15:1 – The black and the yellow

We had a few Gold comments last week (including the Real Oil vs Real Gold chart).  The Buttonwood column in this week’s Economist (hat tip to Scott Frew) takes on some of the history of these two commodities:

The black and the yellow

So much for black gold. What about the real thing, which fans have been expecting to take off for months, if not years, in tandem with it? After all, the last time oil was on such a ride (in the 1970s), gold tore right along with it, ending up at $850 an ounce in 1980.

Since the second world war, gold bugs say, the prices of oil and gold have followed each other about, give or take the odd lag. An ounce of gold has fetched just over 15 barrels of oil, on average, and whenever that ratio got seriously out of whack one price or the other quickly adjusted. But gold and oil have been drifting apart for at least four years. While oil has blasted up by 60% so far this year, gold has risen only fractionally. These days an ounce of gold, at just under $450, buys a mere seven barrels of oil. In other words, the purchasing power of gold has been badly eroded.

Gold is a strange substance. It is a commodity, an investment and a means of exchange, and its price reflects all those roles.

Ahhh, but that’s the entire point: If any of the reason for owning gold still exist, and if one believes in botht he 15:1 ratio (I’m agnostic) and in reversion to the mean (true believer), than thatwould bode well for Gold — eventually.

Given the psychological component to being an owner of Gold, that suggests some shock would have to occur prior to any outsized move. For the Gold bugs, there’s no end of leading exogeneous shock candidates.   

Buttonwood continues:

Like any commodity, it responds to the laws of supply and demand. New figures from the World Gold Council, which groups producers, show that demand for physical gold is growing strongly, up by 21% in tonnage terms during the first half of 2005 compared with the same period a year earlier. Supply, meanwhile, increased less quickly, by just 18%, thanks partly to slowing central-bank sales. Gold supplies are eminently manipulable, however, and if prices rise substantially, a lot more of the stuff will hit the market.

It is from its role as an investment and a means of exchange, though, that gold derives its real mystique. Sentiment is important: in a small market, a few big positions affect prices more than, for example, they could do in the oil market. And that sentiment depends, more than anything, on expectations about inflation and the value of the dollar.

When people believe that paper assets are worth something approaching their face value, they buy gold to wear but not to put in a safe

In the past, gold prices rose with oil prices because inflation did too, and gold was seen as a safe store of value. Yet investors have not really viewed inflation as a threat for a couple of years, continuing to buy shares and houses, for example, in preference to gold despite the huge run-up in crude prices. The notion that higher oil prices will tax growth rather than stoke inflation has gained, dare one say, currency. (emphasis added)

What’s all this have to do with the economy, markets, consumer spending, etc?  Read on:

Just as inflation has, until now, lain low, and gold with it, America’s dollar has also been resisting arrest. Gold is after all a monetary metal, an alternative to the paper currency that replaced it at the heart of the world’s trading system, when times are tough. But they haven’t seemed tough so far. Despite America’s famous twin deficits, everyone else’s currency has been even less appealing, and big exporters such as China have had their own reasons for propping up the dollar. Now, as Katrina heaps billions on a national debt that is already close to $8 trillion, might that perception change? The time is surely not far off.

For at the end of the day, the price of gold reflects confidence, more than anything. When people are confident that their central banks will control inflation while permitting the economy to grow, when they believe that paper assets are worth something approaching their face value, they buy gold to wear but not to put in a safe. Alan Greenspan has achieved the remarkable feat of suspending disbelief in America’s gerrymandered finances for the past few years. On his departure, watch the gold price soar."

Interesting stuff. In addition to the technical breakout of gold, there are other reasons for those who are concerned about 2006/07 to own the stuff.  I prefer the GLD trust holders — I first mentioned this on a Power Lunch (3/30/05) — but the more adventurous amongst you can certainly look into the futures market and own the yellow stuff directly.  The usual caveats apply . . .

Pump panic, gold glee
Time to roll out the safe havens?
The Economist, Sep 13th 2005

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Discussions found on the web:
  1. D. commented on Sep 19

    I’ve come across a few articles arguing that our current financial system of flexible rates is on the verge of being tested.
    Who knows but I think an interesting question is how much would an once of gold be worth if, to restore confidence, we ever had to go back to a gold peg in the event of a run on the US dollar or other currencies?
    With all the dollars floating out there, I’m sure it’s more than 500$!

  2. vinod commented on Sep 19

    The biggest hoarders of gold are from Asia, particularly from India. The current generation does not seem to fancy the metal anymore. They are more taken with fancy designs rather than just showing a slug of yellow around their neck. I wonder what this change in attitude (mind you there is alot of gold in private hands in India) does to the supply side of this metal and thus the 15 barrels of oil long term average.

  3. spencer commented on Sep 19

    From WW II to1967 both the price of gold and the price of gold were essentially constant at $35 for gold while oil rose in a few steps from $2.50 in 1948 to $3.00 in to 1967.

    From 1967 to 1980 both prices rose sharply and had a very strong correlation. But over that period almost all commodity prices rose strongly as it was an era of generalized inflation.

    But after 1980 the correlation between gold and oil
    fell sharply. It has only been 0.33 since 1980.

    So the supposed tight fit between gold and oil really only hold for one short period of time.

    It may be an important and valid relationship, but the argument against it haveing a close relationship is just as strong.

  4. kdawg commented on Sep 19

    To paraphare Bob Hoye of Institutional Investors.

    In gold, what you have is currency with a long history. Indeed, one can go back 300 years, not 100, in recorded financial history to find instances where gold has been a haven for safety when liquidity in the prevailing government system disappears.

    Historical arguments to the contrary that the gold / dollar intersect is being debunked. Gold can move up relative to the world senior currency going up. It has happend before in history and will happen again.


  5. David Andrew Taylor commented on Sep 19

    The article mentioned the purchasing power of gold eroding. Interesting. Don’t all currencies eventually erode in purchasing power over time, i.e. inflation? Wouldn’t that also be a sign of the U.S. dollar in general? It’s been eroding a good deal over the past four years. That’s about the same amount of time that the purchasing power of gold eroded. As a blogger and trader, I’m all of a sudden very curious about these two relationships.

  6. Captain Ned commented on Sep 19

    The gold bugs drive me nuts. Do they really believe that gold has some extrinsic value that sets it apart from any other medium of exchange? Or is it that they pine for the faux stability and implied stagnation of a return to the Bretton Woods system?

    There is no absolute, immutable standard of exchange value.

  7. Captain Ned commented on Sep 19

    I must say, though, that the 15:1 ratio does not, for me, conjure up a comparison of oil & gold. I think back to much earlier times and a certain Democratic presidential candidate who got his ass handed to him in the Scopes trial.

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