Coming Inflation Good for Commodities

By: Frank_Holmes

By Evan Smith and Brian Hicks - Higher inflation is coming. It’s impossible to predict exactly when it will arrive, but the trillions of dollars worth of new money injected into the global financial system make it inevitable.

The prospect of inflation will likely be one of the key drivers for the energy and commodities sectors over the medium term. Inflation will eat away at the dollar and other paper currencies, raising the value of tangible assets as a hedge. In this way, commodities are similar to gold.

The economic slowdown has reduced demand for oil and natural gas, but the supply-and-demand fundamentals are tightening rather than loosening. This is because supply has been declining at a greater rate than demand.

OPEC has cut its production by more than 2 million barrels per day, and its members have been surprisingly disciplined about not cheating on quotas. Hundreds of gas wells in Texas have been shut in and petroleum companies have slashed their capital budgets. This year’s spending on oil and gas exploration and development is expected to be down 20 percent from 2008.

The chart below shows world oil supply growth going back to 2005. This year, PIRA sees a slight increase from non-OPEC suppliers and a dramatic drop-off from OPEC in the first quarter. For the rest of the year, both producer groups are expected to be significantly negative.

It’s also important to point out that it is much cheaper and easier to cut supply than to bring that same supply back on line. Demand for commodities will likely be hastened by the trillions in stimulus spending by the United States, China, Europe and others. When that happens, there’s a good chance of a supply shortage.

China has been buying commodities at a record pace in an effort to secure future strategic supply. Many have speculated that the Chinese are opting to invest in commodities and other hard assets rather than continuing to invest their massive currency reserves in low-yielding U.S. Treasuries. This concept was originally introduced by the famed economist John Maynard Keynes in a system called the Bancor model, which touts the benefits of a world currency backed by a basket of commodities.

Here’s a comparison to give you an idea of the scale of supply constraints. Between 1975 and 1985, non-OPEC oil supply grew more than 30 percent. In the latest 5-year period, non-OPEC suppliers boosted their output by only 1.5 percent.

For copper, the bellwether industrial metal, it was expected several years ago that 7 million tons of new supply would come onto the market by now. Only a small fraction of that amount has actually materialized.

Banks are essentially being given free money, and so far most of it has been used to patch up their flimsy balance sheets. That stands to change soon—a number of the most damaged banks are reporting a profitable first quarter, so it’s reasonable to think that the banks will stop hoarding cash and increase their lending.

If the stimulus is successful in reviving the U.S. economy, the additional money in the system combined with rising consumer optimism will set the stage for an inflationary spike. It would be extremely difficult for the government to raise interest rates to counter inflation, particularly as we head into the mid-term elections.

And if the stimulus fails to achieve its goal, the government may well respond by printing even more money. The result would be to raise the risk of even greater inflation down the road, which would be a major negative for the dollar and make gold and commodities more attractive.

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Evan Smith and Brian Hicks are co-managers of the U.S. Global Investors Global Resources Fund (PSPFX). This week, they will be hosting an educational web presentation on the market for natural resources titled, “Commodities: Reasons to be a Bull When Everyone’s a Bear.”

Please consider carefully the fund's investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Gold funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The price of gold is subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 5% to 10% of your portfolio in gold or gold stocks. The following securities mentioned in the article were held by one or more of U.S. Global Investors family of funds as of 12-31-07 : streetTRACKS Gold Trust.

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