There’s a school of thought that subscribes to a fair value relationship between gold and oil, or in other words, how many ounces of gold does it take to buy one barrel of oil. They’re two very different assets, both of which face unique supply constraints, but they do have some interesting parallels. High oil prices tend to be associated with higher rates of inflation and lower periods of economic growth. With gold being a popular hedge against inflation, there should be a degree of correlation in any price movements.
The chart below illustrates the Gold:Oil ratio from March 1983 to April 2019:
The above chart (data source Bloomberg) shows the Gold:Oil ratio over the last 36 years, based on opening prices of gold and front month WTI crude on the last trading day of each month.
The long-term average of the Gold:Oil ratio using the data above is around 16.7. That’s the average number of barrels of oil it takes to buy an ounce of gold. Over the last 36 years, the ratio hit a low of 6.32 in September 2005, and a high of 36.54 in March 2016. Clearly there’s a significant range here, but unlike the way gold or oil trades against the US Dollar, this chart shows repeated reversions to the mean.
Some market participants may talk about the Gold:Oil ratio as providing a guide of fair value for either asset. At the time of writing, WTI crude is trading at $64.34 a barrel, so using the long-term average ratio of 16.7, gold should cost $1074.50 an ounce, rather than the $1286 it currently trades at. The price of gold needs to fall, or the price of oil needs to rise, to see a return to the long-term average. The significant gains seen by oil in the first quarter of 2019 have been responsible for driving the ratio from above 28 down to current levels.
As always, past performance can never be taken as an indicator of what will happen in the future but the Gold:Oil ratio certainly has advocates when it comes to looking for a useful market indicator.
A recent article illustrated some examples of what has been driving the oil price of late, and what might happen in the future. Since publication of the article, US sanctions were indeed tightened against Iran and the limited impact of this news so far is notable, although there are suggestions that the impact of tighter supply won’t be felt until the summer.
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As noted above, gold is seen as a safe haven asset. It provides a hedge against inflation and has previously seen the price rise ahead of the threat of war. Given the complexities of the ongoing situation across much of the Middle East, any deterioration here could result in some significant buying interest of the asset. Equally, the threat of increased inflation in the US if the Federal Reserve was to adopt a more dovish approach to monetary policy despite the strength of the underlying economy could also drive interest in the precious metal.
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Sometimes you have to throw conventional wisdom out the door and just let the good times roll