The “Unholy Trinity” in Crude Right Now

by | published March 4th, 2010

Earlier this week, my Money Morning colleague Martin Hutchinson wrote the latest in his well-reasoned columns, “How to Profit from the Next Spike in Oil Prices.”

Martin outlined three investment options as we move into another rise in oil prices: 1) Companies with access to high-cost but stable reserves; 2) oil exchange-traded funds (ETFs); and 3) Canadian or U.S. oil trusts. If you missed it, you are well advised to read Martin’s sage advice.

It just happens to also segue well into another trinity we wrestle with in the oil and gas sector – three factors upon which major developments will play out over the next several months.

This very unstable combination among three incompatible elements – oil trading prices, global market capital mobility, and national energy policies – will prompt some fundamental alterations as the playing field changes. These three lead in different directions and will be colliding repeatedly as 2010 rolls out.

They are also likely to take up much of my time over the next several days here in the U.K., animating some lively discussions among heavy hitters as we move into the weekend. At that point, I shall make a formal recommendation to the gathering that could allow some heftier profit days for individual investors.

That approach will be the subject of my next column.

First, we need to set the stage for what is about to happen in the oil market. This is not simply about price; it is fundamentally about how one profits from rising uncertainty.

I am certainly in the right company to pull this off…

Royal Oil

I’m writing from our quarters in Windsor Castle outside London, awaiting the opening of this year’s Windsor Energy Group meetings – three days of intense discussions with some very famous energy sector people. Queen Elizabeth II founded the group several years ago by royal decree and will convene the annual proceedings.

In anticipation, my wife Marina has been practicing her curtsying for the past two days!

The setting itself is about as impressive as it gets. William the Conqueror began constructing the castle in 1070, making it the oldest inhabited royal house in the world (and also the largest – 484,000 square feet). In addition to several private family properties, Windsor is one of the queen’s three official residences, along with Buckingham Palace in London and Holyrood Palace in Edinburgh. It is also her favorite.

She often spends weekends at Windsor, across the river from Eton and amidst the Berkshire countryside. Upon occasion, that includes hosting international gatherings like ours.

But I’m not here for a tour…

How to Profit from the “Unholy Trinity”

Twenty-seven of us from four continents have been invited for a royal weekend to review the events of the past year in the global energy sector. We’ll make projections and decide on a supported course of action.

This is where that “unholy trinity” raises its face, as well as our chance to make some money.

Much like a sick patient who tries to get out of bed too quickly, international credit and financial markets are making staccato attempts to find some degree of normalcy.

In the oil market, however, normal is a thing of the past.

What we will experience is accelerating volatility. Some of this will result from traders experiencing problems in bridging futures contracts (paper barrels) and actual crude oil consignments (wet barrels). Additional pressures will come from supply difficulties, regional imbalances and shortfalls in the face of rising demand.

We need to structure a strategy to profit from the volatility, whether the actual price is moving up (the most likely scenario) or down. The pricing factor seeks equilibrium and stability, but will witness neither with oil.

That will prove increasingly difficult because of the other factors in the trinity.

Capital mobility, especially into and out of cross-border accessible paper, is certainly essential to the global financial markets. However, given oil’s position as a financial asset rather than only a commodity, financing its forward trade (rather than its production) will put upward pressure on prices. This is already happening because of the usage of oil as a staple part of “hot money” cycles worldwide. Capital moves will emphasize those markets commanding higher prices, with the derivative paper based upon it ratcheting up prices elsewhere.

Since oil is priced in dollars, and remains the most basic element of economies globally, this will have a major destabilizing impact.

Think bubble, replace subprime mortgages with oil futures, and you have the makings of our next wild ride.

And that brings in the third element…

As the volatility increases, and oil availability and pricing concerns quickly follow, governments will step in (even more so than they have already). A national energy policy seeks to cushion the impact of uncertainty for a given domestic market. What all of them taken together accomplish globally, however, are new rounds of policy competition. These take the form of taxation, increasing regulation of commodity and derivative trading, and destabilizing subsidies that succeed only in accentuating longer-term economic costs.

These three elements will intensify as we move forward. It is not whether we can prevent the competition among price drives, capital movements and short-term national policy changes. These will collide, period.

Our interest is how we profit from that collision.

This will involve our own trinity: positioning, valuation, and asset counter-balancing to benefit from rising market volatility. It is during times of highest price volatility that the prepared investor makes the greatest return.

It is also an application of Moors Rule #17 (remember, there are 42 of these): “Usually, when all the market lemmings run right, there is money to be made by going left.”

So stay tuned. Next time, I’ll tell you how the meetings went and fill you in on our strategy.


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