On Hedging Inflation, Part II: Crude Oil

crude oil rigPreviously we reviewed how, historically speaking, gold has proven to be a rather poor hedge against inflation, despite the reality that many continue to promote it for just that purpose. What, then, is a reasonable inflation-hedging investment vehicle? It just so happens that a historically-significant and helpful one is also a commodity – crude oil, the most widely and heavily traded commodity in existence today. Historical data indicates that it functions better than most other proposed hedges out there, especially gold.

Borrowing from Erb and Harvey’s study, “The Golden Dilemma“, mentioned in the prior article, if we plot the change in the inflation rate against the percentage change in the price of West Texas Intermediate (WTI) crude oil from 1987 through 2014 (the US Energy Information Administration’s, or EIA’s, dataset begins in 1986 only), then we end with the following chart. Note the clear existence of correlation, with positive changes in the inflation rate corresponding with positive percentage changes in the price of crude, and negative with negative. There are many fewer cases of a disjoint between the two figures than there were when considering gold against changes in the inflation rate.

crude oil unexpected inflation chart

Data sources: FRED and MeasuringWorth

 
As a matter of comparison, here is the equivalent gold chart again, with a clear lack of correlation.

exhibit 3 the golden dilemma gold versus unexpected inflation

As posited in the last article, an additional and rather interesting way to look at how inflation and crude oil interact is to treat inflation as just another asset andĀ see how well indexed percentageĀ changes in crude oil are to percentage changes in the inflation rate. For instance, if the inflation rate has a positive 100% change, does crude? Here, for a perfect hedge, we would expect to see a 1-for-1 change.

crude oil inflation performance index

Oil does not give us that exact 1-for-1 indexed change, but the chart does indeed reflect a group of values for the selected time period that gather around an average of just slightly above 1 (green line) with most points above zero, that is a positive percentage change in the inflation rate is accompanied by a positive percentage change in the price of crude oil, and a negative one by a negative one.

Again, as a matter of comparison, the corresponding gold chart, with an average below zero.

gold inflation performance index

Against inflation, the data indicates that crude oil would have historically served you better than gold. To be certain, crude oil prices are at the mercy of a host of factors as the current supply stance of OPEC indicates, so one needs to proceed with caution, but OPEC or no, we should also take note that the developed world is in a deflationary state, so we should expect lower oil prices anyway. Central banks from Canada’s to Switzerland’s to the US’s continue to cut interest rates or delay raising them. Hence, if your objective is to hedge inflation as part of a sound, well-balanced portfolio strategy, now looks like a potentially good time to realize that strategy, what with depressed prices and a lack of inflation, as the historical record implies that you stand a better chance with black than yellow gold.