Has Petrodollar Conversion into Gold Reached its Peak?

St. LOUIS (ResourceInvestor.com) -- June 2008 delivered a remarkable record to hard asset investors. For the first time since 1970 you needed just six and a half barrels of oil to buy an ounce of gold. Conversely, you needed almost a whopping 16 ounces of gold for every 100 barrels of oil bought.

The ratio peaked on 12 June when gold traded at $862.25/oz and oil for $134.51/bbl.

Looked at another way, if Venezuela had converted its oil exports to arch-enemy America (roughly 1 million barrels per day) into gold, the country would have added 4.56 tonnes to its bullion reserves on one day in June alone. That's a little more than 1% to the country's current gold stockpile of nearly 357 tonnes. It wouldn't take much at all for Venezuela to double its gold reserves within a year without using all its oil revenues.

Compare that with December 1998 when you needed nearly 28 barrels of oil to acquire an ounce of gold, or more than four times the cost this past June. That would have allowed Venezuela to add just 1 tonne of gold to its vaults.

Unfortunately for gold bugs, Venezuela prefers to buy perishable political commodities with its oil wealth. And at the rate Venezuela is driving its economy into the ground it may end up needing to sell its gold reserves for food.

The last time gold was recently as cheap was September 2005 when it bottomed at six and three quarters of a barrel of oil per ounce of gold. At that time oil was a touch short of $70/bbl whilst gold had yet to breach $500/oz.

History

The oil-gold ratio should never be confused with a law of physics, but it's a very useful indicator of cost inflation in the mining industry as well as discretionary spending power among sellers of oil.

When it is cheap to buy oil with bullion, gold mining equities tend to do better than they normally do. Indeed, the start of the commodities up-cycle in 2000-2001 takes a dramatic change in the oil-gold ratio as one of its markers.

On the other hand, when it is cheap to buy gold with oil, oil producers tend to embark on spending binges which can manifest in mythic projects, such as Dubai's terraforming, or in military ambition, such as Venezuela's Bolivarian belligerence that requires all sorts of new shooting goodies.

Whipsaw

The oil-gold ratio has whipsawed viciously since the mid-June low thanks to retreating oil prices and rising gold prices. If you had the means to trade the oil-gold ratio, and had gone long-gold short-oil, you'd be up rather handsomely.

However, even at today's ratio of 7.3 barrels per ounce, you're still more than one standard deviation below the long-run mean. That suggests gold remains the more attractive component, but caveat emptor. The oil-gold ratio shows distinct phases favouring one commodity over the other, rather than regular reversions to the mean.

For example, from February 1974 through December 1985, you definitely wanted to be on the oil side of the trade. However, from January 1986 through December 1998 it was better to be long gold. Since then it has been a one-way street in favour of oil.

That said there have been tremendous opportunities within the macro-cycles. For example, from November 2000 to February 2002 the value of gold relative to oil doubled. That represented the most opportune time for gold companies to hedge their future energy requirements. Conversely, the value of gold relative oil nearly halved from January 2004 to September 2005.

The odds seem to be inclining toward another bullish phase for gold rather than oil.

The question for regular rather than exotic investors is how this translates into profit potential.

The most obvious benefit should come from improved gold mining fundamentals simply by virtue of the favourable exchange of value between the primary output and primary input. If the gold up-trend is sustained, then we might expect gold equities to report improved earnings and cash flow, with a consequent bump in M&A activity.

Bernanke's Bull

Another plus factor for gold right now is negative real interest rates in the United States.


With consumer inflation topping 5% annually for the first time in June, real interest rates fell below negative 3% for the first time in the current commodity up-cycle. That's two-thirds of a per cent lower than the previous bottom four years ago. The running average for July suggests it is only getting worse.

The Federal Reserve is now in a viciously coiled trap. Inflation and the declining dollar demand an increase in interest rates. However, systemic financial peril demands loose money and credit. At this time, America's political factions have allied (or erred) on the side of funding the credit crisis with cheap money.

We also do not believe the financial crisis has run its course. Mortgage problems are the order of the day for newspaper headlines, but they are not reflecting that each defaulted mortgage is likely entraining defaulted credit cards, cell phones, cars, furniture, big screen televisions and so on.

At the risk of sounding conspiratorial, it seems reasonable to conclude that the Fed is playing a timing game on interest rates. The greatest risk from an interest rate hike now is that it would shock consumers and radically inflate default rates. That would prolong and deepen the liquidation now being suffered by the key financial players.

The banks and broker-dealers have already been extended considerable latitude not to mark their junk assets to zero immediately, but to bleed them out quarter-by-quarter. An interest rate shock would unravel the soft landing strategy that appears to be in place.

Even though the risks to the gold price from a surprise increase in interest rates are high, the risks to growth are higher if the Fed tightens. That leaves gold on a reasonably sound footing for the foreseeable future. However, be warned that gold could be well and truly thumped if there is any let-up in inflation, and that might happen if inflation is tamed - statistically at least - by oil prices correcting lower in response to slower demand.

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