Is Gold Really Cheap, Or is Oil Just Expensive?

A feeding frenzy is taking place in the financial media about the prospects for oil prices reaching $200 per barrel.

Based on the sheer number of outlets who have picked up this story – and the volume with which they’re repeating it – you would think, perhaps crude will reach this forecast “target” sometime next week, if not sooner.

Yesterday’s Financial Times ran a short story and interesting graph that compares the price of gold to that of crude oil over time (a similar graph from the folks at www.zeal.com is below).

The upshot of the story is that commodity investors, eager to seize on any opportunity to reinforce their bullish long positions, are now focusing on the historic gold-oil ratio.

This ratio is said to be a good measure of the relative value between these two “headline” commodities. The article points out that “a common refrain of goldbugs is that an ounce of gold now buys less than eight barrels of oil, against a long-run average of just under 16. On that basis, gold is cheap and ought to rise as it reverts back to its ‘mean’.”

Of course this “long-run" ratio of 16 has often strayed far and wide from that mean. In fact the ratio has been over 30 and below 10 at extremes. It’s said that historically, whenever the ratio rises above 25, oil is cheap relative to gold. Likewise, whenever the ratio falls below 10, gold is a bargain compared to oil.

The article correctly points out that “making judgments on the future through a backward-looking ratio of market-set prices is nonsensical.” This reminds me of the old rule of thumb on Wall Street in the pre-1990’s era that said stocks aren’t cheap enough to buy until you get a single digit price-earnings ratio.

Investors who religiously followed that ratio “signal” have been on the sidelines – for the past 25 years – still patiently waiting for the next buying opportunity in stocks!

Still, the gold bugs will tell you the yellow metal is a screaming buy at today’s gold-oil ratio reading of about 8, and they may be right on the money. But, what happens if you turn this ratio upside-down and take another look?

Then the ratio may be telling us that instead of gold being dirt cheap at $869 an ounce – perhaps crude oil is too expensive at $122 a barrel!

In fact, both gold and oil have suffered sharp corrections during the extraordinary bull-run they’ve jointly enjoyed this decade.

Nearly every time there has been a break in the uptrend, it was gold that peaked first and started to correct in price ahead of oil.

Gold has declined about 15% from its recent peak above $1,000 an ounce, yet crude oil keeps setting new record highs. Something’s got to give – I’m betting it’s the price of crude. Stay tuned…