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A "Leeb oil shock" is the term I use to describe occasions when the year-on-year price of WTI crude exceeds 80%. As far as I know this was first pointed out by Stephen Leeb in his book The Oil Factor. According to Leeb, stocks (particularly the Dow) tend to rise until year-on-year crude increases 80% and then fall until crude falls below a 20% increase.

Modifying this somewhat, I have found that Leeb's "Oil Indicator" can be applied to either the Dow or to gold, depending on the trend of the Dow/gold ratio, but I will return to that at a later date.

Since I first encountered Leeb's wonderful discovery, I have been very curious as to how one might predict these Leeb shocks. And, I have made a little headway, although like most things in the market it is as much art and intuition as it is science.

The prices of oil and gold are probably the two most important factors in modern markets, by which I mean the Pax Dollarica we have had since the Nixon Shock. And, the oil/gold ratio may be the single most important indicator in the markets. For the last 40 years it has signaled changes in the Dow/gold ratio, interest rates, and in the oil market.

I had originally thought that the oil/gold ratio could only be used to predict oil prices in unusual circumstances, such as in 1973-1974 and 2009-2010, but I have found that it is less circumscribed than I had assumed.

In fact, every Leeb oil shock we have ever had has been preceded by a massive rise in the gold/oil ratio, with the sole exception of the 1990 oil shock apparently triggered by the Iraqi invasion of Kuwait. (Note: I am going to speak of the gold/oil ratio instead of the oil/gold ratio since I believe it will make it easier to picture the relationship.) In the case of Kuwait, the gold/oil ratio had, rather unusually, never retreated after the 1987 oil shock.

Unfortunately for people forecasting markets, not every "massive rise" results in a Leeb shock. Once in the mid-1980s and once in the mid-1990s, these kinds of moves did not result in anything approaching a Leeb oil shock. And, once in the early 2000s, a massive rise in gold/oil brought us to the brink of a Leeb shock but then retreated.

The key number in the gold/oil relationship is 14.28. (Note: This is 0.07 in terms of oil/gold.) Typically, when the gold/oil ratio starts somewhere around 10 or in the single digits and then breaks above 14.28 within a relatively brief time frame (say, within a year), one should be on the look-out for a Leeb oil shock twelve months after gold/oil peaks.

There are occasions such as in 1997-1998 when gold/oil was just barely under 14.28 and went to 25 that resulted in a Leeb shock or in 2006-2007, when it began as low as 7 and then fell short of 14.28, but nevertheless was followed by an oil shock that brought us the first installment of the Great Recession. In this latter instance, the lag was not 12 months but 17 months, so to repeat, this is hardly a perfect science.

Before going on to look at what this summer might have to hold, I would first like to show three historical examples, two of which are the 1999 and 2008 outliers.

First, the 1987 oil shock, a nice, clear demonstration of the principle [click images to enlarge]:

gold/oil ratio 1985-19871987 oil shock

Then, the 1999 oil shock, which was still orthodox, but cut it close:

gold/oil ratio 1997-19991999 oil shock

Finally, the most unusual of them all, the 2008 oil shock, which did not strictly hold to either the timing precedent (12 months) or the trigger levels (14.28):

gold/oil ratio mid-2006 - mid-20082008 oil shock

That brings us to today. There is a pretty distinctive spike that occurred over the spring and summer of 2011, but does it indicate that we are on our way to a Leeb oil shock sometime in August or September of this year?

gold/oil ratio

It did not start at a particularly shallow low, and it did not peak at an especially high level, but it does share a resemblance with the run-up to the 1999 oil shock, in my opinion.

Year-on-year oil is currently quite weak.

Year-on-year crude today

And, since this time last year oil continued to weaken into the late summer, to predict a year-on-year rise in prices this summer, especially if oil were to come off its current lows, is not an especially bold call. But, I am of the opinion that we could see unexpectedly strong oil prices relatively soon.

A "Leeb shock" would see prices approaching $150, and it is very difficult to see any strictly economic reasons for such a price any time soon, but I don't need to remind anyone that there are plenty of geopolitical factors that could bring us to those levels. Even a 50% increase in prices to, say, $120 could prove problematic in the world economy's current state.

For commodity investors asking themselves what this means for them today, it would seem prudent to look for entry points into WTI (particularly where it tests 2011 lows) in order to hedge against a possible geopolitical threat to oil supplies.

Specifically, an oil futures tracking fund like USO might provide the most direct exposure to an oil spike.

For stock investors, the possibility of an energy shock, particularly if it should originate from the geopolitical side, suggests a bias in favor of defensive stocks and energy. If one believes that a boost in energy prices in the next three months could stem from economic bullishness, then one should shun defensive stocks and turn to energy to hedge against excessive froth in the oil markets.

In my next piece, I hope to look at another fairly reliable lead indicator of Leeb oil shocks, and perhaps that will provide a clearer picture of what to expect.

Source: Is An Oil Shock Coming This Summer?