The Gold/Oil Ratio: Oil, Gold and New Ways to Profit

Dan Denning looks at the changing gold/oil ratio — and points out that the change is not because oil is getting cheaper relative to gold, but that it has something to do with the value of the dollar.

“That means two things: First, it takes fewer barrels of oil than ever to buy an ounce of gold. So far, this has been evidence of oil strength, and not of gold weakness. Gold futures are in the $450 range as we go to press. The ratio, then, can’t be explained away as gold weakness.

“The second thing the ratio indicates is coming gold strength. This will happen even as oil prices climb higher. Obviously, that means gold prices have to climb faster than oil prices. In the inflationary scenario I describe below, you’ll see just how that happens. If you don’t yet have a position in physical gold or gold stocks, now is the time to take one.”

Since then, spot gold prices have moved up another 20%. And oil, despite coming off all-time highs, is trading just a hair under $60. It’s time to bring the issue up again, not only because gold is making new highs, but because ConocoPhillips just bid $31 billion for independent producer Burlington Resources.

Today — with oil at $59.94 and gold at $538 — the ratio is at 9 and climbing. But the good news is the ratio could double from here and still have plenty of room to grow.

The Gold/Oil Ratio: The Meaning of a Growing Ratio

What would that mean?

The ratio skyrocketed then because the world was awash in cheap oil and gold rallied. In other words, the ratio was high not because gold was “back,” but because oil was historically cheap.

Today, the situation is entirely different. The age of cheap oil is over. The age of more expensive oil is just beginning. And it’s beginning at exactly the same time gold is emerging from its two-decade-long slumber against the dollar.

In investment terms, we’re headed to a place where the oil/gold ratio doesn’t make a new high, but gold and oil both make new highs in absolute and inflation-adjusted terms. We’re headed to a place where the gold/oil is around 20, and oil is at $100 with gold at $2,000 an ounce.

It isn’t.

The move of about $500 is the Normandy invasion. And above $525, the July 1944 breakthrough of German lines in Operation Cobra. This move turned the war from a creeping reenactment of World War I to a war of movement again, the way it had begun with the German blitzkrieg of France.

Only this time, it was American and British tanks moving east, not German tanks moving west. Of course, it’s worth noting that the allied drive to the Rhine stalled in the Ardennes forest in December 1944. In fact, on Dec. 18, 1944, the 101st Airborne Division, unarmored, was surrounded at Bastogne during a surprise German winter offensive.

The battle at Bastogne is described well in the miniseries Band of Brothers (which makes a nice Christmas gift). And not to put too fine a point on it, but let me reproduce a quote for you from the Army’s after-action report from Bastogne. I mention it because the higher gold goes, the more shrill the outcry against it will be from defenders of the dollar.

As I’ve been writing for over two years now, the dollar standard is ending. It will mean the end of a lot of familiar and comfortable arrangements for people. And for investors who haven’t thought of — much less prepared for — a world where the dollar is worth dirt, it’s a terrifying thought, one they’ll want to shout down. Shouting that something should not be, though, is a bad strategy, as is fixating on it:

“Preoccupation with the key position of Bastogne dominated enemy strategy to such an extent that it cost him the advantage of the initiative. The German High Command evidently considered further extension to the west or north as both logistically and strategically unsound without possession of Bastogne, as that town overlooks the main roads and concentration areas of the spearheads. By the end of the month, the all-out effort in the north had become temporarily defensive; in the west, there was a limited withdrawal, and the array of German forces around Bastogne clearly exposed the enemy’s anxiety over that position. Until the Bastogne situation is resolved one way or the other, no change in strategy can be expected.”

The situation was resolved, of course. The Allies broke out at Bastogne and on March 7 of 1945, crossed the Ludendorff railway bridge at Remagen, across the Rhine and into Germany. Of the 22 road bridges and 25 rail bridges across the Rhine, the bridge at Remagen, taken by the 9th Armored Division, was the only bridge the Germans had not destroyed, although they tried to demolish it twice.

“This bridge is worth its weight in gold,” Eisenhower is claimed to have said.

The Gold/Oil Ratio: Moves in Oil and Gold

Gold does not need a bridge to the future. But higher prices are one way of getting there. And the move gold is making now argues for bigger and stronger gains ahead in 2006.

And this assumes the Kuwaitis (or the Saudis, or the Iraqis) can actually produce what they target. And even if they can, for how long? Oil wells don’t deplete as fast as natural gas wells. But when you have to start pumping seawater into a well to boost production, you’re simply hastening the rate at which you exhaust all the cheap, high-quality petroleum from the ground.

Also note that the Kuwaitis are not boosting money spent on exploration, but production. Perhaps they are hoping to get top dollar for the 96 billion barrels of oil they claim to have in the ground. Regardless of the economics of their decision to boost production, the geopolitics of oil, as dangerous as they are politically, are quite bullish for the oil price.

Gold will actually have to climb much faster to keep up with oil, I suspect. In the meantime, you probably won’t see Congress hauling the gold miners in front of the TV lights to ask about huge mining profits. But that doesn’t mean the insiders at the gold majors haven’t already done what their colleagues in the oil industry did: make a list of acquisition targets.

Gold production CAN be increased, but you’ve got to find the gold first. That means you have to explore for it. And with higher gold prices on the horizon, the incentive for finding it is definitely there. Gold majors, looking to add new assets to their balance sheets, are going to be in an acquiring mood.

Fortunately, I think there’s a simple way for investors to profit from this Christmas shopping by the gold majors — without having to speculate in junior exploration stocks. I’ve recommended how in the January issue of my stock research newsletter.

Regards,
Dan
December 18, 2005

“This scenario is beginning to unfold just as U.S. investors are stampeding to foreign stock markets, chasing the rallies that overseas bourses have lately been relishing…But investors are probably catching foreign stock cabooses, not locomotives. The dollar, which I think will keep climbing (with help from Fed rate increases), is eroding overseas stock gains. When U.S. consumer-spending weakness is felt globally, export earnings and economic activity abroad will nosedive and murder foreign stocks. Best advice: Unload your foreign equities now on all those bullish latecomers. Start first with the export-led Asia tigers, especially China. They’ll suffer the most.” ~ Gary Shilling

“So after the war, we go back to recognizing the limits of government. But we want to put the full authority that we have and our technology to use immediately to try to thwart terrorists” ~ Dana Rohrabacher, US House of Representatives on CNN

Headline(s) of the week: “Oil prices projected to remain above $50 a barrel for decades” ~ The Arizona Republic

“Bush: Eavesdropping Helps Save U.S. Lives” ~ The Associated Press

Reverent relevance: Doesn’t look like the explosive housing boom treated new real estate agents all that well in the DC and Baltimore metro area. Since 66% of a realtor’s business comes from previous customers, even if the market smokes, it’s tough for a newbie agent to prosper. According to the last survey from the National Association of Realtors, agents with 2 or less years of experience pull in a meager $12,850 in commissions per year. The number of licensed agents in the Northern Virginia-Baltimore axis has doubled in the past 6 years.

So it looks like speculators and happy families weren’t the only ones seduced by the housing boom. There are 143,000 agents in the above mentioned area and there is a record count of 2.5 million countrywide. The last time the housing market slowed, in the nineties, 20,000 agents in Maryland packed it in and quit. If these plentiful junior agents have trouble making a buck in boom times, what’s gonna happen when the market turns? Maybe those forlorn former real estate agents can go look for jobs at the Fed.

Relevant irreverence: Your Whiskey website has a new face. Please go here to check it out: http://www.whiskeyandgunpowder.com/  If you have a moment, please have a looksee…what do you think of it’s appearance and utility? Please e-mail me here to give me some pointers or opinions on your new digs: greg@whiskeyandgunpowder.com