Analysis of correlation between gold and crude oil prices

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“ANALYSIS OF CORRELATION BETWEEN GOLD AND CRUDE OIL PRICES”

INTRODUCTION

After the world has faced the global economic meltdown situation, now the situations seem to get normalized. The world's supplies seem to return to normal state and the trade is also seeing a better phase as compared to what it has been through in the near past. The factors leading to the strong increases is the abundance of liquidity in the markets.

If we are to discuss the gold and crude oil prices, then many of the economists are of the view that the that the correlation between the prices of these two commodities is strong enough. They are able to draw such conclusions because crude oil is considered the most important commodity as far as the energy sector is considered and same goes for the gold, as it is also an inevitable precious metal for individuals and a trusted commodity for investing so as to achieve higher returns.

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But gold-oil price correlation is unlikely a defining factor in 2009. If we are to trust the price trends of the gold it seemed to gain importance in the past few months as a safe haven. As the markets are improving in their performance the demand for gold is also seeming to stabilize. There are macro and micro factors responsible for the hike in the commodity prices of gold and oil in the foreign markets which would be discussed in the latter part of the term paper.

HISTORY OF GOLD PRICES

Data Source: Global Financial Data

The chart attached in the appendix section tries to depict the history of the gold prices by showing the data since 1973. It also marks the important events in the foreign market and shoeing its impact on the gold prices. It starts from the Yom Kippur war where the price was around $120 and later at the time of Iran Iraq war the prices soared to $650 later on it again slipped to $270 and this was the phase when the international trade was obstructed by the destruction of world trade centre on 9/11 later it showed a steady increase by reaching out to $650 till 2004.

Factors determining the gold prices in the short and long run

  • Data reveals a one to one increase in the gold prices as the general price levels in USA register an increase. In oother words we can say that if the inflation rate in the US economy show an increase of about one percent then the gold prices also tend to appreciate by 1%
  • Experts are of the view that even though the long term prices of gold are governed by the general price levels in the US economy but that too is under the limits and one can say that it is under 95% confidence.
  • Even the prices of gold in the international market are governed by the authorities like The Central Banks of different countries and even the International monetary fund by making provisions regarding maintenance of gold reserves in their treasury so that the economy as a whole can be strengthened and can withstand the global competition and pressures.
  • Demand and supply of gold is one such Factor determining the gold prices which goes without saying.
  • The recent hike in the gold prices is the result of the global crises where the investors lost the trust on any other commodity for investment and trusted only upon gold for the reasons of liquidity and higher returns.

Oil Price History

Even the history of prices of crude oil is depicted in the similar fashion. It begins from the Yom Kippur war 1973 where the price recorded was $15 per barrel later it showed an increasing trend and till the Iran Iraq war after which the prices showed fluctuations and registered a steep decrease in the period Saudi Cease period where it fell to $10 per barrel. After this phase even the fluctuations continued along with the increasing trend registering the price of $74 per barrel in 2004.

Determinants of crude oil prices in the global market

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Globally the prices of crude oil is determined by the forces of demand and supply. Since

The supply of the crude oil stands limited as the decision power is vested in the hands of the OPEC countries. But then too they do not act as dictators of prices otherwise they would have been the richest countries of the world as they are into the possession of such an important energy resource upon which the functioning of the world machine is dependent.

What is Driving the Real Price of Crude Oil?

  • All the major real oil price increases since the mid-1970s can be traced to increased global aggregate demand.
  • The latter demand shifts are consistent with sharp increases in demand.
  • Disruptions of crude oil production play a less important role, suggesting that the traditional approach of linking oil price increases to exogenous shortfalls in crude oil production must be re-thought.
  • The increase since 2003 is primarily driven by strong global demand for industrial commodities. No evidence of speculation, oil supply disruptions, or uncertainty about oil supply shortfalls driving this increase.

RELATIONSHIP BETWEEN U.S DOLLAR, CRUDE OIL PRICES & GOLD PRICES

  • If U.S dollar falls, gold will remain the same price for the rest of the world. But, for the U.S, we will end up paying more for the same amount of gold.
  • If the U.S dollar falls, oil prices will rise for the U.S., but oddly. It will fall for other countries. This is because crude oil is primarily traded in U.S dollars.
  • Since oil is used in the process of excavating & refining the gold, if oil prices go up, so does gold prices.

Correlation between gold, dollar and crude

Many discuss about the correlation between gold price, dollar movement and crude price. Of all the financial assets, rising oil price is of particular concern. A positive correlation can emerge between the dollar movement and the gold price. An increase in oil price results in inflation, which affects the countries importing oil. It affects the cost of the finished products and prices in general and the economy. According to a study, the global resource of oil is depleting at an annual rate of 6 per cent while demand is growing at an annual rate of 2 per cent.

Taking various factors into consideration it is certain that the era of cheap oil is over. The question now is the impact of oil with regard to gold and dollar movement. Oil and gold were priced in US$ since 1975. Upto 1971 the dollar can be converted into gold by central banks. The price of gold was fixed at $35 per ounce and the oil was steady at $3 per barrel. When the convertibility was removed, some of the oil producing countries converted the dollars into gold. This had its own impact for both oil and gold.

With inflation round the corner and the deficit widening, the dollar is weakening. There

are reports that some of Arab countries may demand in euros. Over the last five decades there has been a positive movement between gold and oil. However, with a recent increase in oil, the relationship between oil and gold is not moving in tandem. If the price of oil increases due to supply and demand mismatch, and the dollar declines, the price of gold and silver will increase. If the hedgers and participants start demanding in euros, the fall will be more pronounced. The impact of the price on the precious metals will be more. It is like a situation where too much money chasing too few goods. Even though there is a lag between dollar movement and gold price in the short run, a relationship exits between the two in the long run. Some experts feel that when oil touches $100 per barrel, the price of the gold will touch $1400 - $1500 per ounce. Similarly, the price of the silver will move up. When oil prices increase and the demand for dollar diversification takes place, there will be more petro dollar chasing the precious metals.

Correlation between gold and crude oil prices past trend

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The fortunes of gold and oil have reversed 180 since July, when we witnessed the most speculator fall in oil's history in the last 100 years. Oil price plunged over $110, or 75% from $147 to $37 a barrel. You can't possibly explain away such dramatic correction by fundamentals. So what if super tankers are storing oil and world oil inventory now can sustain 59 days instead of 54 days of global consumption. Would you see the price of milk go down 75% because people are cutting back consumption?

In my view, the freefall of oil price has more to do with the collapse of Lehman Brothers, US banking, and US hedge fund industries. Many of those outfits are leveraged up to 30 times, bankrupt, and had to close out entire line of positions (including oil) in a hurry at any cost.

We can also see the rapid and all-out deleveraging through the reversal of yen carry trade. The yen has gone up 24% since August not because Japan all of a sudden became a star investment destination.

Where is gold headed?

Adjusted for inflation/CPI/money supply growth, various analysts have pegged a fair gold price of between $700/oz and $1,200/oz. Gold authority James Turk will show you how gold has exchanged more or less the same units of oil through hundreds of years. The lower and upper horizontal bands in the chart above show an oz of gold has exchanged between 22 and 10 barrels of oil since 1989. The ratio dipped to as low as 7 and right now it trades at 20. One shouldn't buck against the trend and I expect the ratio to exceed 20 to reach perhaps 30 or more.

You can play with two of the three variables (oil, gold, and ratio) and come up with the third. For example, at ratio of 30 and oil price of $50/barrel, the formula produces a gold price of $1,500/oz. I honestly have no idea what future lies, except

  • Oil is oversold and cheap
  • Gold is not expensive by historic means
  • The gold-to-oil ratio will keep rising until it comes down.

Fundamentally gold is attractive as investment of last resort. It's no good to leave money at the banks earning zero interest, or buy real estate that is faltering, or invest in equity market during recession.

While gold's blow-off phase is yet to come, I like to offer a word of caution. Given how quickly things can change, it might soon be a good idea to hedge gold position by longing oil.

Correlation in the period ranging from 2008-2009

The correlation can be best depicted by the following chart:

although many commodities declined sharply in 2008, we are still in the secular bull market in the commodities. The most important commodity - crude oil - has also been hammered and - contrary to gold - did not pass it's previous highs yet. Although oil's underperformance to gold might put the commodities' bull market into question, I believe the situation is slowly moving back to the normal state. In other words, I don't think that one must be worried about the fundamental situation in gold, nor in the crude oil.

The precious metals market has been trading sideways this week, and points raised in the previous Premium Update are still relevant today. The most likely scenario for the coming weeks in my view is that gold and silver would move briefly higher and then correct the post-$1000-breakout rally.

The Gold-Oil Ratio

The Link Between Gold and Oil

The gold/oil ratio expresses the interrelationship between the commodity that forms the foundation of our entire global economy. The commodity that has been the ultimate form of money for six millennia of human history is gold in the eyes of investor. The gold/oil ratio is such a crucial measure because it expresses the entire complex interrelationship between the king of commodities. This ratio allows us to discern when gold or oil prices are probably out of whack and hence a mean reversion is highly likely.

Gold and crude oil prices tend to rise and fall in sympathy with one another. There are two reasons for this:

  • Earlier, purchases of oil were paid in terms of gold. Even today, a significant percentage of revenue from oil ends up being invested in gold. As oil prices increase, much of the increased revenue is invested. -- and much of this surplus is invested in gold or other hard assets.
  • Rising oil prices place upward pressure on inflation. This enhances the appeal of gold because it acts as an inflation hedge.

In general, the price of gold and oil have a positive correlation.

When oil prices rise,there is an upward pressure on inflation. This enhances the use of gold as an inflation hedge.

Gold-Oil Ratio = Price of Gold (per oz.) / Price of Crude Oil (per barrel)

FIGURES OF CRUDE OIL PRICES & GOLD PRICES FROM SEP 2008 TO SEP 2009

DATE

CRUDE OIL PRICES (in dollars)

GOLD PRICES

(in dollar) (per ounce)

Sep 2008

106.89

889.60

Oct 2008

67.81

922.30

Nov 2008

54.43

968.43

Dec 2008

44.60

909.70

Jan 2009

41.68

888.66

Feb 2009

44.76

889.49

Mar 2009

52.38

939.77

April 2009

51.55

839.02

May 2009

66.31

829.93

June 2009

69.16

806.62

July 2009

69.45

760.86

Aug 2009

72.74

816.09

Sep 2009

66.04

871.96

CALCULATION OF CORRELATION

(Where x is taken to be the crude oil prices and gold prices is taken to be the y series)

Correlation= -0.2

Interpretation: the above value indicates that the value of one commodity is independent of the price of the other and the direction of their movement is also negative ie., when the price of one commodity increases the price of the intends to fall but the fall is not exactly the same as the increase which is depicted by the value of -0.2

The following graph would make it more clear:

Review of literature

Article 1: Gold and oil what is the correlation

Analysis: as per the article the calculation of correlation between the crude oil prices and the gold prices is largely dependent on the data under study. Typically the studies have shown weak correlation between the price of two commodities and this is so because the data analyzed is for short periods so much so that it extends to months or a year. The correlation figures for some period are given as under

1965-1994

+0.879

1995-2000

-0.133

2001-2004

+0.715

experts are of the view that the crucial question arises here is that whether the prices of these two commodities are interrelated or there are other forces driving their prices. The answer given to this question is that the forces of demand and supply are the biggest drivers and the recent hike in gold prices is the result of the activities of speculators and those investors who try to ride the bull run.

2) Gold and crude oil rallies signal price correlation

Analysis: the article lays stress on the fact that the negative correlation rally between gold and crude oil prices has come to an end. A lot of factors has been underlined like inflation, market trend s theat define the correlation. The fact is supported by the news that where at one side the gold was reaching its all time highs there on the other hand the crude oil was seeing its historical lows and this was the result of global crises the world was going through.

3) Oil Prices: Where Will They Go In The Second Half Of 2009

Analysis : analysts are of the view that if we see mathematically there is no direct correlation between oil and gold prices. The correlation is present between gold prices and US dollar levels and that too over a long period of study. They consider gold to be another currency that investors usually resort to when dollar weakens. Hence the prices are more governed by the investor behavior as their want for commodities like gold increases when they give more importance to the liquidity motive of holding it.

1. Fighting Deflation and the Negative Impact on the U.S. Dollar

The widely publicized easy monetary policies employed by the Federal Reserve, highlighted by zero interest rates and a $1.72 trillion quantitative easing program, have combined with profligate legislative and executive branch stimulus spending to create a $1.4 trillion budget deficit and, consequently, a flight away from the U.S dollar. As Bloomberg reported late yesterday, “About $12 trillion of fiscal and monetary stimulus, the world's lowest borrowing costs and a record $4 trillion of government bond sales between 2009 and 2010 will weigh on the U.S. currency.” Michael Churchill of Classical Insights recently opined, “The dollar's value is not something the Fed is supposed to care about - it is not part of its official mandate (unwise as that may be).” The resolve and determination of both U.S. and global bankers and politicians to fight deflation presents a macro-economic backdrop supportive for higher gold prices.

2. Low Rates of Return on Capital

The most obvious example of the lack of return available in competing asset classes is the disappearance of yield from money market accounts. Clearly the U.S. is the best example of this phenomenon as its banks offer essentially zero return on cash deposits. However, this is not solely an American issue as yields have plummeted across the globe. The opportunity cost of holding a sterile asset such as gold has been nearly eliminated. Gold, which pays no rate of interest, no longer faces competition from money markets - or even intermediate-term bonds, evidenced by the paltry 0.72% yield on the two-year Treasury bill. Dividend yields, near 2%, are well below the historical norm, and equity markets have failed to deliver, with the S&P 500 producing a negative return over the past decade. Former Treasury Secretary Larry Summers and Robert Barsky wrote in their acclaimed 1988 paper “Gibson's Paradox and the Gold Standard”, the price action of gold is driven by the reciprocal of the real rate of return available from the global capital markets. The current lack of return or yield available has driven investors into gold.

3. Central Banks Become Net Gold Buyers

High-profile purchases of gold bullion by central banks - highlighted by India's $6.7 billion gold purchase from the International Monetary Fund (IMF) last month - is a phenomenon that has both a fundamental impact as well as a psychological one. The psychological impact of growing central bank hoarding on private investors is as important as the resulting reduction in supply from the reversal of central bank net selling to net buying in driving the price of gold bullion. The Russian central bank was the most recent sovereign nation to announce an increase in its gold hoard - in order diversify away from the U.S. dollar. Additionally, the net flow of gold reserves from developed countries to those with emerging economies presents an interesting topic for discussion as it pertains to the shifting balance of economic power underway across the globe. BlackRock's Evy Hambro, who manages two of the world's largest commodity funds, forecasts that in 2009, for the first time since 1988, central banks will be net buyers of gold.

4. High-Profile Institutional Investors Emerge

This past year has witnessed the entrance of high-profile institutional investors into the gold sector. John Paulson recently announced that he is launching a gold fund January 1, 2010, and will invest $250 million of his own money in the venture. Paulson has been moving aggressively into the gold sector over the past year, investing roughly $3 billion of his firm's capital into gold and gold mining stocks. Mr. Paulson is not alone. David Einhorn of Greenlight Capital, Paul Tudor Jones of Tudor Investment Corp., Kyle Bass of Hayman Advisors, and Eric Mindich of Eton Park Capital have all disclosed to their investors significant allocations to the gold sector over the past year. With the entire market capitalization of the gold mining stocks being smaller than Exxon Mobil (XOM), some have speculated that the supply of shares does not exist to accommodate the large generalist institutions. Billions of dollars could chase the gold price and the gold miners much higher by the mere fact the sector cannot accommodate a tidal wave of capital. But the chase to position ahead of Paulson's launch on January 1st is underway - and greed is the operative word with gold's upward trend picking up steam as of late.

5. Declining Risk Aversion, Heightened Speculation, and Enhanced Liquidity

Germany's finance minister Wolfgang Schauble recently sounded a warning with respect to the confluence of low U.S. rates and the weak U.S. dollar, stating “more likely today is a scenario in which excess liquidity globally creates a new asset market bubble.” However, it is not solely U.S. policymakers who have their foot on the accelerator - China's M2 growth is at an all-time high of 29% on a year-over-year basis. Central banks and political leaders across the globe, through loose fiscal and monetary policies, have spurred investors to increase their risk appetites. The S&P 500 is up 62% off its March lows, China's Shanghai Composite, India's Sensex, and Brazil's Bovespa are higher by 81.7%, 76.4%, and 76.6%, respectively, thus far in 2009. The oil price and copper price are higher by 126% and 119%, respectively, leading to the conclusion that the gold price rise is by no means occurring in isolation. Correlations have risen across a broad spectrum of asset classes, and the tailwind from renewed speculation and liquidity, no doubt spurred by a weak dollar, has helped to propel gold higher.

While there are other short-term factors that influence the gold price, these are the five chief fundamental factors influencing the gold market. The weakening or diminution of any of these pillars has the potential to cause a correction to ensue. They all bear monitoring and close scrutiny as gold commands the front pages of the financial press.

REASONS FOR THE RECENT LOWS IN CRUDE OIL PRICES

  1. Credit problems of oil intermediaries:
  2. as we all know that the oil is an important commodity used in the production of almost all commodities used by the individuals in this world. One of the reasons traced for the lower lows in the price of crude oil is the credit problems being faced by the intermediaries. Since most of the oil is made available to countries through shipment. The intermediaries fear for their payment. And, since they are not into the habit of slowing any credit to the countries this having a direct impact on the overall demand of crude oil. But this phenomenon is applicable oil in the short run. In the long run we see that the demand for the product will not decrease but eventually increase until and unless another source of energy production is established.

  3. Liquidation of positions by hedge funds and other speculators:
  4. Hedge funds have been through pressure from several directions, to liquidate their positions in oil:

    • Investors have been disappointed by the performance of the hedge funds and they wanted to quit their position and Oil futures are easy to sell, so the may be sold first.
    • leverage level is high in case of hedge funds. In the past month, many of them have received margin calls because of declining values of the securities they held (oil futures, stocks, bonds). Again, oil futures are easy to sell quickly.
    • Banks are also under pressure to reduce their lending as they have low reserve margins, and because of concern that hedge funds may not be good risks. They have been putting pressure on hedge funds to reduce their leverage.

    Since hedge funds and speculators realized early this year that the price of oil was rising, most of them had net long positions. When there was a need to sell these futures contracts (because of margin calls or for other reasons), the sales of these contracts tended to bring down the price of oil.

  5. Hedging of future oil prices by oil companies
  6. Rise in the value of the dollar
  7. Trend Trading or Systematic Trading
  8. Drop in Asian growth
  9. Small size of the oil (and other commodities) market, relative to the rest of the market
  10. Increased volatility when supplies are very tight

ESTIMATING PRICE MOVEMENTS OVER THE DIFFERENT PERIODS

Price Movement of Crude Oil over shorter term: It is very difficult to estimate the price movement of the crude oil over very short term. However if any estimates are to be made, the closest indicator can be the preceding inventory data.

Price Movement of Crude Oil over medium term: Over medium term we can get a rough estimate based on the yields, performance of other asset classes. This is due to the movement of money flow across assets. Inflation prediction is also good way as Crude is one of the important factor in inflation index.

Price Movement of Crude Oil over long term: This is the safest bet. Over long term horizon, over a period of more than 10 years, crude oil does follow the growth in world GDP and resulting energy demand. To be more precise, it follows the crude oil dependence out of the total energy demand. Thus, proving the old war house of supply and demand true over a longer period. In shorter term, the one off events do create euphoria or panic thus bringing in strong price movements, which could be termed as irrational exuberance and can be left to be analysed and debated further.