Gold & The Credit Contraction - Gold To Oil Ratio
Adam Brochert
April 12, 2009
Gold has been acting and will continue to act as money during the current deflationary downturn. When one thinks of gold as the strongest and most debt-free currency on the planet, there is no difficulty in explaining its' behavior over the past 12 months (day-to-day fluctuations aside). When one thinks of gold as a commodity and tries to explain gold's price behavior over the past year, it is much more difficult.
Gold's role as money during a credit contraction becomes particularly evident when one looks at the gold-to-oil ratio, a ratio that was recently at extremes relative to the past 40 years. The gold-to-oil ratio chart below is from www.ZealLLC.com and covers the period from 1985 to 2004. Such a ratio chart is created by plotting the product obtained when one divides the price of one ounce of gold by the price of one barrel of oil.
And below is a gold-to-oil ratio chart from 1990 thru April 11, 2009. This chart demonstrates the relatively extreme nature of the spike of this ratio to 26 at the end of February, 2009 and puts the current price action into a 19 year historical context:
This recent spike is certainly extreme relative to recent history. In fact, markets have already shown the wisdom of a short-term arbitrage trade (short gold and long oil) since the recent February peak in this ratio.
However, this time is not different, but it is unrelated to recent history. The credit contraction that has begun is secular, not cyclical. The last time a secular credit contraction happened was in 1929. If you believe, like I do, that markets dictate the primary trend and government can only prolong or distort the primary trend, then the 1930s period is much more relevant to a current analysis. Government cannot stop the private sector credit contraction, though it can heap insane amounts of public debt on top of the taxpayers' backs to try to "buffer" the blow and save the politicians' skins.
By the way, this is exactly what happened in the 1930s, though revisionist history tries to pretend that government didn't "do enough" to prevent the last credit contraction. This foolish Keynesian thinking will once again be exposed for the fraud and hoax that it is, but it will take time for everyone to once again realize these policies don't work (ask Japan, which has stimulated itself more than a subway frotteurist and still finds itself deep within a 20 year stock market and real estate deflation).
Nonetheless, the private sector dictates the primary trend and the primary trend is that of a deflationary credit contraction. Yes, inflation is a monetary phenomenon, but private sector credit creation is at a standstill and therefore the economy (and stock, commodity and real estate prices) will continue to contract viciously. The point of all this blabbering is to look at the gold to oil ratio in a better historic context - the 1930s. This ratio is important because it is a proxy for gold mining costs/profitability and those invested in the gold mining sector need to know how the profitability in this sector will fare during the next few years to make appropriate investment decisions.
When the gold-to-oil ratio is rising, profits are increasing for gold miners. Although energy is obviously not the only cost associated with mining, it is a major one. Labor and heavy equipment are other major costs, and these costs are both declining nicely as in typical deep recessions. The bottom line is that as long as costs are falling faster, a falling gold price can still make gold miners more money (think of the Wal-Mart model of the 1990s if this doesn't make sense to you - they kept lowering prices while squeezing costs even more).
Below is a chart of the long-term price of oil from 1913 to 2008 from www.thechartstore.com:
Notice the secular low for oil was $0.25/barrel in May, 1933. Notice also that a previous plunge in oil during 1932 got down into the $0.37/barrel price range. During this time period, the price of gold was fixed by the U.S. government at $20.67/ounce. As an aside, it wasn't until 1934 that the U.S. government declared the gold it stole from its' citizens the previous year was worth $35/ounce (pocketing a hefty 69% one year return on their stolen property).
This 1930s data yields a gold-to-oil ratio spike to roughly 55 in 1932 and a final high in this ratio of 82 in May, 1933. So, while the recent ratio spike may seem like a multi-year top to those who use charts from the past 40 years, I believe we are just getting started and the recent spike is the end of the third inning in a nine-inning game.
When the gold to oil ratio is increasing, this is a rough measure of gold miner profitability. Rising profits eventually translate into a rising stock price. I believe gold mining stocks will explode higher over the next few years as the credit contraction continues and I believe they will vastly outperform the price of the metal itself, much as in the late 2000-2003 cycle.
Please visit my blog for additional information on gold and the general markets.
http://goldversuspaper.blogspot.com
Adam Brochert
April 12, 2009
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