Gold Prices in for Short-Term Rise, According to 'Gold to Oil Ratio'

Includes: ABX, AUQ, AUY, GG, UXG
by: Andy So

In September, 2006 I wrote about "Gold’s downward spiral."

Taken from the article:

Gold appears to be headed down along with the price of crude oil. Historically, there has been a correlation between the price of crude oil and gold. Most gold fans and economic historians peg the ratio between the price of gold to oil at 10:1. The price of crude oil is currently $65.71 per barrel. Using the 10:1 ratio would mean that gold should be priced at $657.10 per ounce. Gold is currently trading at $590.40.

Gold has not been following the historical ratio as geo-political pressures and concerns over terrorism have contributed to a risk premium in the price of crude. If the historical ratio between oil and gold is to return, either gold has to rise or crude has to drop. I am more inclined to believe that gold will rise. Physical demand for gold tends to be strong going into the fall.

During September, 2006 gold was priced around $590 and oil at $65. The gold to oil ratio was roughly 9:1.

Currently Gold is priced around $920 and oil at $117. The current gold to oil ratio is roughly 7.9:1.

For the historical ratio of gold to oil to remain true, either gold would have to rise close to $1200 levels or oil would have to drop toward $90. There are a number of factors supporting rising gold prices in the short-term. Principally, due to the weakness in the financial sector, the Federal Reserve must continue to lower interest rates to make access to capital easier.

The lowering of interest rates is the medicine needed by financials to engage in income producing activities, such as investment in alternative higher yielding currencies, or direct investment in foreign economies. Financial institutions will continue to borrow USD to shore up capital and in order to recover non-performing assets.

If interest rates on the dollar approach 1% levels, the currency will begin to gain strong favor as a carry trade currency similar to the yen. Lower interest rates will inevitably lead to inflation and eventually hyperinflation as we are seeing with rising oil prices. In the short-term, gold will continue to be a strong hedge against inflation and a falling dollar due to low interest rates.

In the medium to long-term, I believe we will emerge with a stronger economy and a stronger dollar. This will put downward pressure on gold. For the moment, I expect that we are in the final bullish phase of this cycle and will see continued and escalating daily volatility in gold prices.

I would continue to monitor shares of miners such as Yamana Gold (AUY), Gold Corp. (GG), and Barrick (ABX). I also see a large opportunity in junior miners and exploration companies such as Northgate Minerals (NXG) and US Gold (UXG). Shares of smaller gold companies have barely moved in the past half year in light of rising gold prices. Eventually these companies will begin to rise as capital returns to the market and overall economic conditions improve. Earnings should improve for gold miners as prices remain high for gold.

I would pay special attention to companies that begin to hedge their sales in the future. For the past few years, gold miners have de-hedged their sales since they were locked into selling gold at low prices. Now with gold prices rising and possibly reaching over $1500 by some estimates, we should begin to pay special attention to miners that lock in high sales prices by selling their gold forward and hedging themselves against falling gold prices. This will be a big opportunity going forward.

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