Oil Can Be Another Inflation Hedge

by: Thomas Noon

Gold has been on a run since 2005 or so....or should we say that the exchange rate between gold currency and paper currency around the world has been going through some major earthshaking adjustments. Inflation fears have turned into currency valuation realities. Reality tells any holder of wealth to shift your wealth storage plans from a currency that can be created from thin air to one that cannot. Hence, those who own wealth that is not currently deployed in hard assets (buildings, equipment, etc.) or that is not immediately needed as working capital have been using their paper currency of questionable future value to buy gold and other things of value. (Anyone with experience in the world of investment-grade collectible antique guns can tell you that 2005-2010 have been banner years in achieved auction prices.)

But, for those who have concern that gold may be "less in demand as an industrial product", deploying some wealth into oil may be a wise alternative for some of your portfolio. (I am not that concerned about the industrial usefulness of gold. Gold is much more transportable - and able to be hidden - than oil or corn; although lumber is very useful for industrial purposes, I wouldn't recommend trying to take $100,000 of lumber with you to Zurich.)

The gold/oil ratio is now over 15 (price of 1 ounce of gold / price of 1 barrel of oil), even with oil and most energy ETFs at a 52 week highs today. The 100-year average on this ratio is a bit over 10 and the average for most of the past decade was 10 before the recession hit in 2007. (See chart of this ratio over the last 30 years here. See chart of last ten years here.) That would argue that recent pricing on oil at $144 is not as incorrectly priced as it may have seemed at the time.

The other possibility is that gold is overpriced and should come down to reduce that gold/oil ratio back toward 10. But, we are all aware of the fundamental drivers in the exchange rate between gold and the US$..... M1 and M2 money supplies skyrocketing double or higher in the last 1-2 years and debt levels that would portend additional money printing is coming (or at the very least, argue against a sharp reduction in money supply for the forseeable future). And, the inverse correlation between money supply and the price of gold has also been discussed at length.

So, no, it is not the price of gold that is out of whack.

I would argue that oil is far too low and is probably being held down by the ongoing recession that is containing the demand for all petroleum-based products (from gasoline and diesel to plastics of all kinds). Once demand recovers, we will see the underlying true price of oil and I would expect a return of the gold/oil ratio to its 100-year trendline of 10. Historically, oil was paid for in gold, not in paper currency and the trend is back toward that standard. And, oil is not only consumed commercially but the "peak-oil" phenomenon predicts that it is being depleted and the supply could be half what it is today within the next 20 years.

If you add to this dynamic the argument that gold's price is still in a bull run based on fundamentals such as the rising money supply, worldwide governments' addiction to spending, and the soft ratios of gold's price to the S&P 500 or DJIA averages (which predicts $1800 for gold this year), then this would predict that oil at $150 is not in the too-distant future and ETFs like DIG should have a very good year in 2011 and into 2012.

$120-130 for a barrel of oil in 2011 is not an irrational expectation whatsoever.

Better buy a Prius. And, adjust my portfolio to hedge against $6 gasoline?

Disclosure: I am long DIG, GLD, GDX.