Can The Gold To Oil Ratio Predict Exxon Mobil's, ConocoPhillips' And Southwest Airlines' Future Returns?

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Includes: COP, LUV, XOM
by: Daniel Thurecht
Summary

The gold to oil ratio caught my attention as a possibly simple way to predict the future return from companies' shares who are heavily influenced by the oil price.

This article provides my analysis of whether this ratio can be used to predict the future returns from Exxon Mobil's, ConocoPhillips' and Southwest Airlines' share prices.

My analysis indicates the gold to oil ratio offers a degree of assistance when timing long-term investments, however, it should remain a secondary supporting factor not primary factor.

Introduction

Despite being a fundamental long-term investor I cannot deny the idea of finding a simple indicator that leads to reliable and sizable profits remains alluring. If nothing else, finding an indicator that assists when making investment decisions would be a valuable conciliatory prize. One particular indicator that caught my attention was the gold to oil ratio and upon completing my analysis I thought it would be interesting to share the results with the readers of Seeking Alpha.

Overview Of The Gold To Oil Ratio

Since some readers may be unfamiliar with the gold to oil ratio I will first provide a brief overview and explanation to provide the rest of the article with context. The calculation of this ratio is very simple with the price of gold being divided by the price of oil, which in this case was West Texas Intermediate crude oil. This theoretically provides insight into whether oil is currently over or undervalued, with a higher ratio indicating it’s undervalued whilst a lower ratio indicates it’s overvalued. After reviewing the graph below it certainly appears as though a high gold to oil ratio historically signals the bottoming out of oil prices and thus poses the question of whether an investor can incorporate this information into their investment or trading decisions.

Crude oil and gold to oil ratio

Image Source: Author.

Methodology

Since I suspect the majority of the readers on Seeking Alpha are more interested in trading and investing in shares rather than futures contracts, I’ll analyze this ratio against relevant shares that should be heavily impacted by oil prices.

The three companies selected were Exxon Mobil (XOM), ConocoPhillips (COP) and Southwest Airlines (LUV). Since the back testing period spans the last 48 years, it was essential to select oil companies that were in a similar position in past decades as they are currently. Although the results focus on Exxon Mobil and ConocoPhillips, when performing the analysis the same back testing was applied to Chevron (CVX) with very similar results being produced and thus given the similarities it seemed unnecessary to include their results.

On the surface the inclusion of Southwest Airlines may seem rather strange, however, fuel comprised nearly one quarter of their total expenses last year and thus theoretically there should be a negative correlation to oil prices. The reason they were selected instead of other airlines is because sadly they’re the only major listed airline to have avoided the frequent bankruptcies that have plagued the industry.

The analysis involved comparing the one, three, five and ten year annual returns for each of the three companies to the gold to oil ratio. Ideally if the gold to oil ratio has meaningful predictive power then there should a fairly narrow dispersion of returns, a clear and strong upwards slopping trend line that is accompanied by a fairly high R-squared value.

The data for the three companies’ share prices were retrieved from Yahoo Finance and was spot checked from other various sources, whilst the data for the gold and oil prices were retrieved from Macrotrends.

The earliest date selected was September 1971, which was the first monthly data point following the removal of the Bretton Woods agreement. Unfortunately due to limitations in the available data, the back testing for ConocoPhillips and Southwest Airlines began in December 1981 and January 1980 respectively.

Results & Discussion

Exxon Mobil returns verse gold to oil ratio

Image Source: Author.

After reviewing these result it’s clear that on average the gold to oil ratio doesn’t accurately predict returns during the following one, three and five year periods for Exxon Mobil. This is evidenced by the very wide dispersion of returns regardless of the gold to oil ratio, the almost flat trend line that is accompanied by incredibly low R-squared values. The one year results are particularly interesting as the trend line is slightly slopping downwards, which indicates that lower oil prices actually begat lower share price returns during the following one year period. Given the highly cyclical nature of oil prices this seems to be logically invalid and possibly results from noise in the data set caused by other factors outside of the oil price, regardless this highlights the difficulty of picking successful short-term trades.

The predictive power of the gold to oil ratio slightly improved for returns during the following ten year period, with it indicating investors face less downside risk when the ratio is high. Although the dispersion of returns when the gold to oil ratio is low is still very wide, the range narrows when the ratio is high. Since September 1971 there has only been one instance when an investor would have suffered a small loss during the following ten year period when the gold to oil ratio was above 20. Aside from facing less downside risk, investors are also offered higher expected returns as the gold to oil ratio increases, as evidenced by the upward slopping trend line. When the gold to oil ratio is 6 the expected annual return is approximately 7.5%, whilst a ratio of 34 has a moderately higher expected annual return of approximately 12.5%. I believe this is potentially material enough to assist investors with timing their investments, not as a primary factor but rather a secondary supporting factor.

ConocoPhillips returns versus gold to oil ratio

Image Source: Author.

After reviewing the equivalent results for ConocoPhillips it’s clear that overall the gold to oil ratio provides more accurate predictions than it did for Exxon Mobil, however, in the one, three and five year periods these are still far from perfect. Although the dispersion of returns is still quite wide, it’s not as significant as Exxon Mobil and thus the R-squared values have all improved materially along with a steeper upwards slopping trend line. It appears as though a higher gold to oil ratio begat higher expected returns and less downside risk, however, I believe this could only be used as a secondary supporting factor.

When moving to the ten year period the predictive power increases significantly, as evidenced by a narrower dispersion of returns, a steeply upwards slopping trend line that is accompanied by a decent R-squared value. This provides the same indications as the ten year period for Exxon Mobil, however, with greater certainty and meaningfulness. When the gold to oil ratio is 6 the expected annual return is approximately 5%, whilst a ratio of 34 has a considerably higher expected annual return of approximately 15%. Similar to Exxon Mobil I believe this is potentially material enough to assist investors with timing their investments, not as a primary factor but rather a secondary supporting factor.

Southwest Airlines returns verse gold to oil ratio

Image Source: Author.

The results for Southwest Airlines were quite surprising, since they’re a consumer of petroleum products I initially expected to see a downwards slopping trend line, essentially the opposite of oil companies. Clearly this didn’t eventuate and after rerunning the back testing from the beginning again I achieved the exact same results. After reflecting on the results and discussing them with fellow investors I came to the view that the correlation between higher economic growth and higher oil prices is the primary cause for this relationship. When the economy is growing strongly the increase in demand for air travel as well as generally higher share prices pushes up the returns on Southwest Airlines shares despite their fuel expense increasing from higher oil prices.

Similar to Exxon Mobil the gold to oil ratio doesn’t have any meaningful predictive power during the first year period, as evidenced by the very wide dispersion of returns regardless of the gold to oil ratio, the almost flat trend line that is accompanied by incredibly low R-squared values. Although this improves slightly during the three year period, considering the wide dispersion of returns I don’t believe it provides any material assistance timing investments.

Interestingly the gold to oil ratio provided the most accurate predictions during the five year period, with a very steeply upwards slopping trend line that is accompanied by quite a decent R-squared value. Since January 1980 there hasn’t been any instances when an investor would have suffered a loss during the following five year period when the gold to oil was above 17. Aside from facing less downside risk, investors are also offered higher expected returns as the gold to oil ratio increases. When the gold to oil ratio is 6 the expected annual return is approximately negative 5%, whilst a ratio of 34 has a staggeringly high expected annual return of approximately 50%. Similar to Exxon Mobil I believe this is potentially material enough to assist investors with timing their investments, not as a primary factor but rather a secondary supporting factor.

Relating The Results To The Current Situation

To round out this article I’ll briefly relate the findings to the current situation for these three companies. Presently the gold to oil ratio is sitting at slightly over 22, which is moderately high by historical standards. Since September 1971 there has only been one instance when purchasing Exxon Mobil shares would have produced a negative return, before dividends, after holding for the following ten year period and this loss was very tiny at less than 1%. Based on this model the expected annual return is approximately 10.5%. This theoretically indicates it’s currently a good time to purchase their shares, however, an investor should conduct more research before committing to such an investment.

Since December 1981 there has been zero instances when purchasing ConocoPhillips shares would have produced a negative return, before dividends, after holding for the following five and ten year periods. Based on this model the expected annual return is approximately 9.6% for the following five year period and 10.9% for the following ten year period. Once again, similar to Exxon Mobil, this indicates it’s currently a good time to purchase their shares.

Since January 1980 there has been zero instances when purchasing Southwest Airlines shares would have produced a negative return, before dividends, after holding for the following five year period. Based on this model the expected annual return is approximately a massive 28.4%, which clearly indicates it’s currently a good time to purchase their shares, however, investors should once again ensure their investment decision is supported by more analysis. Since the ten year period model produced sub-par results when compared to their five year model it’s unnecessary to relate those findings to the current situation.

Conclusion

I was quite surprised when conducting this analysis, firstly I believed the gold to oil ratio would provide better one and three year predictions than ten year predictions, however, this didn’t eventuate. Secondly, as mentioned earlier the results from Southwest Airlines were very surprising and certainly went against the general rule of thumb I had assumed previously.

If the reader is to take only one thing away from this article, it’s that despite the promising appearance, once again there isn’t a simple silver bullet for timing investments or trades. That said, indicators such as the gold to oil ratio can still provide a useful secondary factor when timing investments providing the investor is considering a long-term holding of approximately ten years for Exxon Mobil and ConocoPhillips and five years for Southwest Airlines.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.