Checking In on the Gold-to-Oil Ratio

What you're looking at below is a chart of the gold-to-oil ratio. The gold-to-oil ratio is exactly what it sounds like. You simply take the spot price for an ounce of gold -- around $900 per ounce as of this writing -- and divide it by the price of a barrel of oil.

Right now the gold-to-oil ratio is trading around 7. That means a single ounce of gold is roughly worth seven barrels of light sweet crude. With oil trading near $130 a barrel, this is an extreme low point for the ratio.

The previous drop in mid-2005, when an ounce of gold was briefly worth 6.5 barrels of oil, was the lowest the ratio has been in decades.

Oil Too Expensive, or Gold Too Cheap?

So what does it mean when the gold-to-oil ratio moves toward an extreme like this? In historical terms, it suggests that something is out of whack. Either oil has gotten too expensive, or gold has gotten too cheap.

The last time we saw an extreme in the other direction was late 1998, when the gold-to-oil ratio rose above 26. That was a case of oil being way too cheap... and of course, crude oil bottomed out for all time just a few months after that.

Given the way oil is trading now -- the recent rocket ride to $130 a barrel, etc. -- some think that oil has gotten too expensive, too fast. Their view would be that the price of oil has to come down, perhaps by a lot, and that the gold-to-oil ratio is reflecting this.

Your humble editor disagrees with this view for a number of reasons.

For starters, there's a lot of hot air about how oil could be a bubble and speculators are driving oil prices... but there is little proof of this charge, and a lot more evidence pointing in the other direction.

Germany's Folly

Angry German politicians have gone so far as to call for a worldwide ban on oil trading. They think that $130 oil is all the evil speculators' fault, and that all the traders should have their hands tied.

This is about the dumbest thing I've ever heard, and a good example of how politicians can be dangerous. One of the key functions of markets is price discovery; through self-interested buying and selling, the markets act as a useful forecasting tool. (One of the best forecasting tools we have at any rate.)

Without a functioning market mechanism to determine the price of a valued good, the market breaks down. You either have lots of one-off transactions taking place in the dark, or else you have some government committee setting the price by fiat. I hear Soviet Russia tried that. It didn't work out too well.

The activity of traders and speculators also provides much-needed liquidity to markets. When, say, an airline like Southwest buys heating oil futures contracts to lower its exposure to jet fuel costs, more often than not there are traders on the other side of the transaction. Without someone to take the other side of a trade, end-users of oil and gas products have no way to hedge their business risk.

In a very real sense, speculators are paid to take on risks that hedgers don't want. Risk transference is a vital market mechanism. The German politicians don't get this. Or maybe they do get it, but they just don't care.

Trying to restrict trading would be a fool's errand anyway. There is more than enough competition among global exchanges to keep the trading going, even if some goofball government tries to ban trading on a local basis. That's a very good thing.

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Et Tu, George?

Hedge fund legend George Soros is blaming the speculators, too, calling the oil price a bubble. Without putting too fine a point on it, this is a major piece of hypocrisy.

Why? Because the existence of men like Soros show exactly why big markets are hard to manipulate.

If the price of oil were truly in a bubble, some big hedge fund player with guts and foresight could come along and make a killing by shorting the daylights out of it... thus driving the price of oil back down to non-bubble levels in the process.

This is exactly what Soros himself did in 1992. That was the year he earned the nickname "The Man Who Broke the Bank of England," for the huge score he made shorting the British pound.

Back in '92, Soros was so convinced that the pound sterling had to fall, he took a huge $10 billion short position in one currency trade. When the pound finally broke under the strain, Soros made a billion dollars in profit in less than 24 hours.

Soros had similar exploits in the Malaysian ringgit and the Thai baht, after which government ministers called him all sorts of nasty names. The thing is, Soros made money in all those trades for fundamental reasons -- not because he was jamming the market. He was right... the pound did need to fall. So did the ringgit and the baht.

Point being, if Soros is so convinced oil is in a bubble again now, why doesn't he just put his money where his mouth is? That's how markets work. So what do you say, George? Are you planning to step up here or what?

T. Boone Pickens, another billionaire trading legend, did in fact step up. Pickens was short crude just a few months ago, and voiced the opinion it would fall. Boone had the good sense to change his tune and go long though, once he saw $100 a barrel give way like tissue paper. If I recall correctly, Boone now sees $150 per barrel in the cards.

Plenty of Reasons

There are plenty of reasons for oil to be trading as high as it is right now.

Not least among them are the big problems with oil production all around the world. There's production trouble in Norway, Mexico, Nigeria and Russia. Venezuela is a powder keg. Indonesia just announced plans to leave OPEC because it's now become a net importer of oil, thanks to growing demand at home. The big oil majors are getting less and less bang for their E&P buck. ("E&P" stands for exploration and production.) The list goes on and on.

Hello, Contango

Another interesting thing that's happened is the historic shift in oil markets from "backwardation" to "contango."

Backwardation simply means that further out oil prices trade lower than the current "spot" price. This is the normal and traditional state of the oil market.

The fact that the oil futures market has now moved to "contango" -- where oil contracts years into the future trade higher than the present day price -- suggests at least two things.

First, it suggests that traders no longer believe in the cost-lowering powers of technology. It used to be that resources got cheaper as technology to mine and extract those resources improved. No longer. Memory chips and iPods might keep falling in price, but not oil.

Second, oil markets in contango -- again, where future dated contracts are higher than spot -- suggest a rethink of the storage question. Normally, if long-dated oil prices get too far ahead of the spot price, traders can buy oil here and now and hold it for later delivery at the locked-in higher price.

With demand tight enough and supply restrained enough, however, this storage factor gets canceled out. (Falling dollar concerns play a role, too.)

So basically, if oil futures stay in "contango" for an extended period of time, that could be the clearest evidence yet that Wall Street is finally accepting the reality of peak oil.

Finally Having an Effect

The other reason why oil prices feel right -- as opposed to feeling like a bubble -- is because the pain of high-priced oil is finally having an effect on end-users. That is exactly what's supposed to happen.

There is a saying in the commodity biz: "The best cure for high prices is high prices." (It also works in reverse for low prices.) The idea is, when the price of a commodity stays high for a long period of time, it forces change on the market. It makes end-users do things differently, or induces new supply to come on line, or both.

With oil trading where it is, we are seeing real change for the first time. We are seeing Americans ditch their SUVs and give up long driving trips. We are seeing companies rethinking their travel and shipping costs. We are seeing outcry over $4 a gallon gas in the U.S. and $9 a gallon in Europe.

This is exactly how the market is supposed to work. This is how change happens. For those who think the price of oil should collapse from here instead of just dip a little, how much sense would that make? If oil collapsed back to levels where it didn't hurt anymore, the change would fall by the wayside, too.

The point isn't that markets are some benevolent change-inducing force. It's that the current price of oil matches up with a world where demand has expanded and expanded until finally the supply limitations got to be too much. Oil is trading where it is because we've finally hit the edge of the pain envelope... not because traders are propping it up.

Here to Stay

The bottom line is, $100 oil is probably here to stay. We'll see dips where Wall Street rejoices and naysayers say "See, I told you so," as they?ve said with every single oil dip over the past few years. But then we'll probably see oil climb right back up again.

This reality is reinforced not just by global demand, but by the fate of the dollar, too.

A big factor driving the price of oil higher has been global demand. Therefore, if global demand slows down, some folks argue, that means energy use slows down and the price of oil could fall.

But those folks forget what also happens when energy use tails off: the printing presses kick into high gear.

In other words, if American consumers and businesses cut back enough to really put a dent in oil demand, that turn of events will set off flashing red lights in the smoky back rooms of Washington and the Federal Reserve. Those red lights will in turn keep the printing press cranking double time, flooding the system with dollars. And finally, that mass of paper dollars will keep the price of oil (and other commodities) sky-high.

Either the world keeps on truckin' or the dollar keeps on fallin'... or both at the same time. Pretty much no matter how you slice it, high-priced oil is here to stay.

A Golden Opportunity

Now let's get back to that gold-to-oil ratio for second.

If you think, as I do, that high-priced oil is here to stay, and that the combination of global demand and the Fed's paper dollar printing press will keep it that way, then we can safely rule out the "oil is too expensive" option as an explanation for why the gold-to-oil ratio is so low.

That means there's only one other explanation left... that gold at $890 per ounce has gotten too cheap relative to the price of oil.

This explanation also fits the backdrop of events. Inflation is still a serious problem, and one that is only set to get worse. Remember, once again, how the Fed has responded to every single financial crisis of the past 20 years -- by printing money like mad. And remember that we still closer to the beginning of U.S. consumer woes than the end.

When the Pendulum Swings

We know that markets tend to cycle between extremes. First you see high volatility, then you see low volatility. First the pendulum swings in one direction, then it swings in the other direction, and so on.

Right now, as we pointed out earlier, the gold-to-oil ratio is near its historic lows of 6.5. A little over 10 years ago, the gold-to-oil ratio hit an extreme high of 26.

So just to hypothesize, if we saw the gold-to-oil ratio return to historic extremes -- and if it happened in an environment where oil stayed above $100 per barrel -- that would put the price of gold above $2,600 per ounce.

Far-fetched? I don't think so? but you can be the judge of that.

And by the way, if you're looking for good ways to play the precious metals -- ranging from safe and conservative to highly aggressive -- then you might want to subscribe to the Taipan newsletter. I have it on good authority that a special report on that very topic will be coming out soon.

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