Could High Oil Prices Derail Overvalued Stock Markets? 5 Hedge Ideas

"In China the question is not price subsidies, the question is about first time drivers," warned Jeff Rubin, the former Chief Economist of CIBC World Markets. Rubin argues that the Chinese have surpassed the United States in car sales and coal consumption, and will not stop driving anytime soon-- regardless of higher oil. Rubin postulates that as higher oil prices restrain demand for gasoline for U.S. drivers, these higher oil and gas prices will not hinder demand by Chinese drivers who have no price memory of oil (moving from bicycle to cars) and who are only now hitting the roads in large numbers.

Rubin also argues that the world is not running out of oil, but that the world is running out of cheap oil at an alarming rate. Canadian oil sands and other non conventional oil supplies are plentiful but they rely on $200 a barrel oil. Rubin suggests that the collapse of subprime and housing markets in the U.S. were not the only cause of the recession and that an oil price shock was partly or largely to blame for the last recession, when oil touched $147 a barrel in mid 2008.

Rubin thinks we are headed for higher oil prices and for another economic downturn from the next oil shock that he believes is coming very soon (with the protests around the globe centered around high inflation, this may already be developing).

Here is the video in which he explains why oil prices are so important to the Global economy and why big changes must me made to prepare for the next oil shock.

Here are 5 option ideas to hedge your portfolio against higher oil prices and a potential oil shock.

• RJI -- Currently I am long 50 RJI June $8 calls for $1.6 or so per contract.

• Seadrill Limited (SDRL) -- I am considering selling the Jan. 2012 SDRL $35 Put options for $3.8 per contract (the stock is currently trading at $38 per share)

• Canadian Natural Resources (CNQ) boasts one of the largest reserve / market cap ratios in the oil sands and the company is highly profitable at current oil prices. I am looking to sell the Jan. 2012 $45 put options for $4.4 per contract. The current prict of CNQ is $49.7, so this investment carries a nearly 20% margin of safety for our option position, while the return on our risk (that CNQ falls below $40.60 at expiration) is 10.8% over that time period.

• Diamond Offshore (DO) trades for just 11.5X TTM earnings and is one of the stronger offshore drillers in the world. The January 2012 $74.50 Puts can be sold for $8.2 per contract or a return of 12% on our risk (that DO falls below $66.3 at expiration).

• JA Solar (JASO) is likely to benefit from higher oil and coal prices. As the low cost provider in its market, this company could see increased profits and demand with higher oil prices. The June 2011 $7 puts can be sold for $.75 per contract or a 12% return on your risk by June expiration, or a 20% plus annualized return on investment. JASO currently trades at $7.37 giving our investment a 15% margin of safety from today's prices (meaning the stock has to fall 15% by June for the trade to lose money).

Remember that one of two events could happen in commodity markets that could potentially damage equity markets:

• Stagflation could result from higher commodity prices not being passed through to consumers who are still hurting from high unemployment and low wage growth.

• Oil prices could fall sharply, setting off a correction in all risk assets as leveraged players wind down margined positions.

My personal thinking is to remain either flat or bearish on equities and long a diversified basket of commodities as a "long hedge" until a definite collapse is apparent. In any futures or macro trade, experienced trend followers will tell you that cutting losses quickly is tremendously important -- the same can be said of stock positions, but remember that an undervalued stock that goes down may represent an even better long term investment after a price drop as the discount to intrinsic value increases with the fall in stock price. Over many years, stocks tend to perform well as they accrue earnings and book value grows with profits even if the company exhibits little to no growth in revenues and earnings.This is why short selling is more speculative (along with unlimited losses) but can be utilized when overall markets become extremely overbought and overvalued (as the Russell 2000 is today, in my opinion).

With the RSI, Stochastics, and MACD on the already overvalued stock markets at extremely overbought levels, I would not be surprised to see a 10% correction from current prices... The 50 day looks to be in play in the futures markets at some point this week and the next stop on the break of the 50 day would likely be the 200 day moving average.

Being cautious and conservative should pay off as the price shock of $99 a barrel oil will start to hit the economy in negative ways. Remember that $147 a barrel oil came at a time when homeowners were flush with refinanced cash and stocks were still at lofty valuations and price levels. The consumer had a much better balance sheet (almost 1/3 better), so that this time around the effects of high oil and food prices are obviously much worse on market participants and consumers than in 2008.

Furthermore, most retail investors are not anywhere near back to even after swearing off the stock market in March of 2009 and abandoning a buy and hold strategy. Many of the same investors are only getting back into the market now, at prices 90% higher than where they sold at the bottom a couple of years ago.

In conclusion, higher oil and gasoline prices are stifling the economies of the world, and stagflation is a real possibility for the economy which would make stocks a tough place to make money, while government programs and large deficits could continue to fuel the rally in commodities, which many view as speculative. Of course, a good degree of speculation is certainly at play right now in commodities, but the fact that those calling the boom in hard assets "speculative" while the U.S. has become the largest debtor nation in the world always seems to be absent from any discussion on higher oil, gold, or food prices. Paper currencies under a system which cannot sustain entitlement spending programs are likely a culprit behind much of the rally in non-paper assets besides residential real estate. The rally in farmland-- and raw land in general-- tends to back the paper currency devaluation thesis as well...

In any event, my feeling is that debt is the real driver of commodity prices over the long term as well as the end of easy to find light sweet crude oil, as discussed in the above video. Either way, buckle your seat belts as we are in for some wild trading in all listed markets.

Disclosure: I am long JASO, RJI, DO, RJI, GLD, PSLV.