Long energy and short financials has been a winning hedge fund trade this last quarter, but has since unwound. Oil has fallen nearly $30/barrel off it’s highs approaching $150/barrel, and financial stocks have been all the rage of late. Concensus is that, although we’re not in a recession, GDP growth is stagnant and markets are all over the place. How should a prudent investor approach today’s environment, particularly in dealing with energy?

Ben Stein is one of my favorite economists. I urge everyone to read his recent article on oil prices, in which he argues prices will continue to drop. He predicts they will absolutely rout at some point, although he is humble enough to admit he does not know when that will be.

Stein correctly states that the majority of oil price increases have been due to the fall in the US dollar. Before the Federal Reserve instigated its recent round of bailouts and general loose monetary policy, oil was trading for $70/barrel. Actually, Stein attributes 85% of price increases to US dollar devaluation.

The other 15%, Stein argues, comes from unusual speculative activity in futures markets. Supply and demand have remained relatively constant – in fact, US demand has actually waned slightly – so there are few fundamental reasons to explain energy prices going up in the short term.

If Stein is right, which he often is, we should pay heed to waning US oil demand. This is the biggest indicator of oil’s future price direction; and measured from historic performance, “In the past, when US oil demand has fallen, world oil prices have literally collapsed.”

My personal take on it is that it’s too early to tell where oil is headed. The US has fundamental fiscal issues which is driving monetary policy. As such, it’s too early to predict a resurgent dollar, which would be one of the biggest contributors to a general oil market collapse.

However, as with any “bubble,” risks increase and prudent investors should trim back on long exposure with every uptick. Overall portfolio weightings should probably be reduced, but measureably.

There could still be quite a bit of upside ahead with a deteriorating US economy and its subsequent inflation. In fact, I think oil’s best argument right now is its use as a hedge on inflation.

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