Energy Could Be Ready to Rally Again

This column was originally published on RealMoney on Nov. 22 at 12:00 p.m. EST. It's being republished as a bonus for TheStreet.com readers.

Crude oil may be bottoming out here and setting up for a strong 2006 rally. Will oil and gas stocks recover along with crude prices?

Energy stocks topped out in September, after Katrina spiked prices to all-time highs. However, the group was unable to sustain those levels and fell to earth in a persistent correction that's now in its 12th week. As I pointed out on Monday, there's good reason to believe the selloff is at or near sustainable lows.

Oil and gas equities performed unevenly last summer, with some stocks charging to new highs while others got stuck in the mud. In particular, oil service stocks pressed marginally higher but never enjoyed the strong rally that most of us expected after crude oil broke resistance in the low $60s.

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Diamond Offshore Drilling(DO Quote) offers a good example of this limp response to bullish developments in the energy pits. After hitting $57 last June, it has been wobbling around in a seesaw pattern that shows minor gains and considerable danger. Despite hitting a marginal new high, upside momentum has deteriorated significantly and now suggests a broad topping formation.

On a positive note, accumulation has declined minimally since the October peak. This indicates that long-term investors still believe the stock is in a secular bull market that has several more years to run. But the next rally isn't showing up on this stock's chart yet, or the companion charts of most oil service stocks.

Valero Energy(VLO Quote) is one of the new wave of oil refining issues that trade more like tech stocks than energy companies. It printed an all-time high after Katrina, because its physical location and efficient processes put it in the perfect position to capitalize on the damage in the Gulf states.

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However, the stock topped out just days after the hurricane and dropped quickly below its 50-day moving average. It's been grinding sideways at this level for the last six weeks, showing few signs it wants to charge back to its highs.

As with oil service stocks, orderly selling in the refiners has the look of a bull market correction rather than the frenzy expected after a major top.

This brief look at two major energy companies offers little support to bullish signs now evident in the underlying commodity. So which market will lead and which will follow on the next sharp move for this broad group? In other words, does limp equity performance predict lower oil prices, or do firming oil prices predict higher equity prices?

Perhaps trading in late 2004 offers some clues to this developing conflict. Back then, crude oil bottomed out on Dec. 13, ground sideways until Jan. 4 and then took off in a three-month rally. Let's compare crude oil's moves with oil service stock performance over the same period.

The Oil Service HOLDRs Trust (OIH Quote) bottomed out in early November last year, a full month before the commodity. Like crude, the exchange-traded fund ground sideways until January and then mirrored the oil rally throughout the first quarter.