There are a lot of very big questions facing investors right now. Where are oil prices, inflation expectations, interest rates, and the dollar headed? How will the direction of each of those factors impact economic growth and the financial markets? Needless to say, they are all interrelated, could break either way, and bear close monitoring.

Perhaps the issue getting the most attention at present is the price of crude oil. The price of a barrel of crude oil got close to $60 in March, although it is trading around $55 in early April as I write this. Prices are up over 25% in 2005 so far, and this is after gains of 80%+ in 2004.

Energy prices are the leading reason why the broad-based commodity indices just had their sharpest quarterly increase in prices since 1988 and are now trading at multi-decade highs. Oil prices are also generating the most headlines and the most nervousness among investors. As a result, much of the price action in the markets at present is being driven by the outlook for oil.

$105 Oil?
One such recent headline involved a report by Goldman Sachs analyst Arjun Marti. In the report, he predicted a "super spike" period in which oil can range from $50 to $105 a barrel. While the article raised some good points, it is interesting to note how many headlines only focused on the higher number in his predicted range.

Demand Should Continue To Grow
The factors for higher energy prices are well documented, but a review could still be useful. First, global demand has been on a steady rise in recent years as the world economy continues to rebound nicely from the last recession. In particular, emerging economies, specifically China, have seen sharp spikes in their appetites for such basic commodities. I know it seems like we have been hearing stories about the potential impact on the global economy from China's development for years, but it may finally be here. While we recognize that their growth won't be a straight shot to the moon, it is undeniable that China's appetite for energy will continue to grow. One interesting fact that highlights this point: today China has 20 million cars; in 15 years they are expected to have between 120 million and 145 million.

While Supply Growth Is Limited At Best
Supply is, of course, the other part of the equation and the news isn’t good there either. At this point, supply simply cannot keep up with demand. Not only is there not enough oil on hand at present, but given the lack of investment in exploration and drilling in recent years, it's unlikely we will see supply overtake demand in the near future. Yet another troubling factor in the supply chain is the unstable geopolitical situation in many of the leading oil-exporting countries. While OPEC may have the ability to modestly raise production from current levels, it's not difficult to envision various scenarios arising that could result in diminished production levels by even greater amounts.

One item that is probably not as large a factor as many suspect is the involvement of hedge funds. Undoubtedly hedge funds have been attracted to the increased volume and volatility in the energy markets, and their activities are most likely amplifying that volatility. However, in the end, supply and demand factors will determine where oil prices ultimately go.

All else being equal, the rise in energy prices is obviously not a positive for the economy. Higher energy prices can impact economic activity in several ways. First, overall consumer demand will ultimately be reduced as higher energy costs “crowd out” other spending. Second, higher energy prices can lead to higher inflation expectations, which in turn would cause an increase in interest rates. And higher interest rates, again all else being equal, are not positive for the economy or the markets.

However, it could be argued that there are some potential longer-term societal benefits. Sustained high oil prices should encourage the use and further development of alternative fuel sources. It should lead to a new drive for energy efficiency. At minimum, higher prices would reduce the demand for oil itself and would buy some time for energy companies to develop new supplies.

Commodities Tend To Move In Long Cycles

As shown in the chart above, commodities tend to move in long cycles of performance. Commodity futures went essentially nowhere for 15 years (1957-1971); then moved sharply higher for 9 years (1972-1980); then trended down (with a lot of volatility) for the next 21 years (1981-2001). The most recent move upwards is just two+ years old having begun in 2002.

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What Should Investors Do?
In light of all these factors, maintaining exposure to natural resources still makes sense for most client portfolios. That said, given the strong price increases of the last quarter, we are not eager to increase energy positions at present. As with all volatile asset classes and economic sectors, total returns don't follow straight lines, but instead accumulate over long — and often quite volatile — time periods. We are wary of a retracement of recent gains, which would be a natural market reaction.

Much as "buying on dips" was a reasonable approach for the general stock market in recent years, we believe that increasing exposure to natural resources during periods of relative weakness will prove to be a sound strategy in the coming few years. As shown in the chart on the previous page, commodity prices tend to move in fairly long cycles, so even with their strong gains of the past 24+ months, we could still be only in the relatively early innings of this game.

As always, I thank you again for your confidence in us. If you have any questions, please do not hesitate to contact your Account Executive or any one of our staff.

Sincerely,