Authored by Steve H. Hanke of the Johns Hopkins University. Follow him on Twitter @Steve_Hanke.
OPEC will hold its semi-annual meeting tomorrow. All eyes will be on Vienna. But, when it comes to oil prices, the “golden constant”, not OPEC, rules the roost.
So, just where is the price of oil going from here? To answer that question, we have to have a model – a way of thinking about the problem. In this case, a starting point is Roy W. Jastram’s classic study, The Golden Constant: The English and American Experience 1560-2007. In that work, Jastram finds that gold maintains its purchasing power over long periods of time, with the prices of other commodities adapting to the price of gold.
Taking the broad lead from Jastram, my colleague, David Ranson, produced a study in April 2015 in which he used the price of gold as a long-term benchmark for the price of oil. The idea being that, if the price of oil changes dramatically, the oil-gold price ratio will change and move away from its long-term value. Forces will then be set in motion to move supply and demand so that the price of oil changes and the long-term oil-gold price ratio is reestablished. This is nothing more than a reversion to the mean.
We begin our analysis of the current situation by calculating the oil-gold price ratios for each month. For example, as of May 24th, oil was trading at $49.24/bbl and gold was at $1231.10/oz. So, the oil-gold price ratio was 0.040. In June 2014, oil was at $107.26/bbl and gold was at $1314.82/oz, yielding an oil-gold price ratio of 0.082. The ratios for two separate periods are represented in the accompanying histogram – one starting in 1946 and another in 1973 (the post-Bretton Woods period).
Two things stand out in the histogram: the recent oil price collapse was extreme – the February 2016 oil-gold price ratio is way to the left of the distribution, with less than one percent of the distribution to its left. The second observation is that the ratio is slowly reverting to the mean, with a May 2016 ratio approaching 0.04.
But, how long will it take for the ratio to mean revert? My calculations (based on post-1973 data) are that a 50 percent reversion of the ratio will occur in 13.7 months. This translates into a price per barrel of WTI of $60 by March 2017. It is worth nothing that, like Jastram, I find that oil prices have reverted to the long-run price of gold, rather than the price of gold reverting to that of oil. So, the oil-gold price ratio reverts to its mean via changes in the price of oil.
The accompanying chart shows the price projection based on the oil-gold price ratio model. It also shows the historical course of prices. They are doing just what the golden constant predicts: oil prices are moving up.
The post The Golden Constant, Not OPEC, Rules appeared first on crude-oil.top.