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Tackling the oil to gold ratio paradigm – fact or fiction? A short analysis

By: Lior
 
 
There are many "crystal balls" that are sold on line that suppose to help us understand how to trade and invest in commodities, and even help predict commodities' prices such as crude oil prices
 
One of these "crystal balls" is a ratio commonly used – the oil to gold ratio. A quick search on Google came up with nearly 4 million results of this term. One of the first results stated that there is normally a positive linear correlation between crude oil prices and gold prices. I have decided to check out this paradigm and see what kind of relationship there is between these two major commodities – gold and crude oil, and is it sensible to use this crude oil to gold ratio as a predicting tool.     
 
To that end I have checked two basic facts: the trend of both of these commodities and the level of correlation between the two.
 
In the following graph you can see the trend of both of these commodities' price series – gold spot prices in USD / oz. and WTI crude oil spot prices USD / barrel, for the years 1998-2010 (monthly basis prices). In order to make these series comparable I have normalized the figures to 100=1/1998 (i.e. January 1998 was set to be 100).
 
 
The graph appears to show some relationship between the two commodities' prices. Nonetheless, since we all know that charts could be sometimes misleading I have also checked the correlation between the two series.
 
In the table below I have checked the level of correlation between the monthly percent changes (from month to month) of crude oil prices and gold prices. While for the entire period there seems to be a weak positive correlation, when breaking the time series to couple of years, a different picture reveals. In the table you can notice that in some periods there is a positive correlation (such in 2000-2001), while in other there is a negative correlation (such in 2009-2010). Also notice that the strength of the connection also varies between the periods, such is the case in 2006-2007 with a whopping +0.57 correlation.
 
*Monthly average prices; Source: EIA website and World Gold Council website.
 
 
What does it all mean?
 
For one thing, the correlation between the two commodities is not predictable and varies, that is the only prediction you can make based on this exercise. Furthermore, since correlation doesn’t mean causation, I think that in this case it's very much true with these two commodities. And finally, there are additional variables, much more important, that affect these two commodities' prices (i.e. interfering variables) in the same (or opposite) direction, such as the previous Quantitative Easing program from March 2009 of the Federal Reserve which apparently had a positive affect on both of these commodities' prices.

  



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.