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

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.

Comments

[jo0hn2:]

"Principally, due to the weakness in the financial sector, the Federal Reserve must continue to lower interest rates to make access to capital easier. "

Though helping the financial sector does increase the value of the dollar which you can also peg to gold it would help but when you get to lowering interest rates thats just going to weaken it and make gold rise even more. its also going to add to the inflation since actual inflation not the government given stats is almost 12 %.

2008 Apr 22 09:44 AM

[enviro111:]

Your premise that the gold / oil ratio should average around 10 is false. Just because it has done so in the past is no guarantee it will continue.

1. Gold has been de-monetized to the point that it is no longer money. Thus, it is open to the laws of supply and demand just like oil.

2. Your reasons for the oil prices rise are incomplete. The primary reason is Peak Oil. Peak Oil means that the worldwide oil supply cannot grow following the Peak Oil event. This event is now likely in the past. Thus, the oil supply is constrainted. Geopolitical reasons for the oil price rise are mostly secondary. Should True geopolitical factor emerge, the oil price will go ballistic! The demand for oil on the other hand is rising. This combination of constrained supply and galloping demand is leading to the oil price rises. The rises are large in terms of fiat currencies and more muted in terms of gold. However, oil will rise in terms of gold and paper money.

3. The world contains lots of gold and little or none of it is being consumed. This is not true for oil.

4. The only way for gold to really go up is for a continued debasement of the US dollar and other currencies. Oil goes up for the same reasons plus the supply and demand factors previously mentioned. Expect the gold / oil ratio to keep dropping - slowly.

2008 Apr 22 03:56 PM

[bas3:]

I agree with enviro111.

2008 Apr 27 12:20 PM

[Raw Greed:]

I posted a new image of the historical gold to oil ratio on Raw Greed.

2008 Apr 29 06:27 AM