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.