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Balancing Gold and Oil: Part three

March 22, 2010 12:09 pm

To illustrate the price development, a chart of the Gold/Oil-ratio (from 2005 until now) has been included, courtesy of Futuresource.com. This chart illustrates that the GOR barely traded below a value of 7 and that 22 was the highest level in the last five years. Even in the last three decades even, the GOR rarely showed a value under 10, and almost never a value above 30. History illustrates that the GOR bounced off a level of 20.

Theoretically it could be expected that historic trends can also prove valid for the future: i.e. that ‘extreme’ highs and lows in pricing will sooner or later reverse to the ‘historic mean’. This meant that in March 2009, there would be a good chance that oil could outperform gold.

Last year, the Gold/oil ratio showed a peak level of approximately 22, which illustrated that oil was relatively cheap in comparison with gold. Twelve months later, gold is trading at around $1,106 and oil is trading at $80.6 leaving us a ratio of 13.7.

In percentage terms, oil has risen more than 80% while gold has risen ‘only’ 23%. Investors who ‘sold’ the GOR, therefore could have cashed in a profit of at least a decent 8 points. The question is of course, will this ratio drop even further? The GOR is now ‘somewhere in the middle’. It is important to understand that oil is an industrial commodity, meaning that price development is (mostly) driven by economic factors. On the other hand, gold is a precious metal. Gold is in a lesser extent seen as an industrial metal and is being used more often as a safe haven.

Assessing gold, oil positions

In order to assess a new position, an investor should form an opinion on the relative performance of gold versus oil. If an investor expects that oil will drop again, and more steeply than gold, it would be wise to reverse position: To buy gold and to sell the ‘black gold’.

Trading in two different asset classes, in other words to spread risk by buying one asset and at the same time to sell the other, is very different to directional trading. With directional trading, an investor/trader has to judge whether the price is going up or down. Spread trading is relatively more complicated, because a strategy has to be developed concerning two assets.

Each investor/trader is different: While some traders prefer to have a directional position (long or short), other traders prefer to spread the risk by going long one asset and being short another asset. It is not a matter of good or wrong, as long as traders respect their system and strategy.

Investor/traders with the opinion that the GOR would even drop further, might consider staying (or being) long oil and short gold. In 2008 the GOR showed an ‘extreme’ value under 7. A GOR of 11, while oil traded at $90 per barrel implies a gold price of $990. If the GOR does fall further, investors currently being long oil and short gold, are able to sit back in their comfortable seats and watch the investments work for them.

Mercurious offers several extensive training courses concerning commodity and energy markets. If you are interested in oil trading and crack spreads, please contact us.