Prices of certain commodities are largely tied. The relationship can be straight or inversely proportional. Straight correlation was observed between the price of Oil and Gold, of course it’s for a longer period.
There are specific factors such as cyclical and asset-specific factors, which sometimes mix this correlation.
This misbalance is accepted by investors as a good time to invest in order to restore the proportions, in which two assets were traded after a certain period. We can determine the Gold and Oil for such correlation.
In the financial world there is a correlation term Gold/Oil Ratio (GOR). It is calculated in a very simple way – just divide gold price over the price of oil. In the long term, or the last 50 years, this ratio was at 15.4.
What Does the Gold-Crude Oil Ratio Mean?
What this ratio infers is that when the current ratio is below 15.4, gold is either too cheap, or oil is too expensive. When the ratio is greater than 15.4, oil is either too cheap or gold is too expensive, as noted in this InflationData.com chart.
Let us give you an example. Back in the beginning of 2009, crude oil prices were at $34.57 a barrel. Gold prices were at $874.50 per ounce. This means that back in 2009, one ounce of gold bought about 25 barrels of crude oil. That’s not on the chart above…
Since then oil prices have nearly tripled, while gold has gained 61%.
Many times in history has been a significant divergence from this value. This divergence is often seen as an opportunity for one of the two asset to catch in a given direction and this happened more than once. This is indicated in the chart below, with points from one to six. This moments are marked in the period between 1965 and mid 2005.
* Graphics – www.ZealLLC.com
Using the Gold-Crude Oil Ratio
You can use the Gold/Oil ratio as a “reality check” to some predictions. But you can also use it to see if gold or crude oil is overpriced or underpriced. But it’s only the first step in your analysis.
Clearly, when oil prices were trading at $34 a barrel, crude was hugely underpriced. Just as oil was massively overpriced at the peak in 2008. Right? In hindsight we know this to be true.
Once you determine the relationship between the two, you have to look at fundamentals to decide which commodity you think is going to move. For example, when oil prices peaked in 2008, and the ratio was an anemic 6, one of three things could have happened to bring the ratio back to 15.4.
- Oil could have stayed at $147 a barrel, and gold could have climbed to $2,264 an ounce.
- Gold could have stayed at about $885 an ounce, and oil could have fallen to $57.50 a barrel.
- Oil could have fallen as gold climbed.
In general, historically, the movement of the indicator is in the range between 10 and 30, at 10 there is strong support and strong resistance at 20. In this respect at a level below 10 the ratio is considered undervalued and over 20 too high.