John Kingston is the oil expert for SONAR, FreightWaves’ data product. He and other members of the SONAR experts’ team regularly write in-depth looks at their respective areas of expertise: freight volumes, freight markets, weather and macroeconomics as well as oil. This piece is from a recent report to SONAR subscribers republished here.
Between the start of the year and early October, West Texas Intermediate crude traded in a range of $60-$75/barrel, with the lower numbers at the start of the year and the higher numbers consistently seen in September and October. Markets then commenced a slide that has taken prices to less than $50/b as the year comes to an end.
But that’s not what we’re looking at. How can one determine “normal” for outright price that fluctuates every day? Instead, we are trying to define normal as the size of the relationship that currency and trading geeks have long looked at: how many barrels of oil it takes to buy an ounce of gold.
Why these two things have anything to do with each other may be a mystery to a truck driver filling his rig or a fleet manager looking at the company invoices for what they are paying for fuel or getting billed for fuel surcharges.
In recent years, the spread of gold vs. oil has been as disrupted by the rise of the U.S. shale industry. As production poured on to the market from the shale fields, what had been considered a normal spread retreated far, far in the rear-view mirror.
So what is normal? The number that conversations start with is 15, that it takes 15 barrels of oil to buy one ounce of gold. Up until a few years ago, if you charted the relationship between the two going back until 1984, soon after the New York Mercantile Exchange launched the highly successful WTI crude contract, the long-term average came in between 15 and 16.
Why 1984? Because that is a year after the NYMEX launched that WTI contract, and that is the same year that S&P Global Platts launched its WTI physical crude assessment, the history of which FreightWaves is using and which I have used in previous looks at the WTI-gold spread.
That doesn’t mean it always stayed at 15. Far from it. There were periods of extreme weakness in the price of oil when the number would climb well over 20. In February 1999, when oil prices were at $12-$13/barrel, a level that most analyses would tell you was the all-time inflation-adjusted low price, the ratio was about 24. In June 2008, leading up to the all-time high price of early July of that year—more than $145 on the day before the Fourth of July, dampening the happiness of barbecues all over the land—the ratio was below seven. In both those cases, and many more, the ratios did not hold and prices moved back toward that sweet spot of a 15 ratio. A few years ago, there were days when the price of oil was so weak it soared above 30.
And then the shale revolution occurred. As oil has poured out of U.S. fields, and the Canadian oil sands as a secondary growth source, the spread blew out. In some ways, this could be viewed as a good thing. What is oil? Is it a financial asset or is it a source of energy? Because if it’s the latter, there is absolutely no obvious reason why there should be some sort of natural relationship between the two. And if there’s lots of it, that’s good for consumers, and its ratio with gold be damned. Why should anybody care if its price looks too low relative to gold while they’re filing their truck at attractive prices?
Unless…unless…you think that gold is the ultimate store of value and that the price of everything measured in gold is the “true” expression of that value. As a trader told me one time, if you could get the price of a suit from the 1700s and compare it to the then-price of gold and take a similar suit today and compare it to today’s gold price, the ratio would probably be about the same.
A few years ago when we ran these numbers, it showed that in 2016, the average for the year was just under 30. The average ratio for 2017 was just under 25. That made sense. Oil markets were groaning under the weight of supply from the U.S. and the price of oil was sliding.
Meanwhile, gold didn’t stray too much from trading in a $200 range on either side of $1,200. It held steady in a world where inflation was very much at bay and had not need to rise as an inflation hedge, which has long been seen as its primary value in a portfolio.
The question then was whether the shale supplies had so fundamentally changed oil markets that a ratio of 15 to 16 for oil vs. gold was a relic of the past. That brings us back to defining what oil is. Should its value be seen as being part energy source and part—undefined in size—financial asset? Or if it’s just an industrial commodity, and suddenly there’s a whole lot of new supply of it as part of the radical technological change brought about by the marriage of fracking and horizontal drilling, then maybe the old normal is completely out of date and should just be ignored. Time to find a new one. I’ve thought that the last few years when I conducted this little end-of-year experiment and saw the average ratios climb.
That’s why it was fascinating to run the numbers and find the ratio this year moved closer to the norm. The average ratio through December 13 was 19.42, narrowing by 5 “points.” It should be noted, however, that it was moving up sharply at the end of the year, no surprise given the slide in the price of oil that began in early October.
If we had to draw conclusions from that, they might be as follows:
—The ratio of oil vs. gold, to get seriously thrown off its historic norms for any lengthy period of time, needs a big disruption. Gold supply disruption is almost impossible; it’s been a store of value for thousands of years and increases only incrementally. But in the history of oil, it is possible there hasn’t been anything as short-term disruptive as shale. Other technological breakthroughs, like deepwater drilling, took time to make their impact. Shale did it in a few years.
—OPEC’s latest deal to reduce oversupply may not work in 2019. But the efforts it launched in 2016 did clear the market of a significant overhang, and it was that fact pushing the ratio back down toward the 15-16 norm. (The average for June through September this year was a little more than 17.) It has long been whispered in oil markets that OPEC oil ministers do look at the oil vs. gold spread. There’s no proof of it, of course, but if so, that the ratio had widened starting in October was most certainly on their mind when they decided to cut output for 2019 at their early December meeting.
—Returns to the norm can take a long time. If you want to trade it, you better be patient.