Oil Prices May Play Out Like It's 2008

Includes: IEZ, PBW, USO
by: Michael A. Gayed, CFA

Before I begin, let me make it very clear I don’t want to be branded as the guy who does nothing but call “crashes.” While I was able to argue for a significant decline in silver two days before the spectacular crash week, and the stock market's summer crash, I assure you its only because, in many ways, I find it easier to spot extremes than have an opinion on the middle. I remember an interview that Marc Faber had some time ago in which he argued that forecasting is only really valid at extremes. Quite simple, this is because mean reversion usually kick in, making it a relatively high probability event of a significant move in the other direction.

Having said that, because I study intermarket relationships (and have a deep appreciation of academic research in the field of finance), I do notice extreme disconnects happening internally in the market. I believe there is an extreme message coming out now in the energy markets, perhaps signaling a 2008-like collapse in oil prices. Yes, we may see sub-$60 oil prices reflected in the Unites States Oil ETF (NYSEARCA:USO) in the very near term.

Take a look below at the price ratios of the Powershares Clean Energy Portfolio (NYSEARCA:PBW) and the Dow Jones US Oil Equipment ETF (NYSEARCA:IEZ) relative to the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA). As a reminder, a rising price ratio means the numerator/energy sector is outperforming (up more/down less) the denominator/Dow. Note that this is a relative way of looking at markets. A rising price ratio can occur even if both the numerator and denominator are declining. The issue is the magnitude of the relative movements.

Alternative Energy: In a World of Hurt

Alternative energy needs to compete with oil in order to be used. Generally speaking, alternative energy is kind of like an out-of-the-money call option on Oil prices. After all, presumably alternative energy companies would see a significant pickup in interest if oil prices were expected to rise substantially in the near term. This is because there is a break-even point under which alternative energy becomes cheaper to use than oil.

Note that the ratio has utterly fallen off a cliff this year. This may be warning that investors in alternatives, whose primary concern should be what the cost of oil is likely to be, believe oil prices are going to head much lower. Also note the massive underperformance that was occurring at the far left of the chart as oil prices were dropping like a rock in the latter half of 2008.

Oil Equipment (Drillers): Just Starting to Look like 2008?

The above ETF also theoretically should do well when expectations are rising for higher oil prices. Because these companies tend to get more business when drilling activity increases, this is perhaps the most sensitive area of the energy market to actual oil price expectations. After all, these companies get more contracts to provide equipment and services when harder-to-reach and more expensive oil becomes cheaper than spot oil. The ratio stopped making new highs in mid-March of this year, and has only started to substantially go down. Also notice that the steepness of the break is reminiscent of 2008.

Bottom line? The relative performance of alternative energy and oil equipment may be signaling much lower oil prices ahead. This should not seem that far-fetched. The global economy is slowing down and may be in recession. China is raising rates to cool its economy. Germany, the strongest country in the eurozone, is seemingly entering recession. And the U.S.? Our bond markets are screaming deflation. When will oil prices realize what’s ahead?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.