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Oil, Copper & Gold – Beware the Snake?
Monday February 11, 2013 09:32
“What! Wouldst thou have a serpent sting thee twice?”
Shylock in Merchant of Venice, William Shakespeare
Feb. 11, 2013
What path will the Year of the Snake choose for global commodities oil and copper and precious metal gold? China’s appetite for all three is at times voracious so markets will closely watch the behavior of Chinese traders when they return after this week’s Lunar New Year celebrations. A correlation map can help track the snake’s first move – recent history suggests it may be treacherous.
The correlation map
A scatter plot of rolling correlations with gold has served me well in divining the next market directions for the worldly trio by a simple technique illustrated in Figure 1.
Figure 1 – Correlation map
In this example, the 3-month (Y-axis) and 1-month (X-axis) correlations of copper with gold are updated each market day and the correlation pair is plotted as a red diamond. Connecting the day-to-day points (red lines) creates a correlation “trajectory” of not only correlation values but also implied direction (red arrow). The resulting plot or correlation map is divided into four quadrants. The upper-right quadrant (green) represents positive 3-month and 1-month correlations of the red and yellow metal; the lower-left (red), negative correlations. In the upper-left and lower-right quadrants, the correlations have mixed signs and are called “Transition Zones” (yellow).
When gold behaves as a commodity it can correlate strongly with copper and other base metals. For this analysis, a correlation exceeding 0.6 for both short- and medium–term calculations is considered strong and defines the darker green area within the upper-right quadrant. This region is referred to as the “Bullish Zone” because commodities typically do best when gold runs with the pack. Trajectories that enter the bottom-left quadrant are in the “Danger Zone” when gold leaves the pack and commodities are often left to falter. In Fig. 1, as falling short-term correlation erodes a longer-term positive relation, the correlation trajectory moves counter-clockwise from the bullish zone, through the (- , +) transition zone to finally the danger zone where all correlations are negative.
A historical perspective
Revealing statistics arise if the correlation map of Fig. 1 is applied to the history of oil, copper and gold prices from mid-2006 to Friday’s close. This is an important interval because gold has steadily gained value relative to copper and oil over this 6-1/2 year period (Ref 1). The percent-time oil-gold (WTI) and copper-gold (Cu) correlation pairs spent in each of the upper-right and lower-left quadrants is shown in Fig. 2 (Note 1). Also shown is the percent-time of simultaneous occurrences of oil-gold and copper-gold correlations with common signs (Cu & WTI):
Figure 2 – Correlation pair percent-times in key areas of the map (mid-2006 to present)
Reassuringly, both oil and copper spent roughly 60% of their time in the upper-right quadrant; 39% of that time together. This reinforces the notion that gold price follows commodity prices a majority of the time. Strong gold correlation (>+0.6) with oil and copper is less frequent at 16-17% with only 5.2% of that time scored for both commodities in the bullish zone.
When gold goes its own way and plays the part of monetary alternative, safe haven in crisis or some mix of both, correlations are typically mixed in sign (“Transition Zones”) or worst case; descend to the “Danger Zone” of negative correlation. Fortunately, oil finds itself in this latter condition only 10% of the time and copper 14%. Oil and the red metal both registering short- and mid-term negative correlations is the least likely condition at 3.7%.
It is a sobering fact that from mid-2006 to the present, some of the most horrific moments in the commodity space have occurred after oil and copper trajectories enter the lower-left quadrant together.
A “textbook” example
The copper-gold trajectory of Fig. 1 & 2 is the path taken during the fateful August of 2011. That marks the concluding days of the calamitous debt ceiling debate in Washington followed by the downgrade of U.S. debt on August 5, 2011. Fig. 3 captures that trajectory (red diamonds and lines) together with the correlation path for oil (gray triangles and lines). The U.S. downgrade is shown by a red-outlined white triangle for both:
Figure 3 – A “textbook” example – August 2011
This map is a “textbook” example of how quickly conditions can deteriorate in the commodity space when confidence is lost in such bedrocks as the credit standard of U.S. securities. In late July, Nymex oil prices are near $100 per barrel and Comex copper tops $4.50 per pound. As the Congressional wrangling heats up, copper-gold correlations are still in the “Bullish Zone” on August 1 and oil-gold is at least in the upper-right quadrant albeit marginally. Comex gold closes at $1,621.7 per ounce on the first day of that month.
After the Aug. 5 debt downgrade oil prices fall below $80 per barrel and copper drops below $4 per pound as gold rises above $1,800 per ounce and eventually breaches the $1,900-level on an intraday basis Aug. 23. This building negative correlation between gold in safe-haven mode and key global commodities is shown in Fig. 3 as increasingly negative 1-month correlation quickly erodes the 3-month positive relation.
The space between day-to-day data points or trajectory “velocity” is important to note as well as correlation value and direction. In early August, the spacing is greatest as the copper and oil trajectories bolt from the green upper-right quadrant, quickly accelerate though the transition zones and fall into the danger zone of negative correlations. Only when gold approaches its peak on August 23 (red dotted ellipses) do the velocities slow appreciably (i.e. spacing narrows).
This market turmoil would not end in August with Comex gold setting a new record above $1,900 per ounce in September followed by Comex copper testing $3 per pound and Nymex oil, $75 per barrel in early October.
The bearish correlation trajectories of August, 2011 presaged a $1.5 per pound fall in copper price, a $25 per barrel drop in crude and a nearly $300 per ounce move to new gold records.
Beware the Snake…
Fig. 4 is a correlation map for oil and copper from early December, 2012 to Friday’s close. There are chilling similarities and important differences when compared to the August, 2011 map of Fig. 3:
Figure 4 – Entering the Year of the Snake
As they start their journey, neither oil nor copper trajectories are in the bull zone on Dec. 3 but both are solidly in the green upper-right quadrant. Their paths are more complex than the previous example: the oil mid-term correlation initially rises and points in the direction of the bullish zone on Dec. 17 while copper correlations retreat to the region of (-, +) transition. There are cross-currents affecting commodities at this time within the long shadow of the impending U.S. fiscal cliff. The shadow then recedes some on reports of progress in the ongoing budget talks and better-than-expected signs of recovery from China. Nonetheless, on Dec. 20 a global selloff votes no confidence in the U.S. budget negotiations and both oil and copper 3-month correlations with gold start their troubling descent lower.
Individually, oil and copper prices get a boost when global markets rally at the beginning of the year and both make a net gain from early December levels on news that Congress struck a last-minute agreement on the deficit. Gold rallies too but not enough to erase a net loss for the same period. This pattern continues through January with oil and copper scoring net positives for the month and gold a net negative reinforcing the falling correlations with both commodities. The oil-gold correlation actually enters the danger zone alone Jan. 7, recovers to the (+,-) transition zone and then takes a “UFO-like” turn with the copper-gold correlation following the Jan. 23 close.
Although the reasons behind this synchronized turn are unclear the paths of oil and copper trajectories have ominously crossed into the danger zone in concert as the Chinese calendar moves from dragon to snake.
Wouldst thou have a serpent sting thee twice?
Given market records from mid-2006 to the present, Friday’s close confirms a fairly rare event with a track record of market turmoil to follow. In addition to the cited 2011 example, Nymex oil dropped below $35 per barrel and Comex below $1.7 per pound under similar conditions February, 2009 during the market depths of the Great Recession. Unlike either of these cases, the present broader markets continue to move higher and the S&P volatility index, or VIX, is very low – both making levels not seen since 2007. During August, 2011 the VIX hit 48 and during February, 2009 touched 53 – both numbers are in stark contrast to Friday’s VIX which closed at a lowly 13.
So what can we expect? If oil and copper negative correlations with gold persist there are two likelihoods. The best case for commodities is a rise in price on improving global economic conditions accompanied by a fall in gold prices. This would erase some of the premium gold has accumulated over the last 6-1/2 years and return gold-to-oil and gold-to-copper ratios closer to historical norms. The worst case would be a dramatic fall in commodity prices as expectations for global recovery sour and gold rewards safe-haven investors with rising prices and possibly new records.
A middle path may be a second turn in the trajectories to positive correlations. Although not supported by recent price movements, a return to the more trodden upper-right quadrant of green could present bullish possibilities for all three as gold moves again with commodities.
Whatever the outcome in the coming months, the correlation map is a powerful tool to anticipate the snake’s next move.
Note 1: The 6-1/2 year record for this analysis is Jul. 20, 2006 to Friday’s close, Feb. 7, 2013 – a total of 78-1/2 months. NYMEX Western Texas Intermediate (WTI) crude was selected for this analysis because of its greater liquidity compared to global benchmark ICE Brent crude. Percent-time is defined as market days in a particular area of the correlation map divided by the total market days.
References:
Ref 1: Oil, Copper and Gold – All in the Family (Richard Baker, Kitco commentary, Jan. 22, 2012)
By Richard Baker, CP Value Analytics
http://eurekaminer.blogspot.com/
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