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Thinking of Entering the Gold Market? First Check the Relationship Between Gold and Oil Prices

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There seems to be a relatively strong relationship between gold and oil prices, but not between gold and oil returns. Here's how this relationship can help investors.

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In the financial markets, gold is usually ascribed to the commodities category. In this group of assets you will find your good old friend, silver, along with several others metals like platinum, palladium, copper etc. Apart from that, commodities encompass a broad range of other products in the like of corn, but also crude oil, gas, minerals and other. Such groups of assets are usually traded on commodity exchanges specialized in this kind of products, for instance on the Chicago Mercantile Exchange or the London Metal Exchange.

Commodities differ from stocks or bonds in the fact that, usually they have significant importance for some industry. For example, silver is used in the production of electrical conductors and oil is used as fuel for various kinds of machines. The main difference from a financial point of view is that, other than bonds and stocks, commodities do not give you cash flows in the like of dividends, coupons, or the principal. The only way in which commodities generate returns (excluding industrial applications) is when their price changes in the direction you bet on.

Since price changes are of crucial importance for commodities investors, relationships between these commodities are often examined in detail to establish if prices of one commodity can fuel prices of another. It is, for instance, almost universally acknowledged that there is a strong relationship between prices of gold and silver, where the price of silver strongly depends on the price of gold.

Most precious metals investors have probably analyzed the gold to silver ratio more than once in their investment career, but such relationships can be found not only between metals. It is argued that prices of gold and oil are also related. Higher price of oil would translate in higher prices of gold. Since there is no apparent intuitive connection between what happens with oil and what happens with gold, there is need for some explanations here.

The main idea behind the gold-oil relation is the one which suggests that prices of crude oil partly account for inflation. Increases in the price of oil result in increased prices of gasoline which is derived from oil. If gasoline is more expensive, than it's more costly to transport goods and their prices go up. The final result is an increased price level – in other words, inflation. The second part of the causal link is the fact that precious metals tend to appreciate with inflation rising (in the current – fiat – monetary environment). So, an increase in the price of crude oil can, eventually, translate into higher precious metals prices.

To see if this is actually the case, let's take a look at the chart below. It presents prices of gold and Brent crude oil in the 1987-2012 period.



As it turns out, both commodities tend to trade in the same direction. The relationship is far from perfect but it seems to be there. We have measured this relationship by calculating the R-squared for gold and crude oil in the above-mentioned period. R-squared is a statistical measure, but you don't need to be a rocket scientist or have a Ph.D. in mathematics to understand it. The basic idea is simply that if you have two quantities (e.g. price paths), R-squared shows you how much of the changes in one of those quantities can be explained by the other quantity. To put it simple, in our case R-squared shows you how much of the changes in the price of gold can be explained by changes in the price of crude oil. The result is 78.7% which, quite intuitively, tells you that, in fact, price levels of gold and crude oil are strongly related. This is further confirmed by another chart.



On this chart, we have plotted prices of gold in relation to prices of Brent crude oil. This chart can be interpreted in the following way: The horizontal axis shows you the price of oil on a given day and the vertical axis shows the price of gold on the same day. So, if you look at the horizontal axis and find oil at, say, $70, looking up in a straight line will tell you what gold cost when oil was at $70. We see that the cloud of points is generally rising in the price of oil. This suggests, just as the previous chart did, that there is a relation between the two price levels: higher prices of oil coincide with higher prices of gold.

One puzzle here is that it usually takes some time for higher oil prices to materialize as higher prices in goods and services. But it does not seem to take too long for gold you have in your portfolio to trade in line with oil. One explanation can be that, once oil appreciates, precious metals investors discount the expected future higher prices o goods in the price of gold and gold goes up.
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No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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