How Far Down for the Gold / Oil Ratio?

March 25, 2009 | By: Hard Assets Investor

by Brad Zigler

Real-time Inflation Indicator (per annum): 8.6%

Gold or oil? How are you going to hedge?

Last month, the gold / oil ratio reached a decade-high 28-to-1 as the global recession etched away demand for fuels, and investors sought the safe haven of hard metal. The ratio's ascent from its July 2008 record low at 6-to-1 was stunningly vertical.

The ratio's reversed course and is now headed steeply downward. At last look, an ounce of gold could buy 18 barrels of oil. That's a 30% pullback from the February peak; enough of a drop to convince some observers that an economic recovery is being priced into the ratio. Historically, pullbacks in the ratio generally coincide with economic stabilization, while rebounds often precede slowdowns.

The question pondered by many, though, is the extent to which the ratio may fall. Where is the new baseline going to be established? And when?

Well, if recent history is any guide, summer seems the most likely time for a bottom in the ratio. Where that bottom may be is more problematic. Considering the resistance levels broken in the run-up last November, an objective of 12-to-1 makes sense as an intermediate target.

A declining ratio depends upon oil increasing in value relative to gold, brought about by a rally in crude, a sell-off in metal or some combination of both. This puts hedgers in a quandary: Do they sell gold or buy oil?

Futures-savvy hedgers can do both, of course, through a spread. Securities investors have to look at exchange-traded funds as proxies. The purchase of an inverse gold product like the ProShares UltraShort Gold ETF (GLL) together with an oil tracker such as the ProShares Ultra DJ-AIG Crude ETF (NYSE Arca: UCO) could produce the desired exposure with a 2X leverage kicker, to boot.

Disclosure: None

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