Gold vs. Black Gold?! It’s Worth Spreading.

The Yellow Metal vs. Black Gold

Believe it or not, there is a correlation between gold and crude oil prices.  Perhaps this is due to the fact that both respond to inflation/deflation in the same manner.  Heck, one could even say that crude prices are the cause of inflation/deflation.

By observing the plot of weekly closing prices over the last three decades, the correlation is easy to see from the macro view.  However, there are certainly periods where these two markets appear to be non-correlated or even inversely correlated.  This is to be expected since gold and oil have different fundamental drivers.  But history has shown that the non-correlated and inversely correlated periods have always been followed by reconciliation between the yellow metal and black gold as the correlation returned.

Non-correlated periods include 1985-1986 when the Saudis flooded the world with crude oil and caused the price collapse, a short period in 1990 after the invasion of Kuwait when gold peaked in the second half of August and oil shot higher until October, the first half of 2005 when gold was stuck in a trading range as oil rallied, and the first half of 2010 when oil was range-bound as gold continued to set new record highs.

Gold Crude Oil overlay weekly

Gold Crude Oil overlay weekly

Inversely correlated periods include 1993 when gold rallied throughout the year as oil kept dropping, 1996 when it was gold’s turn to drop all year as oil pushed higher, the first two-thirds of 1999 as gold dropped continuously and reached a multi-decade low while oil rocketed higher in the same period, the second half of 2000 as gold prices slumped and crude prices increased, the summer of 2003 when crude oil made a sharp correction as gold continued higher, the first four and a half months of 2004 where gold followed a downward trajectory as oil ran higher, during the great Financial Crisis when gold rallied from the October ‘08 low through February ‘09 as oil dropped and then as gold dropped from February ’09 through April ’09 while crude rallied, and April through September of 2013 when gold slipped lower as crude oil rallied for months.

After each of these periods of non-correlation and inverse correlation, the correlation between gold and crude oil returned.  Spread traders who recognized the changes in the relationship had ample opportunities for profits.

The Gold/Crude Ratio

If we’re going to spread the gold market against the crude oil market, it’s good to know where the relationship is at in comparison to where it has been historically.  To do that, we can look at the ratio between an ounce of gold and a barrel of crude oil.

Currently, the gold/crude ratio sits around 26:1.  This means that it would take twenty-six barrels of crude oil to equal the value of one ounce of gold.  Historically, the ratio has only hit 25:1 or higher half a dozen times in the last three decades.  Therefore, the current ratio of 26:1 is an outlier.

Gold Crude Oil ratio weekly

Gold Crude Oil ratio weekly

Furthermore, the current ratio is following an excursion to an all-time high of 42:1 that was hit about four months ago.  It appears that a capitulation high was established there and that the tide has turned.

When it finally reversed, the previous ratio readings of 25:1 or higher were followed by declines to 14:1 or lower.  Therefore, it is not unreasonable to expect the current decline to reach this level as well.

On the flip side, a spread trader should start watching for a buying opportunity when the ratio hits 10:1 or lower.  Who knows, perhaps we’ll get a chance to do so when the current bear market reaches its conclusion.  Like the old saying goes, “The bigger the bull, the bigger the bear”.  We just came off of the biggest bull market in the history of the ratio so the pendulum could swing to extremes the other way.

The Yellow & Black Spread

Now we’ll take a look at the spread between the value of a 100 oz. gold futures contract and the value of the sum of three 1,000 barrel crude oil contracts.  We are using three crude contracts to get close to equalizing the values of both sides of the spread.  Otherwise, the gold leg of the spread would have more than two and a half times the value of the crude leg of the spread.  This would mean that the changes in the gold market would be the dominating factor in the spread.

Normally, one gold contract is worth tens of thousands of dollars less than the sum of three crude oil contracts.  But this year the gold contract reach a record high of being worth as much as $35,590 more than the sum of three crude oil contracts.  It’s been nearly twenty-eight years since one gold contract has exceeded the value of three crude oil contracts, so this was a big deal.

Gold Crude Oil (x3) spread weekly

Gold Crude Oil (x3) spread weekly

Historically, the gold/crude (x3) spread is stretched thin whenever it has reached -$3k or less.  This means that gold came within three thousand dollars of matching the value of the sum of three crude oil contracts.  The spread has only made it near -$3k or higher on five occasions in the last thirty years.

Gold Crude Oil (x3) spread (1986 top) weekly

Gold Crude Oil (x3) spread (1986 top) weekly

The first time was in 1986 when the spread made it to +$2,120 (premium gold).  It then backed off to -$22,240 (premium crude) over the following year.

Gold Crude Oil (x3) spread (1988 top) weekly

Gold Crude Oil (x3) spread (1988 top) weekly

The second run-up peaked in late 1988 when the spread crested at +$3,080 (premium gold).  Eleven months later, it was priced at -$26,340 (premium crude) and a year after that the spread was at a record low of -$80,320 (premium crude).  This extreme price occurred because of Saddam’s Invasion of Kuwait, but it is still relevant.

Gold Crude Oil (x3) spread (1993 top) weekly

Gold Crude Oil (x3) spread (1993 top) weekly

The next time that the gold/crude (x3) spread peaked was in the last two weeks of 1993 when it posted a five-year high of at -$2,990 (premium crude).  Six months later, this spread was sitting -$22,970 (premium crude).  The bear market actually lasted about three years and didn’t establish a final bottom until it reached -$42,450 (premium crude) in January of 1997.

Gold Crude Oil (x3) spread (1998 top) weekly

Gold Crude Oil (x3) spread (1998 top) weekly

In December of 1998, the spread made it as high as -$3,290 (premium crude) before turning over.  Now, I know I wrote earlier that -$3k or higher was the line in the sand…but closing just $290 away from this price at a five-year high is certainly close enough!  Anyways, the spread crashed from there and sank to an eye-popping low of -$80,460 (premium crude) in just under two years’ time.  Interestingly, this undercut the 1990 Gulf War low by a mere $140 before turning around and ripping higher.  But the long side of the gold/crude spread is a discussion for another day.

That brings us to the current situation.  The gold/crude (x3) spread inverted –meaning that the gold contract had the premium over three oil contracts- in December 2015.  The spread posted a new record high in the first week of the year and finally topped out at +$35,590 (premium gold) when the second week of February started.  The premium went back to the crude oil side of the spread in mid-April and it has continued lower since.

Gold Crude Oil (x3) spread (2016 top) weekly

Gold Crude Oil (x3) spread (2016 top) weekly

If the current bear market stays intact, the spread could try to challenge price support at last summer’s low of -$61,960 (premium crude).  And if the ratio drops to 14:1 or lower like it has done in the past, the gold/crude (x3) spread would be priced somewhere between -$78,000 and -$148,000 (premium crude).  This puts a lot of profit potential on the table for spread traders.  Given the fact that the spread bottomed just below -$80,000 in 1990 and again in 2000, this would not be unprecedented.

Current Outlook

The December gold/crude (x3) spread peaked at +$14,850 (premium gold) on February 11th.  Since then, the spread has been in a downtrend, marked by lower lows and lower highs.  The bounces have been short sale opportunities.

After tagging technical support at the rising 75-day Moving Average in mid-March, the spread rallied $12,270 over a two-week period.  This made a Fibonacci 50% retracement of the initial decline.

The bounce faded and the spread made a two-day close below the rising 75-day MA in the first half of April for the first time since November.  This confirmed the trend change and sent the spread even lower over the following weeks.

Currently, the spread has rallied $17,940 in just over week.  This bounce took it to the Fibonacci .382 retracement of the entire decline to date.  Furthermore, the spread is just shy of the declining 75-day MA.  This particular moving average now serves as resistance because the spread is below it.

December Gold Crude Oil (x3) spread daily

December Gold Crude Oil (x3) spread daily

Another observation is that the December gold/crude (x3) spread has made lower monthly lows for four months in a row.  If the spread does not close above -$9,090 (premium crude) in the next two weeks, it will also mark four consecutive months of lower monthly highs as well.

In light of the current price pattern, the IMC blog is going to take its first crack at this spread by selling this rally into the resistance zone and risking a breakout above last month’s high.  If we get knocked out, we’ll quickly set new short sale parameters.  The train is confirmed to be south-bound, so now we need to find a way to hop on for the ride.

FYI, if this was a podcast instead of a blog, we’d cue Ozzy’s Crazy Train to start cranking right here…

Trade Strategy:

The blog will make a hypothetical trade by selling one 100 oz. December gold contract and simultaneously buying three December 1,000 barrel crude oil contracts at -$15,000 (premium crude).  Initially, the spread will be liquidated on a two-consecutive day close above -$9,000 (premium crude). 

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