Oil Prices Impossible to Predict

Last year I was still trading stocks based on a simple system of selling high and buying low. I began selling when oil hit $80 a barrel, and began buying when it hit $60. I had already adjusted that system from a $40-$60 trading range, and even that replaced an even simpler system I once used, which was to buy oil stocks when gasoline hit $1 a gallon and sell when it reached $2. Believe it or not, that system actually worked quite well for years. Nothing lasts forever. My strategy of selling calls last fall backfired when I had to buy them back to keep the stock. In January, with oil over $100 a barrel, I took gains on the long-term call options I'd been holding, further reducing my exposure.

With benefit of hindsight, of course, I wouldn't have sold the calls or taken the gains. Still, in my last oil column I made the point that there's no point in having a system if you're going to change the rules, or only follow it when you feel like it. But at some point you have to acknowledge it's no longer working.

That time is now. Oil prices are no longer in any kind of predictable trading range. I'm not alone in thinking his. I noticed that Goldman Sachs (GS) analysts have been changing their oil predictions even more often than I have, recently calling for oil as high as $200 a barrel within six months to two years. I'm not going to pretend to understand the underlying causes of soaring prices: geopolitics; demand from China, India and other emerging markets; the weak dollar; rising inflation; or speculative excess, all of which I've heard offered as causes. Perhaps it's all of the above.

Nor am I losing any sleep over whether we're in an oil and commodity "bubble." Maybe we are. The strange thing about bubbles is that they don't seem irrational while they're going on, otherwise they'd never happen. As investors we have to live with what the market gives us. If you declared oil prices to be in a bubble last fall and got out of the energy sector (a not-unreasonable proposition), then you've had a pretty tough six months. My energy and commodity stocks are the reason I've outperformed the averages this year.

Nevertheless, I return to my long-held conviction that nothing goes up forever. Consider this: Oil was at $100 a barrel on Jan. 2. Last week it was at $125. That's a 25% gain in 18 weeks, or nearly 100% annualized. At that rate, oil will be at $200 by January $2009, and at $400 in January 2010.

This strikes me as unlikely, not to mention disastrous for the world economy. Even if it does get to those levels that fast, I don't believe it will do so without some interim selloffs. At the least it seems a statistical probability.

So last week, with oil at $125 a barrel, I again took some money off the table, selling calls on stocks like Suncor Energy (SU), the Canadian oil sands producer which has been a pretty good proxy for oil prices. This wasn't easy, given the comfort my energy positions have given me during the recent tough quarter. I'm not claiming the decision is part of any system. It just seemed prudent, even as a simple matter of re-balancing. If prices keep going up, I'll sell more.

Beyond my own interests as an investor, there's much to be said for lower oil prices right now, or at least a leveling off while we adjust to $4-a-gallon gas. Lots of people without ready access to public transportation are experiencing financial hardship, and high oil prices are fueling inflation in a wide array of products. I'm happy to have made some money off my energy investments, but I won't enjoy my further gains if they keep coming at the expense of everyone else.

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