Congress is talking about going after oil speculators in an effort to lower prices by limiting the amount of money flowing into oil contracts.

We realize that they’re upset, but they’re going about this the wrong way. What’s more, they’re demonstrating a near complete ignorance as to how financial markets actually work.

It doesn’t help that they’ve got energy analysts from some of the top firms telling them the price of oil could drop as low as $65 to $75 per barrel, bringing gas down to around $2 per gallon within 30 days of legislation that puts limits on speculation.

While we normally wouldn’t give a darn about the ignorance of elected officials, the bad news is that, judging from the solutions on the table, Congress is just crazy enough, and the vast majority of American people just angry and uninformed enough, that any legislation passed in haste could actually drive oil prices far higher rather than lower as intended.

Of course, that would create an entirely new set of profit opportunities for savvy investors in the process, but what’s a few trillion dollars of excess oil profits among friends?

Seriously.

While we applaud the fact that our leaders are angry enough about soaring fuel costs that they feel they have to do something about high oil prices, the danger is that they might actually succeed.

Here’s why.

One of the first things any licensed professional trader learns – particularly those holding the Series 3 like I did – is that in order for markets to function properly, they need a constant mix of buyers and sellers.

Together, those buyers and sellers agree on a price and make their trade. If there are more buyers than sellers, prices rise as demand outruns supply. If there are more sellers than buyers, prices fall as supply overwhelms demand. It’s a very simple equation.

When it comes to commodities such as oil, admittedly it gets a little more complicated because of geopolitical concerns and the whole peak oil argument. But not by much.

The commodities industry not only thinks about buyers and sellers, but also groups them into two segments: hedgers and speculators. The trick is that the commodities industry does not use these terms the way congress does, which is part of the flap here and, ironically, what demonstrates their naiveté.

Hedgers include companies or individuals that have commodities for sale or companies for whom the future of a given commodity presents financial risk. Examples include oil producers who may have to price their oil reserves years in advance and airline companies who are getting zapped now because they didn’t.

Speculators are typically companies and traders who assume immediate price risk in businesses that are subject to price changes. Examples include processors and refineries, as well as bankers who lend money (which is actually a financial commodity) at fixed rates.

It’s important to note that speculators are not gamblers. In contrast to gamblers who simply place bets for monetary gain, speculators trade economic goods like oil for profit based on their utility and scarceness. They also absorb risk and provide liquidity.

Not only does the presence of speculators help the markets function properly, but also they actually help keep prices down because their presence ensures that the markets are "liquid," meaning traders can get in and out of positions easily.

If speculators were taken out of the markets like some Congressional leaders are proposing, the net effect would be an artificial reduction in liquidity. And history shows beyond any shadow of a doubt that illiquid markets are more difficult to trade, tend to produce worse pricing and, when demand is increasing, far higher prices.

And then there’s the potential for hoarding and panic buying – both of which could also drive prices far higher in a real hurry.

So, the real danger is not that Congress wants to dampen future hikes, but that it may inadvertently cause price increases by eliminating one part of the equation that has historically helped hold prices down.

What about the related proposals that reference the introduction of higher margin requirements and increased financial transparency for foreign exchanges?

Again, those ideas are great in theory but each could have unintended consequences if not enacted in exquisite detail with tremendous forethought.

For instance, one of the proposals at hand includes increasing the amount of margin traders need to buy and sell oil contracts. While that could be seen as a limiting factor, the net effect is that it’s going to raise the cost of doing business for people who need the futures markets the most – big oil companies, refineries, airlines and trucking companies just to name a few.

And in the process, those businesses will pass along the new costs to already stressed consumers in the form of higher fuel taxes, fuel surcharges, and simply higher prices.

Another bill being sponsored would increase disclosure rules associated with global energy trading. While this could be great in terms of knowing who’s actively trading the markets on any given day, it could quickly drive oil markets offshore to less regulated, less transparent exchanges. The net effect of which would be that we would know less, rather than more, about who is trading what – which kind of defeats the purpose.

And that brings us to the profit opportunities.

If this plays out the way we think it’s going to, here’s what to do about it.

First, grab onto a piece of the Middle East and the so-called Frontier Markets. Many are literally awash in excess petro-profits and their markets will reflect that in the years ahead. Of course, they’re coming up a very low base so they are going to be really volatile, but we think the ride will be worth it over the long haul.

Second, follow an energy-centric "picks and shovels" strategy with an emphasis on drillers, shippers and refiners. A well-balanced blend of the three could really pay off no matter which way Congress takes things.

Third, follow the Sovereign Wealth Funds, many of which are profiting from high oil prices. These "Global Cash Barons" are investing their money around the world in businesses poised to profit from emerging consumerism and, big surprise, high oil prices. And they don’t like to lose, which is why newly established positions in China, the former Soviet Union and even Africa have all the upside in the world.

News and Related Story Links:

• MarketWatch:
  Gas could fall to $2 if Congress acts, analysts say

• Wikipedia:
  List of Securities Examinations

• Wikipedia:
  Peak Oil

• Money Morning:
  Outlook 2008: Three Ways to Profit From Sovereign Wealth Funds – the "Next Wall Street"