How Much Oil Can Gold Buy?

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"The [gold/oil] ratio's not likely to hang out at its current level very long."

Imagine going into a filling station and being asked to pay for your gasoline with gold instead of dollars. How many one-ouncers would you have to pull from your pockets to top off your tank?

That's the kind of equivalency described in the gold/oil ratio. The ratio reflects the price of gold expressed in number of barrels an ounce of metal can purchase. Historically, buying opportunities for gold are flashed when the ratio turns up from a bottom. Gold selling is indicated when the ratio turns down from a top.

From a broad perspective, the "bottom" was about six barrels per ounce, when crude's barrel price spiked over $140 in the summer of 2008. The most recent "top" came eight months later, at around 28 barrels per ounce. Presently, the ratio's at about 17-to-1. The ratio's not likely to hang out at its current level very long.

Let's just, for the moment, paint a bleak scenario in which the ratio continues its rebound; in other words, where gold gains purchasing power relative to oil. How could you play it?

You'd first need to find a short exposure to oil in one of several ways: futures, exchange-traded notes (ETNs) or exchange-traded funds (ETFs). We can obtain some of the leverage of futures together with tight index tracking by using the PowerShares DB Crude Oil Double Short ETN (NYSE Arca: DTO).

You can find an analogous long gold exposure with the PowerShares DB Gold Double Long ETN (NYSE Arca: DGP). You'd want the double-exposure ETNs because of their greater liquidity versus the single-exposure editions.

This year the oil ETN's been more than twice as volatile as the gold ETN. If you think history will repeat itself, you'll need to hedge that excess volatility by purchasing two gold notes for every oil chit bought. The year-to-date hedge ratio is 2.3-to-1, so for every 100 DTO notes, you'd buy 230 DGPs.

If you'd done the trade with a 2.3x volatility adjustment, the return would have been a percentage point lower, but you'd have cut your risk by about 13%. And in a market like this, who couldn't afford to shave a little risk?

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