We have a delicate balancing act at hand between the threat of an emerging nuclear power, our rapacious thirst for oil, and responsible diplomatic policy.  The consternation in the air is palpable, bringing to mind Buffet’s famous words “Be fearful when others are greedy and greedy when others are fearful”.  So how does one put such words of wisdom into an actionable trade idea?  Since going long nuclear fallout seems short sighted, let’s look at how to take advantage of a potential event driven jump in the price of oil once we fully grasp the situation at hand.

At the mentioning of the country results in a harsh, metallic taste of uncertainty and fear in the back of your mouth when you consider the effects on your portfolio.  Developing a perspective on the state of affairs is difficult, especially solely from sorting through headline after headline; from the  motorcycle delivered assassination of nuclear scientist Mostafa Ahmadi Roshan on Wednesday near Iran’s main enrichment facility to Europe’s proposed boycott of Iranian crude, to the menacing threat of a barricade in the Strait of Hormuz.

Lets break things down and set the scene so we can take a more accurate look.  We have two main catalysts; the increasing threat that Iran poses to the rest of the world and of course, oil.  It was most recently reported that Iran’s nuclear program  had passed the low enrichment rate of 3-5% and begun to reach the threshold of weapons grade uranium, breeching the 20% level which is sufficient enough for a crude yet effective nuclear weapon.  The assassination of Roshan yesterday only supports this theory, suggesting the program had progressed far enough to merit a public killing regardless of  the political fallout.  While the nuclear threat from Iran doesn’t seem all that immediate (at least until they find another sucker to be Director), former CIA chief Michael Hayden still feels the country ” ..is the single greatest destabilizing element right now with regards to global security”.

Fear aside, this brings us to the second catalyst: oil.  One fifth of the world’s oil passes through the 34 mile wide channel, accounting for 35% of all waterborne oil traffic..  an ideal conduit for a battered and beaten nation to draw in an unwavering audience.

Now Iran gets pushed around quite a bit, with the most recent abuse in the form of sanctions against all crude oil exported from the nation; starting what Iran has referred to as an “economic war” on the country’s largest export.  A ten day long display of naval tactics in the Strait was just the beginning for Iran’s government, stating that “if sanctions are adopted against Iranian oil, not a drop of oil will pass through the Strait of Hormuz.”  Responding in turn, the US Navy ordered a second Carrier Battle Group into the region, just to keep an eye on things (which must make China feel all warm and fuzzy inside).

So now that we have pieced together a relatively coherent picture of the different catalysts in the scenario that could lead to a spike in oil prices, lets take a look at how to best position for such an event.

1. In an effort to reduce variables in such a complex and politically driven scenario, a simple strategy is highly recommended for the average investor.  One of the easiest and cheapest options to develop a position is through buying the corresponding ETF, although since these funds generally invest in near term futures contracts due to the difficulty of holding the physical asset there is potential for some tracking error on the part of the fund.

2. Another option that provides a more direct investment is to own the actual oil companies (SLB, HES, HAL, XOM, etc.)  Although also relatively inexpensive in terms of trade costs, this strategy subjects you to the headline risk of the individual companies rather than limiting your exposure directly to the price of oil.  This strategy also lacks a guarantee that the correlation between oil company and oil price will appreciate in line with each other.

3. Which brings us to a play more directly linked to the movement in the price of oil and involves less capital than option 1 and option 2: buying options on the futures contracts.  Each contract is for 1,000 barrels and a $.01 move in the price per barrel equals a $10 move in contract price.  The pricing of these options requires some understanding of both the futures markets and options strategies, so is not appropriate for the average investor.

While some sort of drama ensuing from the Middle East debacle seems imminent, there is no guarantee that events will play out as expected and oil prices will respond in turn.  Buying stock in a solid, multi national company with a strong balance sheet and diversified portfolio of assets might be a safer play on the chance that Iran can agree to some sort of terms on their Nuclear development program.