The gold-to-oil ratio serves as a valuable metric in understanding the relationship between gold and oil prices and can provide insights into potential economic crises and stock market volatility. Over the past 30 years, the peaks in the ratio have coincided with significant market events.
The ratio is calculated by dividing the price of gold per ounce by the price of oil per barrel. When it rises sharply, it suggests a combination of factors at play. For instance, a decline in oil prices due to weak demand or oversupply, coupled with an increase in gold prices driven by investor concerns and a preference for safe-haven assets, may indicate an impending economic downturn. Such a scenario could point to reduced economic activity, heightened uncertainty, or investors seeking safer investments amid turbulent times. During the COVID-19 pandemic in 2020, the worldwide demand for oil fell rapidly as governments closed businesses and restricted travel. In April that year, an oversupply of oil led to an unprecedented collapse in oil prices, forcing the contract futures price for West Texas Intermediate (WTI) to plummet around -$37 a barrel, which threw the ratio out of whack.
This chart gives a different view of the data from the chart above, comparing the percentage change between gold prices oil prices (WTI) over time.
In 2016, oil prices experienced a significant downturn as a result of a supply glut in the global market, largely driven by the rise of U.S. shale oil production. The advancement of shale oil extraction techniques allowed the United States to significantly increase its oil output. This surge in production, combined with other factors such as OPEC's decision to maintain high production levels, created an oversupply of oil.
In an unprecedented event, the price of oil turned negative in 2020 due to a combination of factors, primarily the COVID-19 pandemic and an oversupply of oil. As global lockdown measures were implemented to contain the virus, travel restrictions were imposed, leading to a sharp decline in oil demand. With businesses shutting down and people staying at home, the demand for transportation fuels plummeted. At the same time, oil producers continued pumping oil, resulting in a significant surplus of supply. As storage capacity reached its limits, traders faced the challenge of finding storage space for excess oil. This situation created a unique market dynamic, causing the price of oil futures contracts to turn negative briefly.
As the chart above demonstrates, the gold-to-oil ratio correlates strongly with the VIX for the S&P 500, which is a measure for stock market volatility.
During times of heightened market volatility and uncertainty, investors often seek safe-haven assets as a means of protecting their investments. Gold is widely recognized as a traditional safe haven asset, whereas oil is considered a riskier asset due to its exposure to geopolitical events, supply disruptions, and changes in global demand.
Conversely, during periods of lower market volatility and increased risk appetite, investors may shift their focus towards riskier assets, including oil. This increased demand for oil can lead to a decrease in the gold-to-oil ratio, as the price of oil rises relative to gold. A declining ratio suggests a relatively stronger performance of oil compared to gold, indicating a decreased preference for safe-haven assets and potentially lower market volatility.
The chart above displays the 1-year rolling correlation coefficient between the price oil and the price of gold. A correlation coefficient of +1 indicates a perfect positive correlation, meaning that the two assets moved in the same direction during the specified time window. Conversely, a correlation coefficient of -1 indicates that they moved in opposite directions. There are periods during which the prices did not change, which results in a standard deviation of zero and a correlation plus or minus infinity. These periods are removed from the data set and appear as gaps in the rolling correlation series.
Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
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