On the Oil-Gold Ratio: Why Oil’s Going Higher

Discussion in 'Announcements' started by TT News, Nov 23, 2016.

  1. TT News

    TT News ET Sponsor

    This post was originally published on Trading Technologies' Trade Talk blog.

    On the Oil-Gold Ratio: Why Oil’s Going Higher
    By: Prof. Steve Hanke, President, The Johns Hopkins University


    The following is a guest post authored by Steve H. Hanke (Twitter: @steve_hanke). He is a professor of applied economics and co-director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore, a TT CampusConnect™ partner school. He is a senior fellow and director of the Troubled Currencies Project at the Cato Institute.

    This post was originally published on the Cato Institute blog. At the time of publication in September, Steve was predicting crude oil futures would be priced around $45-46/bbl in mid-November. The market appears to be confirming his projections, with CLZ6 closing yesterday at $48.03.

    A big story to come out of the last G-20 summit was that the Russians and Saudis were talking oil (read: an oil cooperation agreement). With that, everyone asked, again, where are oil prices headed? To answer that question, one has to have a model–a way of thinking about the problem. In this case, my starting point is Roy W. Jastram’s classic study, “The Golden Constant: The English and American Experience 1560-2007.” In that work, Jastram finds that gold maintains its purchasing power over long periods of time, with the prices of other commodities adapting to the price of gold.

    Taking a lead from Jastram, let’s use the price of gold as a long-term benchmark for the price of oil. The idea being that, if the price of oil changes dramatically, the oil-gold price ratio will change and move away from its long-term value. Forces will then be set in motion to shift supply of and demand for oil. In consequence, the price of oil will change and the long-term oil-gold price ratio will be reestablished. Via this process, the oil-gold ratio will revert, with changes in the price of oil doing most of the work.

    For example, if the price of oil slumps, the oil-gold price ratio will collapse. In consequence, exploration for and development of oil reserves will become less attractive and marginal production will become uneconomic. In addition to the forces squeezing the supply side of the market, low prices will give the demand side a boost. These supply-demand dynamics will, over time, move oil prices and the oil-gold price ratio up. This is what’s behind the old adage, there is nothing like low prices to cure low prices.

    We begin our analysis of the current situation by calculating the oil-gold price ratios for each month. For example, as of September 5, oil was trading at $46.97/bbl and gold was at $1323.50/oz. So, the oil-gold price ratio was 0.035. In June 2014, when oil was at its highs, trading at $107.26/bbl and gold was at $1314.82/oz, the oil-gold price ratio was 0.082.


    We can calculate these ratios over time. Those ratios are presented in the accompanying chart, starting in 1973 (the post-Bretton Woods period).

    Two things stand out in the histogram: the recent oil price collapse was extreme–the February 2016 oil-gold price ratio is way to the left of the distribution, with less than one percent of the distribution to its left. The second observation is that the ratio is slowly reverting to the mean, with a September 2016 ratio approaching 0.04.

    But, how long will it take for the ratio to mean revert? My calculations (based on post-1973 data) are that a 50 percent reversion of the ratio will occur in 13.7 months. This translates into a price per barrel of WTI of $60 by March 2017–almost exactly hitting OPEC’s sweet spot. It is worth noting that, like Jastram, I find that oil prices have reverted to the long-run price of gold, rather than the price of gold reverting to that of oil. So, the oil-gold price ratio reverts to its mean via changes in the price of oil.

    The accompanying chart shows the price projection based on the oil-gold price ratio model. It also shows the historical course of prices. They are doing just what the golden constant predicts: oil prices are moving up. That said, there remains a significant gap between the January 2018 futures price of WTI, which stands at $51.50/bbl and the implied price estimate of $70.06/bbl which is generated by the oil-gold ratio model. Best to be long oil.

  2. Hanke's great, but using Excel for graphics -- ouch!
    murray t turtle and wintergasp like this.
  3. oilfractal2.png

    kinda like this above.
  4. oraclewizard77

    oraclewizard77 Moderator

    Oil is going higher on possible deal on Nov 30 to limit production. If the deal goes through, then oil may continue to go higher. If the deal fails, then 100% we will see a over a $ 5 drop in the price of oil.
  5. Overnight


    That's a forthright statement. (Bolding is mine). Jan CL closed yesterday at $46.06. But is it prescient? If OPEC fails to reach an agreement, will we see CL drop to $41 per barrel? Heck, it did recently. Will it do it again?
  6. [​IMG]

    oil is right at macro resistance
    murray t turtle likes this.
  7. Roy W. Jastram’s contention that “gold maintains its purchasing power over long periods of time, with the prices of other commodities adapting to the price of gold,” is very interesting. That he looks at almost 450 years of history makes me wonder how it might be applied to any short-term (0-6 months, for example) time frame. For example, given that crude prices peaked within about a month of the articles publication – to about $58 basis the June ’17 futures contract – how does that comport with his prediction that the price per barrel of WTI would stare down $60 by March 2017? The prediction is practically right on the button regarding price, but about five months early regarding timing.
    murray t turtle likes this.
  8. %%
    Oil priceis going down form JAN 1st, nice down move on OPEC meet + greet; most longer term TX Tea price [WTI] charts are going up.$44.44 + up , may work as far as a bottom area.......
  9. Oil has traded sideways and gold has gone up since Jan 1.

    I don't think the author's point is as valid today as it was 20 years ago.

    When the AY-rabs ran prices up to $149 8,9 years ago ( I remember it reached a peak on Friday July 3, but not the year) that was the beginning of the end for their monopoly.

    A lot of different sources of oil become profitable at higher oil prices. Canada and the U.S .need $60 a barrel to break even on shale oil production and oil companies invested billions in researching new sources of oil. The $149 oil prices allowed the oil companies to invest anywhere and everywhere. The ME only invests in their home nations.

    They found a major site off the northern coast of Alaska with 1.2 billion barrels of oil under the Arctic Ocean last year, 2 major fields (1 with 8BN barrels & a major gas field) have been found off the coast of Brazil that rival the reserves of some smaller Middle Eastern nations. Venezuela still has the largest reserves in the world. Some reports suggest the U.S. does. China is beginning to exploit the oil fields in the China Sea that they stole from their neighbors.

    When oil ran up to $149 a barrel, the oil companies reinvested their revenues into research and exploration, the Middle East spends it on 12M dollar cars from Rolls Royce.

    Oil is not going to rise much higher than it is now. It is going to stay between 48-55 dollars a barrel. It might reach 60 dollars for a brief period but that is as far as it goes. When it gets any higher, the other sources of oil come online...that are more expensive to produce...flooding the market and driving down prices again.

    The Arabs got greedy and this is where it got them. More research, greater reserves and a public that has spent more money on alternative sources of energy (solar energy and electric cars) so they won't be held hostage to foreign manipulation.

    Gold prices are generally speaking, a function of confidence in the future. The prices move on supply and demand, but more often based on political and economic events.

    Oil prices change based on supply and demand and there are more documented supplies now than there have ever existed.

    I think the ratio of oil and gold may have been valid in the last century but not this one.



    murray t turtle likes this.
  10. %%
    Well put it simple; i agree + black gold + gold both have the word ''gold in itself''.
    Many people when they note oil, they mean oil derivatives. I like the elitetrader that with wisdom noted.....'' its correlated to itself.LOL'' Dont use YTD charts much but plenty of downtrend on oil YTD .Nice uptrend,uptrend trend line on oil; especially if someone likes quarterly candles, quarterly bars.LOL
    #10     May 31, 2017