RISKY
BUSINESS The rise and rise of gold and
oil By Jephraim P Gundzik
Recent consolidation of gold prices and
sliding crude-oil prices will be short-lived.
Politically motivated dollar depreciation, rising
US inflation, and mining-industry consolidation
are expected to push gold above US$800 per ounce
in 2007. And despite gathering US economic
weakness, intensifying global geopolitical
instability, declining natural oil production and
greater output discipline among major petroleum
producers will send oil prices
back above $70 per
barrel.
In the past month, gold has
consolidated above $600 per ounce, leading many
analysts to believe that prices have peaked in the
current cycle. However, significant changes in US
economic policy and an overly dovish Federal
Reserve are expected to induce dollar weakness and
higher inflation in 2007, pushing the price of
gold much higher.
The Democrats' victory
in the November mid-term elections has put several
economic-policy changes into motion in the United
States. The most important of these will be
efforts to push the value of the dollar lower
against other major currencies to boost flagging
economic growth and reverse America's long-term
decline in manufacturing employment.
While
dollar depreciation may help boost exports and
manufacturing output, it will also have the
untoward effect of increasing inflation by making
imports of many goods more expensive. Higher
import prices will increase upward pressure on
core inflation, which is already above 2.5% and
rising.
Contrary to popular expectations,
increasing core inflation in the US will not be
reversed by temporary weakness of energy prices.
This much was clear in recent inflation
statistics, which showed core inflation has
continued to increase despite the sharp
late-summer drop of energy prices.
Continued complacency at the Federal
Reserve will allow core inflation to move higher
in 2007. In 2006, political considerations
surrounding the election forced the Fed to stop
what was an exceptionally gradualist approach to
monetary-policy tightening. These political
considerations have been replaced with growing
fear among Fed officials that higher short-term
interest rates could exacerbate the collapse of
the housing market, greatly increasing systemic
risk to America's financial system, which is
heavily exposed to the housing sector.
With recent statistics showing no let-up
in dramatic downturns in housing starts, building
permits and home prices and an unprecedented
increase in real-estate foreclosures, the Federal
Reserve has reason to be concerned with systemic
risks. Concern over the solvency of America's
financial system will increasingly trump concerns
over rising inflation in 2007, leaving monetary
policy too loose and propelling core inflation
higher in the months ahead.
Accelerating
inflation will further undermine the value of the
dollar, increasing the appeal of gold to investors
worldwide, including many of the world's central
banks. Growing investor demand for gold will be
met with falling supplies. Consolidation in the
gold-mining industry, which began in earnest in
2001, is likely to continue as cash-rich metal
producers swallow rivals, as indicated by the
just-announced buyout of Phelps Dodge by Freeport
McMoRan. Such consolidation, combined with
internal consolidation of output among individual
gold-mining companies, will reduce supplies, also
supporting higher prices.
Oil to trend
higher Though Democrats will soon control
Congress, giving them much greater power over
economic policy, they will refrain from
influencing America's foreign policy. Rather,
Democrats will be content to let the
administration of President George W Bush continue
to strangle popular support for the Republican
Party in pursuit of its conflict-ridden agenda.
The resulting intensification of global
geopolitical instability will underpin oil prices.
No real change is forthcoming in
Washington's Iraq policy. Though both the Pentagon
and the independent Iraq Study Group are
conducting reviews of how to win the war in that
Middle Eastern country, neither is expected to
come up with a groundbreaking solution. More
likely, these reviews will simply justify the Bush
administration's "stay the course" policy with
minor tweaks in troop levels, Iraqi-military
training efforts, and methods to enhance internal
security.
Any suggestion from the Iraq
Study Group that Washington engage Iran and Syria
will be quietly discarded. Confrontation rather
than engagement has been President Bush's hallmark
since 2000 and has been fundamental to keeping
America's religious right on the side of the
Republicans. Without engagement, there will also
be no new initiatives from the administration to
end the Arab-Israeli conflict, which, along with
Iraq's increasingly bloody civil war, will further
destabilize the entire Middle East in 2007.
Confrontation will also continue to
characterize Washington's efforts to thwart the
nuclear ambitions of Iran and North Korea. As
demonstrated with North Korea after its recent
nuclear test, the Bush administration will try to
contain Iran with punitive sanctions over the next
several months. This will do nothing to halt the
advancement of the Islamic Republic's nuclear
program, setting the stage for a military
confrontation with Iran in late 2007 or early
2008.
Intensifying instability in the
Middle East and escalating confrontation between
Washington and Tehran will inevitably disrupt the
region's oil production and exports in 2007,
reducing world oil supply. At the same time,
declining production among the world's oldest and
largest oilfields will further crimp world oil
supplies.
In the Americas, oil production
from mature fields in Canada, the US and Mexico is
rapidly declining. Canada's oil sands, which are
being touted as another new source of petroleum
reserves, have not been proved commercially
viable. Mature oilfields in the Middle East, most
notably at Ghawar in Saudi Arabia, are also
experiencing diminishing production. The same is
true in Europe's North Sea.
Though a few
new oilfields, such as in Central Asia and South
America, have recently come online, this new
production will not be enough to offset declining
oil production in the rest of the world. Finally,
production discipline among the world's largest
oil producers is much greater than many believe.
In Russia, the world's foremost oil exporter, the
Kremlin continues to extend its control over oil
production, most recently by revoking the
operating permits of foreign oil majors on
Sakhalin Island.
The same is true in
Venezuela, which has begun to nationalize the
operations of foreign oil majors in the Orinoco
region - an area that holds what may be the
largest untapped crude-oil reserves in the world.
Many investors have taken the recent
weakness of oil prices, in spite of announced
production cuts, as an indication that the
Organization of Petroleum Exporting Countries will
be unable to deliver. However, OPEC production
cuts as well as cuts among non-OPEC countries,
including Russia, will not impact prices for a few
more weeks when actual deliveries begin to
decline.
World oil supplies are likely to
shrink more significantly in 2007 than world
demand despite weakening US and global economic
growth. This will ensure that crude-oil prices
move higher in the months ahead. At the same time,
higher energy prices will contribute to higher US
inflation, aggravating dollar weakness.
The bull runs for gold and oil prices are
far from over. In contrast, the global equity and
bond bull markets are becoming exhausted.
Jephraim P Gundzik is president
of Condor Advisers. Condor Advisers provides
investment risk analysis on developing countries
to individuals and institutions worldwide. Visit
www.condoradvisers.com for more information.
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