The inflation picture is starting to look downright ugly -- the rate is not only high, but it is accelerating at a frightening pace.  This morning it was announced that the CPI [core price inflation] rose 1.1% in the month of June, up sharply from 0.6% in May and 0.2% in April.  Put another way, if June's increase were annualized (just for illustration, I doubt we will see this rate of inflation for 12 straight months), inflation would be running at 14.0%, a rate most commonly associated with WIN buttons, leisure suits and disco. 

Stretching it out to an annualized rate over the last three months, we are looking at inflation of 7.9%, and over the last 12 months it is rising at 5.0%.  We have not seen these rates of inflation in a long, long time.  The one-month increase is the biggest since Sept. 2005 and the effects of Hurricanes Katrina and Rita.  Before that one has to go back to 1982 to find a higher one-month jump in prices. 

The year over year increase is the largest since May of 1991.  Energy was the primary culprit, just as it was back in the high inflation days of the 1970's.  For the month, it was up 6.6%, which, if annualized (115%) would start to sound something like Peru in the 1980's or Germany in the 1920's.  The three-month annualized increase for energy is 53.6%, and over the last 12 months it is 24.7%. 

Food is also a big problem, with prices up 0.8% for the month (10.0% annualized), at a 8.5% rate over the last three months and up 5.3% over the last year.  So-called 'core inflation' is in better shape, but even there it is higher than it is comfortable, up 0.3% for the month (3.7% annualized), 2.5% over three months and 2.4% over the last year.

If one looks further up the pipeline, things get even more scary.  Yesterday the Producer Price Index (PPI) was released.  At the finished goods level it was up 1.8% (23.9% annualized) for the month of June, up 14.1% annualized over the last three months and 9.2% over the last year.  The prices for intermediate goods were up 2.1% for June, and have been rising at an 26.8% rate over the last three months.

Despite these levels of inflation, yields for the whole treasury curve remain quite low, with the three month T-bill yielding only 1.31%, the two-year note at 2.42% and even the 10-year note at 3.92%.  Clearly this is due to a flight to safety trade, not because anyone could rationally think that their money will be worth more in real terms including the interest at maturity than it is today.  They are currently certificates of confiscation, but they confiscate wealth at a slower rate than do the Federal Reserve Notes in your pocket. 

While the sharp drop in Energy prices over the last two days might provide some hope of inflation leveling off in the future, it smells to me to be just another short-term correction in the price of oil, not the start of a sustained downtrend.  For the most part, the world economy has held up pretty well so far, and with it demand for oil. 

The supply response to higher oil prices has been so slow that it is clear that there are major long-term problems in raising supply to meet growing demand, and the only way to get the market to clear is for the price of oil to rise far enough to choke demand down.  The oil we do find is harder to drill, which requires more oil service intensity and more expensive rigs to drill. 

The price of oil has risen relative to just about everything else.  While the Energy stocks have far out-performed the market, they are not up anywhere near as much as the price of oil or as much as their earnings have risen. 

We have seen a bit of a pull-back in the names with this dip in oil prices.  I would take advantage of it.  My favorite way to play the rising cost of energy is through the offshore drillers and some of the oil service names.  These would include Diamond Offshore (DO), Transocean (RIG), National Oilwell Varco (NOV) and Baker Hughes (BHI).  The E&P companies would be next on my list and some names to consider would be Chesapeake (CHK), Cabot (COG) and Anadarko (APC) among the larger-cap names.  Some very interesting smaller names are Double Eagle (DBLE), Warren Resources (WRES) and Petroleum Development (PETD).