Thursday, December 11, 2008

Fear Factor

A few months back, I was of the opinion that gold and oil would decouple. Since gold is typically thought of as an inflation hedge, the two commodities usually rally and fall together (higher oil prices lead to inflation and vice versa). My premise was that the economy would slow down due to credit constraints, yet the instability in the financial markets would prompt gold to rally (or at least stay flat). The below graph tracks the price of one troy ounce of gold versus the price of one barrel of crude oil: this tells us how many barrels an ounce of gold will buy.

The bulk of the recent upward move in this graph has been the amazing drop in the price of crude oil. Gold has been moving a bit higher over the last few days, but is still 20% of its 2008 highs. OPEC and other oil producing countries are in a bind because they need anywhere from $50 - $75 per barrel to balance their budgets. Cuts are imminent, so this ratio may retrace in the near term. However, the case for buying gold remains unchanged. I would not recommend shorting gold and buying crude at this point. I have recommended to some readers over the last few days buying the Canadian dollar and selling out of the money puts on gold. Both trades benefit from a continued commodity bid in the short term.

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