Checking In on the Gold to Oil Ratio
May 28th, 2008 | By Justice Litle | Category: Gold MarketWhat you’re looking at below is a chart of the gold-to-oil ratio. The gold-to-oil ratio is exactly what it sounds like. You simply take the spot price for an ounce of gold — around $900 per ounce as of this writing — and divide it by the price of a barrel of oil.
Right now the gold-to-oil ratio is trading around 7. That means a single ounce of gold is roughly worth seven barrels of light sweet crude. With oil trading near $130 a barrel, this is an extreme low point for the ratio.
The previous drop in mid-2005, when an ounce of gold was briefly worth 6.5 barrels of oil, was the lowest the ratio has been in decades.
Oil Too Expensive, or Gold Too Cheap?
So what does it mean when the gold-to-oil ratio moves toward an extreme like this? In historical terms, it suggests that something is out of whack. Either oil has gotten too expensive, or gold has gotten too cheap.
The last time we saw an extreme in the other direction was late 1998, when the gold-to-oil ratio rose above 26. That was a case of oil being way too cheap… and of course, crude oil bottomed out for all time just a few months after that.
Given the way oil is trading now — the recent rocket ride to $130 a barrel, etc. — some think that oil has gotten too expensive, too fast. Their view would be that the price of oil has to come down, perhaps by a lot, and that the gold-to-oil ratio is reflecting this.
Your humble editor disagrees with this view for a number of reasons.
For starters, there’s a lot of hot air about how oil could be a bubble and speculators are driving oil prices… but there is little proof of this charge, and a lot more evidence pointing in the other direction.
Germany’s Folly
Angry German politicians have gone so far as to call for a worldwide ban on oil trading. They think that $130 oil is all the evil speculators’ fault, and that all the traders should have their hands tied.
This is about the dumbest thing I’ve ever heard, and a good example of how politicians can be dangerous. One of the key functions of markets is price discovery; through self-interested buying and selling, the markets act as a useful forecasting tool. (One of the best forecasting tools we have at any rate.)
Without a functioning market mechanism to determine the price of a valued good, the market breaks down. You either have lots of one-off transactions taking place in the dark, or else you have some government committee setting the price by fiat. I hear Soviet Russia tried that. It didn’t work out too well.
The activity of traders and speculators also provides much-needed liquidity to markets. When, say, an airline like Southwest buys heating oil futures contracts to lower its exposure to jet fuel costs, more often than not there are traders on the other side of the transaction. Without someone to take the other side of a trade, end-users of oil and gas products have no way to hedge their business risk.
In a very real sense, speculators are paid to take on risks that hedgers don’t want. Risk transference is a vital market mechanism. The German politicians don’t get this. Or maybe they do get it, but they just don’t care.
Trying to restrict trading would be a fool’s errand anyway. There is more than enough competition among global exchanges to keep the trading going, even if some goofball government tries to ban trading on a local basis. That’s a very good thing.
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Et Tu, George?
Hedge fund legend George Soros is blaming the speculators, too, calling the oil price a bubble. Without putting too fine a point on it, this is a major piece of hypocrisy.
Why? Because the existence of men like Soros show exactly why big markets are hard to manipulate.
If the price of oil were truly in a bubble, some big hedge fund player with guts and foresight could come along and make a killing by shorting the daylights out of it… thus driving the price of oil back down to non-bubble levels in the process.
This is exactly what Soros himself did in 1992. That was the year he earned the nickname “The Man Who Broke the Bank of England,” for the huge score he made shorting the British pound.
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Justice Litle is Editorial Director for 