Using the Gold to Oil Ratio to Monitor Gold Equity Investments

In September, 2006 I wrote the article, 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: 14.05 -0.35%, vol: 8,692,176), Gold Corp. (GG: 40.70 -0.90%, vol: 5,143,471), and Barrick (ABX: 42.87 -0.63%, vol: 5,280,304). I also see a large opportunity in junior miners and exploration companies such as Northgate Minerals (NXG: 3.23 -1.82%, vol: 2,585,048) and US Gold (UXG: 2.47 -3.52%, vol: 393,804).

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. Gold prices may reach over $1500 by some analysts and authors estimates. We should begin to pay special attention to miners that lock in high sales prices by selling their gold forward. Traded companies that hedge themselves against falling gold prices, will present a big opportunity going forward.

Comments

[Arcturus]

What makes you think oil and gold prices must be linked in some way? This smells like a meaningless junk ratio. Having said that, buy NXG!

[johngonole]

Don't know if the ratio is correct or not. The author from his previous comments was wrong and gold went up instead of going down. Then in this article he posits that either gold goes up or oil goes down. Then he goes on to say we might have to expect hyperinflation if the FED keeps printing money. Hyperinflation should lift Oil prices so gold should follow. I fail to see how gold or oil go down if we have currency inflation. Also I'm assuming when you conclude that we will merge with a stronger dollar that you mean relative to other currencies. Prices of items and services we buy on whole have never come down in my lifetime and I don't expect them too. Silver is a good inflation hedge since supply is pretty constant. Silver should hold its real purchasing power.

[Raw Greed]

Arcturus, there has been a historical relationship of oil to gold. They tend to rise in line with each other. The article is meant to point out that gold has potential upside to $1200 levels for the 10:1 ratio to hold true. I've written and invested in NXG in the past.

Johngonole, the September 2006 article points out that I suspected gold would continue to rise. You are correct that inflation and hyperinflation will cause both gold and oil to rise. The articles objective is to point out that oil was/is rising dramatically out of line compared to gold.

[cruiser9805]

The relationship still holds if you take into account that the dollar value is at .75. Multiply the 120 X .75 and gold comes out to approx. 900, it,s present value. I believe oil is now more valued than gold . So if oil goes to 200 and the dollar value stays fixed we will see gold at about 1500. However if the dollars value goes down to .5, you will see gold at 1000 with 200 dollar/barrel oil. Very funny relationship.