Jennifer Yousfi explains how US gas prices could keep on rising…

If oil stays near $140 per barrel, gas prices could easily top $4.75 a gallon by the Fourth of July holiday, Mark Zandi, chief economist at Moody’s Economy.com (MCO), said in a recent research note.

And while the thought of gas at almost $5 per gallon is distressing enough, Money Morning’s Investment Director Keith Fitz-Gerald thinks gas prices could go even higher. In fact, U.S. motorists could easily be looking at $7 a gallon gasoline within just two years. And that could have a disastrous impact on the U.S. economy.

“The bottom line is that the effect on the economy is going to be a lot worse than anyone’s talking about right now,” said Fitz-Gerald, a longtime energy bull who recently boosted his oil-price projection to $225 a barrel. “The bottom line is this: Until someone develops a truly [interchangeable] alternative for oil and gasoline – something that works the same, costs the same and is just as effective – Americans are just going to have to face the fact that over time they’re going to pay more.”

By fixating on near-term prices, and near-term fallout, Fitz-Gerald says that investors and economists alike are missing the bigger point: Long-term – or at least until a true replacement for oil is found – the U.S. economy is going to be badly stung, and U.S. consumers who don’t take steps to protect themselves are looking at a markedly reduced standard of living.

Moody’s Economy.com’s Mark Zandi agrees.

“Unless oil prices soon recede and Washington changes its views and acts to shore up the housing market and broader economy, the outlook for 2009 will weaken further in coming months,” Zandi said.

Zandi added that the U.S. Federal Reserve “will sacrifice near-term growth for the sake of stable prices and the economy’s longer-term prospects” and that the high cost of oil will prevent any further interest rate cuts.

But don’t look for gas prices to move up in a straight line to $5, $6 and $7 a gallon, Fitz-Gerald says. Prices will continue to fluctuate. There will be rallies, and retrenchments, as is the case with the price of any commodity.

But prices will rise, as there is still no truly “fungible” – interchangeable – replacement for petroleum. That’s what’s needed, Fitz-Gerald says.

In the interim, investors should: be “long” on oil and other commodities; have alternative-energy-related investments; and look for profit plays in ancillary sectors, Fitz-Gerald says.

First, fuel. Crude oil reached US$119.41 on the NYMEX. That’s a nominal record. The latest big story is that British Petroleum shut down a key pipeline from the North Sea that carries nearly 40% of the U.K.’s daily oil output.

The company shut down the pipeline because of a strike at a refiner that supplies nearly one-tenth of Britain’s refined fuels. The strike at the Grangemouth refinery is important though, because the refinery also produces power that goes to a neighbouring facility which processes oil coming on land from at least 70 oil wells off shore in the North Sea.

A strike shuts down power. Power shuts down the refinery. And if the refinery ain’t refining, you don’t pump crude oil to it. It all makes perfect sense in its own way.

The strike at the refinery is a ‘finance’ issue. The employees apparently want better pensions. The company who runs the refinery, Ineos PLC, does not seem willing to oblige. The resulting impasse has led to 15 straight days of higher fuel prices for British motorists.

This little fuel crisis has nothing to do with an actual shortage of crude oil (though production from the North Sea is falling). It does show, however, how quickly a “system of systems” can be laid low by any interruption, man-made or otherwise. In the modern world, there’s a thin line between light, mobility, and abundance on the one hand, and darkness, immobility, and scarcity on the other hand.

For its part, oil is rising on both supply issues (in Nigeria), demand strength (everywhere), and dollar weakness (seemingly perpetual). On that score, some of oil’s 40% rise this year (and 20% in the last three weeks) is probably anticipation that the U.S. Federal Reserve will cut its target funds rate when it meets Tuesday in America.

We asked Friday if the Fed had reached the limits of effective monetary policy via interest rates. It’s kind of a Zen issue at this point, isn’t it? If a target rate is lowered but banks still won’t borrow or lend money, have rates really been cut?

The U.S. Fed, like the Reserve Bank here in Australia, finds itself helpless to control inflation in two key components that do not usually figure in ‘core inflation,’ food and fuel. Yet as you know, food and fuel prices are, indeed, rising.

For consumers at the margin, increases in food and fuel prices are very real factors on the household bottom line. They are not balanced by declines in the price of imported white goods and electronics. You can’t eat a dishwasher.

There is now a great deal of speculation in the press that the RBA should abandon its inflation targets. Pundits worry that the RBA will slam the economy into recession by raising rates to contain inflation that it can’t really contain anyway. Rate rises won’t contain price gains in food and fuel, they’ll just make houses more expensive, so the argument goes.

We don’t have an answer for the Bank here at the Old Hat Factory. In fact, we’re not even sure there IS a good answer. A decade of low interest rates has led to a surge in global growth (not least in population). That’s led to an increase in demand for real resources. Fiddling with the money supply may reduce investor’s appetites for speculation, but it is not going to make people in China and India less hungry.

The idea that fixing the price for money solves all economic woes is central to the Age of Finance. But maybe, along with the age of cheap oil, we’ve passed the peak of cheap money. Peak Finance!

“For the past three decades,” reports Justin Lahart in the Wall Street Journal, “finance has claimed a growing share of the U.S. stock market, profits and the overall economy. But the role of finance the businesses of borrowing, lending, investing and all the middlemen in between may be ebbing, a shift that would redefine the U.S. economy.”

We can only hope. The business of making money by moving money is nice work if you can get it a(especially during a bull market in credit). But it doesn’t really add economic value. Nothing real is produced, and obviously, the capital itself hasn’t been allocated more efficiently. Just ask investors in mortgage backed securities or bank and brokerage stocks that have taken billion in losses on bad loans.

The bubble in finance is popping just like the bubble in dot.com stocks popped. The deflating of the finance bubble has much bigger real world consequences, though. And in the stock market, the stocks that led the last bull market never lead the next one. We wouldn’t waste too much time picking through the rubble of the financial sector. Instead, you want to figure out what’s going to lead the market up next.

The trouble is, the market itself may not be headed up at all. That is, the indexes could move sideways or down, in real terms, over the next few years. Passively owning “the market” through an index fund will probably be a losing strategy. We reckon that the bear market in credit favors tangible assets.

We also reckon that investors who have outstanding investment returns will get them by focusing on asset quality, low debt levels, businesses with regular cash flow, and businesses that have a competitive advantage of some sort.

That all sounds pretty routine. And truly, there’s nothing revolutionary about it. But it’s amazing how many fund managers have been getting by on rising index values alone. Time to start working for your money again boys! Let’s hear it for good old fashioned securities analysis.

“Golden future emerges for precious metals,” reads a headline in today’s Financial Review. The fundamental appeal of gold as an inflation hedge still looks good.

Dan Denning
The Daily Reckoning Australia

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–Valuations are out the door for now. If small brokers that offered their clients leverage keep collapsing and liquidating their portfolios, you’d have to be a daredevil or playing with someone else’s money to be a buyer.

–It’s not that there’s no value in the market. It’s that there are so many sellers. The trouble is you just don’t know how much more forced selling there’s going to be. With so much stock being dumped on the market, it pays to be very discrete.

–A quick word about GE before we move on. GE is a world-class jet engine maker. It’s also a shameless money-lender.

–GE’s commercial finance business in Australia has a much higher profile than its business in the States, which goes under a different name altogether But the company’s dirty little secret is getting out: it’s really a financial company masquerading as an industrial.

–The company generated huge earnings during the credit boom as a commercial lender, not an industrial manufacturer. GE reported a double digit decline in first quarter earnings, and promptly blamed the whole thing on Bear Stearns. But if GE’s CEO Jeffrey Immelt were being candid with investors, he would admit that the problem isn’t with Bear Stearns, but in the performance of GE’s financial segments. Don’t take out word for it. Look below.

GE Summary of Operating Segments (unaudited)

Source: Edgar Online

–You can see that GE’s two big financial segments, Commercial Finance and GE Money, showed a twenty per cent and a nineteen per cent decline in profit in the first quarter, respectively. Earnings in the infrastructure business were actually up.

–GE used to be company that made money by making things. Now it’s a company that loses money by lending money. It’s a pretty good symbol for much of what’s wrong about American capitalism. The truth is, it should probably be two companies, not one.

–While the share market digests the news of collapsing brokers and falling financial profits, the grand poobahs of the world’s economy are wringing their hands in worry. What’s keeping them up at night? The three Fs, each its own kind of crisis: food, fuel, and finance.

–”The World Bank met on Sunday faced with a mounting food price crisis that has sparked deadly unrest in developing countries, underscoring the urgency of fighting hunger and poverty,” reports Channel News Asia.

–How urgent, you ask? The Prime Minister of Haiti was sent packing this weekend by crowds protesting soaring food and fuel prices. We don’t even know who the man is but reckon he won’t be the last public official to be ridden out of town on a rail before this current crisis is over (and it may not be any time soon).

–As usual, it’s the people at the margin (whether lending or with food) that are affected first when surplus turns to scarcity. Despite all the daily signs of abundance here in Australia, let us not forget that there are about four and half billion people on the planet who have little margin for error in their daily lives. If food prices go up, many of these people go hungry.

—World Bank President Robert Zoellick, doing his best impersonation of Franklin Delano Roosevelt, wants a “new deal” for global food programs. He’s asked richer nations to contribute US$500 million immediately to help get food to poorer nations.

–IMF President Dominique Strauss-Kahn was less pragmatic but more rhetorical. Wrapping up his organisation’s annual spring meeting, he said that, “Food prices, if they go on like they are doing today … the consequences will be terrible…Hundreds of thousands of people will be starving…As we know, learning from the past, those kinds of questions sometimes end in war.”

–People often talk about resource wars being a common feature of the coming century (or decade). But it’s usually oil and energy they’re talking about, not rice and wheat. Food is fuel for the body (we’ve been watching the Biggest Loser). If you don’t have access to cheap calories, what good is cheap fuel?