Commodities send coded clues on inflation

February 23, 2009

John Kemp Great Debate– John Kemp is a Reuters columnist. The views expressed are his own –

After an 8-year period of remarkable stability, the ratio between gold and oil prices has broken down spectacularly.

The relative rise in gold is consistent with other indications that the market is bracing for a delayed upturn in inflation between 2010 and 2012.

From 2000 to 2008 one ounce of gold bought between 6 and 15 barrels of light sweet crude oil but for months the markets have been moving in opposite directions. In recent weeks, one ounce of gold has bought as many as 27 barrels of oil (https://customers.reuters.com/d/graphics/OILGOLDRATIO.pdf).

If both gold and oil prices encapsulate a view about prospects for the world economy and inflation, the divergent price moves present a seeming contradiction.

The surge in gold prices suggests investors are anxious to protect their capital against inflation, currency depreciation and bank failures. But weak or falling prices for oil and other commodities suggest investors are also bracing for a prolonged period of economic weakness and deflation.

How to reconcile these views?  They cannot both be right.

If the massive liquidity injections into the banking system as a result of rescue packages and quantitative easing causes inflation to pick up, oil prices reflected in the forward curve will turn out to be far too low. If the world economy falls into a long deflationary slump, gold will be too high.

In either event, it ought to be able to trade the ratio, selling expensive gold futures to buy cheap oil ones, and wait for the ratio to converge back to more “normal” levels.

But such trades are more dangerous than they look.

Ratios can be remarkably stable and show strong trend-reverting properties for long periods of time. But when they break down, divergences often go further and last longer than most anticipate.

John Maynard Keynes warned that the market can remain irrational longer than the average investor can remain solvent. All but the strongest investors with deep pockets will struggle to meet margin calls until the ratio corrects and profits are made.

Moreover, it is impossible to be certain until afterwards whether the shift in the ratio represents a temporary divergence that will be corrected in time, or the start of a fundamental structural break.

TIMING DIFFERENCES

In any case, the current divergence in gold and oil prices may not be as irrational as it looks. It probably reflects differences between institutional and retail investors about the timing of future inflation rather than the probability.

Both types of investor have recently shown interest in commodities as a hedge against inflation, currency depreciation and bank insolvencies.

But unlike large institutional investors, who can protect themselves from inflation and currency risks through inflation and currency swaps, inflation-protected government bonds, or futures positions in oil and industrial metals, retail investors have fewer options. Owning physical gold is one of the few ways they can protect capital in an inflationary environment.

Much of the heightened interest in gold has come in forms favoured by retail investors, such as coins, bars and holdings in exchange-traded funds (ETFs) (which give private investors an opportunity to “own” physical gold more or less directly through shares in a trust vehicle quoted on equity exchanges).

Different views about inflation embedded in gold and oil futures may therefore mark different views between retail and institutional investors, with the retail base more worried about an upturn in inflation, and professional investors more sanguine.

It probably also captures differences about timing. The whole objective of quantitative easing is to generate more inflation over time to counter the deflationary tendencies within the economy as a result of the slump.

But an upturn in consumer prices is unlikely to occur until a cyclical recovery is well underway, and could therefore be several years away.

Less sophisticated retail investors focused only on the longer-term inflation threat risk piling into commodities too early, paying several years worth of storage and financing costs (contango, or negative roll yield) before seeing an eventual upturn. Institutional investors seem content to wait until signs of a cyclical recovery and pick up of inflation become more imminent.

Gold is also a much more convenient and cheaper way than crude oil to buy medium-term protection from inflation.

Because of the huge storage charges, the cost of buying cheap oil at the bottom of the cycle and financing and storing it until prices and inflation pick up in two or three years time, is prohibitively high.
Gold is much easier and cheaper to store. The cost to buy gold or gold futures now and hold them until inflation picks up is little more than the cost of finance, which in a world of near-zero interest rates is almost nil.

For both retail and institutional investors, gold has therefore emerged as the vehicle of choice for protecting capital against a deferred break out in inflation rates in 2010-2012.

The stretched oil-gold ratio is a perfectly rational reflection of timing differences (deflation in the short term, inflation in the long term) and storage charges (high for oil, low for gold).

The current constellation of commodity prices does indeed send a carefully coded warning about the prospects for a pick up in inflation — but not for another 2-3 years.

20 comments

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Russia is buying gold now.In 1999, Germany bought as many gold as it could get.At DAVOS, Russia and China were implying that the USA dollar as reserve currency was dead.if this is truth we have not seen the worst of this calamity.

Posted by saul | Report as abusive

So, what if the rest of the world begins looking at the dollar as a dead reserve currency? Are we at the threshold of a new economy model for our beloved capitalism? What is the worst case cenario for us Earth inhabitants?

Posted by gustavo | Report as abusive

With all of the fear that exists about a potential devaluation of the dollar, one would think that the price of gold would already be much higher than it is. With tons of big money being moved into US government debt, it looks to me as if the world still views the US dollar as the safest place to be. Owning gold these days is a sort of feel good thing, like a warm blanket. Only time will tell if that feel good feeling will also turn out to be a good investment.

Posted by JayRay | Report as abusive

So, either the price of gold is going to come down, big time; or the price of oil is going back up, big time. We won’t stay out of balance for long.

Posted by Dave | Report as abusive

I think that the stock merkets will perform okay in 2009 and maybe into the first half of 2010. I do think that there will be massive inflation and I am especially concerned from 2011 onwards.

I think that gold and commodities are the place to be.

Posted by D Rumsfeld | Report as abusive

Its just the last effort by banks to liquidate the gold holdings they have and post september 2009 Gold will be just another piece of metal.

All banks need liquidity and they will liquidate the gold sooner.

Posted by Strategist | Report as abusive

The points made are, I think, apparent divergence is not a contraction as it may appear as timing will correct for the almost sure certainly of inflation.

Institutional investors react short-term(ly), with quarterly reports and call for dividends. As a retail investor, one can diversify with various commodities, thus averaging out the divergence(s), and be rewarded long-term,…. 2-3 years. Other precious metals such as silver are industrially consumed, thus tend to increase demand with diminishing supply. Diary products and produce do likewise. So yes, it’s no big deal…. while we digress and distract from the more subtle (and important) message of the well-written articles. In summary, see the bigger picture; truth and wisdom would be shared.

Posted by ric prop | Report as abusive

Clearly, with (a) catalogued oil reserves being consumed at 80+Mbbl/day worldwide (down only a few Mbbl/day since peak 2007 economic activity), (b) oil services industry wounded and hobbled, (c) and difficulty/cost of replacing depleted oil ever-increasing, the supply-demand curve for petroleum is correcting week by week. Traders have bet that storing >80 Mbbl of crude in tankers around the world is a worthwhile contango game for the next few months; thereafter, crude prices will start to stabilize north of $US30-35/bbl [break-even for geopolitically-safe Canadian tar sands/oil shale deposits]. Because short-term inventory & consumption data tracking remains an “art form” and new stimulus package oil is years away, crude price volatility will continue during the economic downshift. As the driver of transportation-related activities, plus chemical & agribusiness industries (feedstocks), a greater % of consumer, government, & industry $$ will of necessity be allocated toward energy purchase going forward. Gold will continue rising toward $2000/oz counter to the massive inflation of world fiat money systems.

Posted by John - SE PA | Report as abusive

One important factor not considered in the article is the fact that so much of the pricing mechanism is a captive of the “too big to fail” (tbtf)philosophy. Sure, companies cannot raise prices as long as the weakest, subsidized “tbtf” companies cannot actually price to their costs + profit and are being protected from normal market forces (i.e. bankruptcy). This means that these crippled giants actually sabotage the entire pricing mechanism of “free markets”.

This is only one of the perils of the moral hazards promulgated by a corrupt politician/corporatist class. Only by allowing capacity to shrink to demand will the healthier companies be able to claim victory by market share and price increases which reflect the real costs of doing business in an environment where the currency is being diluted and devalued. The corruption of the market system is the real news here; not the price of gold or oil.

Posted by Jonathan Cole | Report as abusive

Physical gold seems to have done better than gold stocks. I suspect there’s a great deal of knee-jerk buying of physical gold. But then comes the day when someone asks, “Yes, but what do you DO with gold?” The answer is use it in industry, and those industries are in contraction.

Posted by Pete Cann | Report as abusive

Are we getting into the medieval period,where god was considered as the barter currency? If that be so, then what will be the fate of huge dollar reserves held by some asian countries ?

In India, people generally buy gold for future investment, is it hold true for the rest of the world ?

Posted by Manish | Report as abusive

I think that money is over-rated. Why should we be so entirely wrapped up in the value of a physical object that we really don’t need in order to live. Money is only as important as WE make it. Surely, there must be some other way we can make our society work. And I don’t mean communism, socialism and all that garbage. There is always the Barter System and Agrarianism and if kept simple there may be a whole host of other possibilities. I’m sure all the power mongering money grubbers have something negative to say about that, but from where I’m standing these sure look reasonable.

Posted by Not Disclosed | Report as abusive

We have beebn hearing that US Dollar is ugly, but still better than other currencies. We have heard the first salvos of rating agency wars – Mr. Baffet’s Moody’s downgrading European banks and Paris-based Fitch doing the same on US firms. We have heard crude forecasts from US that the price will go down to 20. The Euro/$ is still in the 1.25 to 1.35 corridor, Brent has been trading above 40 (probably because Shell and BP will lose money even at that price) and Hillary calling upon Chinese to keep buying UD Treasuries (on which they are likely to lose handsomely, if yields go up). Europe and Japan have been certainly struggling, but big chunks of US economy have effectively already collapsed. US government claims that industrial contraction is not as severe as elsewhere; it very well may be, but data available shows that US well ahead of the rest of the world in terms of reductions in steel and car output. What all this seems to amount to is an information war to prop up Dollar as the “safest” investment instrument. But with gold still rising, apparently not everyone is convinced.

Posted by dv | Report as abusive

Personally I don’t consider gold a worthwhile metal either from a commercial standpoint or aesthetically. But demand from India is coming on line, and my understanding is that they love gold. Oil has never been comparable to gold since the value of oil is largely determined by its usefulness. Not only are there alternatives to oil, but overtime with technological improvements our demand for it tends to decline. Also some of us are turning away from plastics and polyester. Oil is really a relic of the disco era with its heydeys in the production of really tacky dancing outfits. Probably at this point the chemical bonds are starting to break down and resulting in peculiar carbon molecules leading to the feminization of male children.

Posted by Don | Report as abusive

Good article. Note that the peaks of the Oil/gold ratio have mostly occurred during period of time whenoil prices collpased…1986/1987, 1998 and today.

Very insightful Dan,

“Personally I don’t consider gold a worthwhile metal either from a commercial standpoint or aesthetically. But demand from India is coming on line, and my understanding is that they love gold. Oil has never been comparable to gold since the value of oil is largely determined by its usefulness. Not only are there alternatives to oil, but overtime with technological improvements our demand for it tends to decline. Also some of us are turning away from plastics and polyester. Oil is really a relic of the disco era with its heydeys in the production of really tacky dancing outfits. Probably at this point the chemical bonds are starting to break down and resulting in peculiar carbon molecules leading to the feminization of male children.”

When people wake up and realize the global significance,
of the cancer industrialization has brought to the planet…they will know precisely how to solve the problem. Or will we? We are prisoners of our own device, without “our” water and land.

Posted by Cindy | Report as abusive

I’m not sure about the US dollar being a dead currency, as some posters have suggested.

No other currency is capable of taking over, either for goodwill or solvency issues. China would burn through its foreign reserves quickly if it tried to backstop the world economy. And Russia?!? PLEASE!! Russia is a 2nd rate economy riding on a wave of late 20th Century enthusiasm. Russia has neither the economic strength nor management knowledge required to act as a currency safe haven. And there is the small matter of corrupt government in both China and Russia.

At least in the US, the baubles and nice goodies appear in the US budget. In China and Russia, they are hidden until some newly rich former shoe-lace salesman builds a castle in Caucasus, or Inner Mongolia.

Transparent flows of money are what a stable currency requires, even during times of stress. No other currency is as large or transparent as the US dollar.

Posted by Rob | Report as abusive

Yes, inflation is going to be a problem during the next, especially with the way the government is giving away money. Right now though, gold I think is in a bubble. Eventually, the bubble will pop.

Posted by Brian Bigelow | Report as abusive

We have beebn hearing that US Dollar is ugly, but still better than other currencies. We have heard the first salvos of rating agency wars – Mr. Baffet’s Moody’s downgrading European banks and Paris-based Fitch doing the same on US firms. We have heard crude forecasts from US that the price will go down to 20. The Euro/$ is still in the 1.25 to 1.35 corridor, Brent has been trading above 40 (probably because Shell and BP will lose money even at that price) and Hillary calling upon Chinese to keep buying UD Treasuries. And there is the small matter of corrupt government in both China and Russia.

At least in the US, the baubles and nice goodies appear in the US budget. In China and Russia, they are hidden until some newly rich former shoe-lace salesman builds a castle in Caucasus, or Inner Mongolia.

Transparent flows of money are what a stable currency requires, even during times of stress. No other currency is as large or transparent as the US dollar.

Posted by Narmadha | Report as abusive

The difference between oil and gold makes all the sense in the world. As the markets crash, there will be a decreased need for oil, because investment in industry will decline. As industry declines so does oil. However, there will be sharp rises in inflation. As the currencies all lose their value, Gold will keep its value. Gold is valuable because it is rare and easily traded. Oil is valuable because it is useful. Oil is becoming less useful and gold is becoming more rare. Makes sense that oil’s price will decline and gold’s will rise.

Posted by Mike | Report as abusive