I think it is coming. In fact, in many ways, it’s already here, just not yet widely recognized. The deflationists still hold sway in the bond market, where investors happily accept puny yields.

The deflationists argue that the dollar will buy more tomorrow than it does today. It is inflation’s opposite. When most people talk about inflation and deflation, this is what they mean. This definition would pain the old economists who were more careful in their use of language.

Be that as it may, deflation today is an argument facing death by a thousand cuts. Every day, evidence rolls showing that the dollar is buying less. Today’s Wall Street Journal points to the whale in the aquarium. One headline reads, “From Cereal to Helicopters, Commodity Costs Exert Pressure.”

The article goes on to point out what is painfully obvious to anyone who follows commodities and companies. The cost of nearly everything is going up.

General Mills will boost the price of a quarter of its cereals to reflect rising prices for grains. Kraft is raising prices. Domino’s Pizza hasn’t said it will yet, but it did say the price of cheese is up 29% from a year ago. Profit margins are suffering in the meantime.

There is a long list of companies battling rising costs of the commodities. As the Journal notes:

“Corn is up 44%, milk is up 6.5%, hot rolled coil steel is up 4%, copper is up 29% and oil is up 14% from a year ago… Across Corporate America, more companies are wrestling with when and how much to raise prices as raw materials costs climb.”

Still, the Journal’s article had no discernible effect on the optimistic bondholders. (Or I should I write “bag holders”? For soon, they will be left holding the bag.) The bond market seemed bored and yields inched up just a touch today, such that the 10-year note pays a whopping 2.506%.

By the time the bond market says inflation is here, it will be too late — too late for bondholders.

In the meantime, the prices of gold and silver are up too. All of these things point to the obvious: The dollar is buying less.

Why?

Let us the count the ways. There is the U.S. government bleeding red ink and heavily in debt. Both portend bad things ahead. How will they square the circle? The easiest — and the most politically expedient — way is to print more money.

There is the jawboning going between central banks of the world all trying to cheapen their currencies. The rationale is to stimulate exports, but don’t be fooled. The real effect of a cheapened currency is that your dollar will buy less.

There are kinds of fancy names for what the Fed is doing — “quantitative easing” comes to mind. But at bottom, they all mean the Fed will create more money.

I was at Grant’s Fall Conference in NYC this week. Jim Grant, the host and editor of the excellent newsletter Grant’s Interest Rate Observer, said: “Don’t you sometimes get the feeling that the economists are pulling our leg? A bartender would call it watering the whiskey.”

That is a good way to think about it. More dollar printing simply dilutes the buying power of all dollars. And so we see today the beginnings, the mere sprouts, of a fully fledged inflation. It can and will get much worse.

Don’t pay attention to that thing called the Consumer Price Index, or CPI. It is running at about 2%. It is an engineered figure and not to be trusted. Oskar Morgenstern, who along with John von Neumann contributed so much to game theory, once described it as a “mere index of doubtful validity,” as Grant relayed.

Nonetheless, on the basis of this suspect fluff, the Fed tells us inflation is under control. In fact, it is complaining that the inflation rate may be too low. As Grant quipped, “That’s like the New York Police Department complaining about the lack of crimes.”

Bernanke would have us believe the Fed can calibrate inflation within tolerances of 100 basis points. But it way overestimates its powers. Once the inflation train gets going, it will be very hard to slow down. One day, the Fed will wish inflation were only 2%.

Regards,
Chris Mayer
Whiskey & Gunpowder

October 29, 2010

Inflation Is Already Here with Lots More to Come was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But with all the artificial stimulus money floating around, you can never be sure of what you see. Is this a real recovery or is it an artificially ripened tomato, and hence an imposter? When the stimulus money stops flowing will the recession get worse?

It’s hard to say, but let me give you a couple examples of distortions…

CNN’s bailout tracker reports that US government stimulus has totaled $2.8 trillion so far this year, with another $8.2 trillion in commitments. Most of this money has gone to the financial sector. Some of it has gone to infrastructure projects and to consumers (cash for clunkers, for example).

That is a lot of money. It is hard to say how all of this spending has artificially boosted economic activity in some sectors of the economy. It is obvious that such spending cannot continue indefinitely.

This has also been a worldwide phenomenon. There isn’t an economy of size that does not have some stimulus-spending program in place. Governments are spending money they don’t have. The result is widening budget deficits and higher debt levels.

First up, take a look this graph, from the Economist, which shows the industrial production of emerging Asia compared to the United States.

Looks like Asia is recovering pretty well. That chart shows the “decoupling” that became such a hot topic of discussion last year. The idea was that the emerging markets would not necessarily follow lockstep with the Western countries.

But this graph only tells a part of the story. China is one of the countries in “Emerging Asia.” China supposedly grew in the first quarter at an annualized rate of 15%. Yet, the government also spent a lot of stimulus money. As Eric Sprott writes in his latest letter to shareholders:

“The Chinese have injected a stimulus equivalent to 64% of their first half 2008 GDP in the first half of 2009… The Chinese government has effectively spent and lent enough in six months to buy 122 Ford Class aircraft carriers at US$8.1 billion a piece. It is akin to the US government injecting (and US banks lending) almost $4.5 trillion USD to its citizens and businesses before July 2009…an ungodly sum that would impact every asset class under the sun. Is it any wonder then that the Shanghai stock exchange has more than doubled from trough to peak since its November lows?”

Let me remind you that GDP is a clumsy way to get at an economy’s size. It is a figure that includes government spending. So, put another way, stimulus money this year is about 64% of the recorded economic activity in the first half of last year for China.

Where the Money is Going — Commodities

In some ways, the Chinese government spent well — investing in the commodities it craves. It’s locked down oil and gas assets, iron ore contracts, interests in rare earths and more. It’s put up power plants and laid down roads and pipelines. It’s made long-term investments in Africa and Brazil. Some of that will pay dividends down the road, if not already.

For instance, in the first six months of this year China became Brazil’s single largest export market. That’s the first time that’s ever happened. The Chinese and Brazilians are doing deals. For instance, China will lend $10 billion to Petrobras in return for 200,000 barrels of oil per day. China, in fact, has been active throughout South America, investing billions in mines, refineries, ports, and railroads.

These shifting patterns of trade always fascinate me. And we are living in an era of great change on that front, as new patterns emerge on a scale we have never seen.

It’s clear that China will have enormous needs for commodities over time. In the short-term, we are surely seeing distortions from the stimulus money. But the long-term demand is there nonetheless and the Chinese have a lot of money to spend.

Global Infrastructure is Still Getting Older Everywhere

In fact, infrastructure needs — especially in the areas of water and energy — are becoming more of a headline issue than ever. Not a week goes by where I don’t pick up a handful of stories of infrastructure falling apart somewhere. This, too, is a global story.

This week, for instance, there was a terrible accident in a Russian hydropower plant. Eleven people were killed and 65 were missing after water burst into a turbine room. It also destroyed the turbine. Besides the irremediable loss of life, it will take hundreds of millions of dollars and years to repair the demand.

As the FT reported, the accident “was a powerful reminder of Russia’s dire need for hundreds of billions of roubles in investment in its crumbling Soviet-era infrastructure.”

Putin’s government put aside $200 billion for infrastructure in two oil windfall funds, but that money is already being tapped for social spending programs and to help make up budget deficits. As in many places, including in the U.S., money set aside for infrastructure has been essentially hijacked by the political process and diverted to other uses.

Another story this week comes from Britain. Britain faces huge deficits in energy and the risk of widespread blackouts. Its energy complex is old and strained. The Economist reports: “The nuclear stations are simply too old to carry on: most are over a quarter of a century old. Around half have already been shutdown and are being decommissioned.”

About half of its electricity comes from natural gas, a legacy of its North Sea riches. But the North Sea peaked in 1999 and has been in steep decline ever since. Britain’s coal plants struggle under new pollution control rules and the effects of age. It’s an ugly situation that will cost a lot of money to fix.

The positive for investors is that there are several firms that are right in the sweet spot of this global infrastructure crisis. We own a few.

Regards,
Chris Mayer

August 25, 2009

The Effects of Epic Stimulus was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

If we were using numbers instead of metaphors, we’d say the CRB Reuters/Jeffries Index had its biggest monthly rally in 34 years. It was up 14% on the month. That was the best performance since July of 1974.

A monthly performance like that can only mean one thing. We’re just not sure what one thing it is. It could mean commodities have rebounded from being oversold, as they were in late 2008. It could mean that markets are less pessimistic about the global economy than your editor at the Old Hat Factory (though we doubt that).

It could also mean that investors increasingly prefer tangible assets as a long-term growth strategy over financial assets. Even after $1.465 trillion in realized losses by global banks and financial institutions, there are trillions more to come. Commercial real estate…the option-ARM recast period in the U.S. housing market…European banks…any or all of these things could conspire to lead to more losses and more capital raisings in the financial sector.

Perhaps that is what explains crude oil’s biggest monthly gain in a decade. July crude futures traded at $66.52 in Friday’s New York action. The U.S. dollar price of gold powered to $981.20, before sliding back a bit $975.

The Aussie gold price is fighting its way up despite the fact that the Aussie dollar keeps gaining on the greenback. While the Aussie gold price is up just $1.71 in the last 30 days (0.14%), the U.S. gold price is up nearly nine percent. We reckon the Aussie gold price will begin moving up closer to $1,500 again on a combination of events (weakness against the greenback for one.)

There are also two data releases this week that will affect the Aussie dollar. The RBA meets today to decide the price of money in Australia (set interest rates). And then Wednesday, the March quarter GDP figures come out. This will tell us how bad the recession is, although not how bad it may become.

It’s no use predicting these things, but for what it’s worth, our view is that we’re in a bit of a plateau between down moves. The “down moves” will come again in financial stocks, although they may not be as “down” as before, and employment. Mostly, the indices are going to have to price in very slow GDP growth for the remainder of the year and more job losses.

The wildcard for Australia is trade. Its proximity to Asia means that a rebound in that part of the world provides some cushion to resource companies. But then, we thought the resource stocks would be pretty well insulated from the first round of deleveraging too, and we were wrong about that. And the second time around?

Well, even if the long-term underlying demand for Aussie resources is real and growing, it still takes real money to make new projects happen. The financing of resource projects will continue to be a key issue in your stock selection. The other issue, obviously, is the direction of commodity prices.

Take LNG, for example. Last year the Australian Petroleum Production and Exploration Association said it wanted to triple Australia’s LNG output to sixty million tons per year. Meeting this weekend in Darwin, the group says 50 million is a more realistic target, given both the slump in energy prices and tight credit markets.

If LNG prices track oil prices-as they did in the big run up to $150 per barrel for crude-the economics of big Aussie projects get a lot better. Our view is that energy prices are going structurally higher anyway. Global recession aside, the big plunge in energy capital spending virtually guarantees a supply shortage in the coming years anyway.

Besides, you have to wonder why big international energy firms would be investing in conventional and unconventional Australian LNG projects if they weren’t convinced that a) oil prices were going higher, or b) more carbon-friendly fuels like gas would gain as coal gets politically demonized and punished with cap-and-trade or emissions-trading-schemes.

Obviously, if global trade continues to contract and a second round of losses in the global banking industry triggers another financial crisis, demand for energy is going to fall. And while we’re at it, stocks would probably test the 2003 lows too. We enter a new stage of grimness.

In the meantime, energy and precious metals stocks are riding higher commodity prices. And there’s a distinctly 2007 mind-set in the air. It’s vogue to be long-commodities and indifferent to risks in the financial system. It’s enough to make an investor with a short memory nervous.

Regards,
Dan Denning
Daily Reckoning Australia

June 2, 2009

What Are Commodities Saying About the Financial Crisis? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

I just want to sing my little song,” plot my stock charts, love my great sailor, play in my greenhouses, buy gold no matter what the economy is doing, and be the happiest sweet little old lady in the whole USA.

Unfortunately, (1) in order to stay as wealthy as I want to be (a leisurely, joyous life seeking knowledge is true wealth, not the Sultan of Bahrain’s vault) by reading runes, I have to live in a free country with a free market that is able to function without hindrance from the government, a reasonable desire Mr. Obama is frustrating, and (2) Executive Order 10-998, dating back to JFK, concerns all of us.

The exact language is of EO 10-998, which allows federal control of “all food resources” is:

“‘Food resources’ means all commodities and products, simple, mixed or compound, or complements to such commodities or products, that are capable of being eaten or drunk, by either human beings or animals’ (sic) irrespective of other uses to which such commodities or products may be put, at all stages of processing from the raw commodity to the products thereof in vendible form for human or animal consumption. For the purposes of this order the term ‘food resources’ shall also include all starches, sugars, vegetable and animal fats and oils, cotton, tobacco, wool, mohair, hemp, flax fiber, and naval stores, but shall not include any such material after it loses its identity as an agricultural commodity or agricultural product.” (Naval stores traditionally include lumber, timber, tar, turpentine, paint, and rope.  In modern naval provisions that could cover almost anything.)

10-998 authorizes the confiscation of everything edible and much that is not, including our stores of flour and un-ground wheat, the beef in your freezer and that I have on the hoof…what is in your pantry and your garden…my chickens and Mr. Sanderson’s, and perhaps our little dogs to feed visiting Chinese.  That EO lays claim to a friend’s vast wheat and corn harvests, cattle feed, and your small daughter’s night-night snack.  Alcohol is a form of grain, so you can’t even count on having a little tot of whiskey if locusts in full battle gear clean you out.

In a world of rising demand and costs Liberals are doing everything possible to lower food production.  Very severe restrictions on small farms are popping up; 100 pages strangling small milk producers is in the Texas legislature and a similar measure is going before Congress.  It will be practically impossible for anyone without megabucks to stay in business, because without a Grade A Diary license the proposed regulations expressly forbid even giving milk away, as well as transporting it privately, on pain of fines and even jail time!  Milk:  the new contraband.

Farmers’ markets are under attack, and if they deny us those there are no markets left.  Small farms cannot begin to meet the needs of large grocery stores, certainly not year around.

Produce can only be labeled “home grown,” not “organic,” a term that has been redefined from what most of us think it means to restrictions that only agribusiness can meet.  Add that to the whack the big boys are getting from losing subsidies they have long regarded as “income,” and a flier in commodities could be a pretty good bet for those who can’t stand being out of the market, and emulating the Mormons in accumulating a year’s supply of food seems like an excellent idea.  If you can hide it.

We have to survive in the world that is and the one we can forecast, and then we can concentrate again on excelling at picking stocks and buy and sell points.  Survival first is why we keep talking about a very deep depression and “peak food.”

It wouldn’t matter how much your portfolio were worth if the grocer’s shelves were bare and armed men had taken your last cans of asparagus and foie gras.  Maybe the colonists didn’t know when they were well off; troops quartered in my house would have a vested interest in preserving the larder.

Sincerely,
Linda Brady Traynham

March 20, 2009

Executive Order 10-988 was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The first half of the year saw ALL-TIME HIGHS in gold, crude, wheat, unleaded gas, copper, corn and soybeans. But as they say, what goes up must come down, and the force with which commodities fell from the sky was rather amazing.

At any rate, I believe there are great things in store again for 2009 — the entire world concentrating on global economic problems and messing with natural market forces could create a lot of unintended consequences. And commodity traders should be able to take advantage.

The dollar has recently strengthened with negative numbers out of Europe, but the economic stimulus package details dwarf any short-term data. Remember, money will be spent like never before in American history.

The strategy is to rebuild infrastructure and create 25,000-50,000 jobs for every billion dollars spent by the government. The connection couldn’t be more obvious. Construction of bridges, dams and roads and improvement of decaying schools and other government buildings get back to the basics of supply and demand.

It all comes back to commodities, with depressed steel and copper leading the way.

Hidden Inflation

Sometimes, we get inflation that you don’t see. It just sneaks up on you when you aren’t looking and just trying to start you day with the usual bowl of oat wheat sugar flakes cereal and, “Hey, either my hands have grown larger or this box is thinner than just a few weeks ago!”

This downsizing of packages is one way for food manufacturers to avoid raising prices. At first, it was to offset higher fuel and commodity prices, but now it has turned into profit growth — with 10 less potato/potatoe chips in my bag.

The indented bottom of a Skippy peanut butter jar got more indented, turning an 18-ounce jar into a 16.3-ounce one. Ice cream containers shrank by one-quarter of a quart. And for breakfast, a jug of Tropicana orange juice got 7 ounces lighter, while that box of Froot Loops lost more than 2 ounces.

According to recent analysis by Nielsen Co., about 30% of all packaged goods have lost content over the past year. This at a time when U.S. grocery bills are rising — up 7.5% in October versus a year ago — at the fastest rate in 18 years.

More indirectly, with more stimulus, consumers will eventually have more money to fiesta, in this case, and spend as the year goes on — all the time feeding inflation.

Commodities Past and Present

Consumer spending has been impacted by the extremes of the stock market and commodities, as well. The wealth effect created by escalating home prices from 2000-2007 drove demand, and consequently all costs and goods, higher. That trend reversed in 2008 and the 40% stock sell-off has constricted almost all buying for most of us. The challenge is to not let the overriding psychology affect your market sentiment – or your trading mentality.

You can’t see the beautiful stars if your head is down.

The tie between a stock recovery and commodities demonstrates a rebuilding of economic confidence. By the time most investors get comfortable enough to get back at it, a large move will have already been made.

As stocks hold and build stability, commodities will continue to find more equilibrium, possibly much higher, with people having little choice but to eat, heat and drive every single day.

How will we know that the government stimulus is working to stabilize the markets?

I was on Chicago radio a couple days ago and answered that very same question.  I’m normally at no loss for words, as anyone who has seen or heard me speak will testify to, but the answer didn’t hit me until the caller was gone.

Very simply, It ALL comes back to commodities; we will know that the financial markets will stabilize when… oil prices rise again.

The economic data that the media tend to focus on are often lagging indicators. Unemployment, GDP, corporate earnings and retail sales tell us what has already happened… not what is going to happen.

The stock and credit markets most times have discounted and factored in the dire information that we are getting every day. Markets are forward looking, and higher crude oil prices are a sign that the worst is over and a recovery is under way.

Let’s not get too positive or too negative — both ways cloud sound judgment. Investors seem paralyzed by the events of the last six months, but they need to roll with the punches, instead of getting knocked out. Don’t call it a comeback; call it an opportunity for those with the proper fight training.

There will be plenty of opportunities this year with commodities.  After all, it all comes back to commodities.

Regards,
Alan Knuckman

February 2, 2009

A Commodities Outlook for 2009 was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This is very good news. It means you will have a chance to buy gold at lower prices before it goes up higher later this year. Much higher, in fact, according to the 2009 forecast made by Diggers and Drillers editor Al Robinson.

Not everyone agrees that gold is going higher, mind you. “The deflationary scenario is still incredibly intact, even though the government has thrown trillions of dollars at it,” one Leonard Kaplan told Bloomberg. Kaplan is the president of Prospector Asset Management in Evanston, Illinois. “Gold has a long ways to go down,” he added.

Daloob. Seriously daloob. Daloob is a word that means whatever you’d like.

But what does it mean to say that the deflationary scenario is “incredibly” intact? Does this mean that the scenario is “not credible?” Or does it mean the scenario explains and predicts what’s ahead? The statement is incredibly opaque.

Either way, the deflationary scenario that Kaplan refers to is worth a few lines. The scenario is one where commodity and stock prices fall as the credit depression gets its hands around the neck of the economy and squeezes. Under that scenario, gold would fall. And under that scenario, the cost of paying off debts would rise massively as cash gained value. Old debts would become economy-killing burdens for households, businesses, and, dare we say it, governments too.

In fact, the real economic consequences from this kind deflation are so destructive that we would bet our left big toe that the Federal Reserve is going to do everything in its power (and perhaps some things not in its power) to prevent it. It’s not a risky bet. The Fed is firmly moving down the path to monetary weirdness. We are well and truly down the rabbit hole in 2009.

In the meantime, falling commodities prices are telling you that the forecast for the economy in 2009 is not good. Gold, oil, metals, and grains all moved down yesterday while the U.S. dollar moved up. It will be worth watching if commodity shares follow commodity prices down. Commodity shares, as we know all too well, were decimated in 2008.

But based on some analysis from our old friend Dr. Marc Faber in his latest Gloom, Boom, Doom report, commodities as an asset class are about the only stocks actually in a similar position to where stocks found themselves in 1987. That is, while the entire market was savaged last year, commodities may be the only sector worth taking a punt on in 2009, based on Dr. Faber’s analysis of previous bull and bear cycles in various asset classes.

What cycles? Faber says that the length of the cycle immediately preceding a correction or crash has a lot to do with what you can expect next. “If an up-cycle was brief,” he writes, “the down-cycle is also likely to be brief. If the up-cycle lasted a very long time and was accompanied by huge excesses, the downturn from the peak of such a cycle is likely to be lengthy-as was the case for gold after 1980, and for the Nikkei and the Japanese economy post-1990. Similarly, if a down-cycle lasted a long time (20-30 years), the up-cycle is also likely to last for an extended period of time.”

The bull market in commodities began in 1999 and was preceded by an infamous 20-year bear market. Equities, on the other hand, enjoyed an 18-year bull market from 1982 to 2000, but have been in a bear market since then (with a robust, credit-induced bear market rally from 2003 to 2007).

By that logic, the down-cycle in equities should be a lot longer because the up-cycle preceding it lasted so long. On the other hand, the down-cycle in commodities should be shorter because it was preceded by a much shorter up-cycle and a very long down-cycle. Stocks down. Commodities up. Got it?

But is it right? The reasoning makes sense, especially if you compare it with the historic numbers Dr. Faber presents (which we will not replicate here for the sake of space). But there is a simple objection that must be dealt with. What if the commodities cycle is itself a function of an even larger cycle, namely the credit cycle?

If you argue that the bull market in credit began in 1973 and a world of floating exchange rates and competitive currency devaluations (or 1913 when the Federal Reserve was founded, or 1694 if we want to go all the way back to the Bank of England again), then the direction of asset prices would be dictated by whether credit was in an up-cycle or down-cycle.

It’s pretty safe to say that credit appears to be in a down-cycle, starting in August of 2007. What’s more, it was preceded by a massive “up-cycle” in which the supply of money and credit grew globally. That “up-cycle” drove up all assets in all countries simultaneously. We will find out this year if another “up-cycle” can be artificially spurred by Obama and Bernanke.

But if we are now in the “down-cycle” for credit-the Credit Depression-then how can commodities possibly outperform equities and rally while stocks fall?

Well, the only possible way for commodities to go up in price during a credit depression when global economic activity shrinks…is if we experience massive, central-bank backed money printing and the inflation that ensues. Not that this is an outcome we find desirable. But it’s clear as day from the Fed’s actions and words that it will produce inflation at any cost to prevent being crushed by debt and deflation. For all its real wealth destruction, the Fed appears to prefer hyperinflation to credit depression.

And don’t worry that the Fed is out of interest rate bullets in its pursuit of reinflating the credit bubble. There are other weapons. It will mail checks directly to people or buy assets directly on stock markets. You can expect the debt-to-GDP ratio in the United States to approach and exceed 100% before Obama’s first term is over. You can also expect to see more direct government asset purchases and intervention in markets.

How can we be so sure that we’re on the verge of a brave new world of government-managed markets and economies? It’s simple. Central banks and national governments the world over face an existential crisis: the loss of public confidence in paper money. Action must be taken to restore confidence or real economic activity (lending, borrowing, spending, and investing) will grind to a halt.

Perversely, the monetary authorities will destroy public confidence completely through massive inflation. It will also unleash a great deal of social and political disorder. But the authorities appear to prefer this chaotic result (which they can then police and manage with new rules) to another Great Depression characterised by too little money and price deflation. The excesses of the credit bubble will not be liquidated. Instead, they will be perpetuated and subsidised. The resulting economic and social disorder will be met with more State activity in your personal and economic life.

All of this is a long way of explaining why the current lull in the gold price is a great buying opportunity. You know the tactics and strategy of the central bankers. And you have a pretty good idea that any rally in the stock market is a fake out rally, not sustainable based on the economic forecast OR previous cycles (where markets are coming off 20-years of rising prices). What you don’t know is if gold prices are going to fall further before eventually heading higher.

To find the answer to that, you can consult 1974. At that time, stock markets looked oversold and gold had begun to move and was on the verge of a correction. “If someone really felt that the similarities between the 1974 low and the current market conditions are overwhelming,” Dr. Faber adds, “he should consider purchasing gold and oil rather than U.S. equities (and also shorting U.S. bonds)…Gold corrected between the end of 1974 and the summer of 1976 by 40%, while the stock market surged. But from its August 1976 low, the gold price increased eight-fold.

“If we are really in an environment such as we were in at the 1974 lows (and I have serious reservations about this assumption), then we should expect some further weakness in gold prices when equities rebound. Such weakness would then provide an excellent buying opportunity.

“However, keep in mind that even if you bought gold at its 1974 high at US$196 per ounce, by 1980 you would still have quadrupled your money, which was far better than the return the stock market provided. So even if you endorse the view that we are in a similar situation as in 1974, I would be reluctant to stay out of the gold market entirely in the hope of buying it at lower prices.

“Another reason why gold may not sell off as much as it did between 1974 and 1976 is that governments’ interventions with monetary and fiscal measures around the world are unprecedented. ..Therefore, based on my time/cycle analysis above, commodities and commodity-related shares would also seem to be in a far more favourable position to resume their up-trend than broad U.S. equity indices, which (a sharp rebound aside) are unlikely to enter a sustained longer-term bull market.”

If Faber is right, what will it mean for Australia’s broad equity indices? Well, you’d expect them to go higher as commodity prices react to the increase in global money supply. It certainly seems like most of the deleveraging is done in commodity stocks, meaning it would take something monstrous for mining shares to retest the 2003 lows.

Monsters are real though, so we can’t completely discount the possibility that 2009 will be worse for resource shares than 2008. However, one needn’t be a raging bull on Aussie resource stocks to see that the case for gold looks good. It’s distressing that gold looks so good because the outlook for the economy is so bad. More on that tomorrow.

Regards,
Dan Denning

January 15, 2009

Cheering Gold’s New One-Month Low was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Roubini’s four forces of Stag Deflation are: a slack in goods markets, a “recoupling” of the rest of the world with the U.S. recession, a slack in labor markets, and a sharp fall in commodity prices. These factors would, “reduce inflationary forces and lead to deflationary forces in the global economy,” he writes in an article in Forbes.

“Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets,” he writes. “There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.”

You’ll have to bear with us a moment, dear reader, as we work out what this means. First, though, is Roubini right? Well, he’s certainly right that there’s a big fall in aggregate demand in the U.S. It’s obviously passing through to manufacturers and commodity producers (China and Australia). But won’t monetary and fiscal policy designed to combat deflation…you know…cause inflation?

Roubini takes that point head on. He says the liquidity measures taken on by the Fed to get credit flowing and recapitalise U.S. banks are not all inflationary. He says once liquidity is restored to the credit markets (banks begin lending, money market funds starts buying commercial paper again) the central bank can simply “mop up” excess liquidity before it seeps into the real economy to cause inflationary damage.

And what about the tendency of governments to fight debt deflation with inflation? Not a worry either, says Roubini. He says that most of the household debt in the U.S. is short-term variable rate debt that’s resistant to being “inflated away” by cranking up the printing presses. Is he right?

Well it all comes down to how much money the Fed and the Treasury are going to need before the recapitalisation of the American financial sector is over and how they plan to raise that money. The banks will probably need more capital than anyone’s expecting. And there are other landmines down the road.

In short, the Treasury and Fed will need more money. Roubini assumes the Fed can simply remove the lending backstops it’s provided once the market returns to normal. But what if it doesn’t and the Fed can’t? What happens next?

Governments get money three ways, taxing, borrowing, or printing it. You can rule out an increase in taxes large enough to fund the Fed’s needs. It won’t happen with an economy already contracting. Even if Obama raises taxes, it won’t be enough to meet the Fed’s immediate needs. That leaves borrowing and printing.

On September 17th, the U.S. Treasury announced a Supplementary Financing Program. It initiated the program at the request of the Federal Reserve. The Fed needed the Treasury to go out and sell more bonds so the Fed would have money to fund its various lending backstops. The Fed was nearly broke.

Since then, thanks largely to the huge flight to Treasuries sparked by deleveraging and the collapse of the dollar/yen carry trades, the Supplementary Financing Account set up by the Treasury has fed the Fed nearly $560 billion. Some of that may have gone to AIG. Some of it to Fannie and Freddie. Some may go to Chrysler, Ford, and GM. Who knows?

But the main point, from Roubini’s perspective, is that as long as the Fed can finance its lending with new borrowing from the Treasury, it’s not inflationary. The only thing that would make this armada of liquidity measures and loan guarantees and bailouts truly inflationary is if the Treasury couldn’t go out and sell new bonds to gullible foreign investors. As long as the Treasury can sell more bonds, the Fed can make more loans without sparking inflation.

But if we’re right and the bond bubble began bursting in late October, well then the Treasury’s line of credit with global savers is nearing an end. Global creditors will be reluctant to finance American deficits. In order to borrow, the Treasury is going to have pay much higher rates of interest to reflect the credit risk the U.S. government has become.

Trouble is, the U.S. can’t afford to borrow at higher interest rates right now. So that leaves the option Roubini thinks is least likely: printing money. The fancy term for it would be “monetizing the debt.”

That means the Fed would buy public debt issued by the U.S. Treasury with freshly printed money. And THAT, we reckon, is super inflationary. Any time you start rolling out new greenbacks to pay for new bonds which you give to corporations in exchange for their garbage securities, you’re going to damage the confidence people have in the currency (the U.S. dollar).

But then, Roubini has been right about an awful lot lately. It’s possible the Fed will not be forced to monetize the debt. It’s possible that a global contraction is truly deflationary. We don’t really know. But we’re not nearly as sanguine as Roubini that you can expand the monetary base as quickly as the Fed has and be confident it can all be mopped up later without causing inflation. Try getting motor oil out of an engine and back into the bottle.

Regards,

Dan Denning
November 05, 2008

Falling Commodities and Inflation in the Wings was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Pabrai delivered a great presentation about the dilemmas that often face value investors. I’ve just read his great book, The Dhandho Investor: The Low-Risk Value Method to High Returns . I want to share my thoughts and a few quotes. Value Investing Congress attendees received a copy of Pabrai’s book at registration. It’s still available on Amazon, but perhaps not for very long. Pabrai’s last book, Mosaic, which I received at last year’s Congress, must be out of print. It was selling for $475 on Amazon. I recommend Pabrai’s books for anyone who wants to learn how the world’s top value investors think about risk.

Literally translated, “Dhandho” means “endeavors that create wealth.” Pabrai tells interesting stories about entrepreneurs that built empires following the time-tested principles of hard work and frugal living. But what makes Dhandho investors unique is their intelligent use of outside capital to invest in ventures where risk and reward can be boiled down to the phrase “Heads, I win; tails, I don’t lose much.”

The world is a very uncertain place and this uncertainty can ruin the best-laid plans of brilliant entrepreneurs. Dhandho investors realize this and seek to minimize the size of the losses they can potentially suffer. The best way to minimize the size of losses in the stock market is to minimize the price you’re willing to pay for shares in a business.

Low-Cost Production: The Commodity Company’s Moat

Pabrai writes about how Lakshmi Mittal, one of the richest men in the world, has achieved remarkable success in the steel business, a business most ignore, for many good reasons. His company, Arcelor Mittal, is now a leading steel producer listed on the NYSE under the ticker “MT.” Using a “heads, I win; tails, I don’t lose much” approach, Mittal’s strategy relies on paying low prices for undesirable steel mills, implementing disciplined cost controls and expanding market opportunities:

“When Mittal picks up assets for pennies on the dollar and then streamlines operations, he has an unassailable low-cost producer advantage. Over the years, he has developed a second enduring advantage — global arbitrage on labor, raw materials, energy costs, and the best-selling price. With plants in a wide range of geographies, he optimizes the type and quantity of steel produced by geography to maximize this advantage. And now, his tremendous scale and brand gets him a third enduring advantage. His volumes and capacity allow him to negotiate better prices than his competitors with both buyers and suppliers — driving his costs even lower.”

Perhaps Lakshmi Mittal is a fan of John D. Rockefeller. Whiskey & Gunpowder colleague Byron King (also editor of Outstanding Investments ), wrote a great piece on the Rockefeller era of the oil industry. You can find “John D. Rockefeller and the Age of Oil” at this link. “By the early 1870s, Rockefeller was certain that the refining business was on the verge of a massive shakeout. Thus, he was consumed with a focus on efficiency in his operations,” Byron writes.

Both Mittal and Rockefeller sought to buy assets on the cheap and constantly wring costs out of the steel business and the oil business. They knew that low-cost commodity producers survive — and even thrive by consolidating the industry at low prices — when commodity prices weaken. Commodity companies are not playing a zero-sum game. There are clear long-term winners, mediocre players, and unfortunately, many outright frauds — Mark Twain’s proverbial “hole in the ground owned by a liar.”

Mittal has definitely established a very valuable “moat” of low-cost steel production that can continue growing as long as cost discipline remains a focus.

Different Types of Moats

What other kinds of moats can companies use to defend their businesses?

In the wake of the euphoria about the proposed Alcoa-Alcan merger, one of the speakers at the Value Investing Congress warned the audience that “commodity companies have no moat.” This is generally true in a world where 10% or 15% of the world’s population has a virtual monopoly on consumption of its natural resources; this was the world of the 20th century. This is not true in today’s world, where natural resources must be shared among a larger consuming population and it’s not cheap or easy to scale production quickly enough to meet demand.

What does this mean for commodity companies like BHP Billiton (BHP) and Companhia Vale do Rio Doce (RIO)? Should we assume that they have “no moat”? The term “no moat” may apply for small-fry commodity companies, but not for those like BHP Billiton, whose management still assumes very low future base metal prices when they decide whether or not to invest in a new mine. BHP has learned to survive in a low commodity price environment and should continue thriving as long as management remains disciplined in their decisions.

The statement “commodity companies have no moat” also doesn’t apply to CVRD. Based in Brazil, CVRD is the most dominant miner of iron ore in the world. CVRD controls 35% of the seaborne iron ore trade, followed by Rio Tinto and BHP Billiton, with 25% and 20% market share, respectively. The fragmented steel industry has to write awfully big checks to these players for their crucial raw material. There’s really nowhere else to get reliable supply.

Not only has this Brazilian giant done a great job keeping production costs low, but it’s also long held the luxury of being able to force price increases onto its customers — including the formidable Arcelor Mittal. Its growth in earnings and cash flow resembles its chart below, which covers the time frame it’s been on the SI recommendation list (since August 2004 — when it was originally recommended by former editor Dan Denning):

When CVRD acquired nickel miner Inco last summer, most media sources considered it a sign of a top in the commodities market. Commenting on the Inco acquisition, I wrote the following in the Aug. 14, 2006, SI update: “Billions in startup capital may not be very hard to come by in today’s hyper-liquid credit environment, but securing a scalable, high-grade reserve base in a stable country, a team of geologists, and a fleet of heavy equipment is no small feat (particularly at a reasonable ROI).” In hindsight, it now appears that CVRD not only made a great strategic move, but got a real bargain. Earnings from Inco’s operations are soaring.

In the March 12 SI update, I wrote that CVRD “is successfully integrating last year’s acquisition of Canadian nickel miner Inco and now controls four out of the six major new nickel projects coming online over the next three years. Even if the price of nickel consolidates after its breathtaking 2006 rally, it will still be an enormously profitable metal to mine.”

So I’d argue that CVRD’s competitive moat holds two qualities: access to world-class, low-cost metals in the ground and a management team with great foresight. This moat can keep growing, provided humans keep fashioning iron ore into steel.

Technology Moats Can Shrink

As investors, we must not remain psychologically anchored to the past. The world is changing and investors need to adjust their perspective. Commodity companies, indeed, have strong moats. If you don’t agree, try starting your own iron ore mining business and competing with CVRD or BHP Billiton on price. Their expertise, managerial talent, and, most importantly, massive cumulative past capital investments in mines make these companies irreplaceable. And steel companies must now pay these dominant producers an arm and a leg for what they all need — critical steel ingredients like iron ore and nickel.

Countries like China, India, and Brazil have sprinted out of the gates in the 21st-century economic race. We should assume that they are not going to squander another century of progress on idiotic socialist or communist projects that turn back the clock on living standards. We should not assume that we are the only ones that can think for a living and that everyone outside the Western world should sweat for a living (to paraphrase the GaveKal argument).

Using the example of Google, Pabrai does a great job illustrating how this old economy/new economy concept should be applied to fundamental stock analysis:

“If we were to look at a business like Google, it starts getting very complicated. Google has undergone spectacular growth in revenues and cash flow over the past few years. If we extrapolate that into the future, the business appears to be trading at a big discount to its underlying intrinsic value. If we assume that not only is its growth rate likely to taper off, but that its core search business monopoly may be successfully challenged — by Microsoft, Yahoo, or some upstart — the picture is quite different. In that scenario, the current valuation of Google might well be many times its underlying intrinsic value.

“The Dhandho way to deal with this dilemma is painfully simple: Only invest in businesses that are simple — ones where conservative assumptions about future cash flows are easy to figure out.”

This is why I tend to avoid technology stocks. It’s not that you can’t make money in technology; you’ve just got to be extremely confident that the technology you’re investing in isn’t made obsolete within a couple of years. Who knows if Google or Yahoo — or Baidu — will dominate the search engine business during the 21st century?

What separates all-star investors from mediocre investors? It’s the accuracy of the assumptions in their valuation models. Emerging economies are growing. They need copper, iron ore, nickel, oil, gas, coal, and other building blocks of Western living standards. You don’t have to make heroic assumptions about what technology will look like in 10 years to make money in leading commodity companies — companies that have wide moats. To lower your risk while investing in commodity companies, follow the “Dhandho” principle of paying the lowest possible price. Maybe you’ll get a shot at lower prices the next time the media mistakenly calls the end of the commodities bull market.

Good investing,
Dan Amoss, CFA

May 16, 2007

Dhandho Investing in Commodity Companies was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Two weeks ago, the average was $94.44 cwt, an increase of $3.32 over the previous week. Translation: Prices for cattle in the cash market are climbing fast and they will most likely continue to do so. Demand is the driver. As more countries reopen their markets to U.S. beef, demand will increase. Meat packer margins are hovering at break-even levels. Right now, tight cattle supplies and plentiful inexpensive feed will likely result in a firming up of the cattle price. This holds true especially for cattle producers and feedlot operators.

Then, of course, there’s avian flu. If one case of bird flu migrates to the United States and infects one person, people will swear off poultry and head right to the meat aisle in the supermarket. In reality bird flu is not actually spread by eating poultry, but often in trading perception is reality and just the threat of bird flu is enough to get the general public to shun poultry. Even though eating it isn’t the cause of the illness, the general public won’t differentiate. And who would want to bite into a chicken of death when they could opt for a nice juicy steak?

What mad cow? Typically, market participants have a short memory, so it’s important to act on fear while it’s still in full swing. The cattle and meat markets in general are the butt of many jokes in the investment world — Hillary Clinton’s infamous cattle trade comes to mind, as does the aforementioned question about pork bellies. Truth be told, the meats are a good agricultural market with solid fundamentals and can be a great learning market for the novice trader — just make sure no one knows you’re a novice.

In 2006 I carried October live cattle positions and made some very good profits on the 86 call options, and later on the 88 call options. The cattle market is a volatile one and relatively illiquid, so it can be a difficult market if you’re just starting out. You may want to avoid it until you get some experience.

The coffee, sugar, and cocoa markets are near and dear to my heart. These three commodities are also known as the tropicals, because most grow in the tropics, or softs, I guess because they’re all soft in texture. But whatever you want to call them, these are some of the best performing and least understood or talked about markets. I spent much of my early career running between the pits of the coffee, cocoa, OJ, and sugar markets, and let me tell you, these are markets that trade like no others. Gold and oil may get the lion’s share of the sound bites and headlines, but if excitement is what you’re looking for, these markets have it.

Sugar, for example, is one of my favorites. It is growing exponentially in demand as a result of ethanol production and being widely used in foodstuffs; meanwhile the supply is shrinking due to factors such as European subsidies being curtailed. Sugar is likely to double in a couple of years, in my opinion, and the writing is already on the wall. Much the same can be said for markets like cocoa and coffee.

Worldwide demand is sucking up supplies faster then these commodities can be harvested. I know the coffee market well — very well, in fact. It’s one of the first markets I traded when I started out in commodities 18 years ago. It’s also one of the fastest-moving and most volatile markets, which means it’s loaded with opportunity for you to make a lot of money. This is a good example for talking about one of the best features of trading commodities: the ability to short a market just as easily as going long. That’s correct — unlike equities, you can short commodities futures just as easily as going long.

A market like coffee is particularly important because of its volatility but also because a new Starbucks pops up on every corner from Maine to China and every farmer who could possibly grow coffee beans is doing so, resulting in a glut of beans on the market. Even Juan Valdez, from the TV commercials, hung up his sombrero in 2006. Coffee is thus one of those markets you can play from both directions to get maximum profits — something futures allow you to do, with astounding results.

Cotton gave this maniac trader his start. My first full seat was on the New York Cotton Exchange (now the New York Board of Trade). My badge was 8015 QUEST, as in Jonny Quest. (I was young and had blonde hair and a dog named Bandit; when the guys on the floor found out I had done cartoon voiceovers as a kid, the name just stuck. Everyone gets a nickname down there, and it usually isn’t something you’d choose for yourself.)

In any case, cotton is an “old boy” market, much like cattle or the grains — not old as in stale, but old in that it has been around a very long time and the people who trade it have been doing it a very, very long time. Cotton is a great market to trade, but you must understand the fundamentals at work and the differences between old crop and new crop. This simply means that two different cotton crops are produced each year in cotton, and you must make sure you know which crop you’re looking at and then make your decisions based on that. Cotton is one market that’s crucial not to underestimate and, much like the ocean, never turn your back on. Trust me, I worked in there for a number of years.

Right next door is another very active market, especially in the winter and during hurricane season: orange juice. Orange juice is a perfect market for learning about fundamentals the hard way. Many of you have seen the movie Trading Places, with Eddie Murphy and Dan Aykroyd. If you haven’t seen it, do — it will give you a good laugh. The movie was filmed on the old World Trade Center trading floor and was about trading OJ, but the reality stops there (or does it?). Actually, with tongue in cheek, I can say that it’s probably a fair depiction of the old trading pits.

Today, however, the OJ market is tightly controlled by supply and demand and is certainly ruled by weather factors — not just winter hard freezes, either. It may surprise you to know that hurricanes in Florida are the biggest factor influencing this market, not only before the hurricane hits but after, too. The main concern is citrus canker; after the winds and rain die down, this fungus can develop on the crop. Fundamental information like this is important to know and take into consideration when initiating a position.

Every market is different, so you must study the fundamentals for all of them. For example, you must understand what soybean meal is used for as opposed to soybean oil. Soybeans are used for biofuel, among many other things, so nowadays soybean prices more closely parallel those of crude oil and heating oil than those of the regular crop reports.

Keep in mind that these markets move on the basis of supply and demand. Right now, the demand for soybeans is picking up in a big way due to biofuel consumption, which in turn relates to how high heating oil prices are. It’s not hard to connect the dots to identify what affects a specific commodity, but sometimes you’ve got to do a little research first. Biofuel is used primarily for home heating, and as ethanol is derived from corn, biofuel is derived from soy. The bottom line is that you must know, inside and out, the basics about whatever commodity you choose to trade, whether it’s rough rice or natural gas.

More importantly, you need to know new factors that may affect a particular market — and these can change.

Regards,
Kevin Kerr

April 27, 2007

Standby Commodities was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The international oil trade does not operate in a vacuum. Despite what energy resources may or may not lie underneath the ground, "aboveground factors" matter very much and tend to matter more as prices rise. Just because we can use computer models to estimate that so many billion barrels of oil are in some reservoir in some remote part of the world doesn’t mean that this potential supply will affect prices five or even 10 years from now, if at all.

As my colleague Byron King pointed out in "Bakhtiari’s Event of the Century ," concerns about oil scarcity are not likely to be taken very seriously until the world faces a crisis — a crisis that could impose serious change on financial markets. I agree with Byron that the issue of future scarcity will be addressed only "if informed people and the industrial and political policymakers of the world actually take Peak Oil as a serious matter and set policy accordingly."

Unfortunately, right now, long-term perspective hardly exists in industrial and political policies. A pair of economists recently tested the logical assumption that most free market operators extract oil as fast as they can, rather than maximize the productive life of a reservoir. Why? From the perspective of those funding massive projects, a barrel of oil produced this year is far more valuable than a barrel produced 15 years into the future.

Technology Cannot Completely Mitigate Oil Scarcity

The history of large oil projects shows that technology — while vital to extending the boundaries of exploration — has rarely been able to reverse a depleting field once it’s passed peak production. In a paper entitled "Technology and Petroleum Exhaustion: Evidence From Two Mega-Oilfields," John Gowdy and Roxana Julia, two economists from Rensselaer Polytechnic Institute, tested the assumption that technology can ramp up oil production on demand. Here’s the abstract:

"In this paper, we use results from the Hotelling model of nonrenewable resources to examine the mainstream view among economists that improvements in recovery technology can offset declines in petroleum reserves. We present empirical evidence from two well-documented mega oil fields: the Forties in the North Sea and the Yates in West Texas. Patterns of depletion in these two fields suggest that technology temporarily increases the rates of production at the expense of more pronounced rates of depletion in later years — in line with Hotelling’s predictions. Insofar as our results are generalizable, they call into question the view of most economists that technology can mitigate absolute resource scarcity. This raises concerns about the capacity of current mega-fields to meet future oil demand."

The "Hotelling model" refers to a rule outlined by 20th-century economist Harold Hotelling. Hotelling was noted for his work on the economics of nonrenewable natural resources. He argued that prices for scarce natural resources rarely include an accurate premium for scarcity. But as we’re seeing, the scarcity premium, or "fear premium," is growing and is likely to increase as more evidence of scarcity arrives.

Generations ago, Hotelling was ahead of his time in arguing for a scarcity premium. It simply can’t develop when aboveground supplies are consistently ample. But this has changed over the past few years. Rather than being seen as a mere commodity price, the price of oil should be viewed as a combination of production costs, profit, taxes, and scarcity premium. Economics textbooks tell us that, over the long run, a commodity will sell at its marginal cost of production, but evidence is growing that the different grades of crude oil are making oil less and less of a "commodity" in the economic sense.

Available Oil Becoming Heavier, More Sour

The widely held assumption that technology can immediately address a shortage of crude oil fails to address the quality of the crude we have to work with. World refining capacity is not optimized to deal with the reserves that remain. David Wood & Associates clearly shows in the following diagram that light, sweet crude is growing increasingly scarce. This diagram, published in the April issue of Petroleum Review, is a great snapshot of the oil production that refiners have to work with. The size of each of these bubbles is proportional to 2005 production volumes:

Source: www.dwasolutions.com

Wood concludes from his studies that "The average global crude oil currently produced has an API gravity close to 32 degrees and a sulfur content in excess of 1 weight percent (wt %). Only some 20% of global oil production supply can be classified as light and sweet, with the remaining 80% or so classified as medium/heavy and sour [emphasis added]."

But perhaps more importantly, "Medium-gravity, sour crudes dominate the oil production from the Middle East and Russia, and heavier crudes are dominating remaining oil reserves." This chart, from the July 2006 issue of Strategic Investment, shows that over time, crude has become heavier and more sour. The axes on this chart are the opposite of David Wood’s chart, but the red dots show a clear historical trend of declining average crude quality:

This trend is reflected in growing spreads between the prices of West Texas Intermediate blend, which is a type of light, sweet crude, and imported crude oil blends, which tend to be heavier and more sour. If you want to participate in the investment boom, pay close attention to new refinery construction projects and the refiners that are consistently forward-looking.

Economist Ed Yardeni included the following chart in his firm’s latest energy publication:

Source: www.yardeni.com

How are foreign producers reacting to the fact that most of their reserves are of lower quality and will be expensive and difficult to produce and refine? They’ll take their time to ramp production to meet Western demand — and charge higher prices. This involves reasserting control over their remaining resources. Yardeni made a great point in a recent morning briefing:

"We still believe that the cheapest oil in the world is in the U.S. stock market. The sector’s profit margin was 10.4% during Q4 2006, exceeding the S&P 500′s 8.5%. P/Es have been held down by investors’ perceptions that oil prices and forward earnings aren’t likely to rise much from here. We agree, but they aren’t likely to fall much, either, from their lofty heights. So the industry should have lots of cash flow and M&A activity over the next couple of years. The most challenged industry, yet the one most likely to have plenty of cash for acquisitions, may very well be integrated oil and gas, with the sector’s biggest market cap share at 63%. National oil companies are increasingly demanding that the international majors basically accept a service fee for managing their production without much, if any, upside [emphasis added]. This might be one reason why analysts’ long-term expected earnings growth for the sector has dropped from a record high of 12.3% three months ago to 10.0% in March."

Service fees? This goes a long way in explaining why executives at big oil companies like to keep public attention focused on their mega-projects, rather than talk openly about the chance that leaders of oil-rich, underdeveloped countries may choose to follow the Hugo Chavez/Vladimir Putin playbook.

Geopolitics Remains a Wild Card

ASPO-USA’s latest Peak Oil Review describes the situation on the ground in Nigeria in the wake of last weekend’s presidential elections. This country must give several big oil executives sleepless nights, considering the billions they’ve invested in major projects within reach of violent, kidnapping gangs:

"Among the more interesting incidents surrounding the election was a failed attempt to blow up the national election commission’s headquarters with a gasoline truck, plus a massive assault by insurgents on the Bayelsa State Government House in the capital Yenagoa. Nine boatloads of insurgents emerged from the creeks, overcame the police and military forces in the town and burned the governor’s mansion and a police station. The governor, who is also expected to be declared the new vice president of Nigeria, was forced to flee the city for his life.

"The raid illustrates the growing power of insurgents to strike at will and overcome corrupt and ineffective police and military forces. Some weeks back, the insurgents announced a stand down during the run-up to the election but vowed to be back unless the election led to significant changes — which it clearly did not.

"Nigerian oil production dropped by another 100,000 b/d during March to 2.15 million b/d. Although the Nigerian government has been saying recently that Shell will soon resume 300,000 b/d of shut-in production [at Forcados], Shell has yet to confirm this claim. Foreign oil workers in Nigeria now are largely confined to fortified compounds and travel to job sites by armored vehicle or helicopter [emphasis added]. A number of companies have pulled out of the country.

"There was nothing in the recent elections to suggest that the situation will improve soon. The insurgents have said they will step up attacks following the election and usually make good on their promises. Prospects for reduced Nigerian oil production seem likely."

This is a situation in which those fighting for a larger share will keep fighting until they get it. Pressure on the Nigerian government to share the oil wealth will keep mounting. Oil companies operating in the region should beware windfall profits taxes, or even forced changes to production-sharing agreements. Algeria recently set a very alluring precedent for those countries looking to balance the interests of both their citizens and the oil companies.

It’s Mayday for a Few Big Oil Companies

Last week’s Wall Street Journal had a piece describing this trend:

"Even some nations that are new to the oil game are demanding stiff terms. Some of the biggest finds in recent years have been in Angola, which has popularized an oil-production contract built on progressive taxation. As oil prices rise, boosting an oil company’s rate of return, Angola’s share of the proceeds also goes up."

This "progessive taxation" idea will probably catch on elsewhere — a good reason for energy investors to own a few oil service stocks. Regardless of how the resource wealth is shared, more oil field exploration and development must be done. It looks like the Venezulan government has decided to move forward with major development projects practically on its own, but it may enlist the services of companies like Schlumberger or Baker Hughes when it runs into trouble down the road.

Next Tuesday, May 1, marks the end of private control of the vast heavy-oil deposits in Venezuela’s Orinoco basin. This is obviously negative for long-term oil supply, as Chavez has already demonstrated that PDVSA cannot even maintain its conventional oil production. How anyone can expect much out of the Orinoco Basin — as long as Chavez is running things — is beyond logic. The Journal continues:

"To grab more of that profit for itself, the Venezuela government broke existing contracts. Income taxes on heavy-oil projects over the past couple years rose to 50% and royalty rates doubled, to 33%, having previously been raised from the original 1%. The government also legislated that the state oil company, Petroleos de Venezuela SA, be given a 60% stake in existing fields by May — and thus a majority of future profits."

Fadel Gheit, an energy analyst from Oppenheimer & Co., concludes the article with an image any baseball fan will recognize: "’This is like drafting a kid to the major league and he’s making $100,000 a year. All of a sudden, he is hitting 50 home runs. Guess what, he wants to renegotiate his contract, and under the circumstances, one can understand the way Chavez feels.’"

Despite how distasteful it is to view the world from the perspective of a socialist dictator dismantling his country, Gheit makes a good point. It may not be great for oil consumers, or follow the rules of the free market, but a few more emerging oil-producing countries may look to "renegotiate their contracts." What big oil could lose in volume over the coming decade, it must make up in price — if regulators allow such a thing. So energy investors should hedge positions in big oil stocks with positions in leading oil service stocks.

Good investing,
Dan Amoss, CFA

April 26, 2007

Beware of Windfall Profits Taxes was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.