Good Afternoon,

Crude oil's seemingly endless surge continued to fuel dollar selling and additional buying of gold during the midweek session. If ever there was an oil-dominated trading day, today was it as far as gold was concerned. Trading focus remains on just how far up the value scale crude oil can be pushed by speculators before either demand simply dries up or a global recession is triggered.

Gold is riding on oil's coattails, although it lacks the requisite internal fundamentals, as we saw in yesterday's World Gold Council Report. It is simply being dragged along at this stage. Long-range oil futures approached $140 per barrel as speculative funds continued to pour into the commodity. The effects of this were seen across a wide range of assets, but probably none more so than the dollar, which lost another .39 to come very near the 72.05 mark on the index. Stock markets are now falling in the wake of this oil tsunami (the Nikkei picked up on yesterday's 200 point drop in the Dow and fell 233 points, while today's Dow shed another 200 points).

New York bullion reached a high of $931 as oil continued to smash through price level after price level. The explosion in oil prices is threatening to derail the Fed's plan to put a floor under the dollar and could effectively delay the timing of rate hikes as the economy takes the punch. The inflationary effects of same present the other challenge to the Fed at this point. Silver showed a 30 cent gain at $17.96 and platinum rose $44 to $2193 today. Palladium also climbed, adding $10 to $457 per ounce. In our opinion it remains the single metal in the complex with the best outlook and likely the only one that shows true potential for doubling its value. However, much still depends on how the bigger picture unfolds. The credit crunch-induced recession may prove to be a whole lot shallower than the one that the current oil price trend might give rise to.

The last rate cut came awfully close to being the rate cut that wasn't (see my article from April 30). Now we learn that some of the language was quite mild compared to what went on behind closed doors. Marketwatch just reported (10 minutes ago) on the Fed meeting notes. What did we learn?

There was a lack of desire expressed at the Federal Reserve policy meeting for additional rate cuts in June or beyond, especially in light of the inflation outlook, according to an official summary of the meeting released Wednesday. Even more signs of weakness would not be a reason for addition cuts, the minutes said.

Several members noted that it was unlikely to ease policy in response to information that the economy was slowing further, according to the summary. Fed officials did vote to cut rates at quarter-point at the April 29-30 meeting, but that was viewed as a close call.

FOMC members were clearly worried about the inflation outlook. Their forecast for headline inflation as measured by the personal consumption index jumped to a range of 3.1 to 3.4%, much higher than their previous forecast of a 2.1 to 2.4% rise. The risk of higher inflation was just about even with the risks of an economic downturn, members said. Fears of an economic meltdown from a credit crunch had lessened, members added.

Well, they can worry a whole lot more about inflation, now that crude oil reached $132.69 this morning. The US interstates might look deserted come Monday. The debate continues as to whether the spike is to blame on fundamentals or on speculation. reports:

Although supply worries have contributed to the recent leap in oil prices, Global Insight analyst Simon Wardell said this latest milestone was due more to speculation than any shift on the ground. It looks like the short-term balance is fine, and is probably likely to improve, he said, adding that Organization for Petroleum Exporting Countries' (OPEC) output this month was expected to rise by 700,000 barrels per day.

Those hoping for a return to normality sometime soon may be disappointed, according to Wardell. Oil prices were currently locked into a so-called contango, with spot contracts trading at a lower price to futures; oil for delivery in December 2016, the maximum date at which oil can be traded on the New York Mercantile Exchange, settled at $138.38 per barrel on Tuesday.

The market is concerned about the big picture, said Wardell, six to eight years down the line.

If speculation is playing a big enough part in the current record price of oil--perhaps as much as $20 to $25--it would perhaps not take much to reverse the upward trend. A rise in interest rates by the United States Federal Reserve, a firming of the dollar, a symbolic and major change in supply; all of these could trigger a change in appetite for oil.

And now, in the wake of this oil storm, a potential fight is shaping up between lawmakers and market officials as the mushrooming oil price has now become public enemy No.1 in many places (Indonesians protested by the thousands against a 30% fuel price hike). We are told however, that the next time we cringe at the filling station's posted prices, we should be squarely pointing a finger at the managers of our very own pension funds. We have previously pointed out that excessive speculation such as we are witnessing could spark some sort of intervention in particular markets (whether or not such action is legitimate or desirable is not the issue here - it is the likelihood or lack thereof that matters at this time). The New York Times reports that:

The chairman of a Senate oversight committee said Tuesday that he was considering legislation limiting large institutional investors in commodities markets. The legislation would be aimed at speculators and other investors who use commodities like oil as a way to hedge against swings in other investment instruments, like stocks and the American dollar, Joseph I. Lieberman, chairman of the Senate Homeland Security and Government Affairs Committee, said at a hearing.

Crude oil, which settled at a record $129.07 a barrel on Tuesday, has doubled in the last 12 months. The Reuters/Jefferies CRB Index of 19 commodities including coffee and corn has surged 31 percent in the 12 months that ended April 30.

We may need to limit the opportunity people have to maximize their profits because a lot of the rest of us are paying through the nose, including some who can’t afford it, said Mr. Lieberman, an independent from Connecticut.

The plunging value of the dollar, the American housing crisis and widespread problems in the banking sector have led investors away from traditional instruments and toward commodities, witnesses said.

Jeffrey H. Harris, the chief economist for the Commodity Futures Trading Commission, said it was clear that there were more institutional investors in commodities, but he said they had not systematically driven up prices.

Prices are being driven by powerful fundamental market forces and the laws of supply and demand, Mr. Harris said in testimony.

Michael W. Masters, portfolio manager for Masters Capital Management, told the committee that investors were buying up commodities and holding their positions, creating an artificial premium. Assets allocated to commodity index trading strategies had risen to $260 billion as of March, from $13 billion at the end of 2003, he said.

While, Mr. Harris may try to convince Mr. Lieberman that fundamentals are the key driver here, the influx of nearly a quarter of a trillion dollars into these markets speaks for itself. The question is how large the artificial premia are in various commodities and how much of these billions of hot dollars will get up and leave the complex when either the profit triggers flash red, or when lawmakers intervene on behalf of their constituents.

Either way, as some see it, the euro's April 22 surge to a record high of $1.620 -- its loftiest level since it began trading in January 1999 -- was also partly due to surging oil prices. Oil surged over $119 a barrel on that date, before dropping back, and fueling a dollar rise in its wake. Any correction in crude oil futures is likely to coincide with a similar dollar rise, strategists say. A fall in the euro/dollar below the $1.50 level could well prompt a deep profit-taking exercise, taking crude oil back to $100 a barrel, said Bank of New York Mellon's Michael Woolfolk.

You may continue to look for volatile conditions and expect oil to be the first one that gives ground, as it has been in the lead by miles. We do not look for the gold/oil ratio to return to whatever levels are thought to be optimal by pundits, as the relationship is not dependable. The gold/oil ratio has been very low by historical standards recently.

From 1968 through 2003 the ratio ranged from 10 barrels per ounce of told to roughly 38 barrels per ounce. Since 2004 the gold/oil ratio has fallen, to around 7 barrels per ounce of gold. Correctly, many investors have viewed this ratio as an indication that gold prices are not rising as sharply as oil prices have been rising, and that gold is under-valued relative to oil at present compared to the historical relationship between these two assets. Some investors have taken this analysis beyond its logical conclusions, however, and have concluded that the gold/oil ratio must return to 15:1 or 20:1, and that gold prices thus have to rise to $1,350, $1,800, or some other price.

There are no market, mathematical, nor natural laws that support such a conclusion, but that nonetheless is one view prevalent in the gold market today. Gold prices also trade against equities, bonds, and bills. Historically the relationship is virtually zero. This is one characteristic of gold that makes it extremely attractive as a portfolio diversifier. The price of gold is not directly related to the prices of these other assets, which helps smooth out long-term portfolio variability without negatively reducing long-term returns.

However, given the current environment, $100 could be oil's new floor according to analysts. We are not so sure of that. Standard Bank analysts see a possible trip towards $950 for gold should $934 be taken out first. ANZ analysts see firming gold this week, followed by an easing next week and into the summer months.

Happy Trading.