What Explains The Divergence Between Oil Prices And Oil Stocks?

These last few weeks have been confusing, even for a 35-year oil trading veteran like me.

There are some things I'm recently seeing in energy stocks vis-a-vis the energy markets that I've rarely seen before.

I've done exceedingly well during my career by investing in energy stocks using my understanding of the underlying energy markets.

If I went back and charted both of them using data from 2010-2014, or 2003-2007, or 2013-2016, you'd be hard pressed to tell the difference between the two lines on the chart.

But have a look at this:

(Click to enlarge)

There's been a huge divergence between oil prices and oil stocks, starting most apparently in the early winter of 2017 and currently flat-lining the stocks right now compared to oil.

So, what the heck is going on? I suggested a couple of possible reasons in my last column, including rising interest rates, EIA forecasts for future production and a few rogue shale players screwing it up for everyone with continuing breakneck drilling. My old friend Jim Cramer suggested on his show that younger hedge-funders are uninterested in 'old-fashioned' fossil fuels and won't buy. If that's true, they're going to be left out of a global demand picture that, in even the most aggressive estimates, won't begin to flatten until 2040.

Frankly, I've discarded all of these as insufficient to derail a correlation that's been reliable for nearly 40 years. All of these conditions have been seen before, and have ultimately mattered little. If oil goes up, oil stocks go up. It's a rule I've been able to set my watch to.

But something must be going on. And I'll admit, I'm not sure what it is.

What's most likely happening is a (not unheard-of but) unusual period of simple divergence caused by a perfect storm of small factors, all driving the two numbers apart - for a time. So, the complete reason for the lack of current correlation could be all of the above I've mentioned, and perhaps a dozen other smaller factors I cannot yet recognize.

But - and here is the important point - That would imply a strong mean reversion is coming, where the correlation is again restored as it was in the past - and oil stocks again track strongly with oil prices.

If that turns out to be true, then this is an unprecedented opportunity to begin or add to positions of oil stocks. Since the correlative gap between oil and oil stocks is currently very wide indeed, it implies a strong 'make-up' discount is already baked into these stocks. So, even if oil sits still at these levels, oil stocks should move higher. Further, even more bullishly, I do not believe that oil is near any kind of top and should see prices continue to rise throughout the rest of 2018.

All that said, there is a small part of me that recognizes that this might not be a 'simple divergence', as hard as that is for me to believe. So, there is a way to hedge our bets, as I intimated in my last column: with Euro-majors. Both Shell (RDS.A) and Total (TOT) offer solid dividends, far less beta than independent E+P's and should participate somewhat (although less strongly) in any 'catch-up' rally that the oil and oil stock reversion generates. And even in a case where this reversion doesn't materialize, these stocks represent blue-chip value using any metrics - not just from oil prices.

This is where I'd be most aggressive in the next several weeks.

By Dan Dicker