Oil continues to gain ground, spurred by ongoing supply concerns and expectations of continued strong global demand. Rebel attacks over the weekend in Nigeria further disrupted exports from Africa's biggest supplier of crude.

Iran has stated that it would reject any new incentives offered by the west, contingent on the suspension of its nuclear program. Iran is OPEC's second largest producer of oil and heightened geopolitical tensions surrounding its uranium enrichment efforts have set the stage for a showdown with the West, and in particular the US.

Iran claims that its nuclear program is focused on the peaceful generation of electrical power, while the West maintains there is significant evidence that Iran is seeking to enrich uranium to create a nuclear weapon.

Further economic sanctions against Iran could lead to a retaliatory reduction or cessation of oil exports, which would drive prices sharply higher. Any preemptive strike against Iranian nuclear facilities would have the same effect.

Goldman Sach's analysts have projected that oil could reach $150 to $200 per barrel in the next 6-24 months. This analysis echoes a similar outlook made by OPEC last week and is a contributing factor in the recent run-up.

Historically, oil and gold have a very tight positive correlation due to gold's use as a hedge against energy based inflation. The gold/oil ratio tends to run in the 10-15 range and it is currently closer to 7.

The divergence of oil and gold prices in recent weeks has generated an excellent buying opportunity, as we would anticipate the ratio to move back into the normal range over time. If oil does indeed push on to $150/brl and the ratio returns to 10, that projects gold to $1,500/oz.

It is also worth noting that gold mining is a very energy intensive industry. As the cost of mining gold, and other metals increases, the selling price will have to increase as well to maintain present margins.

Gold is also the classic hedge against broader inflation and I don't believe we've even really begun to experience the full inflationary impact of $120+ oil.

Fuel prices are a big part of that equation. With the prospect of gasoline reaching $4/gal in the US later this summer, fuel is going to be an ever increasing portion of consumer budgets.

Food prices have been surging recently as well due in part to the increasing costs of harvesting and transportation. Biofuel initiatives have also played a significant role in driving up grain prices. Higher grain prices in turn result in higher costs for feeding livestock, driving up the price of meat as well.

Fertilizer prices have soared as well, further adding to the inflationary spiral. Nitrogen based fertilizers are synthesized using a process that generates ammonia. 3%-5% of global natural gas production is used in this process.

While natural gas prices have been increasing at a more moderate pace than those of oil, demand for nitrogen based fertilizers has soared as farmers around the world seek to increase the yield of their land.

With an ever increasing percentage of the household budget dedicated to fueling the family and the family car, less money is available to make other types of purchases. This relationship is amplified as families hold-off on discretionary purchases in anticipation of further increases in the prices of necessities.

With fully 70% of US GDP dependent on consumption, the implications for the economy are dire. This is especially true if we enter into a period of stagflation, where prices continue to rise, despite a slowing economy. This is a significant contributing factor to our skepticism about the sustainability of recent gains in the stock market.

A faltering stock market and slowing economy will send the Fed back into action, further reducing interest rates and pumping additional liquidity into the market. Such actions will further debase the dollar and put additional upward pressure on prices.

As the inflationary outlook worsens, investors will increasingly turn to gold as a means to preserve what they've earned.

If equities do in fact go back on the defensive, gold will continue to benefit from reallocation flows. When investors take money out of the stock market, historically they have either gone to cash or bought treasuries. With available yields well below the rate of inflation, neither is a particular attractive option these days. We believe that a large percentage of the outflows from stocks are going to find a home in gold.

Gold Market Movers:

Results of 05-May TAF auction of $75 bln in 28-day funds: Cover ratio 1.29. Stop out rate 2.22%.

Eurozone PPI for Mar surges to 5.7%.

UK services PMI for Apr hits a 5-year low of 50.4, well below market expectations.

Oil hits record $122 on $200 oil prediction, supply concerns

Metals surge as rationing cuts power at biggest mines

Bernanke: High foreclosure rates hurt broad economy

Fannie Mae to raise $6 billion in capital after loss

UBS seen slashing jobs with big Q1 loss

UBS to sell subprime mortgage debt to BlackRock at a 25% discount.