Watch Out: A Correction in Oil is Coming

The nature of business is cyclical. No matter what.

Take the oil sector for example. Despite the hype and fear being promoted by peak oil theorists, the sector is correcting. The price of crude oil is surging to new highs while many oil companies in the DJIA and S&P 500 have not experienced the same type of explosive price action. This lack of investor enthusiasm to boost oil companies to new highs demonstrates the correction is already under way.

Draw a comparative chart using these three symbols: Ultra Oil & Gas ProShares (DIG) (ETF Long of DJIA and S&P 500 oil/gas companies), UltraShort Oil & Gas ProShares (DUG) (ETF Short of DJIA and S&P 500 oil/gas companies), and United States Oil Fund LP (USO) (ETF reflecting price if Texas Sweet Crude).

DUG vs. DIG vs. USO 1-yr chart:

For more than two years, DIG and USO moved higher in unison, with DIG performing consistently better than USO during that time. However, the past month shows a clear divergence in direction between the stock price of USO and DIG. In fact, DIG has crossed below USO and continues to struggle, while USO keeps inching higher. Meanwhile, DUG has started to significantly bounce off its lows, and shows strength despite USO pushing to new highs.

I feel that this comparison demonstrates that the price of oil no longer works as a catalyst for driving oil company stocks. This separation between the price of oil and the companies that provide it only serves as a warning to those invested in the sector. No matter the price of crude, oil stocks should suffer. Arguably, if oil continues to jump to stratospheric levels it will definitely cut into consumer demand hurting oil company sales, and if oil prices begin to settle to more realistic levels based on fundamentals, prices should decrease hurting the bottom lines of oil companies.

I also believe the growing separation between the price of oil and the companies that find, produce and sell it show how speculative oil has become. Although crude oil may go higher in the short run, I would say that the risk/reward ratio to investors in crude is unfavorable.

I like to compare this current price correlation between oil and oil companies to that of lumber prices and housing stocks in late 2004. In a comparative analysis, lumber prices continued to run ahead of the housing stocks as each continued to hit new highs at the end of the housing bull market. Once the price of lumber contracts crossed below the price of the housing index a top was signaled. Within two years, the housing sector and lumber prices were decimated.

What this delineates is that once a pattern involving stock and commodity prices emerges during a sector's rise, one only has to look for a significant deviation from that pricing pattern to signal a top.

Comments

[cjwirth:]

This article is correct, the increasing cost of exploration and extraction of oil from small oil fields, often located in ultra deep water locations is taking a toll on oil company profits. The problem is that at a certain point, banks may hesitate in making loans for very expensive oil and natural gas projects, as reviewed in the report:www.peakoilassociates....

2007 Nov 23 08:42 AM

[pietrogori6...:]

Sir, your line of reasoning is cogent and you may be correct.In the short term there may very well be a correction in the price of oil, though betting against it would - I must confess - make me rather uncomfortable.
As a value investor I am in no mood of selling my oil stocks any time soon. I strongly believe that we've had a structural change of late, and the old way of reasoning - if I can put it that way - don't hold much oil, ehm water, anymore.
Yes the US will be in a recession ( actually it is already there), and it'll be a nasty one. There will be no decoupling: Europe, China, India and all the rest are going to suffer.
BUT oil has become more a supply than a demand story nowadays and, barring utter catastrophe in the East, the imbalance is not going to correct any time soon, if ever.
As for oil stocks, in a nutshell: they are still, IMHO, ridiculously cheap. Almost across the board. Those who have been selling i.e. Schlumberger lately must be either misguided or have big problems of their own (read bankruptcy coming, selling the family jewels).

I did sell Petrochina a while ago at about 190$, but there you had the relevant decouplig. That stock had ceased to be an oil stock and had become a Chinese one

Respectfully
PG

2007 Nov 23 09:20 AM

[pietrogori6...:]

Sir, your line of reasoning is cogent and you may be correct.In the short term there may very well be a correction in the price of oil, though betting against it would - I must confess - make me rather uncomfortable.
As a value investor I am in no mood of selling my oil stocks any time soon. I strongly believe that we've had a structural change of late, and the old way of reasoning - if I can put it that way - don't hold much oil, ehm water, anymore.
Yes the US will be in a recession ( actually it is already there), and it'll be a nasty one. There will be no decoupling: Europe, China, India and all the rest are going to suffer.
BUT oil has become more a supply than a demand story nowadays and, barring utter catastrophe in the East, the imbalance is not going to correct any time soon, if ever.
As for oil stocks, in a nutshell: they are still, IMHO, ridiculously cheap. Almost across the board. Those who have been selling i.e. Schlumberger lately must be either misguided or have big problems of their own (read bankruptcy coming, selling the family jewels).

I did sell Petrochina a while ago at about 190$, but there you had the relevant decouplig. That stock had ceased to be an oil stock and had become a Chinese one

Respectfully
PG

2007 Nov 23 09:20 AM

[sbenard:]

I attribute the divergence in price to the higher production and oil acquisition costs, reflected in Exxon's lower earnings results from last quarter and disappointing forward projections for the next. This has caused selling of oil co stocks, while the price of oil itself has continued higher. Investors have finally realized that higher oil prices adversely affect oil companies' profits, too. The higher and higher input costs are beginning to take their toll. While you may be right (my gas tank hopes you are) in predicting lower oil prices, I'm not yet convinced that the demand for oil will be sufficiently less for the price of oil to be bearish. If the U.S. economy slides further toward recession, perhaps due to poor Christmas retail sales, then demand may slip and your prediction would be fulfilled. Unfortunately, this is looking more and more like the most probable scenario. I'm just not yet completely convinced that scenario will play out, perhaps due to my own wishful thinking. I believe this ETF price divergence is CAUSED by higher oil prices, but not that it is prophetic. Time will tell.

2007 Nov 23 12:18 PM

[User 123899:]

Short USO now.

2007 Nov 23 02:24 PM

[Kunst:]

I have a small recent position in DUG. Long-term, energy has nowhere to go but up. However in the short term, the incipient recession in the US, which will depress the global economy, will reduce demand and prices. Oil is overpriced at this point from a supply-demand perspective. I plan to ride DUG, very likely increasing my stake, for the next 3 to 6 months, then look for the right time to go long oil. The next economic upturn will right smack into peak oil for real.

2007 Nov 23 03:07 PM

[boden11:]

Bunk--

While I too believe some correction-- >10% and more likely 15-20%+ is in the cards for crude prices (most likely shortly after 100 is breached) this methodology is flawed. DIG's largest holdings are the big oil companies which have underperformed lately. This underperformance is due to poorer margins relating to refinery and other operations. Not all oil companies will continue to kick butt as the price of oil soars. IE--I own some Oil & Gas Royalty Trusts which will often hedge prices with all sorts of derivatives. In order to put a floor under them in case oil drops they often have to put a ceiling on profits as well. I know that this example relates to Royalty Trusts and not big oil, but the point is that companies that make money in the oil market don't move tick-for-tick with the price of crude.

It would be interesting to back-test this method with more data...anyone?

2007 Nov 25 01:53 AM

[Warchild NYC:]

Interesting story. I believe that the best approach may be to short oil futures, as it is more of a pure play and provides better bang for the buck in the event of an oil correction. Also, I believe that some of the oil companies are going down because of downward pressure on refining margins, while overall valuations for energy stocks do not yet reflect the benefit of $90-100 oil. If oil were to stay up near the current price, I believe energy stocks would eventually perform quite well. However, they usually will go down in sympathy with the oil price in a correction, which, in a move from $100 to the $70s or $80s, would provide a much better long-term entry point. Perhaps the best near term approach right now is to be short or flat anything energy related. The "limited spare capacity" argument for high oil prices falls away completely (temporarily) in a US recession. It is only the incremental oil production that is expensive. If demand goes back to below 83MM per day for a while, prices could really dive. People forget we were in the $50s earlier this year, and that is without a recession!

2007 Nov 25 09:58 AM