A barrel of black gold has fallen to US$123 from a high of US$145 just a few short weeks ago. Something I talked about before we took a break, when I was eating crow for my Fording (NYSE: FDG) suggestion (see July 7th, 2008 blog).

At the time I suggested that the oil stocks may be a leading indicator of a sell-off in the price of oil. I suggested, assuming you bought into that view, purchasing Horizon BetaPro NYMEX Crude Oil Bear Plus ETF (TSX: HOD), which at the time was trading at $6.73.

HOD seeks daily investment results, before fees, expenses, distributions, brokerage commissions and other transaction costs, that correspond to two times (200%) the inverse (opposite) of the daily performance of the New York Mercantile Exchange (NYMEX) light sweet crude oil futures contract for the next delivery month. In short, a 5% decline in the price of oil should approximate a 10% increase in the value of HOD, which by the way, closed on Friday at $8.55.

Now fast forward to this week, and one could argue that the oil bubble has burst. With perhaps more to come, given that Saudi Arabia has increased production to temper market speculation. Under this scenario, oil at US$100 a barrel is a distinct possibility. At that price, I suspect that HOD will trade somewhere between $12 and $13 per share (for disclosure purposes, I still own HOD which I bought after the July 7th posting).

Having said that, some analysts are suggesting that this so-called bursting bubble may be nothing more than a long-anticipated, but temporary, pullback from a secular uptrend. Under this scenario, analysts argue that at US$123 per barrel, oil has simply re-traced to where it was in May. Looking back at May, that too was a record high price, and really, none of the fundamentals have changed since, global economic slowdown notwithstanding.

Demand for oil remains strong. The US is slowing but has not slipped into a the classic definition of a recession; defined as two consecutive quarters of negative GDP growth. In fact, the US has not had one quarter of negative growth, or one month of negative growth for that matter.

Emerging markets are not likely to skid into a recession either. At best there might be a slowing of growth, but there will be growth nonetheless. So, if demand for oil remains strong everywhere, how likely is it, that even at US$123 a barrel, the global thirst for oil will slacken measurably? Especially when supplies are stretched, and the pipeline that services the market is in parts of the world with a high geopolitical risk quotient.

If speculators are selling oil because of slowing demand, then you have to believe that the slowing demand will be the result of a change in consumption patterns rather than a measurable slowdown in economic activity. And that argument has been challenged on the basis that oil demand is relatively price inelastic. Which is to say, it takes a much bigger upside price shock to appreciably change demand patterns. So what’s new…. more uncertainty!

What we do know is that oil prices are being driven by market sentiment, with solid arguments on both sides of the ledger. The implication from a trading perspective, is that oil may well swing to US$100 per barrel before rebounding. Just as it ignored supply/demand fundamentals when speculative fervor took it to US$147 per barrel on the upside.

If you are going to play oil for a rebound to the upside, I would stick with the oil companies and the fundamentals of their earnings stream. Rather than buying oil outright. The thesis here, is that the oil companies may have already discounted US$100 oil.

The four companies on the rebound side of the oil trade include Imperial Oil (TSX: IMO, recent price $51.19, options implied volatility 35%), Petro Canada (TSX: PCA, $48.42, 38%), Suncor (TSX: SU, $56.12, 46%) and Canadian Natural Resources (TSX: CNQ, $81.28, 60%).

With IMO and PCA options being the cheapest in the sector, and assuming you like the prospects for the companies, I would buy calls. Say IMO Sept 52 calls at $2.35 or PCA Sept 50 calls at $1.85.

SU and CNQ options are trading at much higher implied volatilities. With implieds above 45%, I would look at covered writes on SU say, buying the stock at $56.12 per share and writing the August 58 calls at $1.30. The two week return if exercised is 5.8%, while the return if unchanged is 2.4%.

In the same vein, a CNQ covered call write would require buying the stock at $81.28 and writing the Aug 82 calls at $3.30. The two week return if exercised is 5.2%, return if unchanged is 4.2%.