February 14th, 2009

OIL, USO, DBO: Are they Broken?

A couple of weeks ago, in response to some comments Cramer made about the relative merits of gold vs. gold producers, I presented graphs showing the changes in the price of GLD, GDX and the S&P 500 Index. I demonstrated that while gold producers were performing better than both GLD and the Index in the short run, over a longer time horizon, GLD was the better and less volatile performer. I summed by writing:

“The fundamental issue is whether the factors driving the price of gold are different that those driving stocks? If yes, will there be a reversion to some parity and, if so, will gold price drop or stock prices rise? If not, will gold producers continue to outperform other stocks to be more in line with the price of gold? I don’t have the answers but my preference is always to take a longer-term perspective as the safer and more profitable route over the long-run.”

Something similar is happening in the oil patch. The price of oil finally leveled out and has fluctuated in the $32-42 range since mid-December, down over 75% from its peak just last summer. The whole oil complex including oil service, drillers, exploration and development stocks also entered a bottom formation process. But when you stack the oil commodity (either the OIL, USO or DBO etf’s) against the various operator ETF’s you see a very interesting divergence:

OIL ran up more than the stocks of the complex during the oil shock of 2007, when many were predicting oil prices would eventually go to $200, $300 or even $500/barrel. So now, the pendulum swings back and, as is true of many other “bubbles”, it swings further than is reasonable.

When oil was trading at $145/barrel, the ETF was trading at 225 or 1.55 as much. Today, when oil is at $35/barrel, the ETF trades at 16.50, or less than half as much. The ETF was too high at 225 but it’s too low at 16.50. Zooming in, the ETFs performance since July 1, 2007 looks as follows:

OIL, the ETF for owning the commodity itself (shown in black) has continued to decline while the other ETFs have flattened. Looked at this way, one is compelled to ask a similar question to the one asked above about gold and its producers.

The fundamental issue is whether the factors driving the price of oil are different that those driving the stocks in the complex? If yes, will there be a reversion to some parity and, if so, will oil price rise or stock prices fall? If not, will oil producers continue to outperform the price of oil?

My guess is that, for unknown reasons, the price of oil today is arbitrarily low. “Contango” is the hot word today when speaking or writing about oil. The Wall Street Journal had the following to say a couple of days ago,

“In the oil markets, the trend is continuing, as the price of the front-month futures contract continues to lose ground against later-dated contracts, an indication that many producers still do not expect demand to pick up for some time.”

Looking at the comparison charts above, I wouldn’t be surprised to see a 100-200% increase in the OIL, USO or DBO etf’s over the next 12 months for convergence with the stocks in the oil complex.

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