Is Gold a Substitute for Crude Oil?

Oil and gold are not often considered substitutes, but there is a long-standing financial theory regarding the gold-oil relationship.  On one hand, oil is a major consumable commodity and its market price partly drives US inflation rates (via the cost of diesel and gasoline).  Higher oil and gas prices impact the cost of goods purchased and when these costs are passed through to consumers, prices, and inflation both increase.

On the other hand, precious metals like gold tend to also appreciate with inflation.  So, an increase in the price of crude oil can, eventually, translate into higher precious metals prices, via the link to inflation.

Although not perfectly in step, both commodities tend to trade in the same direction. By our calculations, these two commodities have a long-term regression coefficient (r-squared) of 67%, which indicates their returns have a strong correlation.  However, this relation declines to only about 15% over the last 5 to 10 years. 

The Gold to Oil Ratio can be defined as the price of gold divided by the price of one barrel of oil. 

In theory, if the Gold to Oil Ratio were high versus historical relationships, then gold could be considered expensive versus oil prices.  Therefore, an investing position where one was long oil and short gold would be suggested.  Unfortunately, however, this theory runs counter to the Efficient Market Hypotheses and the Random Walk of stock and commodity pricing.  Today, the ratio is slightly above the historical mean.

While it is an interesting relationship to observe, oil and gold still do not appear to be attractive substitutes for each other.

Crude Oil Outlook

While futures markets aren’t a crystal ball, their price levels and related options are useful for estimating future ranges, or “confidence intervals,” for crude oil and natural gas prices.

The graphic below illustrates the crude oil pricing as of May 15, 2018 and predicted crude oil prices based on options on oil futures contracts (ticker /CL).  The blue lines are within one standard deviation (σ) of the settlement price (the middle, green line), and the outside, red lines are within two standard deviations for each month (for a refresher on standard deviations, see the January 2016 blog).

Based on May 15, 2018, pricing, the futures markets indicate that in mid-July 2018 the expected strip price is $70.43, with a 68% chance that oil prices will be between $63.00 and $79.00 per barrel.  Likewise, there is about a 95% chance that prices will be between $54.00 and $91.00.  For a longer-term view, by mid-December 2018 the approximate one standard deviation price range is between $56.00 to $84.00 per barrel with an expected value of $68.35.  As of last month, oil futures are still in “backwardation.”

Natural Gas Outlook

The natural gas futures contracts are currently trading at $2.86 per MMBtu for the Henry Hub (ticker /NG).  Although more affected by seasonal factors than crude oil, in July 2018, the expected price is $2.87 with a +/- 1σ price range of $2.60 to $3.15 per MMBtu, and the 2σ range (95%) of $2.30 to $3.55 per MMBtu.  For a longer-term view, by mid-Oct 2018 the expected price is $2.87 per MMBtu with a +/- 1σ price range of $2.50 to $3.40 per MMBtu.

Tags: Oil & Gas Price Outlook May 2018, Gas Price Outlook May 2018, Oil Price Outlook May 2018

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