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What Gold Can Tell You About Oil Prices

30 Mar 2017

It’s human nature to pay close attention to market indicators when they seem to be working and show neglect or indifference when they’re not. That is not, however, necessarily the way to buy low and sell high.

Take the WTI crude oil to gold ratio. This is one of the oldest indicators in the market, comparing the price of the world’s most traded commodity with the world’s oldest store of value. For that reason, there is a large data set from which to draw. In addition, gold has always played an important role in commercial transactions and in particular with crude oil in the Middle East. Aside from the gold culture prevalent in the region, transactions were frequently conducted in gold for crude before any kind of sophisticated financial infrastructure was in place. When a number of major countries brought a change to end the decades-old practice of buying and selling oil in U.S. dollars in 2009, gold was included in the currency basket in addition to all the usual suspects. As recently as 2012, in a widely-reported event, Turkey exchanged nearly 60 tons of gold, worth about $3 billion, for several million tons of Iranian crude oil to circumvent Western sanctions against Iran’s energy sector. One suspects that wasn’t an isolated event.

Since World War 2, the annual average ratio has reflected the fact that one ounce of gold could buy precisely 14.83 barrels of oil. Therefore, whenever one ounce of gold can buy more than 14.83 barrels of oil, either oil is comparatively cheap or gold is comparatively expensive. Conversely, whenever an ounce of gold can buy fewer than 14.83 barrels, then oil is expensive or gold is cheap. Spread traders and hedgers pay attention to changes in this ratio to create arbitrage opportunities which are in a sense directionless because they are predicated on convergence or a form of mean reversion.

Currently, the ratio, which bottomed at about 21 at the end of 2016 (see chart), has risen to just over 26. Most importantly, as Dennis Gartman remarked recently (The Gartman Letter, 24 March 2017), the ratio has now clearly broken the trend line that had been established since it peaked in early 2016 at just above 45. So 45 barrels per ounce reflects very cheap oil or very expensive gold; 21 reflects very expensive oil or very cheap gold.

This kind of information can either constitute fodder for a game of Trivial Pursuit or a trading opportunity. Generally, the weaker the ratio, the higher the probability that gold will rise in value and oil will fall, which suggests a pair trade that is still viable. Trade execution implementation could be through short WTI futures and long Comex gold, or via the relevant ETFs, or using cash and/or futures options to create comparable synthetic exposure. Timing is everything, but it may also be possible to leg into the position on a pro rata basis. Follow the Commitments of Traders (COT) report each week from the U.S. CFTC of speculator/investor and commercial interest in the underlying futures markets as your preferred sentiment indicator. Blather from raving gold bulls or blither from OPEC’s propaganda machine is infinitely less reliable.

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