Yesterday, we mentioned the oil market. Today, we slide in deeper.

You’ll recall, dear reader, some time ago we guessed that the feds’ efforts to keep consumers consuming were essentially inflationary…and that the inflation they caused would tend to go more into gold and oil than into economic growth or asset prices.

Since then, the price of oil has shot up over $100. Yesterday, it hit a new record at over $126, before falling back to $124. Gold, meanwhile, has traded above $1,000 – and now is correcting in the mid-800s.

This is already a major adjustment. It comes along with a major adjustment in the purchasing power of the dollar, generally. Americans’ global purchasing power has been cut in half. The value of their assets – on the world market – are only half what they were during the Clinton years. And the value of their most precious asset – their time – has also been greatly reduced.

This is why you see so many Europeans in the United States…America is a cheap place to visit. It’s also why U.S. export industries are reviving; the country has become a low-cost producer for many things; it is now a place where richer nations can consider outsource production.

All of this has gone almost ‘according to plan’ – that is, it is pretty much what we guessed would happen.

But now, we have to ask: are these adjustments enough?

You’re expecting us to say ‘no,’ aren’t you? Instead, our answer is ‘maybe.’

In the case of America’s 50% pay cut, (the U.S. dollar is only worth about half as much as it was compared to other major currencies) we think it should do the trick. Now comes a long period in which people come to realize it and begin living not quite as large as before. They lose their houses. They cut back on their spending. They relearn an old word – thrift – and find they like it. They downsize their lives – with smaller houses, smaller cars, and littler expectations. The economy goes into a long slump – as 70 million people, facing retirement, begin to save money.

In the case of gold, our guess is “probably not.” Gold has still not come near the inflation-adjusted peak it set 28 years ago. Considering all that has happened during those years, we bet that there is another peak to come – even higher than the last. In 1980, the United States still had the residual financial integrity to stand up to inflation. Paul Volcker could push the yield on the 10-year Treasury note up to 16%; he caused a recession, but not a revolution. Most importantly, he protected the dollar. We don’t see any Volcker around now…and we don’t see how anyone – even Paul Volcker himself – could “pull a Volcker” now.

The country has twice as much debt per person. It has a hugely negative current account. It has the biggest government deficit ever (think what would happen to it in a real recession…the deficit would go to $1 trillion). No, we don’t think gold is in danger of a sudden attack of monetary propriety. Instead, we think the gold bull market has much further to go – probably above $2,500 an ounce, before the dollar-based financial system collapses completely.

Agree or disagree, dear reader…but you’ll want to take advantage of this dip in the gold price. Pad your portfolio with the yellow metal – for just one penny per ounce. You can beat that. Find out how here.

But it is oil we set out to reckon with today. And what we reckon is that oil is getting close to its near term peak. If we were holding major positions in oil, we would sell them.

Here’s why. While gold is nowhere near its record high – oil is above it. In today’s money, the top price ever paid for a barrel of oil, until recently, was only about $79. Today, oil seems to be headed to twice that level. And a few experts think it will go much higher. Goldman’s oil expert predicts $200 oil.

But why should it go so high? For all the talk about China’s insatiable demand, it is still true that prices and demand must worth themselves out. When the price goes up, people grumble…but they use less. We filled our tank in France last weekend. The total price came to more than $150. We had been thinking about driving down to the South of France next weekend. Instead, maybe we’ll take the train…the trip would have cost us more than $300 in gasoline alone.

Everything happens at the margin, said a dead economist. Americans alone probably drive millions of marginal miles – to places they really don’t really need to go…when they don’t really have to be there. At over $3.50 – they’ll drive less. Already, the Financial Times reports that U.S. demand is falling more than expected.

There’s so much shifting sand in the oil market – usage, new discoveries, distilling capacity, storage facilities, OPEC policy, inflation, drilling technology, emerging market developments, the dollar, U.S. economic growth – its impossible to know how big the dunes will get. But oil demand – and prices – should generally stay in line with GDP. The more growth, the more oil. Plus, if you measure GDP and oil in dollars you eliminate both inflation and currency depreciation as variables. Well, at $100, reports Martin Wolf in the Financial Times, “the annual value of world oil output would be close to $3,000 bn. That is 5% of world gross product. The only previous years in which it was higher than that were 1979 to 1982.”

Those were not good years to enter the oil business. The price subsequently collapsed.

Yes, you could make a lot of money in oil…many people already have. But sure as fleas come with stray cats, success leads to excess. As the price rises, more and more people imagine that it will keep going up. Some take measures to avoid using it. Some find substitutes. Some increase production. Markets still work, in other words. Every bubble eventually finds its pin. The day can’t be too far off when the price of oil will fall back under $100.

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Source: Oil’s Adjustment