With the recent plunge in crude oil prices, it is a good time to think about the relationship between crude oil and gold and ponder how this might impact gold and gold mining shares. Crude oil is a fairly significant direct and indirect cost input to the production of gold, so one could certainly make the case that a lower crude oil price will help the bottom lines of gold mining companies. This ultimately depends on what’s happening with every other cost in the mining process. If we assume all other mining costs are constant in the very short-term and mine production comes as advertised, then it theoretically does make sense that a lower crude oil price provides short-term relief for the operating margins of gold producers.
More importantly, when there are extremely quick movements in various components of the gold mining company’s cost structure (e.g. a crude oil price that has dropped nearly 40% in less than 6 months), it is very ambitious to expect the army of sell side bank analysts tasked with estimating next quarter’s cost of production to get it right. Very likely, there are going to be some positive surprises when it comes to next quarter’s production costs. Consider that movements in share prices happen at the margin, and it doesn’t take much of a positive surprise to make the stock price of even the largest of large cap precious metals producers to move higher. This is especially true today because the precious metals sector as a whole is attractively priced.
The longer term implication of a lower crude oil price may be painting a slightly different picture. As illustrated by the chart below where each dot represents a month end price for crude oil and gold going back to March 1983, a logarithmic trend line of the data reveals a high R2 of 0.8. This suggests a statistically significant positive long-term relationship between gold and oil prices.
A casual glance at the chart shows many outlier data points - month end prices for crude oil and gold that are far away from the red trend line. Because of the long-term historical relationship, it’s reasonable to expect prices to gravitate towards the red trend line over time. This can be accomplished through a change in the gold price and/or a change in the crude oil price. The recent sharp drop in the crude oil price has not been accompanied by an equal percentage drop in the gold price. As a result, the most recent November 30th data point (the “we are here” data point) lies below the red trend line though it’s not really what one might consider an extreme outlier.
What does this mean? Well, it may not mean much in the near term. But if the crude oil price slump is not temporary and we are in fact staring at prices in the US$60-$70 range for the foreseeable future, then it’s reasonable to expect the gold price to move a bit lower so that the long-term relationship can remain intact.
Putting some numbers to the data, the long-term average ratio of gold to crude oil is 15.7. The November 30th data point clocks in at 17.8, and the ratio has nudged a bit higher since then. If you’d like to assume a US$60/bbl. crude oil price, this puts the gold price at US$942/oz. If you’d like to assume a US$80/bbl. crude oil price, this puts the gold price at US$1256/oz.
Going one step further, in an environment where global economic growth is slowing down, it’s reasonable to expect a higher than average gold to crude oil ratio because crude oil is economically sensitive and gold is not. Similarly, in an environment where global economic growth is just right and inflation is under control, it’s reasonable to expect a lower than average gold to crude oil ratio. The message from the November 30th data point is potentially one of a significant slowdown in global economic growth, and the broad equity market is not priced for such an event.
Kash Hashemi,
Contributor to the Duval Report
www.duvalreport.com
http://antworthy.com/
info@antworthy.com
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