The Gold-Oil Ratio, What Is It Telling Us?

The Gold-Oil Ratio, What Is It Telling Us?

The gold-oil ratio is a method used to determine the value of one commodity, priced in terms of the other. Simply put, the ratio determines how many barrels of oil can be purchased by one ounce of gold. Historically, the gold-oil ratio holds a 16:1 long-term average. However, recently, the gold-oil ratio has reached its highest level ever observed. In April, the gold-oil ratio reached 91:1 as depicted in the graph below. Furthermore, the gold-oil ratio tends to spend majority of the time between 10:1 and 30:1.

Long-term gold-oil ratio

The gold-oil ratio is a good indicator of the health of the economy, a low ratio indicates a healthy economy; whereas, a higher ratio indicates an economy in distress. Furthermore, it is also recognised as a measure of the volatility that comes from significant political and economic events. Thus, it is evident that the COVID-19 pandemic increased the volatility in the financial market tremendously.

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 positive correlation has often meant higher oil prices have coincided with higher gold prices, although one does not directly impact the other.

Historically, the gold-oil ratio has been a reliable indicator of when to invest in oil and when to invest in gold. The lack of a tight correlation between the price of oil and gold, is what makes the gold-oil ratio meaningful. In order for the gold-oil ratio to return to its historic average, oil prices would have to rally by (roughly) 160%. Given the recent ratio, an unprecedented buying opportunity might be presenting itself in oil and oil-related stocks. Almost every example of an extreme high reading in the gold-oil ratio is followed by a full reversal to an extreme low reading of 10:1. If that is correct, then oil prices are set to increase drastically.

The graph above depicts the gold-oil ratio for the past decade. A spike in the ratio is evident in April 2020, reaching 91:1. This is based on the strict lockdown measures implemented worldwide caused by the COVID-19 pandemic, and a record decline in WTI oil prices. Furthermore, we have seen gold prices reach nearly $2 000/oz. These are record prices being witnessed. Oil has also seen record lows in April of roughly $-37 per barrel.

However, at the time of writing, gold is at $1 970/oz and oil at $40.25/barrel. As such the gold-oil ratio is roughly 49. The bottom line here is that oil is considered cheap relative to gold. As is often with gold and oil, international news headlines will tell us the story. Nothing says that the ratio cannot get even more extreme. However, if history is any guide, on a long-term basis, either oil is historically undervalued, gold is historically overvalued, or both. Only time will tell.