Ideal time to invest in Gold Exchange Traded Fund

Crude oil prices inched closer to the USD 150 per barrel mark, clocking an appreciation of almost 50% in the year 2008. Higher oil prices have been sending shivers down the stock markets worldwide, as if the recent global financial crisis was not enough to unnerve it. Indian stocks are down by around 32% in the current year. Inflation has reached double digits at 11.50%; and is showing no signs of respite adding further fuel to the fire.

I happened to be at an oil trader's dealing room. I asked the Chief Dealer, “What's happening to oil?” He was already talking on the phone to someone in Iran, a member of OPEC, an association which controls around 40% of the global oil output. I heard him saying, “So the market talk is that Israel might attack Iran. And the usual problems in Iraq, Nigeria etc. continues with supplies remaining vulnerable to serious disruptions. US stock piles are down too, speculators are bullish…” He hung up the line. I was sure that his next reaction would be to buy more crude oil.

Surprisingly, his next call was to someone in South Africa “How's the mining industry doing, any increase in the output in gold? Will the gold mines face power disruptions from Eskom"? The response from the other side was “No” for the first question and “May be” for the second one. He said “Ok, buy gold worth USD 5 mn.” I was shocked and asked him, “Hey, after your last phone call, I was convinced that you would immediately place orders to buy more crude oil; where does gold come into the picture?

He was grinning from ear to ear and proceeded to show me the following chart.

Gold Oil Ratio


Sources: Bloomberg

He asked me a question “What does higher crude oil prices do to the general price levels in the world?” I said “Of course, higher crude oil prices fuels inflation, since most of the demand for oil is inelastic.” And he further probed “Is gold a kind of proxy currency?” I said “Yes, Infact in the 1900s many countries in the world had gold standards viz. Gold was used as a medium of exchange.”

Let's presume that gold was the currency now.How much gold would be required to buy a barrel of crude oil? Or how many barrels of crude oil will be required to buy an ounce of gold? The answer is around 6.5 barrels of crude oil would fetch one ounce of gold. This ratio is known as the “Gold Oil ratio”.

He continued his questions “Paper currencies like US dollar tend to lose their purchasing power over the years, why?” I replied “Simple - due to inflation”. As time passes paper currencies can't buy the same amount of oil which you could have bought years ago.

And the final words of wisdom came from him

“But gold is different, it preserves value - better known as a store of value, and that's the reason why gold is used to hedge inflation”.

He said, “Look at the long term chart, the average number of barrels required to buy one ounce of gold is around 14.5, which is now at 6.5”. I nodded my head in affirmation and said “That's because crude oil has moved up sharply from $38 in 1980s to $144 whereas gold has not moved in tandem. It is still trading near $940 per ounce, a little more than the 1980s high of $850 per ounce". He jumped up on his chair and said “Bingo, now for the gold oil ratio to reach its long term average of 14.50, at current prices, either the crude oil price has to move down to $ 65 or the gold price has to move up to $2000”.

As I was leaving his office enlightened, I thought with the current uncertain geo-political situation in oil rich countries like Iran, Iraq, Nigeria etc and with no new discoveries, crude oil seems unlikely to move down to say $65 levels for the gold oil ratio to reach its long term average of 14.50. In that case where would Gold go?

With USA on the brink of recession, inflation not abating on higher food and commodity prices and the US dollar depreciating, all the positive factors for a gold price rise are in place.

And by sheer coincidence I got a call from my stock broker, lamenting the fact that the Indian equity markets were heading south and the trading volumes had crashed. He was keen that I buy stocks (to enhance his income); I told him “Sorry, I am now only keen on buying gold.” He was happy “I can help you in buying gold at attractive prices” I was surprised. He went on to explain:

“The most appropriate way to buy gold is to buy a Gold Exchange Traded Fund (ETF) on the NSE, it is as easy as buying any other stock like Infosys, HDFC etc. The units are held in demat form in your demat account thus eliminating the need to hold gold in the physical form.

Acquiring gold via ETFs ensures no hassles of storage, security, quality, insurance, transportation, making charges etc. The fund house stores all the gold backing each unit in secured vaults and also has it completely insured. The price of Gold ETFs will reflect the domestic gold prices, less expenses. There is a Gold Exchange Traded fund which charges very low expenses too. Moreover, easy liquidity and price transparency is ensured due to them being listed on the NSE.”

I immediately told my stock broker to go ahead and buy 100 units of a low cost Gold Exchange Traded Fund and within a few minutes he confirmed that this had been done.

Later in the evening, I reflected on how much the relationship between crude, inflation and gold is important for investment decisions. And, how easy and convenient it is to buy gold and hold it without any worries especially in times like these with high crude oil prices, high inflation and falling equity markets.

Above article is authored by Quantum.

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