Oil-Gold ratio: Dial down deflation concerns

March 5, 2015 12:22 PM


Historical Context

From 1986 to 1999, gold prices were less volatile than oil prices; neither displayed persistent trends, and the oil-gold ratio averaged close to 20 (barrels of oil per ounce of gold). Things changed in the 2000s, as China-led emerging market growth spurred demand for all kinds of commodities. Both oil and gold prices ascended to new heights, however, oil prices initially rose faster than gold, and oil continued to be the more volatile component of the relative value ratio. This emerging market super-growth period took the oil-gold ratio down to an average of close to 10 between January 2000 and September 2008, when Lehman Brothers collapsed.

The financial crisis of 2008, however, set in motion some very different patterns. Since October 2008, the oil-gold ratio has averaged around 16 but has been in an extremely wide range with high volatility. First, oil prices fell as the depth of the recession became apparent, while gold prices went to new record highs reflecting gold’s flight-to-quality characteristic amid fears of financial instability. Then there was a role reversal.

Oil prices recovered with rising global geo-political tensions, while gold prices fell as (a) central banks made clear they were going to backstop the financial system and (b) U.S. dollar based inflation failed to materialize despite massive central bank asset purchases. The current leg in the second half of 2014 and early 2015 has seen a sharp collapse of the dollar price of oil with relative stability in the dollar price of gold, taking the oil-gold ratio to its recent highs.

Short-term Factor

Gold prices currently may be supported by a negative gold forward (GOFO) rate, indicative of tighter supplies or renewed buying from India. Also, political risks in Europe related to new worries over the possibility of a Greek exit from the euro have probably helped support gold buying. Finally, we note that gold has fallen in recent years from a USD perspective, but has held steady or risen from the perspective of investors in many developing economies of the world, maintaining its role as a store of value (Figure 3). Indeed, declines in many emerging market currencies versus the U.S. dollar may have also led to demand for gold from this sector.

Figure 3: Gold: USD, Brazilian real (BRL), Indian rupee (INR) & Russian ruble (RUB) perspectives
Source: Bloomberg Professional, GOLDS, BRL, INR and RUB

Oil prices have fallen faster and further than most industry analysts thought was likely or even possible. See our research report, “Visualizing Energy Market Dynamics” (December 4, 2014), in which we argued that asset allocation dynamics had the potential to overpower physical supplydemand calculations and lead to the oil price spending considerable time below a hypothetical fundamental valuation. Moreover, the combination of oil politics and the cash flow needs of indebted private oil producing companies suggest that production will not be materially impacted immediately by the price drop, even though long-term capital investment projects may be delayed or indefinitely postponed.

Page 2 of 3
About the Author

Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.