What is the Gold Oil Ratio Telling Us?

I discussed the Gold/Oil ratio and Silver Wheaton on StockTwits TV’s “Talk Your Book” Show on 5/20.  My blurb starts around the 5:30 mark.

Backgrounder:

Gold has to be one of the most complex investments to analyze.   It is an inflation hedge; a safe haven; a currency.  It is subject to investment as well as jewelery demand.  There are so many drivers that is almost impossible to figure out what really makes it tick.

I have invested/traded gold and gold stocks since discovering  it as an investment theme in 2002. The Gold Miners/Gold ratio is one of my favorite ways to decipher what’s happening in the gold market.  This past weekend I decided to dig into the Gold/Oil ratio. If my analysis is correct then next few months should be very exciting times for Precious Metals investors.  Let’s take a look at what I am seeing.

The Gold/Oil ratio should be fairly simple to analyze.  There are four combinations to consider: Gold & Oil prices both increasing; Gold & Oil prices both decreasing; Gold is increasing with Oil decreasing and Gold is decreasing with Oil increasing.  However, in reality there are more permutations. Gold and Oil could both be increasing, but Gold  could be increasing faster than Oil.  Gold prices could be flat with increasing Oil prices.  It quickly gets more complicated.

The matrix below captures various scenarios from the Gold/Oil ratio chart over the past 10 years.  The ID#’s correlate to the relationships observed in the chart.  For example, #1 identifies a period of time when Gold prices were flat while Oil prices increased.  The Gold/Oil ratio moved down and the Gold Mining Stocks (GDX) were range bound.

So, what does all of this stuff mean?  The ideal environment for Gold mining stocks is when gold prices are increasing and oil prices are decreasing.  Under this scenario gold mining stocks  run like a scalded chimp (sorry chimp lovers).   Think about it from the miners profit & loss perspective.  If the sales price of  their product is increasing (Gold) and one of their primary expenses is falling (Oil) – tremendous profits drop to the bottom line.

Certainly gold and oil move in opposite directions over short periods of time (days or weeks) quite often.  However,  over a multi-month period this scenario has only occurred a few times over the past 10 years  ( #6 on the chart).  This is simply an observation.  A more detailed analysis is left to those interested.

Each time this scenario has occurred, Gold Mining stocks got the scalded chimp treatment.  It is very difficult to see from the chart, but the GDX move initiated in 2001 was over 100% in 15-16 months.  The move at the end of 2008 was nearly 75% in 3 months.  Guess what? We are in the midst of this playing out again.

Over the past month gold has moved up while oil has moved down.  As expected, gold mining stocks are performing admirably.  From April 16 to May 14, GDX is up nearly 14%.  There is one other observation to note.  Under this scenario, the general stock market takes it on the chin.  True to form, the SPY is down 4.5% over the same time period.

The top panel plots the Gold/Oil ratio on a monthly time frame over the past 10 years.  The other panels plot the Gold Miners index (GDX), Gold, Oil and the S&P 500 over the same time frame.

Note:

I reviewed my analysis with a StockTwits buddy Xiphos_Trading. He agrees with my overall thesis and believes that I’m reading the tea leaves correctly.  He added that even if oil doesn’t decline as rapidly as it did in 2008 the weak economic backdrop should keep oil demand in check.  He also brought up the point that Oil is in contango which is bearish for Oil prices.  The “net-net” is lower oil prices, regardless of its rate of decline,  is bullish for gold miners.