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Oil Gold Parity

All data is shown in monthly prices.  Correlations were made using historical monthly prices for the time period stated.

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Prelude

I pulled this monthly data online and used excel to arrive at these correlations. I included M1, M2, and M3 to show how precisely things are correlated in my data pull. Money supply is near perfectly correlated to inflation which is intuitive. This data also supports the findings of the Phillips Curve unemployment inflation relationship. This is what I wanted to find out so that I know that the rest of my findings will be significant. I used M1 as my reference for money supply since it has the closest relationship to consumer prices.

Observations

The Oil to M1 correlation (.69) suggests that a significant amount of oil price is related to the increase in the supply of money. In the last four years there has been a significant drop in this relationship. The time period during 2004-2008 we saw only a .5 correlation. This suggests that recent oil prices are not entirely influenced by a rise in money supply. This would imply that there is a demand and supply issue regarding oil. Let's look at our Oil/Gold ratio and see if this supports our initial observation.

During May '07 this ratio was .0952 and May '08 this ratio was .1411. This is a 48.2% increase. This means that oil got more expensive 48% relative to gold. This is a significant finding because the 1968-2008 Gold Price M1 Correlation I found was .64. Since oil has a .69 and gold a .64 correlation to M1, they have historically about the same correlation to the money supply. If this was entirely a monetary problem, then gold would increase in value proportionally to the increase in oil. This did not happen. That is why this situation is based significantly on a demand and supply issue for oil. However, this does not explain the entire increase because oil increased percentage wise greater than the increase in the gold value of oil. This means that there was loose monetary influence as well.

Conclusion

Those advocates that claim to use gold as a way to support our currency still could not prevent the recent price rise in oil. However, the 2004-2008 .1108 ounces to barrel of oil average held firm until only a couple of months ago. Right now the relationship is at .15 ounces per barrel of oil ($145/$960). This demonstrates that oil is continually getting more expensive relative to gold. Back in June this ratio increased to .156 ounces per barrel of oil ($135/$860). We saw recently a $100 spike in gold and it reached a $1,000 earlier in the month. The 1968-2008 Gold to Oil Correlation is .84. This is a strong relationship between the two commodities. As we saw when gold spiked to $1,000 this was greatly caused by a huge rally in oil and a weakening dollar.

I would expect that the differential between Gold and Oil will dip under .15 in the near future. Since oil's price increase is due to a demand and supply constraint and a weakening dollar, I think that the likely slower economic growth from the current credit crisis combined with a search for alternative energy will have a slowing effect on the price of oil.

However, I believe that oil price will continue to rise as consumption continues to converge onto refinery capacity. The EIA [DOE] estimate of 87.698 million barrels a day for 2009 world oil demand is an alarming number. Since 1980 the Consumption to Capacity differential has decreased from 17.425 million barrels a day to 2.694 in 2007. This information was taken from BP's last energy report. The 2007 capacity for oil was 87.913 million barrels a day. This trend appears to further narrow the differential between Consumption to Capacity. The 2009 Consumption to 2007 Capacity is only .215 million barrels a day. This is going to present a continuation of supply pressures until more oil comes online. I believe that oil will continue rising in price but a slower pace than over the past year. The oil markets are actually in contango until July '09 at the current 145.08 price at the July 11 close. This is a bearish signal for the commodity.

The current credit crisis and impending government bailouts of Fannie Mae (FNM) and Freddie Mac (FRE) will only likely continue to dilute the strength of the dollar. If the Fed opens up their discount window to these companies, then this excessive supply of money will only further propel gold prices higher. Both of these companies combined have about $6 trillion of debt. The required capital injection is not likely to be completely sterilized as the Fed might promise. IndyMac's (IMB) government seizure is reigniting the credit fears that have plagued the financial industry. It appears that the credit liquidity problems are still not over which may require the Fed to lower their target rate once again.

Trading Strategy

  • Short USO
  • Long GLD

USO is likely to have a pull back by either oil demand and supply easing or a strengthening dollar. GLD is valuable based upon the poor strength of the dollar and a safe haven for the liquidity crisis.

If the dollar strengthens then both funds will likely fall but you will be hedged with a .87 correlation between USO and GLD dating back to January 1, 2007.

This strategy is mainly to profit off the spread between gold and oil price that I believe will further narrow. Historically oil is at an all time high against gold. I believe that technical analysis is preventing gold from reaching a level where .13 gold ounces can buy a barrel of oil. Once gold breaks and stays above $1,000 per ounce, there will be a faster acceleration higher. It is similar to the oil run up. The time it took to finally stay above $100 was longer than it took to get to $120 a barrel. This plays a lot into the behavioral finance aspect of valuations.

.13 ounces per barrel of oil is still an extremely high ratio historically speaking. During the oil supply problems of the 1970s this ratio only reached a high of .1218. I believe a settling at .13 is justifiable for the significant long term demand increase in oil.

Potential Results

Gold is currently trading at $960 an ounce. Oil is at $145 a barrel. If they closed the .2 differential, then these results could possibly look like this.

  • Gold = $1250 an ounce
  • Oil= $162.50 a barrel

This change in pricing equates to a 30.2% increase in gold prices and a 12% increase in oil prices. The spread to be made on a move like this should be around 18%. This is can greatly differ due to trading differences on GLD and USO and the range which these two commodities close this historical gap.

Sources:

  • M1, M2, M3, Unemployment Rate, and CPI were taken from the St. Louis Federal Reserve.
  • Historical Oil Prices were taken from Economagic.com
  • Historical Gold Prices were taken from Austin Gold Information Network
     
Source: Oil/Gold Arbitrage Opportunity