Oil's Spike Is Causing a Distortion

This essay was originally published in DailyWealth Trader, a daily trading advisory, and has been adapted. To learn more about this service, click here.

Oil prices are up 30% in a matter of weeks.

The commodity recently rose above $100 a barrel. The U.S. oil benchmark, West Texas Intermediate, is now around $95. And many warn it could go much higher if the U.S.-Iran war continues.

Check out this headline from Reuters...

Iran's $200 Oil Threat Isn't That Far-Fetched

Or this one from OilPrice.com...

$200 Oil No Longer Crazy Idea as Middle East Supply Collapses

Now, we certainly may see higher oil prices in the near term. If shipping traffic stays low in the Strait of Hormuz, it will keep pressure on the commodity.

But history shows that high prices won't last much longer.

Several signals have pointed to this recently. Now we have a new one... The recent spike drove a key ratio to its highest level in years.

In fact, we've only seen the ratio rise like this a handful of times in the past century.

And typically, once oil prices start to decline, that ratio comes crashing back down... and a double-digit decline in the commodity unfolds.

I'm talking about the "oil to natural gas" ratio.

The world depends on these two commodities. Our biggest use for oil is transportation. And we use natural gas for electric-power generation, industrial processes, and space heating.

When it comes to this key measure, the ratio rises as oil demand soars relative to natural gas. And if oil prices fall while natural gas prices rise, this ratio drops.

It's no surprise that the recent jump in oil sent this ratio skyrocketing. But in the chart below, you can see that spikes like this typically don't last long...

There have been six other jumps like this since 2001. Each run-up lasted a few months... before the ratio pulled back for months or years.

In 2001, oil was coming off a major rally. It rose from $12 a barrel in 1999 to above $30 a barrel by December 2000. The oil-to-natural-gas ratio peaked in mid-2001 following the big run higher.

Then, oil prices fell from $29 a barrel to $18 a barrel from September to November 2001. That's a quick 38% fall.

We saw a similar thing happen in 2006. Oil prices were up from $43 a barrel in December 2004 to $77 in 2006. Meanwhile, natural gas prices were struggling. As a result, the ratio shot higher. It peaked in mid-2006... before oil prices dropped 35% to $50 a barrel.

And we saw setups like this again in 2011, 2019, and 2023.

Each spike in the oil-to-natural-gas ratio came as oil prices were taking off. But when oil prices failed to sustain the rally, the ratio dropped shortly after.

Here's a table of oil-price returns in those cases...

In each case, falling oil prices brought the oil-to-natural-gas ratio down.

In short, we could see oil prices stay high or keep climbing in the near term. But the spike in the oil-to-natural-gas ratio shows the peak in oil prices could be closer than you think.

And when it starts to unwind, 20%-plus declines are common.

Good investing,

Chris Igou