As we write, front month oil futures are back near the highs, north of $100 a barrel. The Iran conflict is disrupting energy flows, and trend strategies are long oil and refined products, short bonds. Direct exposure to markets at the forefront of concern.

We have long written about the benefits of portfolios broadening the tools in the toolbox of diversification into trend following strategies as they give systematic exposures to a genuinely different risk premia, historically uncorrelated most of the time and negatively correlated in equity and bond crises. While the only perfect hedge is in a Japanese garden (although my now 80 year old English father may stake a pretty good claim), when building out diversified portfolios, this is a good combination. Long and short exposures in commodities, currencies and fixed income.

Long energy positions have been very helpful these past few months, and for many who look at commodity only strategies, this move finally justifies allocations. The incredible thing about markets is how adaptable they are and how helpful the pricing mechanism they enable is. The oil shock absorbers start with inventory that gets drawn down, we have seen that play out. Spot prices rise far enough over the futures curve and oil held in storage gets sold. After that, the longer dated parts of the curve increase, acting to incent increased production, as more projects pencil out at higher prices that futures markets allow to be locked in. Similar things happen incentivizing pipeline builds and other workarounds. At the same time, marginal demand starts to drop, which can be unevenly felt as roughly speaking richer countries pay in price while poorer regions pay in reduced quantity.

Nothing cures high prices like high prices.

But the same is true in reverse, and that is the seed worth planting now, while prices are high. There is real benefit to the short side as well. Natural gas short positions are adding currently, sure, but let’s envision a future a few years out when (hopefully) this period is behind us. We could see a period of oversupply coming, when trend strategies can benefit on the short side. Some amount of the demand destruction we see will become permanent. Countries in Europe may restart nuclear power plants and maybe a new government in the UK increases drilling in the North Sea. High oil prices will lead to investment. We may see the beginnings of an increase in Venezuelan oil in the next few years. We are also seeing fractures in the OPEC countries as the UAE splits away. Given the amount of physical destruction in the middle east and the need for rebuilding it is likely that when they can, many countries pump up to and over the quotas to get the funds required. Oil markets typically operate at a little over 100mbpd, with a few percent out of balance on either supply or demand enough to move prices. With a few of these playing out, there are plausible worlds where we see lower prices.

Trend strategies are built to participate on both sides — and the short side matters too.