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Oil, Copper & Gold – All in the Family

Tuesday January 22, 2013 12:38

Mike Stivic: You know, you are totally incomprehensible.
Archie Bunker: Maybe so, but I make a lot of sense.

All in the Family, a popular 1970s American sitcom

Jan. 22, 2013

Living under the same global roof, the day-to-day market behavior of commodities can be as erratic and volatile as the characters in the popular 1970s sitcom, All in the Family. Like Archie Bunker, gold is the boss of the commodity house and can make “a lot of sense” over the long run but prove quite incomprehensible along the way. When gold is away from home and plays the part of monetary alternative, safe haven in crisis or some mix of both – its relation with commodities can have all the drama of a Bunker family episode.

The gold valuation trend

For millennia, gold has been a reliable judge of value and its ratio to different commodities has served as an essential tool of trade.  Expressed in contemporary units of measure, “how many pounds of copper are worth an ounce of gold?” has been a relevant question since the Phoenician traders of yore. The answer was roughly 200 pounds in mid-2006; today it is nearly 500 pounds.

In the last 6-1/2 years, copper has shed considerable value relative to gold (Note 1, Ref 1). The 2008-2009 financial crises produced chilling moments of drama as gold fled the commodity house in safe haven mode and copper prices crashed. In February, 2009 gold spiked above $1,000 per ounce and copper plummeted to $1.6 per pound pushing the gold-to-copper ratio (GCR) above 600 pounds per ounce.

Oil has experienced a similar devaluation relative to gold. In mid-2006, an ounce of gold fetched 10 barrels of Western Texas Intermediate (WTI) crude; today it is close to 18 barrels. Oil fell precipitously with copper in February, 2009 plumbing the mid-$35 per barrel level and spiking the oil-to-gold ratio (Au:WTI) to nearly 30 barrels per ounce.

Fitting gold ratio data over this period with a linear regression model is an effective way to filter out the “incomprehensible” spikes and establish a gold valuation trend that makes “a lot of sense” for these important global commodities.

The same but different…

Figure 1 is an update from my last commentary of the GCR and a 6-1/2 year linear regression model shown from early-August 2011 to Friday’s close:

Figure 1 – Gold-to-Copper Ratio (Updated)

The day-to-day GCR data are shown by the red diamonds and lines. The solid green trend line that moves from the lower-left to upper-right corner represents ratio expansion (i.e. copper losing value relative to gold). The dashed green lines establish plus and minus 2-standard deviation (2-sigma) boundaries from trend. Key dates of ratio peaks and a 3-month moving average (solid red curve) support the discussion below.

Figure 2 is a similar plot of the gold-to-oil ratio and long-term trend over the same period:

Figure 2 – Gold-to-Oil Ratio

The day-to-day oil ratio data are given by gray diamonds and lines; the 3-month average is the solid gray line. The trend line and boundaries are green as in Fig. 1.

There is a startling similarity between these two plots and some notable differences. The Jan. 7 commentary started the timeline several days prior to the Aug. 5, 2011 U.S. debt downgrade because that event began a very volatile period for commodities. Oil and copper both reacted bearishly to the downgrade and their respective ratios spiked. The oil reaction was almost immediate touching 22.7 barrels per ounce on Aug. 15. The GCR trended higher as gold surged to a new record in September followed by a crash in copper prices and a peak of 538.3 pounds per ounce on Oct. 3, 2011.

Other ratio peaks for copper and oil were less severe and fell within days of each other in June and November of last year. Both ratio histories are also comfortably within 1-standard deviation from the beginning of 2012 until the present (light dotted blue lines show the greatest departure over that period). Given the extremes of  Table 1, it is reassuring that the greatest excursion from trend did not exceed 2-standard deviations in either case following the U.S. debt downgrade.

Table – 1 Regression model parameters (mid-2006 to the present)

Since a regression model is zero mean by definition, it is interesting to note that the maximum deviations are biased in a bearish direction for both copper and oil (i.e. high gold ratio). The maximum positive deviations both occurred in February, 2009 when the respective ratios reached their peaks as noted above.

The conventional measure of model quality (R2) is somewhat misleading and a higher (i.e. better) number would result without the extremes of that fateful month during the Great Recession. A more accurate testament to model fidelity is the “The Grand Reversion” for copper (Fig. 1, gray dotted circle) when the 3-month average and trend line converged in magnitude and slope last fall (Ref 1).

Although mean reversion is less pronounced for the more volatile oil ratio data, it is satisfying that both copper and gold records have remained within 1-standard deviation of trend for 2012 and the beginning of this year.

How much longer will it make “a lot of sense?”

In markets, nothing trends higher forever. In gold terms, the above analysis shows that a significant devaluation of oil and copper has occurred over the last 6-1/2 years even though the gold-oil model has a somewhat greater dispersion than for gold-copper. Someday these trends will reverse and return gold-to-copper and gold-to-oil ratios closer to historical norms. Table 1 suggests that a downward departure from trend that exceeds roughly 2-sigma for either oil or copper could signal trouble for the yellow metal. Currently that is equivalent to 360 pounds of copper and 13.3 barrels of oil per ounce of gold.

On the flip-side, a positive (bearish oil and copper) departure of 4- to 5-sigma is unlikely, occurring only briefly during some the darkest commodity markets of the Great Recession. More recent history suggests a bearish ratio expansion of less than 2-sigma is more realistic as evidenced by the aftermath of the U.S. debt downgrade.

Realistically, value trend reversals to the downside would probably require a return to robust global growth and higher interest rates which are probably still several years away. With another debt ceiling fast approaching in the U.S and the possibility of further downgrades looming, a bearish ratio expansion could occur but should be much less severe than in 2011.

For either case, the gold valuation trends for both global commodities are key metrics to monitor in the coming months. Presently the 3-month moving averages are moving in a bullish direction for oil and copper with respect to their trend lines (green arrows; Fig, 1 & 2). This short-term development is expected to continue until at least Chinese Lunar New Year.

Note 1: The 6-1/2 year record for this analysis is Jul. 20, 2006 to Friday’s close, Jan. 18, 2013 – a total of 78 months

References:

Ref 1: Copper and Gold - In the Eye of the Storm (Richard Baker, Kitco commentary, Oct. 30, 2012)

Ref 2: The 2013 Copper & Gold Conundrum (Richard Baker, Kitco commentary, Jan. 7, 2013)

By Richard Baker, CP Value Analytics

http://eurekaminer.blogspot.com/

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals 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 Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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