Gold/Oil Ratio Returns

The price of oil revisited, in terms of Gold Bars...

"WHO CARES what you say," a friend asked (declared) last night, writes Dan Denning of The Daily Reckoning Australia.

"Market cycles, super cycles, unicycles, quadracycles...you throw all those words around to avoid the real subject."

"There's no such thing as a quadracycle," we replied.

"It's a car you moron, and you're ignoring the point."

"Which is...?"

"You blew it. You got the single biggest investment story of 2009 wrong. And now you won't hardly mention it or bring it up. You pretend like it didn't happen. But it did. Real people lost real money because you were wrong. What do you say to that, smartypants?"

Our response from the Old Hat Factory, home to the Daily Reckoning Down Under, follows below. But first, the controlled burn by the world's central bankers is clearly underway. At least they hope it's controlled. The Bank of England cut its key policy rate one full percentage point to 2%, the lowest level since 1939. And while the BoE goes on financial war footing, the precocious ten-year old European Central Bank snapped to attention and slashed its key rate by 75 basis points to 2.5%.

The ECB, like the rest of the global banksters, fears rising unemployment, falling consumer spending and business investment. So do the markets, apparently...up, down and now up again on the promise of Obama-flation.

But the big shocker at the end of last week was oil. It fell nearly 7% to under US$44 per barrel, its lowest level since 2005. Oil is down 70% from its highs. But a Merrill Lynch analyst says that if the economy is as bad as everyone expects in 2009, a barrel of crude may go as low as $25.

Let's take a closer look at oil. But let's do it terms of gold, revisiting the Gold/Oil Ratio.

If you're wondering what the inter-market relationship is between Gold and Oil, hold that thought. Because it's a good question. And the brief answer is that oil and gold both tell you things about what's going on in the economy.

Oil tends to go up with rising GDP; gold rises when the US Dollar is weak. (The long answer would take longer than either of us has today.)

So what is the chart telling us now? Well just to update it for last week's action, the gold futures price was $765.50 and the oil futures price was $43.67. That leaves the current gold/crude ratio at 17.5. Which means it would take you 17.5 barrels of crude to buy an ounce of gold.

You can see the long-term chart is all over the shop. But 15 turns out to be the historic average for the ratio. So if the ratio is rising, what does it mean? It means either oil is oversold or gold is overbought. For the ratio to return toward its historic average, oil prices would have to rise, or Gold Prices fall.

What do you reckon will happen? We reckon the ratio will increase, with the oil price falling more and the Gold Price holding steady or rising. There's no law of physics that says the ratio must return to 15, only that 15 is the average level. But 2009 is going to be a strange one either way.

Oil prices should fall to reflect a dismal world economy. Spot Gold, we reckon, should rise to reflect the inflationary fires being stoked all over the globe. There's no guarantee it will happen that way, of course. We erred in believing commodity prices and resource stocks would hold up (both absolutely and relatively) better than financial prices. But we badly underestimated the pyramid of leverage upon which all stock prices were built.

Gold Bullion, meantime, could suffer from the further deleveraging of planet earth (both household and corporate balance sheets). But we like the way our friend Dr. Marc Faber put it in his latest Gloom, Boom, and Doom report:

"I remain of the view that successful reflation of the asset markets will likely manifest in precious metals strengthening against all paper currencies and other assets. Consequently, I continue to recommend that investors accumulate physical gold and silver."