First of all, thatks Gail for an interesting and informative article! There is a lot to discuss here, probably more than can be digested in a short comment.

Some commodities such as metals (gold, platinum, copper and palladium)and energy have increased while those such as lumber and out-of-fashion metals such as zinc have swooned. What does this indicate? Why doesn't zinc get any love?

There are several basic questions about the current state of the economy that are still controvercial, such as:

- Are we experiencing inflation or deflation?

- Will there be growth or more recession?

- Will energy prices go up or down?

- What energy price level causes damage to the overall economy ... and ...

- What energy price level causes changes in behavior?

Even after two years of contraction there is no consensus about whether there is a background of inflation or deflation. Increase in some commodieties prices indicates inflation as investors (who have all the money, now) seek to swap devalueing currencies for assets that hold value over time such as gold.

Ordinarily, real estate would fall into this 'inflation hedge' category - and the central banks both here and abroad would also like this to happen - but massive overbuilding and the consequent narrowing of real estate's particular usefulness by the development process leaves real estate with a lot more room to fall in relative price. By particular usefulness I mean that a bit of real estate turned into a strip mall can only be easily used as a strip mall, not as a factory or a wheat field, for instance. This being the case and the large increases worldwide in unemployment must be taken together as deflationary.

- Are we experiencing inflation or deflation? ANSWER; Both.

One thing that has changed is how commodities such as oil relate to the overall cost structure of the economy as a whole. Not that long ago, the issue of energy production was one of maintaining profitable price levels - of managing very large surpluses. The strategy was to hold capacity off the market as was done in Iraq and Saudi Arabia during the late 1980s and early 1990s so that the cheaper oil did not cut into (national) energy company profits. Understand that the economic infrastructure we inherit has been built with exceptionally cheap inputs. Cheap energy is just one item at the foundation of the productivity pyramid. These inputs included near- free water, $10 oil, $.03 kiloatt/hour electricity, cheap farmland to develop, and cheap highway and utility construction costs, cheap 'tools' such as cars and trucks and free air and rivers and streams to dump the waste into. That paradigm ended in the late 1990's and from that point no energy source was held off the market except for margnal percentages such as are taking place with OPEC producers cutting production slightly to iron out price fluctuations. What defines capacity is the overall rate of depletion relative to the the discovery and exploitation of large fields such as those in Central Asia and off the coasts of Brazil and Cuba (?). The $64 trillion question is whether the new fields can provide sufficient oil to offet depletion. This fundamental and the second derivative relationship to overall demand is now the factor which determines not just a few of the relative price levels within the world's economies but most and soon all the relative price levels.

The last ten years or so are therefor a period providing entirely new ground rules that governments, banks, consumers and investors, worldwide are currently only becoming dimly aware of.

- Will there be growth or more recession? ANSWER; a longer and deeper recession. This suggests lower commodity prices ... but ain't necessarily so!

Another way to look at this is that previous dramatic oil price increases have had exogenous causes that removed spare capacity from the market - the 1973 Yom Kippur war, the Iranian revolution in 1979, the Iran - Iraq war from 1980- 1988, the Iraqi invasion of Kuwait in 1991, hurricanes in the Gulf of Mexico in 2005 and last year - the situation after 1998 with steadily rising prices culminating with a large and painful 'spike' has largely an endogenous cause. Increasing demand along with natural depletion - rather than politics or weather - has in effect removed spare capacity. Neither finance nor inflation increased capacity. While the mechanics of constrained supply v. depletion and increased demand are no news here, the surprise is that this fundamental has been priced by the market beginning over ten years ago.

As such this represents a sea- change or even a tectonic change; one which places us 'users' of the modern world squarely in the middle of a process that started a long time ago. In other words, the Peak Oil phenomenon is not something that can be considered later. It has already begun and the economic fallout has also begun. Experts have said that the peak will only be seen from a perspective looking into the past. Look at the rear- view. The economic peak is there ... in 1998.

From here out, the foundation of all other value relationships must rest on the energy supply/demand fundamental. Exogenous price inputs have not disappeared, these will be added on top of the fundamental. All the differences between currencies and between interest rates and between convenience rates will be piled on top of the energy fundamental.

Price trends are not continuous. Rising interest rates - triggered by rising energy prices - caused a breakdown in finance in 2003-2005. Commodity prices along with oil decoupled from other asset prices such as real estate or bonds. Energy prices spiked because investors looking to 'park' cash or trying to offset credit losses flooded into 'can't miss' commodities across the board. When prices became unsustainable both at the cash level - because of recession and bottoming demand - as well as at the exchanges level - because of government threats to curb speculation - commodity prices collapsed. Now, energy prices have returned to the mark that existed more or less in line before the 2008 spike.

- Will energy prices go up or down? ANSWER; In the long term and relative to everyhing else, energy will become more costly.

If the government had allowed the financial sector to fail and set about to reconstruct a replacement sector (presumeably one without the defects and corruption of the current sector) energy prices would probably reflect very small demand - the country and perhaps most of the world would be in a very deep and serious recession. In such a scenario, it would be realistic to consider that most demand would not increase until the new finance structre was up and running and legacy debts and insolvencies cleared away by bankruptcy. This probably wouldn't have taken place before 2011. In such a scenario, a re-thinking of the exponential growth model would cause demand for crude - worldwide? - to moderate, keeping the fundamental supply vs. demand influence on relative prices under restraint.

This choice was not made by ANY government or finance sector and vast sums of liquidity have been shoveled at finance in an attempt to keep it afloat. While the original shock of deflationary collapse held prices low for a brief period (and Brad DeLong has a model that indicated a certain momentum oscillator effect taking place) the basic supply v. demand relationship has recovered its fundamental position at the bottom of the economic productivity pyramid. Partly, this is because the OPEC producers did indeed make marginal cuts in production to keep prices from falling further than $35/bbl.

The average yearly price of oil after 2003 has been over $42 a barrel with some fluctuation. This represents a 'stairstep' increase of almost 100%, from slightly over/under $21 a barrel for the period from 1986 - 2002 with very low prices ending in 1998 to early 1999 (see below).

(EIA data)

(Graph modified by me)

The 'support level' indicates prices overall trending upward from the lowest price in 1998-99. This 'trend line' was not broken even during the sharp commodity sell- off in 2008. Since neither finance nor governments (or central banks) have changed their approach to managing the world economy, nor has finance increased capacity ... there is nothing to alter the fundamental, bottom- of- the- pyramid relationship of supply versus demand. This suggests a fairly long- termed 'Bull Market' for crude.

A lot has changed since the beginning of 2007. Credit formation in the finance sector has shifted to credit formation directly by central banks. Since the crisis began in 2007 the various central banks have cut interest rates, injected trillions of dollars,yen, yuan and euros into finance in an effort to keep finance and world economies from out and out collapse. Clearly this effort has worked in that the markets still appear to function - in a zombie sort of way. Previously, credit was leveraged from bank deposits (in any currency into the same currency or into derivatives or securities and thence into other currencies) and amplified by velocity. (See the 'Quantity Theory of Money') This has changed with the crisis.

With the current difficulties in banking there is small increase in credit by fractional reserve mechanisms and velocity is constrained. A reason for small velocity and low credit creation is because there is little public participation - no 'Boom' to buy into and few valuable assets to swap back and forth. What little attempts to create some velocity in both equity and the energy markets is done by large institutions, trading is done with central bank credit. A consequence of this economic 'stimulus' is inflating (as in inflation) prices of stocks and oil ... this market constrained inflation is added to and amplifies the supply v. demand fundamental. Oil prices have gone up and so have prices at the pump.

Prices will likely continue to increase as long as the central banks keep printing money. The short term end of price increases will be when the high energy costs bankrupt enough businesses to trigger the next round of deleveraging and deflation. This in turn will constrain demand and oil prices will dive. After a bottoming out, the relentless fundamental will take hold again and the cycle will repeat. It will continue to repeat until everyone is clear on the fundamental relationship and steps are taken ... or until all businesses in the country have shut down.

- What energy price level causes damage to the overall economy ... and ...

- What energy price level causes changes in behavior? ANSWER; This remains to be seen but it probably isn't all that high.

What makes this final set of questions so hard to answer is that damage energy prices do to the economy lies at the economic margins rather than at more visible levels. People look at pump prices and say, "$2.30 a gallon, that's not so expensive!" Such a price may not effect individual consumers that much but similar price increases embedded at every step of the product supply chain amplify increases at other links. The cumulative effect makes products either unprofitable or unaffordable.

Loss of profits ->
Business failures ->
Increased unemployment ->
Cuts in consumer spending ...

Business profits are spent on petroleum. Petroleum prices shoulder aside investment needs. Speculative investment 'opportunities' are created to replace ordinary productive business rendered less- or unprofitable by increased input prices. That is, financial 'Home Runs' are sought to offest increasing unprofitablity elsewhere. The effests ricochet overseas. This is what is being seen currently despite massive stimulus and monetary easing; widespread business failures, high and increasing prices for some goods such as food, fertilizer and hardware, and large and widespread unemployment against a background of almost desperate financial speculation! Prices can decline over shorter terms because of deflationary episoces and temporary overcapacity ... but the long term trend appears to be UP.

Welcome to Peak Oil ... 1998!