As is commonplace in the market, we use comparisons between commodities or currencies in order to show what the relative strength of a certain commodity is relative to another. The historic ratio between Gold and Oil is normally between 30:1 (30 barrels of oil vs 1 oz of Gold) and 10:1. The exception occurred in April last year with the Covid pandemic where this ratio hit 90:1 at one stage due to the oversupply of Oil, and the market running to safe-haven assets like Gold.
In the below graph we can see the outlier that was last April where the ratio blew out well above the normal ranges but has since returned back towards the 22:1 ratio. This ratio is just above the average mean from 1988 at 17.5:1. From the below graph, we can easily say that above the red line, Gold is overvalued in relation to Oil, and below vice versa.
Currently, we have seen that inflation has hogged the headlines, with a mixture of rising oil prices, QE and supply-side concerns. Inflation was seen to be transitory but the common feeling is that inflation is here to stay. Because the oil price has spiked in the last couple of months, we expect inflation to follow as there is a cause-and-effect relationship between Oil and inflation. This leaves policy makers with a bit of head-scratching to do in order to rein in inflation, oil prices need to move in the same direction, due to the large input oil has in the CPI calculation.
This leads us into Gold where forecasts are a little bit more uncertain, as higher inflation tends to lead to a Gold rally, but the more the Fed turns hawkish the more it could rain on the precious metals parade.
Let’s say for instance that Gold stays relatively flat at $ 1,800 per ounce oil has to rally to above $ 104 per barrel in order for the ratio to mean revert. This gives the indication that Oil is still relatively cheap and still has some room to run higher. It has been 3 years since we have traded anywhere near the means as we have seen a commodity rally with oil prices failing to catch up.
In order for the ratio to revert back to the mean, some trades off need to happen in the near future and we will look to the Fed and their hawkish tone of late to drive the price of Gold a little lower.