Understanding the Gold/Oil ratio

One of the indicators that we look at to determine the health of the world economy is the Gold/Oil Ratio. What is the Gold/Oil Ratio? Simply put, the ratio determines how many barrels of oil can be purchased with one ounce of gold. Historically, the gold-oil ratio holds a 16:1 long-term average and normally the range holds between 10 and 30.

Because Gold and crude Oil are both denominated in US dollars, they are strongly linked. That is because as the US dollar rises, commodities priced in USD fall, and vice versa. Generally, as the dollar declines, commodity prices rise.

Inflation is another important link between Gold and Oil. Because energy comprises about one-third of the Consumer Price Index (CPI) – when crude oil rises, it impacts inflation. Gold and Oil prices have many common factors that influence the prices of these goods to move in the same direction, and Gold is considered to be a hedge against inflation.

Rising global oil prices is likely to fuel inflation, in which case investors will be most willing to direct their investments in assets that will have the highest resistance to inflation. Gold, being a stable reserve for many central banks, will be the most preferred asset class. The demand for Gold is likely to increase, and this will lead to higher gold prices.

Gold and oil are further related: a spike in Oil prices dampens economic growth because so many industries depend on it and its derivatives as a fuel source, i.e., natural gas, gasoline and diesel. (Diesel fuel is a major input for gold mining operations; therefore as fuel costs rise, so does a producer’s costs per ounce, which can lead to lower output. If this happens across the industry, lower gold supply versus demand will hike prices.)

It, therefore follows that, if oil prices are dropping while gold prices are climbing, i.e., an above-average gold-oil ratio, it would mean the global economy is in poor health, and a recessionary period may be around the corner.

Looking at the chart above – when we leave out the COVID-19 spike where the financial markets were in turmoil, we can see the ratio heading back up toward the 30:1 mark where it normally has a swift return downward, indicating that the health of the economy is struggling. This could be an indication of investors running toward safe haven Gold as the uncertainty currently in the market with monetary policy, growth, the banking crisis in the US and inflation is scaring the market.

The price of oil is declining – despite oil production cuts by OPEC countries – and should that continue, we could see the ratio extend further until the recession is ridden out.