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 higherThough 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.
Source: Asian Times
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