Where Are The Oil Vigilantes?

 | Jun 17, 2014 | 12:00 PM EDT
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Throughout an entire career of trading, I seemed to be continually on the wrong end of geopolitical risk. Whenever something would flare up in the Middle East, whenever negotiations with Iran were going badly, oil would absolutely skyrocket, the stock market would crater, and everyone would be on pins and needles until the threat had subsided. Tensions in the Middle East make everyone nervous because things can quickly and spiral out of control into a regional, or even global, conflict, especially if Israel is involved. This is obvious.

So after years of markets having a conniption every time things get scary over there, here we have the prospect of a full-blown Sunni-Shia conflagration, a huge, bloody sectarian regional conflict that spreads from Syria to Iran and beyond. Geopolitically speaking, this is as bad as it gets. ISIS, a group kicked out of Al Qaeda for being too extreme, has stormed through the country and is threatening to take Baghdad. Oil is up small. Stocks don't care. The Volatility Index doesn't care. And most importantly, oil volatility hasn't even budged!

Why does oil freak out over geopolitical risk for years, but not when it should be freaking out the most?

So I am at a loss here. I think it is wise to gain exposure to higher oil and higher energy prices. Over the last few weeks, I bought Transocean (RIG) and ConocoPhillips (COP), so I am lucky to be on the right side of the trade for once. If I were smart, I would buy calls on United States Oil (USO), the crude-oil ETF while they are cheap.

What we are seeing is an extension of the lack of volatility that people are talking about, the complacency that we have all been experiencing. I find it alarming that the market isn't reacting to this. Iraq is responsible for between 3 million and 5 million barrels of oil per day, but in a larger conflict, much more could be disrupted. I understand perfectly that the U.S. is in a much stronger position than it was 10 years ago as it pertains to energy security, but the effects of a regional conflict will be felt worldwide.

I'll tell you what I'm not going to do; I'm not going to go out and short the world because I think Iraq could get ugly. The market won't care until it cares. Then it will care. So in the hypothetical example that overnight, Baghdad falls and we walk in and futures are down 20 handles -- that will be the signal. Until then, it's wise to hedge things up. Downside protection is cheap. And upside exposure to oil is as good as downside protection in the index.

I have nothing further to add. It's an axiom that 99% of market participants are blindsided by stuff like this. This is pretty much the definition of a black swan. Nobody considered the possibility that 4,000 men would be able to conquer half of Iraq in a matter of days. There really is no excuse for losing money here. The market is giving people plenty of warning.

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