Can We Predict Crude Oil? Leeb’s Oil Indicator, the Oil/Gold Ratio, and Klombies’s Copper/Oil Ratio

The following chart should do something to emphasize the importance of the price of oil that we argued yesterday, especially through the lens of Leeb’s Oil Indicator. Each of the recessions marked on this chart is preceded by an oil spike, except the 1982 recession, which was apparently the product of tight monetary policy. On the flip side, the only 80% increase in year-on-year oil prices that did not result in a recession was the 1987 spike that provoked the market crash.

Year on year oil and recession

We attempted to demonstrate in our last post that the dollar-denominated price of oil and oil priced in terms of gold are perhaps the two most salient market signals and that, although they are each powerful in isolation, they ought to be treated in combination.

The next question is then, if oil is to be regarded as the independent variable and assets like gold and equities are the dependent variables, is there any way one can predict oil price movements? If oil could be predicted, then it might bring us closer to an explanation of why our economic system functions quite the way it does. In any case, it would give us as about as complete a market model as one could hope for.

I am quite sure it was Kevin Klombies of the IMRA who first pointed out the relationship between copper and oil. When the copper/oil ratio reaches five, it is only a matter of time before the ratio snaps back to three or lower, primarily under the power of a resurgence in crude prices. If the ratio should go as high as six, then that snap-back appears to be more imminent.

Again, I am constrained by my inability to construct decent charts, but I will attempt to use what I have and beg the reader to bear with me. Although I have a great deal of respect for technical analysis, for a layman such as myself, the plethora of techniques is simply too daunting for me to be able to apply them in a satisfactory fashion, so I usually use point-and-figure (P&F) charting to keep things simple.

P&F charts (thanks to my brother for first introducing me to this technique many years ago) are so fantastic because they eliminate so much of the noise from charts and it is possible to compress a lot more information into a single chart. The drawback is that it is difficult to use them for intermarket work, because they de-emphasize the element of time.

Another drawback is that I only have access to data going back roughly ten years, so I cannot test how durable these relationships are.

In any case, let’s at least look at the last 10-15 years to get an idea of what might be out there. Below is a P&F chart of the copper/oil ratio going back to 1999 or 2000. (Above we noted that the key levels in the copper/oil ratio were 5:1 or 6:1 and 3:1. On this chart, these are expressed as 50:1, 60:1, and 30:1, respectively. The decimal has simply been moved over one spot to the right).

Prior to the oil spike that led to the collapse of the NASDAQ bubble, you can see that the copper/oil ratio went past 5:1. In late 2006 and then April 2007, the copper/oil ratio broke 6:1, which was quickly followed by the burst in oil prices that brought about the financial crisis in 2008.

copper/oil ratio since 1999

Due to the peculiar relationship between Leeb’s Oil Indicator and our Oil/Gold Indicator, oil spiked upwards again in 2009, which caused oil to again trigger the 80% mark by December 2009, which held until oil prices retreated in May 2010. This seemed to be the last straw for sovereign debt in southern Europe and places like Dubai, but that is another story. In any case, this 2009 spike in oil was not predicted by the copper/oil ratio, but it was predicted by the system we outlined yesterday.

That brings us to the present moment. In February of this year, the copper/oil ratio again broke 5:1, which would suggest that another oil spike is likely, one that will probably bring the copper/oil ratio back to 3:1 and result in an 80% year-on-year increase. For an 80% increase to occur at this point, however, oil would have to return to the $140 level or beyond. There is also the question of what might happen to the oil/gold ratio. If, as I suspect, the relative stability of the Dow/gold ratio is nothing more than a temporary break in its secular decline, we would have to expect that a return to the Dow/gold weakness would be marked by the oil/gold ratio breaking 0.12 again.

If gold were to fall even all the way back to $1000, which is unlikely but not impossible, this would still imply a price for oil in the neighborhood of $120.

If we were to put everything we ‘know’ (that is, if we were to apply the historical rules we have observed over the course of the last decade and beyond) side by side and try to forecast the future of oil, it would suggest the following:

First, the copper/oil ratio will sooner or later return to 3:1. Copper is about 4.50 at present, which would imply $150 oil (give or take).

Second, we should expect oil to move upwards (again, sooner or later) until it breaks the 80% year-on-year level. That would imply $150 oil (roughly).

Third, we expect the oil/gold ratio to return to 0.12. If gold were to remain at $1600, that would imply $190 oil. But, there is no reason to assume that gold will hold that level. In fact, we expect that it will begin to show some softness. But, if we were to take the $150 mark seriously, then that would suggest that gold has fairly rock solid support somewhere around $1250.

Obviously, there are a great deal of moving parts here when we try to use these techniques to predict oil, and there is still the question of precise timing, but we have a copper/oil ratio that is more or less primed, we have loose monetary policy and a market that seems to be coming out of a soft patch caused by the end of QEII and monetary tightening around the world, we have an unusually low oil/gold ratio in the midst of what should be a falling Dow/gold ratio. It is hardly a done deal, but the elements seem to be in place.

If we were to imagine a period of declining commodity prices brought on by severe economic conditions in the near term, thus bringing oil and copper prices down, that would make it possible for the first two of the conditions we just mentioned to be less bullish on oil, but one would have to imagine that such a downturn would push gold significantly higher, and if we were to continue to hold our assumption that the oil/gold ratio should break 0.12 probably in the next year or so–my hunch is that this will happen in the months preceding the US presidential election–then that would suggest an even higher price for oil than we have posited above.

This deflationary scenario strikes me as generally unlikely, for reasons I will address in a future posting, but which can be more or less summarized with the words “accommodative monetary policy”. So, although I have been wrong before and I would hardly be shocked if I were wrong again, the weight of evidence strongly suggests to me that we will be looking at an oil price at $150 in the next 15 months. It has the potential to go higher, but there is no reason to get ahead of ourselves.

It would be fascinating if someone could construct a copper/oil chart that went back more than 10-15 years to see if and how this relationship has changed. Unfortunately, I am unable to construct a chart or even find one I can steal off the web!

Advertisements

No comments yet

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: