In January 2008, the price of oil reached the century mark – $100 a barrel – for the first time ever.  By May 2008, American investment banking giant Goldman Sachs was predicting the price of oil would reach $200 a barrel within two years.  It did not.

In September 2008, another American investment bank – Lehman Brothers – filed for bankruptcy.  Bankers across the globe wondered if they might be next and dramatically altered their lending practices.  Investors used to hearing daily quotes of trading on the ASX or the Nikkei or the NYSE now learned what LIBOR (London Interbank Offering Rate) was and began to pay attention.  Credit dried up and by October 2008 was as frozen as the North Pole used to be.  The price of oil collapsed, and so did share markets everywhere, taking down the share price of thousands of fundamentally sound companies.

In January 2010, with the price of oil well below $100, anti-government actions sprang up across the Middle East with the situation in Libya driving the price of oil again over $100 in February 2010.

Some analysts predict continued rises to $200 or $220 and recipients of some investing newsletters are warned of the potential of $300 a barrel.

With the first cataclysmic share market event of this century – the bursting of the tech bubble and the collapse of the American NASDAQ stock exchange – many investors proclaimed the venerable Buy and Hold investing strategy had outlived its usefulness.  If not already dead, it was certainly gasping its last few breaths.

 

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The argument goes that with the interconnectedness of global economies, markets have become much more volatile.  Added to this potentially toxic cocktail is the rise and near dominance of quantitative trading.  Did you know today approximately 60% of the trades made on the NYSE are machine-driven?  While the Terminator movies were pure fiction, the reality is computers are taking over more and more market activity.

What is worse, most of these quantitative trading platforms share common designers and as a result, they tend to react to market conditions in the same way.  On 6 May 2008, someone somewhere pushed the wrong button and the Dow Jones Industrial Average (DJIA) dropped 900 points and then recovered, all in a matter of minutes.  To this day, no one knows for sure what happened.  How can the average retail investor buy a quality stock and hold it under these conditions?

A traditional Buy and Hold investor would approach the current rise in oil prices with the zeal of Sherlock Holmes, attempting to separate fact from fiction.  It is a fact there is a disruption in a small portion of the world’s oil supply and there are tensions in the Middle East.  It is also a fact that today many investors will profit handsomely from these price rises, not from the oil itself, but from commodities futures trading that many believe is the real determinant of the price rise.

If you do not know about options trading, futures trading, and contracts for difference, you need to learn as all have major impacts on share prices totally unrelated to the futures trading.

A fictional tale from ancient history best explains the basics of this kind of trading.  Once upon a time farmers concerned about the price they could get for their crop at fall harvest arranged to sell the rights to delivery of their crop at an agreed upon price before the crop was even planted.  Back then, merchants who bought these contracts to buy actually took delivery of the product.  Both sides of those early trades were hedging against the risk of paying too high a price or receiving too low a price at harvest time.

Then speculators entered the market and began to buy up futures contracts, not because they needed the commodity, but to make a profit from later reselling the contract to either another speculator or a party that actually needed the commodity.

Speculators have always served a vital role but their participation in these markets raises an interesting question.  Is it the supply and demand for the actual commodity that controls the price or the supply and demand for the futures options contract itself?

Today some governments are considering limiting the participation of speculators in the commodities markets.  Oil is not the only commodity on an upward spiral.  Food prices are skyrocketing with no apparent change in real demand and supply.

All participants in futures trading have vested economic interests in the actual price of the commodity at delivery.  For those researching the reality of the situation, this presents major problems.  Information about economic conditions can be misleading or manipulated to favor one side of the argument over the other.  Many retail investors see the headlines about the $200 or $300 predictions but fail to learn they are based on an interrelated set of disaster scenarios.

Buy and Hold investors sniff out the potential vulnerability of that argument – how likely is it all events will occur – and make a bet on the future.  Instead of following the crowd in panic selling of what they own, they actually buy more.  These investors believe there is great opportunity when there is “blood in the streets.”

The current situation with oil gives us a unique opportunity to look at Buy and Hold, since we have a recent historical parallel.  In the middle of 2008, the price of oil was on fire, but it collapsed in October in the face of a real decline in demand due to collapsing world economies.  What has happened since then?

To address that question we have pulled a 5-year share price chart from thebull.com.au.  Here is the chart of one of Australians major oil companies, Oil Shares Limited (OSH).

You can see the dramatic drop in share price in the third quarter of 2008.  You can also see the dramatic rise in share price in response to the rise in oil prices earlier that year, with OSH peaking at around $6.75.  At the end of 2010, the share price eclipsed that level and has been trading close to its high to this day.

Buy and Hold investors brave enough to hold their shares of OSH and add to their positions in the dark days at the end of 2008 have been handsomely rewarded.  Perhaps we should pause a moment before placing a memorial wreath on the coffin of the Buy and Hold Investment Strategy!