A Melman Minute — May 24, 2011

Market action in gold over the past few days has been most encouraging for those who believe the yellow metal still remains inside an ongoing golden bull market. The yellow metal advanced by about $10 yesterday and in early trading this morning is ahead by a similar amount.

As can be seen on the chart, gold has made a significant recovery from the sharp declines of early May and now stands barely $50 from its all-time high. In our opinion, the declines of early May appear to constitute a relatively typical correction within an ongoing bull market and we also believe that the accelerating crisis involving various countries within the Eurocurrency community appears likely to drive further investments into gold and silver for insurance purposes.

An old word is re-entering the lexicon of economic discussion, the term stagflation. Those of us who have been around the world of economics and resource development for several decades recall the period in the 1970s when it was in common usage as that was a time of rising inflation combined with economic contraction.

As Stanford University Economics Professor Ronald McKinnon put things in a just-released study, Stagflation is an ugly word for an ugly situation: persistent high inflation combined with high unemployment and stagnant demand in a countrys economy...We havent experienced it here in the United States since the bad old days of the 1970s.

Professor McKinnon then goes on to point out that unemployment is high at 9.0% and prices are now on the rise, citing producer price indexes which are now rising at an annualized rate of 6.8% and Intermediate Goods Prices are rising even faster, at an annual rate of 9.4%. He blames Federal Reserve Bank policies for this weakened situation, specifically noting that their zero short term rate policy has led not to rising prosperity, but to a situation where, ...the American system of bank intermediation is essentially broken: interbank loans outstanding in March 2011 were only a third of their level in May 2008...it is clear that the Feds zero interest rate policy has worsened the situation...

He summarized the picture by declaring, The stagflation of the 1970s was brought on by unduly easing U.S. monetary policy in conjunction with attempts to talk the dollar down, leading to massive outflows of hot money that destabilized the monetary systems of Americas trading partners. Although todays stagflation is not identical, the similarities are striking.

Lest anyone think that all is well within Americas economy, please consider the following. If the economy was generating huge numbers of high-paying jobs and if the banks were functioning normally, one of the most likely beneficiaries of that happy situation would be the housing construction industry and that would normally be reflected in escalating purchases of their most important raw material, lumber. But that is surely not the case as can be confirmed by one good, long, hard look at the lumber price chart over the past six months.

To the best of our knowledge at TMR, we cannot recall a potent, sustainable economic recovery which has taken place without the participation of a healthy residential construction industry something that is clearly missing from todays economic mix.

Tying the picture together with Professor McKinnons comments, it appears likely that the Fed will continue to keep short-term rates near zero, the dislocations in the banking industry will continue and the Fed will therefore be forced to maintain its aggressive stimulation policies which we believe have played a major role in the decade-long bull market in gold and silver.

One subject which has a strong bearing on inflationary prospects which just will not go away is the price of oil. Despite numerous stories ridiculing the peak-oil theory; despite stories about monumental new finds of recoverable petroleum under the oceans; despite details of new techniques to use horizontal drilling to tap major reserves which had earlier been abandoned despite all this and more, the price of Crude Oil is holding near $100.00 per barrel and, as can be seen from the multi-year chart, since late 2001, the price of Crude has about quintupled from $20 to $100 per barrel!

An Associated Press article this morning is headlined, Oil rises to near $99 as Goldman boosts forecasts and informs us that major brokerage firm is now calling for a price of $140 per barrel for Brent Crude before year-end 2012, a hefty increase from previous forecasts. Goldman Sachs pointed to the war in Libya combined with disappointing non-OPEC production as reasons for their revised estimates.

Others who are also bullish on the price of Crude point to projections by the U.S. Energy Information Administration that worldwide demand for petroleum would reach the highest levels in history; close to 88,000,000 barrels per day by the end of this year.

With this background in mind, we were intrigued by a story authored by petroleum expert Ben Casselman and published by the Wall Street Journal. Casselman points out that many of the worlds present oil fields have now pumped more than half their oil, the point at which production normally begins to decline. In fact, we have learned that some of the worlds largest producing fields have now been forced to resort to the method of injecting water into the fields to lift the oil to where it can be captured a method which normally has a limited life span.

Casselman then discusses a potentially major source of petroleum, but it is of the heavy variety, meaning that it cannot be easily pumped to the surface as opposed to the much more manageable light crude. He declares that there are abundant sources of heavy oil, but the great question is whether they can ever be economically developed.

One of the techniques for raising heavy oil is to inject hot steam into the petroleum pool, but this presents two problems when associated with Middle East oil fields. First, there is no clean water in the area, meaning that sea water, laden with salt and other corrosive minerals, must be used. Second, the only abundant fuel in the Middle East to heat the water to produce vast quantities of steam is already-recovered petroleum, so you would be burning oil to produce oil, a rather inefficient process to put things mildly.

There is ample evidence that the ability of the worlds producers to obtain vast quantities of cheap oil by simply tapping into easily-accessible reserves is diminishing. That by itself may be the reason why we have seen the quintupling of prices noted earlier.

In any case, if petroleum prices reach Goldman Sachs forecast levels or higher the consequences relating to rising inflation, stagflation and economic dislocations could be severe.

As of 8:45 AM PDT, precious metals have been among the star performers with gold now trading close to $1,525 and silver up by more than $1.00 to near $36.25. Base metals including copper, nickel, aluminum, lead and zinc are all up anywhere from 1-3% while mining share indexes are ahead by a strong 2%. It is also interesting to note that the price of uranium has been gradually recovering from the trauma of the Japanese earthquakes/tsunamis and now stands close to the $60 level.

Financial markets in both Canada and the USA are close to unchanged, crude oil is trading just under the $100 level, interest rates are little changed and the US Dollar is slightly weaker in currency markets.

All quotes US$ unless otherwise noted.

Next Melman Minute scheduled for tomorrow, May 25, 2011 to be followed by Friday, May 27

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