Taking Stock of Oil

Includes: IEO, IEZ
by: Hard Assets Investor

It would be stating the obvious to say that crude oil prices and oil company stocks go hand in hand, right? Which is why a piece titled "Oil Rises, But Oil Stocks Lag," in the March 12 Wall Street Journal MarketBeat blog looked so interesting. Here's the chart from the article:

Oil Gains, Stocks Don't

Click on any chart for a larger image

This chart shows that crude oil (proxied here by the OIL ETN) has been a better investment than oil stocks (Amex Oil Index [XOI]) in the past couple of months. Given how oil prices have been rising and the recent behavior of the stock market as a whole, this doesn't seem surprising. But just how locked up are these two anyway? After all, not many people invest in oil stocks because they think the share certificates are pretty ... they're expecting at least some kind of exposure to the precious black goo.


Let's define our terms. The Amex Oil Index [XOI] is a cap-weighted index made up of the companies that find, produce and develop petroleum. As of March 18, 2008, they were:

The piece in the Wall Street Journal used the OIL ETN as its proxy for oil prices. We're going to look at how the actual spot prices compare, using data courtesy of the U.S. government.

Back To The Game

The fact that oil stocks have been down is not surprising given the way the credit crisis has pulled down the entire stock market. But is it more than that? CSFB Analyst Jonathan Wolff wrote in a commentary:

"Oil prices have benefited from a growing appetite for inflation hedging tools and US dollar diversification (USD has depreciated 5% YTD), which the market may interpret as transitory."

Translation: Speculation is at the root of this divergence and the market may correct its "mistake" - if you believe such a thing is actually possible in a free market.

But this "new" divergence is really nothing new. The divergence that Mr. Wolff writes of began, in its latest form, back in July of 2007, when XOI went down as oil prices continued up. The divergence was short-lived, as oil prices dropped and followed, or perhaps pushed oil company stocks lower. But since that point, crude oil has outperformed the oil companies.


This gapping and reversion happens all the time, such as in November of 2007. It narrowed again in December, but rising crude prices continued to widen the gap.

All oil companies are not the same. There are companies that are more involved in exploration, and others that deal in equipment. How have those subsets reacted to high oil prices?

Oil Equipment And Services Companies

A slightly different universe of stocks, the iShares Dow Jones US Oil Equipment and Services Index Fund [IEZ ] has 99.83% of its holdings in oil equipment and services as of March 18, 2008, and shows a similar chart to XOI.


Exploration and Production Companies

The iShares Dow Jones US Oil and Gas Exploration and Production Index ETF [IEO] is similarly focused, with 98.89% of its holdings in companies involved in exploration and production and 1% in electricity. But the graph is subtly different.

IEO is tracking much closer to the spot oil price than either IEZ or XOI. There is still divergence in the recent weeks, but the gap is much smaller. Could it be because these companies are reaping the rewards of high oil prices (especially the production companies) or that investors are putting their money into exploration and production companies with the thought that oil sitting at over $100 means these companies are going to do well in the coming years? It's chicken and egg: Investors are ultimately what drive short-term stock prices, so expectations become reality. Whichever the reason, IEO - and the companies it covers - seems to be benefiting from high oil prices.

10-Year Look Back

Step back farther, say 10 years, and the big picture looks even more interesting.

The graph above speaks volumes: Oil companies seem to be plodding along with low (or near-zero) returns until 2004, when they begin to rise at a quicker rate. Oil, on the other hand, has risen like crazy, up and up and up and up.

And yes, those percentages are correct. Remember $11 for a barrel of oil in 1998? That's a long way from the $100+ barrels we're looking at now. Of course these numbers have not been adjusted for inflation, but since we are just interested in the relationship between the two and not absolute numbers, we'll let it slide.

Even Farther Back

What has been the relationship between crude oil spot prices and XOI over the long run?

The above chart plumbs the relationship dating back to 1986. It looks a little nutty, doesn't it? We think of oil prices as having risen so high and having experienced huge gains, but it is a mere pittance compared with XOI's gains over the long run. For the long run, stocks have been the place to be.

Remember, we're looking at percentage increase from an inception date. That's what makes this chart so impressive, because starting from those low levels means that the magic of compounding kicks in. XOI keeps the tremendous lead here because it grew so much from 1986 through 2000, while oil barely managed to tread water. Once oil started to rise, the game was already effectively over.

Historically, spot prices and XOI tend to run in tandem, but there have been differences in the details. For example, the spot price rise and fall from mid-1990 to early-1991 translated into little effect in XOI. Alternatively, in the period from 1997 to 1999 when oil prices were declining, XOI shows a lot of volatility, and even manages some gains.

What's The Missing Piece?

The S&P 500.

Oil companies are traded on the stock market and that very basic, obvious fact means that there are other factors besides the price of oil that influence its performance. The prime example of this is during that 1997 to 1999 period. Oil prices are dropping, but XOI climbs. While hugely volatile, it manages to show an upward trend because of huge gains in the S&P 500.

Another way of saying it is that over the long term, while XOI is obviously correlated to the price of oil, it's also highly correlated (and influenced by) the movement of the stock market at large.

excel chart 9

Final Score

In the end, all this really shows is that trading oil and trading stocks are two completely different animals. Each has their advantages and disadvantages and each are subject to timing issues. Before investing in either, look behind the fancy charts and graphs and make sure to understand what exactly is being shown. Step back and there might be a completely different picture to be seen.