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What Are Oil Investors To Do?

Oil prices have been fairly stagnant over the past two months, mainly a result in uncertainty surrounding the fiscal cliff.

In September we were looking at oil prices over $100 a barrel, but the precious crude took a dive in October down to around the $86 level, and in the last two months has remained in a pretty tight sideways pattern in the upper $80’s, and is currently trading at $90.10.

Typically you would expect to see oil prices trending higher this time of year. As the cold wintry months approach, oil traders usually turn bullish in anticipation of higher demand for heating oil. This is not happening this year, and the primary reason is uncertainty over what is taking place in Washington in terms of the fiscal cliff.

President Obama and Congress have had a tough time working together in recent years, and the same situation is playing itself out in regards to the cliff. Despite a fairly universal opinion that the nation will fall back into another recession if some sort of deal is not reached, we are still seeing both political parties playing hardball.

Oil traders feel that a deal will not be reached. Another recession will certainly lead to lower demand for energy, so it is totally understandable that oil traders have been sitting on the sidelines.

I expect to see some sort of deal reached by the end of the year. Both political parties are going to play hardball for as long as possible, but it would be political suicide for members of Congress to allow the nation to go off the fiscal cliff if it could have been averted. President Obama does not have so much to lose because he is not concerned about re-election, but he does have to consider the fate of Democratic party members which will catch some flack should they fail to reach a deal.

Once a deal is achieved, as I believe it will be, commodity traders will breath a sigh of relief and return to market. With most economic indicators pointing to an ongoing economic recovery, we think the sentiment will be bullish among commodity traders, and gold and oil are going to start getting a lot of attention.

It will not really matter what sort of deal is reached, as long as there is some sort of deal. The uncertainty is what is holding commodities back, and the details will not matter as much as just the simple fact of some sort of deal being reached.

Having said that, the degree of strength will be determined on the broad strokes of any potential deal. Whether or not the deal is a short term or long term fix will be a big factor in the amount of strength we see come into commodities, but either way we expect to see both oil and gold trade higher. With so much pent up trading in oil, we expect to see greater upside to it versus gold, which is already trading pretty high at $1,670 an ounce.

One way investors can take advantage of what is to come is with a hedged trade on Market Vectors Oil Services ETF (OIH). We will take a bullish stance on the trade, but want to hedge our bet to get some downside protection in case we do wind up going over the fiscal cliff.

OIH is currently trading at $39.60.

A nice hedged trade on XLP would be the April 34/30 bull put credit spread. In this trade, you would sell the April 34 put while buying the same number of April 30 puts for a credit of 40 cents. This trade has a target return of 11.1%, which is 34% on an annualized basis (for comparison purposes only). With OIH currently trading at $39.60, this trade has 14.1% downside protection.

Chart courtesy of stockcharts.com

Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.