Oil/Gold Arbitrage Opportunity

Oil Gold Parity

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

click to enlarge images

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
   

Comments

[Umm, yeah:]

Loved the article. Thanks!

2008 Jul 14 07:29 AM

[Ishortyou:]

Shorting oil and keeping some gold doesnt look bad, at least is a lot better than having cash in the banks which are going belly up and say bye bye to your money because if you have more than 100,000 dollars that you will never see again.

2008 Jul 14 07:37 AM

[Samuel Cash...:]

Article Title is a Misnomer. Arbitrage is riskless profit. This is absolutely not riskless.

2008 Jul 14 10:15 AM

[Samuel Cash...:]

Article title is a misnomer. Arbitrage is riskless profit. The proposed strategy is by no means riskless.

2008 Jul 14 10:16 AM

[phdinsuntan...:]

there's no reason to build new refining capacity because it may increase gasoline supply, so the monopoly would be reduced.
In the short term long DUG instead of shorting, if you enjoy volatility

2008 Jul 14 10:28 AM

[Cash_and_Fetal:]

You want to see PROOF that Oil pricing is a "SCAM".....

Take a look at some of the futures prices of a barrel of oil.

futures.tradingcharts....

Do you see a pattern there?

Look at the 2012 future prices for a barrel of oil...they are trading in the $70's

2012 will be "election season"....

Speculators don't want to touch buying it...

If we were really living in a "tight" market....and $150/$200 a barrel is here to stay...That's the BEST deal OF THE CENTURY you could find, you could TRIPLE your investment in 4 short years...what other investment is there with that kind of "guarantee"...A 300% return in 4 years....?!

Why are people not buying up those futures contracts as fast as
they can?

Because the price if FALSELY inflated....and Oil Pricing is a SCAM manipulated on the ICE markets.

2008 Jul 14 05:21 PM

[CrazyIvan:]

I would assume you are doing the CPI-M1 correlation using the actual levels of the two time series, in which case there is a strong time trend in
both series causing a lot of the correlation. It would be more accurate to correlate the percentage changes in the two time series.

Also I don't see any support for the inflation-unemployment rate trade-off. Given your correlation coefficient, only 1.6 percent of the variation in unemplyment is explained by changes in the CPI.

2008 Jul 14 05:35 PM

[Robert Zingale:]

I understand the problem with using a long time series like I did to show correlation. However, I originally used percentages like you advised. These did not yield desirables results either. It actually did not prove an inverse relationship between CPI and Unemployment. I downloaded all of these time series from the Fed as well so I know that they are sound. What other suggestions might you have to get a more accurate reading? I am eager to learn.

However, the main assumption drawn between the Gold and Oil parity was from comparing their prices. If loose monetary influence is the only influence in driving these commodities, then this ratio would not be up to .15.

Also, to be financially correct this is probably more close to a cross hedge on the U.S. dollar. True arbitrage opportunities only exist for a short while until it is traded away. This is not an arbitrage opportunity. You are correct.

2008 Jul 14 08:15 PM

[gashouse go...:]

>> Look at the 2012 future prices for a barrel of oil...they are trading in the $70's
>> 2012 will be "election season"....

Ugh. Okay, I'll bite.

The data might change. But, at the time I followed your link, May 2011 and Aug 2011 showed $70 *bids* on oil, too, while other months in the same year showed prices around $130. May 2011 isn't an election season. More importantly, there was NO volume at those prices.

Please help me adjust my tin foil hat. I'm not seeing what you're seeing.

2008 Jul 15 04:53 AM

[Robert Zingale:]

Yea I am not seeing that either. When I refer to demand and supply this can mean futures contracts as well. This can also incorporate speculation and whatever else you would like to call it. All this means is that it is not entirely monetary influenced.

As for my strategy it has worked out extremely well since I've enacted it at the start of trading of Monday. I am up 6.64% in about two days. The relationship between gold and oil has closed down to (138.75/978.700) or .141770.

What has happened is that the demand and supply portion of oil's price has fallen simultaneously with a further future dilution of the dollar created by the moral hazard of the government willingness to bail out failing companies. Their role is going to be to loan large amounts of capital to failing companies at artificially low interest rates. This further fear has supported gold's price. This is exactly what I expected to happen in my ideal situation.

The other situation that I thought would cause this ratio to come further together would be a price spiral in oil which would cause such a sudden economic downturn and further financial instability that it would continue to dilute the dollar as a result of the Fed continuing to print money in order to combat these issues. This would likely cause gold to be revalued to historical levels to oil as the dollar would weaken and demand and supply of oil would be severely comprised.

I hope someone took this position and thought my reasoning presented them with a healthy risk adjusted return during a market where that is scarce.

2008 Jul 15 07:26 PM

[Cash_and_Fetal:]

wunsacon....if you didn't believe me with my first teaser....trying reading these articles...

Read these two articles about ICE,
IntercontinentalExchan... Inc.


Ice, Ice Baby Part 1
www.star-telegram.com/...

Ice, Ice Baby Part 2
www.star-telegram.com/...


Here are some teaser quotes:


When Enron failed and took its private, unregulated energy exchange to the grave, another rose to take its place. The Intercontinental Exchange (ICE) was the brainchild of
Morgan Stanley,
Goldman Sachs,
British Petroleum,
Deutsche Bank,
Dean Witter,
Royal Dutch Shell,
SG Investment Bank and
Totalfina.

In 2001 ICE purchased the International Petroleum Exchange in London; renamed ICE Futures, it now operates as an "exempt commercial market" under section 2(H)(3) of the Commodity Exchange Act. As the Senate hearings pointed out in the summer of 2006, "Both markets operate outside of any CFTC oversight."

www.star-telegram.com/...
We started as a society that worships hard labor and the basic business ethic of building value into the goods you create. How’d we get from there to worshiping Wall Street’s billion-dollar boys — who create nothing, build nothing, own nothing and deliver no goods, and yet can throw so much money into products made by others that they determine what we consumers will pay for those goods?

Oil Movements tracks every tanker at sea, from both OPEC and non-OPEC oil countries, along with their cargoes’ final destinations. Anne O’Shea responded immediately to my request with their report dated May 8, 2008. Just so you will know, oil shipments are up from a year ago in almost every class, including Middle East oil in transit and Non-OPEC in Transit. The only class of oil shipment that has declined is covered on page 3 of that report. That chart is labeled, "4-Week Changes in Westbound Oil at Sea."

That’s right, shipments of oil headed west have shown serious declines during the month of April, down 800,000 barrels per day in the week before the publication of the report


This is EXACTLY what Enron did when it's Electricity Manipulation, Turning off power grids to falsely inflate demand on other grids....

2008 Jul 15 08:22 PM

[snoopyjc:]

I hope you played this, because if you did, you'd be up 4x on your investment!!
--joe

May 05 05:33 PM

[chistletoe:]

Stay long gold,
but don't short oil.
The reason that refining capacity is shrinking is that
the companies which refine oil understand
that the crude oil supply is shrinking.
there's no reason to build new refining capacity because there won't be any new crude coming on the market to refine.

2008 Jul 14 08:05 AM