become more expensive to pull out of the ground, while simultaneously, an ever-increasing number of people in the world are demanding it. The price of oil should have gotten more expensive relative to gold in the last few decades, because there are legitimate fundamental reasons for it.

Obviously this relationship can oscillate quite a bit over a period of several years. This is a volatile ratio, but there is a very distinct band in which this ratio fluctuates. Since these are each commodity assets denominated in dollars, over time they will each benefit identically from a depreciating currency.

Each commodity has its own set of supply and demand inputs, and that's really what this chart attempts to get at. It attempts to identify the places in history when one is more expensive than it should be, relative to the other.

These peaks and valleys represent some of the more interesting inflection points of the last several decades. Of obvious interest was early 1980, when this chart was screaming, "Get the heck out of gold and buy oil!" That trade was a home run.

Another interesting point was around 1985. This chart had you shorting crude and buying gold into the "oil glut." That oversupply condition culminated in a nearly 50% crash in oil in 1986, and again, this trade wound up being a home run.

Finally, and perhaps most interestingly, it's worth noting the bottom in June 2008. That was the pinnacle of the speculation-driven spike in oil prices on fear about "peak oil." Crude oil touched $147/barrel, and gold was trading sensibly around $900 per ounce. The chart was screaming to short oil and buy gold. The financial crisis hit a few months later, and we all know what happened. The trade hit a grand slam.

Anyway, you can see from the chart that we are at another one of those interesting historical inflection points.

In the last month WTI crude collapsed from $115/barrel to the low $80s on (possibly irrational) fears that demand will vanish in an economic slowdown. Gold has catapulted from $1,600 to $1,900 because... well, because gold is the only thing that's going up, and investors like to buy things that are going up.

Honestly, I don't know what happens from here. Something dramatic just happened to generate this condition; something dramatic will probably happen to clear it.

What's the Risk?

There's a small, but non-zero, probability that this ratio increases another 15% or so. As of Friday, that ratio was around 21 barrels, and during the complete deflationary panic of early 2009, that ratio got up to just over 24 barrels. Gold's gone kind of parabolic in the last month, and while there's the chance it keeps rocketing higher, we all know those conditions don't last forever -- or even for very long.

Over the short run, the market acts like a crazy person and does things so far outside the realm of rationality that all we can do is sit around in front of the Bloomberg screen and scratch our heads in wonder. Best to understand that and prepare your portfolio for it before you get into the trade.

In any case, I think it's reasonably easy to get a handle on the downside of this trade. It's a relative value trade, which means the odds of a huge loss are naturally smaller. There's a ton of data and history to back it up.

The other risk that warrants mention is difficult to quantify. This is a trade that could go nowhere for a while. Sharp breakouts usually correct themselves rather quickly, but not always. So be aware that these markets could spend a year or longer churning around at these historically high levels. Just don't forget that they invariably wind up heading back towards a historical mean.

What's the Reward?

There's a large, but not certain, probability that this ratio falls back to a more normal level. My guess is that it'll be one of three places, and I would use these specific targets to set your out point:

  1. The recent average of about 15.
  2. Somewhere between 12 and 14 suggested by a long-term regression.
  3. The pre-crisis average of around 10.

Your upside in those three scenarios is 25%, 35% and 50%. That's the base case. Obviously, those numbers change depending on how you actually gear the trade.

Each of those scenarios warrants very different probabilities. My guess is that it would take a rather extreme event to move this ratio toward the bottom end of that range, but it could happen. What if Paulson has to get out of GLD, and that creates a cascade of sell-stops and linked-market chaos? What if something crazy happens in the Middle East and oil rallies 20%?

A move back towards 15 carries a substantially higher probability. That's the kind of thing that could just happen naturally over time as the market normalizes. And my guess is that probability is significantly larger than a continued advance upward.

Also don't forget that this isn't a trade that plays out overnight. It could take a year or so.

Other Ways to Play it

If you're not a macro trader -- and truth be told, those guys are actually rather rare -- you can still benefit from this analysis. You can use this information to shape the rest of your portfolio decisions. This backdrop is relevant for any investor.

I know that Seeking Alpha is a community that tends to gravitate toward bottom-up analysis. But if you poll all the great fundamental, bottom-up investors, these guys eventually run their analysis through some kind of top-level macro filter. It may not affect their strategic decisions, but it can come into play on the tactical side. No portfolio manager worth his salt makes decisions absent some kind of top-down context.

So given this current environment, it's probably time to load up a little on energy stocks, especially relative to gold or gold stocks. For a macro trade like this, I prefer to use an ETF like the XLE or IYE. But you can look at individual stocks as well. All the usual names apply. You can get long the giants like Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), and Royal Dutch Shell (NYSE:RDS.A), or their international counterparts like Petrobras (NYSE:PBR), PetroChina (NYSE:PTR), and TOTAL (NYSE:TOT).

The integrated majors tend to trade more around the macro environment than the smaller players, so you can avoid a lot of idiosyncratic risk by sticking with them. If you're going to use a company like Anadarko (NYSE:APC) with more of a focus on exploration, or a company like Exelon (NYSE:EXC) engaged in alternatives, or even a company like Suncor (NYSE:SU), which occupies a unique space in the industry, you'll want to use more caution and more diversification.

If you are going to go the specific-stock route, make sure you do a little bottom-up analysis to complement today's discussion. Don't make specific-stock investments in a macro vacuum.

On the other side of the trade, feel free to short a gold ETF, either GLD or IAU if you've got the stones. If you know what you're doing, use the futures or trade the options. Short (or avoid) the Market Vectors Gold Miners ETF (NYSEARCA:GDX). Short (or avoid) the major gold miners like Barrick (NYSE:ABX), Goldcorp (NYSE:GG), or Newmont (NYSE:NEM). I know that's a really unpopular thing to say right now, but it's nothing personal. If it's any consolation, I loved all of those companies six or seven years ago, and even as recently as 2009. Some day I will love them again, and I can absolutely guarantee that it'll be when the rest of the world hates them. (My tentative ETA for that is sometime between 2020 and 2035.) For those of us who are searching for true value, the dating pool right now is kind of small.

Anyway, there are a million ways to rig a trade like this. Getting long oil over gold can be as complicated as building a series of vertical option spreads on the futures or as simple as buying an energy mutual fund and selling a little bit of your gold. It's highly customizable, and it's easy to tailor something to your individual risk threshold. Since it's a relative value trade, you can gear it with varying amounts of leverage too.

Two Final Caveats

I mentioned at the top that this is a trade that takes some cojones. It's one thing to look at a chart that appears to tell an obvious story. But it's another thing when that story means you actually have to go out in the market and take some kind of short position against gold.

Scary stuff, I know. With gold at these levels and a chart that looks like a freight train, it seems like a suicide mission to stand in front of it and get short.

But the relative value structure of our trade can mitigate a lot of that danger. Don't forget that there are a lot of factors that push both the gold price and oil price up or down together. I've written extensively about these relative value-style trades, and they are a great way to exploit aberrant conditions like the present without taking on insane levels of risk. They work beautifully for our Trade of the Decade. I like the idea of being long oil over gold for the next 10 years, don't you?

My favorite kinds of bets are those where either the probability of success is high or the return profile is disproportionately skewed to the upside. Every once in a while, I'll come across a bet that combines both of those aspects. Those are the ones that get me really excited, and those are the home runs that real macro traders are always looking for.

I feel pretty good that this is that type of trade. Just don't ask me when the payout actually happens, or how.

Disclosure: I am long XOM.