For decades, two of the world’s most-watched commodities, oil and gold, have typically moved in tandem. But lately, gold has been on steroids while oil prices have decidedly been on Quaaludes.
The big question for traders is whether this is just a separation or an all-out divorce.
Higher oil prices tend to drive consumer prices higher because they increase the cost of making and transporting goods.
On the other hand, holding gold is a favorite way of protecting against inflation.
Geopolitical crises or supply disruptions such as the September Saudi Aramco drone attacks also support higher oil prices. High oil prices tend to coincide with periods of high inflation and lower economic growth, while gold is a popular hedge against inflation, thus the positive correlation.
In other words, higher gold prices have in the past meant higher oil prices, although one doesn’t directly cause the other.
However, this relationship appears to have broken lately with gold rallying 23 percent over the past 12 months, while oil prices have merely been treading water.
Source: TradingView
WTI Crude Prices, 10-Year Chart
Even the massive attacks on Saudi oil facilities failed to move this needle for more than a day or so. In other words, a major 5-percent supply disruption, the biggest ever in history, didn’t help. Related: Floating Nuclear Power: Chernobyl On Ice Or The Future Of Energy?
So why is the market so fickle? For the most part, it’s no longer got blinders on about geopolitical upsets. There’s an ongoing oil glut and lackluster demand that is clearly entrenched now, so the market isn’t biting when it hears talk of potential supply risks.
Oil is, for the first time in a long time, not hostage to that much sentiment. It’s been hijacked by pure fundamentals.
Gold, on the other hand, is a fully sentimental bet.
Gold-Oil Ratio
Crude oil and gold prices have in the past largely moved in tandem with occasional disconnects.
The divergence this time around is getting uncomfortably big and suggests something has to give: either gold prices fall or oil prices climb significantly to catch up to gold.
Source: CME Group
Over the past 25 years, the gold-to-oil ratio has averaged 15.8. What this means is that one troy ounce of gold could buy you 15.8 barrels of U.S. WTI crude oil.
This ratio has been fairly consistent with occasional divergences. The lowest gold-oil ratio over the past 25 years was 6.2 in 2005 when oil prices soared on a demand-driven bull run while gold prices remained low. The highest was 47.6 in 2016 when oil was mired in a serious slump while gold prices remained steady.
The ratio has averaged 24 since the beginning of this year, breaking through 25 in July. With an ounce of gold currently at $1,514.30 and a barrel of WTI crude at $54.24, the ratio is sitting at a multi-year high of 27.9--or nearly 80 percent above the historical average.
Resetting The Ratio
So what really gives? Will the gold-oil ratio reset back to its traditional levels?
Unfortunately, the oil prognosis is not very good.
The remarkable surge in U.S. oil production over the past six years has created a large global supplier that is less susceptible to geopolitical tensions compared to the traditional oil superpowers. Growing exports by the United States is dampening some of the traditional volatility in crude oil prices and capping a good chunk of the market’s price upside.
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Currently, the strength of shale supply and growing concerns about low demand growth are weighing more heavily on the market than geopolitics. It’s doubtful whether the risk environment will reassert itself as the key driver of oil prices any time soon as it has been for gold.
The outlook is far brighter for gold. Related: Protect The Oil: Trump’s Top Priority In The Middle East
We appear headed towards monetary debasement and possibly QE.
Gold prices climbed in September when the European Central Bank (ECB) kicked off round 1 of its QE money stimulus. Although the Fed might not grant Trump his wish for further cuts--at least not this year-- it has already commenced a program that it expected to gobble up $60 billion of Treasury bills every month (the Fed insists it’s simply expanding its balance sheet and not engaging in quantitative easing). This is likely to keep interest rates low, which is positive for gold.
The World Gold Council is also quite bullish on gold in this report and encourages investors to allocate more of their portfolios to gold:
‘‘...lower expected bond returns favor additional gold exposure in well-diversified portfolios. As bond yields fall, diversifiers with higher potential returns, like hedge funds, real estate and private equity, carry heavier weights in optimized portfolios. Our analysis also suggests that the historically higher volatility that accompanies these alternative investments, versus other assets such as stocks and bonds, warrants increasing allocations of gold to serve as a ballast in the event of a stock market pullback.”
It, therefore, appears that the higher gold-oil divergence is the new norm--at least in the foreseeable future.
That means that if you’ve been trading on the oil-gold tandem, you’re likely losing.
By Alex Kimani for Oilprice.com
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Oil prices normally rise when there is a healthy economy leading to rising global oil demand or geopolitical developments threatening a supply disruption or a deliberate restriction of oil supplies by one major producer or a group of oil producers as in the 1973 Arab oil embargo against the United States and Netherlands.
On the other hand, gold prices tend to rise during international crises such as the US-Iran escalation of tension or as a hedge against inflation (probably caused by high oil prices) or rising purchases by China in support of the yuan-denominated crude oil futures (the petro-yuan) which was launched in Shanghai on the 16th of March 2018 in a bid to challenge the petrodollar in the global oil market. China has effectively cornered the market for physical gold. Official Chinese gold reserves have tripled from 600 tonnes in 2003 to 1823 tonnes in July 2016 (Source: Chinese Gold Market Infographic, Bullion Star).
So oil prices and gold prices go in tandem when the global economy is healthy stimulating global demand for oil thus leading to rising inflation and also in times of geopolitical developments as a hedge against devaluing currencies.
The only divergence in recent times was caused by the trade war between the United States and China which has cast dark clouds over the global economy thus depressing the global demand for oil and prices. The war has augmented an already existing glut in the market from a relatively manageable 1.0-1.5 million barrels a day (mbd) before the war to an estimated 4.0-5.0 mbd. This glut has been big enough to nullify the impact of geopolitics on oil prices and also absorb a loss of 5.7 mbd from Saudi oil production. However, the geopolitical influence has benefited the gold price.
Only an end to the trade war will brighten the prospects of the global economy, stimulate global oil demand and lead to a surge in oil prices far above $70 a barrel.
The impact of US oil production on the global oil market has been very limited. It failed during 2016-2017 to cap on prices at $60 and would have failed again to cap them at $70 during the 2018-2019 period if not for the trade war.
Moreover, the claim by the author that the strength of shale supply is weighing more heavily on the market than geopolitics is a misrepresentation of facts. US shale oil production is slowing down fast as confirmed by many authoritative sources. Shale oil will be no more in 5-10 years.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London