Monday, 26 October 2009

Celebrating A Decade of Reckoning
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The Daily Reckoning

Monday, October 26, 2009

Peak Oil is back in town; what this means for investors, 
A housing bust chronology...
Warning: Graphic Content Below, 
Up the mountain without a paddle...or an iPhone...
or an Internet connection...all that and more...
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Bill Bonner, with some thoughts from Buenos Aires, Argentina...

We’re heading for the hills...really!

Last week, stocks went up. Stocks went down. Not much was proved one way or another. The week ended in a draw, as near as we can tell.

But we think we are making progress in understanding what is going on. The private sector is de-leveraging. Now, it’s the public sector doing the heavy lifting. It is leveraging everything it can.

Leverage in the private sector led to the banking crisis/bear market of 2007-2009. Debt always leads to trouble. Next up: a crisis in the public sector.

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But wait...hold on...not so fast...we haven’t reached the end of the private sector crisis yet! Bank lending is still falling. House prices are still falling. Unemployment is still falling. Soon, stock prices will be falling again too...

First, let’s see what’s in the headlines. Last week there was a lot of press about the pay czar and his efforts to limit compensation in the companies that the feds bailed out. The public and the news media love this sort of thing. It’s a battle between the greedy rich and the public interest, or so they believe. The public hates bankers. But they don’t want to see just pay capping; they want to see knee-capping. We’d like to see it too. Or maybe public flogging. Or at least a lapidation or two.

But our true sympathies are with the greedy CEOs. After all, they stole the money fair and square. They should be allowed to keep it. The feds wanted to leverage up the financial sector by giving money to the banks. What’d they expect? The bankers took it.

Yes, the financiers are paid outrageous amounts of money – far beyond anything they are worth. In fact, if you studied it carefully, you’d probably discover that their net contribution to the betterment of mankind is now negative.

The bankers are betting that the money they were given by the feds will be worth less next year than it is this year. So they exchange it for everything and anything, confident that when it comes time to pay it back it will be even easier to come by than it is now.

So far the bet has gone their way. Copper has doubled. Gold is up 20%. Stocks markets all over the world are up 60%. Foreign currencies, too, have beaten the dollar.

Will the wager against the dollar continue to pay off? Well, that’s the big question. If so, you should stay in stocks, gold and commodities. If not, you should move to cash.

But it hardly matters to the gamblers. They’re playing with someone else’s money! If the bets go well, they pay themselves huge bonuses. If they go badly...well...hey...gimme a bailout!

In the long run, bets against the dollar are almost sure to turn out okay. All paper currencies go to zero, eventually. But in the short run, who knows? The whole world is betting against the greenback. With such a massive short position against the buck, it would be just like Mr. Market – aka Mr. Mischief- maker -- to send the dollar up.

But you can’t blame the bankers. They’re performing a very valuable service. They are helping to separate fools from their money. Too bad we taxpayers are the fools....

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And now, over to The 5-Minute Forecast for today’s news...

“This chart shows you it isn’t over yet,” Chris Mayer told our guys over at The 5-Minute Forecast this morning. Chris was up in New York last week with Dan Amoss and Addison Wiggin for attend the annual Value Investing Congress. Here’s what grabbed Chris’ attention, a redux of the famous Credit Suisse chart, courtesy of Whitney Tilson and Glenn Tongue of T2 Partners:


Subprime resets crushed the housing market in ’07 and ’08. Now a new wave of adjustable-rate mortgages is just around the corner.

“These helped frame where we are in the mortgage crisis,” explains Chris, “which has been the main shark in the water over the past couple of years. You should know where that shark is and whether or not it is hungry...

“Clearly, it is not yet safe to get back in the water: Years 2010 and 2011 face big resets in so-called Alt-A and Option ARM loans. What this means is more write-downs and more losses for banks and others who hold these mortgages.

“The bounce in home building stocks looks ridiculous in light of what they have to look forward to. The T2 duo actually recommended shorting the home building stocks through the iShares Dow Jones U.S. Home Construction ETF (ITB)... I like the idea of shorting homebuilders. At the very least, I wouldn’t buy one.”

If you want to know what Chris would buy, you can find out today for just $1. No kidding.

And back to Bill...

Among all the whiners and kvetchers about bankers’ huge bonuses hardly a single one draws the obvious conclusion:

That them that deserve to go bust should be allowed to do so.

“I remain of the view,” writes Martin Wolf, a bit pompously, in The Financial Times, “that the only thing worse than rescuing the system would have been not rescuing it.”

He’s welcome to his opinions. And if he used his own money to bail out the bankers we would have no objection. In that case, it would just be a futile and foolish act. Instead, he insists upon using our money...which raises the charge from stupidity to larceny.

Another message that came through last week was that the real economy is not improving. Good news came in from several quarters. But the news that really counts – housing prices and jobs – was bad.

“It’s all bad. That’s all we know,” said John Stepek, editor of MoneyWeek. “People ask if we’re going to have inflation or deflation. The bulls think we’re going to have inflation. The bears bet on deflation. But I’m not sure it matters. We’re probably going to have both.

“The point is, whichever we have, it’s going to be the bad sort. Neither inflation nor deflation is necessarily bad. Prices have to adjust. That’s how the market conveys its signals. When prices rise, it tells producers to get busy and increase output. When prices fall, it tells them to lay off. In the natural order of things prices usually fall. Or, they should fall. This is ‘good’ deflation. It just means that producers are becoming more efficient, as they should. There’s good inflation too – when prices rise due to increased real demand. When people earn more money, they can buy more things; prices rise.

“But what we’re going to see is bad. Bad inflation. And bad deflation. It is the result of monetary problems and mismanagement. And it is going to send all the wrong signals and inevitably make things worse. First, the deflation is bad because it is result of a massive de- leveraging accompanied by a write-down of debt and assets. It’s a depression. Or a major recession. Or a ‘great contraction.’ Call it what you will. It’s a deflation in which prices fall...and it’s not going to be any fun.

“Then, there’s most likely going to be bad inflation too – caused by the central banks printing too much money. This is bad inflation because it is just an increase in the quantity of paper money, not an increase in real demand.

“We don’t know exactly what is coming. But whatever it is, it will be bad.”

Another big item in last week’s financial press was the “Cash for Houses” scheme. The feds give new house buyers an $8,000 tax credit. But since not all new buyers buy because of the credit, the actual cost to the government per additional new house purchased is much higher than 8 grand. For each additional house purchased because the credit taxpayers are paying as much as a quarter of the entire cost of the house.

And now there is a proposal to extend and broaden the credit. Soon it may be “Cash for Everything.”

This sounds crazy, but there are a lot of economists who think more stimulus is necessary. Nobel prize winner Paul Krugman, for example. And Richard Koo, mentioned here last week. They’ve seen what happened in Japan. And they see that the real economy is not recovering as they hoped it would. Now, they warn that America might have a “Lost Decade” if it doesn’t continue to stimulate the economy.

How long must it continue bailing out and stimulating? Until consumers have finished de-leveraging, they say. How long will that take? Maybe another 5 years, by our calculation...maybe much longer.

But wait...the whole problem is too much debt, right?

Yep.

But the only way the government can stimulate is by going further into debt, right?

Yep.

And isn’t the budget deficit already at $1.6 trillion...or 11% of GDP...the most it has been since WWII?

Yep.

Well, then where’s the benefit? Won’t the public sector have to de- leverage too?

Bingo!

How does the public sector deleverage?

Two possible ways – honestly...and dishonestly. It can pay down its debts to a level at which they can be carried even if interest rates go up sharply. They did it after the War Between the States...after WWII...and even during the Clinton years. Believe it or not, when the Congressional Budget Office looked ahead in 2001, it saw a budget SURPLUS for 2008 of more than $600 billion. Surpluses had been coming in for years during the Clinton administration. They thought it would keep going like that. Instead, 2008 saw a DEFICIT of nearly $500 billion.

The higher the debt and deficits go the harder it is to pay them down honestly. Eventually, the feds reach the point of no return...like a guy who’s so deep in debt he can’t possibly work his way out. Then, you get another crisis...either in the form of default...or (hyper) inflation...or both.

And now for today’s essay...

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The Daily Reckoning PRESENTS: Readers want to know, WITMMG?! (Where Is The Mighty Mogambo Guru?!) He’s on a well-earned break, dear reader...perhaps restocking the MBWIA (Mogambo Batch of Witty and Insightful Acronyms.) We’ll keep you posted...

In the meantime, here is Puru Saxena, musing from his post in Hong Kong, on energy investing and why your money is probably better placed upstream rather than down the river. Please enjoy...

The Truth About Energy

by Puru Saxena
Hong Kong

After oscillating within a trading range for several weeks, the price of crude oil has recently broken out to a new recovery high. Now, you will recall that we have been firm believers of ‘Peak Oil’ since 2003 and we were expecting this bullish resolution.

Look. Skeptics can say what they want; it does not change the fact that our world is struggling to maintain daily flow-rates. Whether you agree with us or not, the energy reality is that the supply of conventional crude oil is very close to its peak and no other fuel source can easily fill the supply gap.

Yes, various governments are now promoting alternative sources of energy and over the following years, we expect this drive to intensify. But those sources will provide too little, too late. So there remains, today, an unbelievable degree of denial when it comes to ‘Peak Oil.’ Most people simply dismiss it as a conspiracy. Others gleefully point to alternative sources of energy, whereas some believe that the vast improvements in oil drilling technology will save the day. Do not be seduced by these delusional hopes.

Remember, crude oil is the lifeblood of the global economy and roughly 70% of it is used to power transportation. Moreover, a vast amount of crude oil is also used up by agriculture (production of fertilizers, pesticides and irrigation systems). In fact, modern-day agriculture can be best described as a process of converting hydrocarbons into calories. Without cheap energy, the world would certainly have trouble producing half of the current food supply and the result could be far worse.

Thus, crude oil is a key ingredient in two of the most critical processes which make modern life possible – transportation and agriculture. And shortages of this vital natural resource will result in extreme pain. In the initial stages, the price of crude oil will rise remorselessly and eventually, we will face rationing.

Now that we have established the importance of crude oil, we will explain why new drilling technology and alternative sources of energy will not make this problem go away.

First, as far as drilling technology is concerned, it is worth noting that America is home to the best oilfield technology on this planet. However, its oil production peaked in the early 1970s and has been in a relentless decline. Furthermore, apart from America, other technologically advanced nations in the world have also failed in maintaining their daily flow-rates. For instance, after exporting crude oil for over two decades, Britain is now a net importer and its production is in a state of permanent decline. Hard data confirms that two of the most advanced countries in the world now live in a post ‘Peak Oil’ era, so what are the odds that other less fortunate nations will succeed in averting ‘Peak Oil’?

Secondly, as far as alternative sources of energy are concerned, they represent a drop in the energy ocean and will not be able to offset the depletion in crude oil. Despite all the euphoria surrounding renewable energy, the ‘sources’ like ethanol and solar panels are net energy losers. In other words, it takes more energy to produce ethanol and solar panels than the energy you obtain from them. For sure, hybrid and electric cars will help us to some degree but you must keep in mind the fact that electricity is not a source of energy; it is a carrier of energy. Even if electric cars become popular, how will we generate sufficient electricity?

Elsewhere in the alternative energy patch, a lot of hopes currently rest on unconventional sources of oil (especially tar sands and shale oil). Once again, this optimism is misplaced, as the increased supply from the unconventional sources will not even make a dent in the overall energy picture. The nearby chart confirms that our world currently produces roughly 85 million barrels per day of total liquids and out of this gigantic sum, only 13 million barrels per day of oil is derived from unconventional sources. So, when the production of conventional crude oil finally declines due to ‘Peak Oil’, it is extremely improbable that unconventional supply will be able to rise to the challenge.


Source: Oilwatch Monthly, IEA and EIA

As far as Canada’s tar sands are concerned, Alberta currently produces roughly 1.4 million barrels of oil per day and under the best case scenario, this figure is expected to rise to just 3.5 million barrels per day by 2020. To complicate matters even further, the tar sands require huge amounts of water and natural gas. In addition to this, the mining procedure is extremely polluting. For example, the process of extracting ‘oil’ from bitumen releases at least three times the amount of carbon dioxide emissions as regular oil production. Accordingly, we have no doubt in our minds that Canada’s tar is not the Holy Grail.

Finally, the new oil shale discoveries in America are not going to help us either because the ‘oil’ trapped in the shale is in fact kerogen – a precursor to oil. So far, all major oil companies have struggled to convert the kerogen into usable oil and it will be interesting to see whether any of them succeeds in the future. In any case, this conversion process is extremely expensive and we can assure you that shale will not be producing any oil at today’s prices. Recent studies reveal that the price of oil will have to rise to several hundred dollars per barrel to make this process economically feasible.

Well, now that we have covered the supply side, let us briefly discuss the demand side of the equation. According to the IEA, global oil usage in 2009 will amount to 84.4 million barrels per day and it will rise to 85.7 million barrels per day in 2010. This means that oil demand will rise by 1.5% over the next twelve months which is in line with the growth rate over the past two decades. If this growth rate continues over the next 4-5 years, there is no way our world will be able to ramp up production.

Unfortunately, positive thoughts and wishful thinking will not change the equation. Precious time has been wasted and we have no margin of safety. We must prepare ourselves for sky-high commodity prices and periods of acute shortages, which will make wartime conditions seem rosy. In fact, we believe we are already a decade into this painful transition but let us warn you that we have seen nothing yet.

If our assessment is correct, it seems prudent to make a sizeable allocation to the energy sector. However, given the realities of ‘Peak Oil’, we do not recommend exposure to the oil majors, as their reserves and production are in decline. On the contrary, we urge you to invest your capital in quality upstream oil/gas companies and businesses involved in the energy services sector.

Regards,

Puru Saxena,
for The Daily Reckoning

Joel’s Note: Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive “Weekly Updates” covering the recent market action. Money Matters is available by subscription here.

Puru Saxena is also the founder of Puru Saxena Wealth Management, his Hong Kong based firm, which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

Copyright © 2005-2009 Puru Saxena Limited. All rights reserved.

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And finally, Bill with the Daily Endnote...

Tomorrow, we’re off on the road to the Andean highlands...

No phone. No internet. No fax. No Blackberry. No iPhone.

We’ve got cows to round-up, wrestle, and vaccinate.

In the meantime, we’ll leave our “Crash Alert” flag flying...and send a message as soon as we can...

Until then,

Bill Bonner
The Daily Reckoning

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