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Over the past 6 months, I have watched the steady under-performance of the large cap oil stocks such as Exxon Mobil (NYSE:XOM), ConocoPhillips (NYSE:COP), BP (NYSE:BP) or Royal Dutch Shell (NYSE:RDS.A). Even the recent stir in Egypt, although producing a risk premium in the near-term price per barrel of crude, is not sparking a major rally in large cap oil stocks.

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The relative under-performance to the S&P500 (NYSEARCA:SPY) index of the major integrated oil companies since the beginning of February 2013 is very distinct in the graph above. This is after an extended period in which the stocks and the market index were highly correlated. Given the change in economic fundamentals recently and the rising rate market environment we are now entering, this break down in correlation may be a market signal of a value play in the making.

Oil Under-Performance Relative to Stocks in Perspective

To put into perspective why the oil stocks are under-performing the major market indices, it is helpful to look at the price of energy (in this case WTI-Crude Oil) relative to the price for a share of stock (S&P 500) over several business cycles. In the case of oil and stocks, the past 10 years provide a wide range of information that is useful in understanding the present market dynamics.

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In the graph above, you can see that the price for a barrel of crude oil over the past 10 years traded in a range of $40 to $140 per barrel (the extremes). More recently, it has traded at $80 per barrel and above. At the same time, the S&P 500 has traded in a range of as low as 666 to its present high levels above 1600 (1692 in May 2013). Over the past ten years, the two indexes have tended to trade on a relative basis together through time, but not in lock step correlation. Over this time period, the correlation is only .61 on a month to month comparison. But, from the chart it is intuitively visible that over time the price of energy has a distinct influence over the value of the stock market. The points at which this influence becomes most poignant is when oil spikes upward in relative price, as it did in 2008, and it did again in early 2011 for a brief period.

More recently, the trend has not been convergence or correlation in oil and stock prices, but relative divergence (see green arrow on the chart). Just as the stock prices of the large integrated oil companies have diverged in value from the overall stock market, so has the relative price of oil recently. I recently heard several news commentators lamenting about the price of oil remaining "stubbornly high". Well, at least not relative to stocks on a composite basis. The interpretation of this recent divergence is where relative value in a very tricky stock market presently might be found.

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The summary table above is an analysis of the past 10 year relative performance of stocks versus oil price levels. From this information, the recent divergence in value can have several meanings, but in general I believe the gap will be closed over time in either case.

The first scenario is the hoped for GDP growth scenario (Friday, July 5th jobs report is supportive of this forecast). In the early stages of an upward change in interest rate policy at the Fed, stocks typically get in front of the oil market. With GDP growing faster and interest rates at all-time lows, the prospect of higher interest rates takes over market sentiment, and the tendency for investors is to move to stocks, but not immediately to oil related energy stocks. However, if the growth scenario is real, the divergence in value between oil companies and the stock market dissipates through time. The conditions for such a scenario are in place now as investable funds continue to avoid high duration bonds as Treasury rates rise, the U.S. continues to have a carbon unfriendly regulatory environment which works to limit supply and keep prices high, and international tensions are returning a premium into the oil price level.

There is another scenario that could be the rationale for the divergence. It is a signal that in general the stock market is just over valued and will converge back to the recent relative price level in relationship to oil. However, this is not as likely a scenario given the current economic statistics and the trading pattern of stocks and interest rates. What is more likely to be a signal of an impending dramatic economic slowdown is a rapid rise in the price of oil, and divergence in spreads between corporate bonds and Treasuries and in the process of this happening the stock market corrects. But at least in the immediate term, it appears that the economy prospects and flow of funds out of Treasury bonds and into stocks will pull the price of oil up.

Current Rising Rate Environment Correlation to 2004 Time Period

Does history provide information to examine for better understand the current market? In this case, yes. In 2004 we entered a similar time period in which the Fed under the leadership of Alan Greenspan was in the process of signaling and implementing an escalation of interest rates from a period of very low short-term rates post 9/11. The rate information, as well as the pricing patterns for the stock market and oil markets is shown on the graph below:

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As you can see from the chart, the interest rate structure in 2013 is beginning a similar process that it did in 2004 - long-term rates ticked up in anticipation of a change in Federal Reserve policy. There could be other factors in play as well that I have written about, (Bernanke's Real Problem - Owners of the U.S. Debt), primarily that specific holders of government bonds (NYSEARCA:TLT) (NYSEARCA:TLH) (NYSEARCA:IEF) (NYSEARCA:SHY) (NYSEARCA:GOVT), such as foreign governments, have become net sellers to raise dollars for specific needs. Whatever the reason, rates have begun to rise. The question for investors is what happens to oil relative to the stock market as rates rise?

The data in the chart is interesting. In the 2004 time period, rising interest rates drove investable funds into the oil market, and the stock market out-performed, but oil did better. This pattern held through 2007 when we reached all-time highs in the stock market and oil per barrel was trading at all-time highs of around $100 per barrel. In 2007 the negative divergence of stocks, Treasuries and oil prices that I referenced earlier in this article took over, and the crash of 2008 ensued, with oil falling late in the correction.

Flash forward to June 2013, and the same relative relationship between oil and stocks is in place as 2007, but this time the Fed is beginning to raise as it did in 2004, not lower rates as it had to in 2007 - and at least at this point in time Treasuries and Corporate bond rates (NYSEARCA:AGG) (NYSEARCA:LAG) are moving up together.

Large Cap Energy Stock Performance as Rates Rose

In 2004-2005, the rising rate environment from extremely low levels combined with improving economic statistics lead to an increased price level of crude oil. As a result large integrated oil companies became clear out-performers.

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The question remains will these stocks stop under performing in 2013 and outperforms as rates rise just as they did in 2004? As for the tremendous percentage gains seen for the stocks in the mid 2000's it is unlikely at the current time. Oil prices rose over three-fold in this time period. Although I don't discount that this could happen, just as it did in the 1970's, and given the level of central bank easing throughout the world, I currently am not seeing this possibility. But a movement back to the 2008 high of $140, just as the stock indexes have recently moved above the 2007 highs, should not be viewed as a low probability event. So, there is room for the oil market to move up and in all likelihood as interest rates continue to go up, just as they are in response to the June U.S. jobs report, oil is likely to move up as well.

Investment Strategy

In a rising interest rate market, investors need securities in their portfolio which are not non-correlated to the depressing affect that increasing rates have on asset values. Oil, and energy based investments in general, have this characteristic. In the current market, there are many investments that can serve as effective hedges as rates rise as long as the prospects remain that there is room for the price of oil to rise without choking economic growth. These include MLPs (NYSEARCA:AMLP), particularly for taxable portfolios, and liquid heavy Royalty Trusts (NYSE:PER).

In this article, I have shown the potential long trade into integrated oil companies as a possibility. The rationale for the trade is shown in the graph below:

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As shown in the graph, the current share price levels relative to the S&P since the 2008 peak in oil price are all under-performing. The primary factor in returning to a higher share performance will be a sustained movement up in energy price levels. The gap in price level of oil relative to the market exists, and the alternative for money to move into bonds is not a good one presently, as it was not in 2004. Exxon Mobil appears to be the relative leader. BP is the biggest laggard due primarily to the overhang of legal proceedings surrounding the Gulf Oil spill disaster in 2010.

Based on these market dynamics, investors seeking stable high dividend paying investments in a rising rate environment should consider these stocks as good buying options at the present relative price levels.

Source: Jobs Up, Interest Rates Up - Buy Energy Stocks

Additional disclosure: I am long individual MLPs not mentioned in the article.