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Throughout modern industrialized history, oil and gold have had a rocky relationship. Fortunately, this rocky relationship provides clues as to where to put your investment dollars.

In some ways the oil and gold are very similar assets, because they are both priced in U.S. dollars. In other ways the two assets are like oil and water, with oil performing well during global aggregate demand booms and gold performing well in periods of money expansion and uncertainty. Even when the prices of oil and gold are moving in the same direction, one asset can perform quite differently than the other.

Regardless of this bumpy history oil and gold have always remained fairly close. As illustrated in the chart below, the gold-to-oil ratio has oscillated within a range over the past century. The dark blue line shows the number of barrels of oil that could be purchased with an ounce of gold. The higher the line, the more expensive gold is relative to oil. The pink line shows the average ratio over the entire sample period.

Why has the gold-to-oil ratio remained rangebound over the past century? Unlike many financial assets, both oil and gold are bound by physical supply and demand. The long-term supply/demand characteristics of oil and gold have more in common with each other than with the growth of financial assets. Consequently, from a relative perspective, one would expect the price relationship between oil and gold to remain rangebound.

Both assets are similarly impacted by the growth of fiat currency, namely the U.S. dollar. In general, as the dollar falls both oil and gold prices will rise (all things equal). This too keeps the price relationship rangebound.

Since oil and gold are similarly impacted by physical supply/demand and the expansion of money supply, one can view gold as a real money measure of the value of oil. In this case, 'real money' refers to the real cost of oil because it strips out the impacts of monetary expansion. (Remember, monetary expansion causes prices to rise even when values remain constant.)

The more it costs to buy oil in gold terms the more likely oil is overvalued relative to gold (dark blue line is low), and vice versa. A savvy investor can take advantage of relative mispricing by buying the underpriced asset and selling the other.

What if an investor had held oil and gold at the peaks and valleys in the above chart? Would one asset really outperform the other? And would the expected asset outperform (peaks: oil outperforms; valleys: gold outperforms)? The table below illustrates the 5yr cumulative performance of each asset at each peak and valley for the gold-to-oil ratio over the past century:

Peak/Valley Oil (5yr cumulative return) Gold (5yr cumulative return)
1911 Peak 80.33% 0.39%
1920 Valley -45.28% -0.19%
1933 Peak 68.66% 32.36%
1949 Valley 9.45% 10.57%
1970 Valley 141.19% 348.02%
1980 Peak 11.58% -48.21%
1985 Valley -16.85% 20.88%
1988 Peak 13.28% -17.66%
1994 Peak 17.97% -27.38%
2000 Valley 88.17% 59.34%
2005 Valley 48.59% 175.22%

In each peak (when oil is undervalued relative to gold) oil outperforms. In each valley, except one, gold outperforms. It appears that the gold-to-oil ratio may have some predictive value when forecasting future relative returns.

Looking at peaks and valleys in hindsight is easy. But in the real world, investors need to work with live data that won't be confirmed as a peak or valley for years. So I looked at the dispersion of the gold-to-oil ratio around the long-term mean as a potential indicator of future returns. Presumably, if the ratio fell below the mean, gold should outperform. Conversely, if the ratio rose above the mean, oil should outperform. The table below displays the results of this test:

When Ratio Below the Mean When Ratio Above the Mean
On average, gold outerperforms oil by 19.41% cumulatively over 5 years after observation On average, oil outperforms gold by 39.20% cumulatively over 5 years after observation

This data supports the previous finding that the gold-to-oil ratio may provide predictive clues for future relative outperformance. (Remember, relative performance could still mean both returns are negative... one is simply less negative than the other. Also remember that average outperformance includes observations during which the asset did not outperform.)

As of Oct 11, 2011 the gold-to-oil ratio was at 19.53, just slightly below the long-term average. The current reading doesn't provide strong impetus to take either side of the relative trade. But keep watching the gold-to-oil ratio to see how it evolves to determine if either gold or oil prices present a potential opportunity to profit from relative performance.

Disclosure: Long gold and a few oil companies (not mentioned in article). This is not advice. While Plan B Economics makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.

Source: How To Play The Gold/Oil Ratio