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What is the relationship between gold and crude oil?

In my previous article, I discussed about the history of Gold, Gold-standards and its place in Indian culture. In this article I will cover a very interesting and important relationship between Gold and Oil prices. It is worth noting that rise and fall in the price of oil affects the price of Gold! I will also cover several investment strategies for Gold and discuss whether investing in gold is better than investing in stocks.

Many of our readers asked me why Gold is so important than the local currency. I will explain this by giving example of Zimbabwe, where inflation is over 1,000,000%. Such a high inflation has led to the devaluation of its currency to such an extent that its value is nothing. You can not even buy a loaf of bread for 500 Million Zimbabwe dollars. Yeah they recently issued a 500 Million dollar note!! So if a person has to buy something in global market he or she will get nothing because the value of his or her country’s currency is almost zero! Hence, no sane person will accept his currency which is getting depleted with every passing second. But if the same person buys anything in global market by selling his or her gold deposits, he or she will get the equivalent price of gold in US dollars or for that matter equivalent amount in any other good currency (Rs, ₤, €, ¥). Thus, gold is a universal currency traded and accepted everywhere irrespective of local or national economy. Also, the value of gold is preserved even in Zimbabwe.

Relationship between Gold and Oil

Oil and gold are arguably the most important commodities on the planet today and the ratio of their nominal prices is far from a trivial issue. The gold/oil ratio expresses the interrelationship between the commodity that forms the foundation of our entire global economy and the commodity that has been the ultimate form of money for six millennia of human history. Gold and oil prices tend to rise and fall in sympathy with one another. There are two reasons for this :

  • Historically, oil purchases were paid for in gold. Even today, a sizable percentage of oil revenue ends up invested in gold. As oil prices rise, much of the increased revenue is invested as it is surplus to current needs and much of this surplus is invested in gold or other hard assets.
  • Rising oil prices place upward pressure on inflation. This enhances the appeal of gold because it acts as an inflation hedge. With the rising interest rates the real return on bank deposits or saving becomes negligible. Hence, most of the central banks across the world put their money in gold to stop the devaluation of their reserves.

Gold-to-Oil Ratio

This ratio measures “how many barrels of oil one can buy with an ounce of gold” and is calculated as:

Gold-Oil Ratio = Price of Gold (per oz.) / Price of Crude Oil (per barrel)

The gold-oil ratio helps us to identify overbought and oversold opportunities for gold. The gold oil ratio expresses the interrelationship between the commodity that forms the foundation of our entire global economy and the commodity that has been the ultimate form of money for six thousand years of human history.

Table below shows the average Gold-to-Oil ratio for the last year (monthly breakup data). We can see that the fall in oil price was much steeper than that of gold. Hence, the ratio actually increased after July 2008 and surpassed historical average of 14 in November. The last three year average for this ratio was about 17. Does this mean gold is trading at its highest price level? Analysts disagree to it simply because the ratio is more of a long-term gauge and not on a month to month, year to year trend. Near-term price direction is difficult to predict trading the ratio.

Date Gold Price($ per oz) Oil Price($ per barrel) Gold-to Oil Ratio
Jan-08 889.60 84.70 10.50
Feb-08 922.30 86.64 10.65
Mar-08 968.43 96.87 10.00
Apr-08 909.70 104.31 8.72
May-08 888.66 117.40 7.57
Jun-08 889.49 126.33 7.04
Jul-08 939.77 126.16 7.45
Aug-08 839.02 108.46 7.74
Sep-08 829.93 96.13 8.63
Oct-08 806.62 68.50 11.78
Nov-08 760.86 49.29 15.44
Dec-08 816.09 32.94 24.78
Jan-09 858.69 37.20 23.08

Oil forms the foundation of the extensive global trade today and hence the world economy. Virtually everything we consume in the first world is transported via oil-powered ships, trains, airplanes, or trucks. Without oil, the incredibly intricate global logistics network on which we heavily rely today would grind to a halt. The world would be thrust back into the Steam Age before flight and global trade would implode. In this oil-powered young Information Age, oil truly is the king of commodities.

And gold always has been and always will be the ultimate monetary standard. Empires and nation states rise and fall, and history are littered with once mighty fiat currencies that became worthless as their sponsoring governments slid out of favor. But gold is the standard by which all other currencies are judged, the only real money of world history. It is highly sought after universally, it is very scarce in the natural world so its supply can’t inflate rapidly, and it is very valuable relative to the tiny volume it occupies - the perfect money.

The gold-to-oil ratio is such a crucial measure because it expresses the entire complex interrelationship between the king of commodities and the only timeless real money in a single data series. This ratio allows us to differentiate when gold or oil prices are probably out of whack and hence a mean reversion is highly likely. If we can figure out which component of this ratio is most likely to lead this mean reversion, gold or oil, then we can position trades to ride the move.

Let us analyze the oil price for few moments. We have seen the fall of crude price from $140 per barrel to $30 per barrel within few months. However, oil consumption did not decrease by even 20% in the same period. Then, what happened to the oil price? Why did it fall so much? Most of the leading hedge funds and mutual funds which had invested hundreds of billions of dollars in Oil have withdrawn their money from them, leading to steep fall in its price.

Investing using Leverage

Bullish investors may choose to leverage their position by borrowing money against their existing gold assets and then purchasing more gold on account with the loaned funds. This technique is referred to as a carry trade. Leverage is also an integral part of buying gold derivatives and un-hedged gold mining company shares (see gold mining companies). Leverage via carry trades or derivatives may increase investment gains but also increases risk, as if the gold price decreases, the investor may be subject to a margin call.

Is it the right Time to invest in Gold?

Let us analyze various factors which affect price of gold and then decide whether it is the right time to invest in Gold.

1. Dollar is quite weak

The dollar is falling against other major currencies because corporate earnings in the US has fallen and pointed to further weakness in the U.S. economy. The decline in the dollar helps boost gold, which is often used as a hedge against inflation and a weak US dollar, world’s safest investment option. Due to this, Chinese have decided to decrease their exposure to US dollar.Also,China is thinking of boosting its gold reserves from 600 tonnes to nearer 4,000 tonnes to diversify away from paper currencies. This will further boost gold prices.

2. Interest rate is quite low

With the deepening financial crisis and US economy into recession, interest rates in the US has almost come down to zero. It might have to struggle with deflation for some time. Thus, countries which are having surplus foreign exchange reserve will now not invest in US treasuries due to extremely low interest rates. This will force them to park their huge wealth in the other most important and safe asset – GOLD. This will lead to increase in demand for Gold and put upward pressure on its price.

3. Check gold-to-oil ratio

In June 2008, the gold-to-oil ratio dipped to abysmal 7 which indicated that gold price was going to rise aggressively. Why? Technically speaking this is because oil price is going down due to lower demand and global recession. Thus, to maintain a historical ratio of between 12 and 14, the gold price has to go up to achieve this ratio. Theoretically speaking, with the lowering price of oil inflation will come down significantly and so the interest rates. This will make the option of keeping surplus reserve in bank unattractive. Hence, most of the investors and central banks will invest them in gold, which is by far the safest investment. However, if we look at the current value of ratio it is more than 20, indicating that sooner or later either oil prices will go up or gold prices come down to reach historical average number.

4. Political uncertainty

The political crisis between Indian and Pakistan, Israel and Palestine war and America’s growing impatience with Iran is creating political uncertainty across Asia and Middle-east. In the event of war like situation, investors prefer to park their money more into external resources. In this time of global recession, gold is again the best option for these investors. Thus, gold price will see upward price movement in the coming days.

5. Global Meltdown

The major economies, US, UK, Japan and other rich EU countries are officially into recession due to unprecedented financial crisis. This has broken down investors’ confidence in traditional financial instruments like stocks and bond. The general rule of thumb in the market is that gold is always attractive when all other investments are unattractive. Why is this? As gold is negatively co-related to stocks, bonds, and real estate, gold is considered to be a safe haven and hence during any crises, investors would like to sell off what they would term as risky investments and be invest the funds in gold. Investors often turn to gold in times of economic uncertainty because the yellow metal's value tends to hold up better than many other investments.

All these factors weigh heavily in favor of gold. Investors are these days really scared of stock markets (especially in emerging economies) and real estate. This leaves them with Gold as the safest and best option. If we assume that gold price increase in future, the gold-to-oil ratio will become even higher; it may cross an all time high of 40. This may not justify the valuation theoretically but investors are hardly driven by intrinsic value and fundamentals. So you may expect further increase in the price of good in the coming months. It will probably touch $1800 per ounce by the end of this year.

I believe the price of gold depends on how crude behaves in the future. The question to ask is whether this increase will be sustainable? I believe not in the long run. A lot depends on how global economy shapes up in the next couple of years. If there is marked improvement in global financial market, investors will again look for equities and bonds as an investment. However, till then gold will continue to glitter!

How to Invest in Gold

Investment in gold can be done directly through ownership, or indirectly through certificates, accounts, spread betting, derivatives or shares.

Gold Bars or Coins : Investment in gold should be either in gold coins or bars. However, it should always be bought from banks which certify the quality of gold. Moreover, only buy government-certified gold coins or bars and preferably the purity level should be 99.9 as they are easy to sell. The biggest drawback of this investment is either the risk of carrying them at home (an unsafe option) or pay the bank to store it. But are risky as well as expensive.

Gold Certificates : A certificate which represents ownership of gold bullion held by a financial institution for convenient and safe storage. There is a fee for storage and insurance.

Gold Futures : Gold contracts are the hottest commodities traded in the Indian market. It is traded on MCX (Multi Commodity Exchange) Gold has become the largest traded commodity in India’s domestic futures market as a large number of traders are taking delivery of the yellow metals through the futures route.

Gold ETFs : You may not be able to touch and feel your Yellow metal through ETFs, but they are perhaps the safest method of buying and owning gold. ETF stands for Exchange Traded Funds. These are generally open-ended funds i.e. they are traded on the exchange just like stocks. There are quite a few ETFs in the market namely- Reliance, Kotak, UTI Gold ETF to name a few.

Jewellery: Buying jewellery is not the same as investing in gold because it is not made up from 24 carat gold as it is quite brittle. Moreover, when you sell jewellery some deductions are made to the jewellery because of its imperfection and age. Also, this is not as liquid as other pure gold related investments such as coins, bars and ETFs. However, investment in jewellery should be considered mostly as an emotional one!

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