Even our fish is wondering. He darted back and forth acrosss the tank this morning as we both watched the overnight report from New York on TV. Who knew fish could be stressed by rising commodity prices?

Our old friend Kevin Kerr back in the States reckons that the combination of peak North American driving season (the Memorial Day holiday this weekend) and a touch of financial speculation will pressure prices higher. There is no relife in sight, either.

Is it demand? Is it speculation? Is it OPEC punishing George Bush for the war in Iraq? OPEC, as we explain in our two-part essay beginning tomorrow, thinks there’s plenty of oil. It’s the declining U.S. dollar that’s to blame. OPEC says that for every one percent decline in the dollar oil rises by US$4, and vice versa.

The solution to high oil prices, then, is not increased supply or reduced demand, but a stronger U.S. dollar! Well, there is certainly some truth to that, but it is not likely to happen any time soon. As a tangible good whose supply cannot be increased by a central banker, the oil price (a little like the gold price) tells you there’s too much paper money chasing too little stuff.

The U.S. dollar, by the way, is not cooperating to bring oil prices lower. After its recent, much-ballyhooed rally, the dollar is giving back some of its gains. It fell yesterday against the euro, the yen, and the pound (the four other ugly contestants in this global currency beauty pageant…where the winner is the least ugly.)

The Aussie dollar played a role in the demise of the U.S. currency yesterday. Australia’s dollar is again at a 24-year high against the greenback. The kicker yesterday came from the release of the notes from the Reserve Bank’s most recent meeting.

The Bank didn’t raise the cash rate then from 7.25%. But the notes reveal it came awfully close. That information was enough to persuade some currency traders to sell America’s currency and buy Australia’s.

After reviewing the conditions in the global financial market (not so good) and the conditions in Australia’s domestic market (much better), members of the Board scratched their collective heads and decided not to raise the cash rate. There was a lot of talking, and wringing of hands, and gnashing of teeth, though.

“The question therefore remained,” after much private discussion, “whether the setting of monetary policy was sufficiently restrictive to secure low inflation over time. Members spent considerable time discussing the case for a further rise in the cash rate. But on balance, given the substantial tightening in financial conditions since mid 2007, and the extent of uncertainty surrounding the outlook, the Board decided that it was appropriate to allow the current setting of monetary policy more time to work.”

A near miss.

The Bank also said something interesting about the terms of trade (which is admittedly a challenge). Housing and business finance have both slowed down. This helps “moderate domestic demand,” to use a central banking phrase. Fewer Aussies borrowing (money and credit creation from thin air) also, hopefully, lowers inflation below the 4% rate its officially running at.

But the strong Aussie dollar is creating a monster in the terms of trade. The notes report that, “Members were briefed on the large increases in bulk commodity contract prices that had been agreed over the past month. In US dollar terms, there were price rises of 80 per cent for iron ore, over 200 per cent for coking coal and 125 per cent for thermal coal.”

Old news. But it’s still astonishing when you look at it, isn’t it? No wonder coal and iron ore stocks are flying.

“Other commodity prices were also high at present,” the notes continued. “The price of Tapis crude oil had risen steadily so far this year, and base metals prices were not far below the peak reached in mid 2007 after having roughly doubled over the previous three years.”

Here is the real surprise; “The rises in bulk commodity contract prices were significantly higher than previously forecast and would lead to an estimated rise in the terms of trade of 20 per cent this year. The increase in the terms of trade was expected to boost national income by about 3–4 per cent, which would be a significant potential stimulus to spending, notwithstanding possible constraints inhibiting a further rise in business and public-sector investment spending.

You can raise the cost of borrowing. But if what you sell to the rest of the world keeps going up in price, and you’re selling more of it, you’re going to have wads of cash in your pocket. That’s itchy.

And here is a statement that puts the entire boom in global perspective, “Members were informed that, measured by the change in the terms of trade over the past five years, Australia had received a larger income gain than any other comparable country, even before taking this year’s projected increase into account.”

Is there another country in the world that’s gained more from the commodity boom than Australia? No, according to the RBA. And that’s before that recent triumvirate of nearly triple digit gains in bulk commodities is figured in.

What does all this mean for shares? Well, the oil price is having two effects, with a third off in the distance. The first is obvious, energy stocks are zooming. Second, the high oil price is making many other unconventional and alternative energy projects sensible as alternatives. THOSE stocks are picking up too.

Eventually, you have to believe that what’s good for the energy sector is bad for the rest of economy—energy being a cost for the rest of us and not a source of income. But we haven’t reached the point yet where high petrol or gas prices are reducing business production or household consumption.

For bulk commodities and minerals, we reckon the land grab will rush on, moving from resource to resource and project to project. Our latest investigative project in the small cap letter…well we won’t give it away. It comes out later this week.

Gold has not been idle either. You’ll notice it appears to have completed its consolidation after the first charge to US$1,000. After regrouping, shaking out the weak hands, and giving the dollar its due, gold is on the march again.

Our friend Kevin was on CBS Marketwatch this morning telling the host that gold could reach US$1,300 or US$1,500 in “just a few months.” His original forecast was for a move to US$1,500 in twelve months. But the speculative money is moving fast, Kevin says, and that could drive the move more quickly than he expected.

The Masters of the World at Goldman Sachs repeated their claim that a ’super spike’ in the oil price could drive it to US$200, on the back of red-hot demand in the developing world and the “non-recession” in the U.S. Supply bottlenecks won’t help.

Take a look at the oil price chart below from Gabriel Andre.

What does it mean? Reading an oil price chart is not like reading a star chart. But it does require a little interpretation. Here’s ours: the increase in the oil price between 2001 and 2006 was a structural revaluation of oil’s value to the global economy. You had the Iraq war driving the geopolitical premium.

Since 2003, you’ve had production peaks/declines in large fields in Mexico and Russia, persistent disruptions to Nigerian production (Nigeria is the world’s eighth largest oil exporter at just over 2 million barrels per day, nearly half of which goes to the U.S.), and gradually increasing demand from emerging markets.

But what happened in 2006? The oil price chart shows that prior to 2006, the world had come to grips with the idea that the era of cheap oil was over. In May of 2006, commodities as an asset class suffered a large correction and investors worldwide reconsidered how long the resource boom would last.

It’s possible-although it would just be a guess-to attribute oil’s meteoric rise since early 2007 to rampant financial speculation. In a recent article, William Engdahl suggests that as much as 60% of the current oil price is speculation. On the other hand, a research note from Citigroup predicts oil prices of US$40/barrel within two years? Who’s right?

Frankly, the oil price is hostage to a number of variables, many of which are not quantifiable. A fear premium definitely exists. Then there is the declining U.S. dollar. And there is the matter of investors treating oil as an asset class and as a “safe-haven” from inflation. The creation of sector funds and ETFs correlated to the oil price has made this possible.

And now? Well, like iron ore and coal, the oil price indicates that the emergence of China and India as productive industrial economies with an emerging consumer class is a lot more resource intensive than any of us imagined.

The oil price chart above suggests there’s a bubble and that it has to correct soon. But by “correct” we mean oil between $95 and $105. In 2003, $40 became the new $20. In 2005, $60 became the new $40. And in 2008… $100 becomes the new $60.

Dan Denning
The Daily Reckoning Australia