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Oil & Gold - Divorce, or Happy Reunion?

By Jon Nadler       Printer Friendly Version
May 16 2008 4:54PM

Good afternoon,

Gold prices picked up another 2.4% on Friday, as the dollar dropped quite a hefty amount, to 72.79 on the index. A $3.69 rise in crude oil during the day (to $127.82) was met with a correlated move in gold this time around. A commendable turn in gold over these past two days. If it can rise to and close above $905, the metal could try for $925 on this wave. However, the risks of a major correction in crude oil have increased exponentially this week and such a fall will carry many a commodity in its brutal wake. For more on this topic, please see below.

New York spot trading was last seen enjoying a $21 gain, quoted at $902.10 per ounce, as participants monitored the dollar's decline. Silver added 31 cents to $16.96 while platinum rose a healthy $47 to $2128 as more forecasts of $3K floated around the market this Friday. Palladium rose $13 to $451 per ounce.

The latest VM Fortis Hedging and Financial Report is out today, and for the full study you are invited to visit the link on our homepage under "Technical and Fundamental Analyses." The report contains a mixed bag of news on several fronts. The good news is that hedging fell through the floor in Q1 and that central bank sales show signs of coming in under target once again. The worrisome news is that hedging is anticipated to grow quite soon and that the ETFs have lost a sizeable amount of gold during the latest correction. Here are the highlights of the release, courtesy of Mineweb:

"Global gold hedging saw the largest decline in percentage terms on record in the first quarter of 2008 as an 18% or 4.8m ounces reduction brought the global gold book down to 22m ounces. But the Fortis Hedging and Financial Gold Report says dehedging volumes will significantly decline in 2009 and beyond.  

The quarterly report issued by the VM Group said AngloGold Ashanti, Barrick, Buenaventura and Newcrest reduced their hedge books with a total of 4m ounces in the quarter. AngloGold Ashanti reduced its hedge book with 1.2m ounces, Barrick converted 1.1m ounces of fixed-rate contracts to floating-rate contracts, Buenaventura closed out its entire hedge book of 0.9m ounces and Newcrest cut its hedge book by 0.7m ounces to 0.2m ounces.

The balance of the reduction in the global hedge book came from 32 different companies making reductions in their hedge books. The first quarter of 2008 also saw the lowest total new hedging since the second quarter of 2002, at 7,137 ounces.

The VM Group has increased its forecast for hedging in 2008 to 10-12m ounces on the back of AngloGold Ashanti's announcement that it will close another 3.8m ounces of hedging this year. 

"This means the global book will be only 15-17m ounces at the end of the year. The support the market has had from producer buybacks is coming to a close, volumes are likely to significantly decline in 2009 and beyond."

The mark-to-market valuation of the global book improved slightly in first quarter 2008 at an estimated negative $11.2bn, $0.1bn "better" compared to end of fourth quarter 2007, said the report. The improvement was small despite the large reduction in hedging, due to the $97/ounce increase in the gold price in the quarter.

Exchange-traded funds suffered its worst month on record for outflows in April. The StreetTRACKs product fell by 62.5 tonnes, but has made a slight recovery since.

However,official gold sales have slowed as Central Bank Gold Agreement signatories battle to reach their 500 tonne maximum sales limit.

"Unless a central bank resumes sales, it is likely that they will collectively undershoot the limit by more than 100 tonnes."

As promised, more on the topic of the connect/disconnect between gold and oil. Allen Sykora from DowJones Newswires bring us up to date (Warning! I am quoted in the story, thus certain tinfoil clubs may wish to avert their eyes):

"Record-high crude oil prices and the dollar's attempts to escape its oversold status are spawning mixed analysis about some of the traditional trading correlations. Some analysts said the traditional correlation between gold and oil could mean further gains for the metal; others said the link isn't automatic and gold instead could focus more on signs that the dollar may have put in a bottom.

Gold often moves in the same direction as crude, and did again Friday with the metal up sharply after crude hit record highs. A link between oil and gold tends to occur as funds move in and out of commodities together. Because high oil means increased commodity-production costs and inflation that in turn supports gold, and due to increased buying of gold by OPEC, flush with cash as oil rises.

Yet, most-active gold on the Comex division of the New York Mercantile Exchange fell from a contract high of $1,038.60 an ounce on March 17 to current levels near $900, while June crude oil rose from a March 17 low of $100.59 a barrel to a spot-month record of $127.82 reached Friday.

 Peter Grant, senior analyst with USAGOLD-Centennial Precious Metals, suspects that gold may have put in a corrective low, in part since the dollar remains historically weak and since physical demand picked up since gold's pullback. "I would also say continued gains in oil are further evidence that corrective lows are in place for gold," he said. "We've seen the gold/oil ratio drop to about 7, which is significantly below the historic norm. So I don't think there is much more downside potential in the spread and would look for it to start to return to the normal ranges."

Even if the ratio gets back to where 8 1/2 barrels of oil buys one ounce of gold, he continued, that would put gold back above $1,000. Analysts say the ratio was between 7 and 38 over the last four decades, with the area around 15 to 17 cited as the norm. Jeffrey Nichols, managing director of American Precious Metals Advisors, said there isn't an automatic link between gold and oil. While gold could benefit if the markets return to a 15 or 16 ratio, there is also a chance the ratio could be achieved by oil falling instead of gold rising. Still, Nichols looks for gold to be benefit from any return to a higher ratio.

 "I don't see oil coming down, at least not sharply," he said. "So this suggests to me gold is undervalued relative to oil and that the adjustment is more likely to come through a rise in gold prices and not a decline in the oil price."

Others downplay the link between gold and oil when forecasting a longer-term outlook. Jon Nadler, analyst with Kitco Bullion Dealers, said traders historically have watched links between gold and other markets as well, including foreign exchange, equities and bonds.

"There is no particular rulebook that says a particular ratio must be achieved," he said. "They're working on different fundamentals." For one thing, he said that oil is consumed, while gold doesn't disappear. Mined gold exists in many forms such as jewelry or investment bars put into storage.

 "Imagine if all of the oil consumed would somehow magically recycle itself and exist above ground," he said.

Nadler suggested a bigger key for gold will be the dollar, and whether it rises if the Federal Reserve stops cutting interest rates, or continues to hike. Gold tends to move inversely to the greenback, so if the dollar firms enough,

Nadler said gold could fall back to the $780-$730 area. If in fact gold strays from oil, he said, this also could mean the metal finds some support even in the event of pullbacks in crude.

"It will depend on what happens with the dollar and on physical demand on the gold side," he said.

Thomas Winmill, portfolio of the Midas Fund, said that a longer-term correlation between gold and oil of around 17 would suggest an average gold price of near $2,200. "But the correlation has gone totally haywire," he said. The outlook for gold based on its relationship with oil depends in large part on how one views gold, he said. "If you view gold as a commodity... I would say the correlation would have to come back on track. Either the price of oil is going to come down or the price of gold is going to come up," Winmill said. "But if you view it alternative currency - there is not really a cause and effect (from oil)." The Midas manager is more inclined to view gold as an alternative currency, meaning its direction will hinge more heavily on the forex market.

Price Elasticity, Dollar Account For Gold-Oil Disconnect

Nichols of American Precious Metals Advisors said there are some good reasons why oil has been outperforming gold. "First, the price elasticity of demand for gold is fairly high, at least in the short run. When gold prices go up, demand tends to fall off," he said. But the world keeps consuming oil "like water" even when prices rise since it is a "necessity," he continued. Furthermore, there are a number of threats to oil supplies in nations such as Iran, Iraq, Venezuela and Nigeria, plus oil is subject to output decisions by OPEC.

Some of gold's recent fall is due to resolution of Bear Stearns crisis, taking some of the "fear premium" out of the yellow metal, Winmill said. "And of course, the dollar has strengthened."

Nadler said a "disconnect" of gold/oil appeared to come about when the euro's relentless rise finally seemed to stall around $1.60. In fact, Nadler said, some speculators may have moved from gold to oil. Also, he noted that as gold rises, users can turn to substitutes such as less-expensive silver for jewelry. But despite efforts such as bio-fuels, there is limited substitute potential for oil.

"It's a little bit different of an animal," he said.

Let's see how next week shapes  up. So far, so good. If you are bullish.

Happy Trading. Pleasant Weekend.

Jon Nadler
Senior Analyst
Kitco Bullion Dealers Montreal



Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.