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The BIG Picture Transcript

  Part 1

 Donald G. M. Coxe, BA, LLB

JIM: Well, certainly to say the old euphemism that we live in interesting times, on the day that we’re speaking here, the market is down a little over 500 points – probably the worst week in S&P history of the market.  Joining us on the program is Donald Coxe.  He’s global portfolio strategist for BMO Financial Group. 

And Don, I want to start our conversation going back to July of this year, you started July 1st and you had oil prices over 140, gold looked like it was about ready to take 1,000; we had rumors on the Street that Fannie and Freddie may be in danger; corn was at 7.50; we had the Dollar Index almost ready to break multi-decade lows; you had the futures market pricing in 75 basis points in rate hikes.  And all of a sudden on a weekend, the market completely flip-flopped and changed.  Take us back to that time and in your opinion tell us what happened. 

DONALD COXE:  Okay.  What happened then was a unique form of government intervention in the capital markets.  What happened is you got together Hank Paulson, who knew the capital markets as well as any man alive, and Ben Bernanke, who is a much shrewder Fed chairman than people realize and a much smarter Fed chairman than his predecessor. 

They were faced with the fact that US CPI had just come out at 5.4 percent year over year, led by foods and fuels; bank stocks were going down and they knew that Fannie and Freddie were toast.  So they decided what they had to do was to take advantage of a big amount of leverage in the system.  They knew that the winning hedge funds had been short bank stocks and financial stocks and long commodities and commodity stocks, and the result of that was extra pressure – commodities had been going up for six years but from the early May they had just soared through until July 11th.  And so what they did was they made the announcement as the Asian markets were opening on a Sunday night, and they announced they were basically backing Fannie and Freddie.  What that did is it had an enormous impact on holders abroad of US dollar paper.  Russia held 100 billion of Fannie and Freddie paper, for example.  And they were getting pressure from these governments abroad saying, We were sold this stuff and we were told it was as good as Treasuries, you’d better make sure it’s good. 

So what happened then was a huge rally in the bank stocks. Now this was the big part of their plan was they knew that the banks needed to get more equity capital in, and late last year and early this year they had gone to the sovereign wealth funds, mostly in the Mideast, and sold a lot of stock.  Well, their stock price had gone way down since then.  They needed to therefore get the stock prices up, so what they did was announcing this; and what that did is it took a huge level of risk out of the US financial system because if Fannie and Freddie couldn't pay their bills all the banks were going to go down.  So they set off a gigantic rally driven by short covering – remember that US stocks do trade thinly in some Asian markets, so these leading bank stocks were rising but the hedge funds couldn't rush in to cover – there was no liquidity.  But what they could do was sell their commodities and in such markets as there were out there to try to take off the other side of their trade. 

By the time they opened in Europe what you had was hedge funds deleveraging by the billions of dollars, selling every commodity contract that they could get and buying in every financial stock.  So we had a sensational rally in the financial system.  There’s nothing like it in history.  The bank index, the BKX, rose 40 percent in two weeks.  Now, it wasn’t enough as it turned out to get people to buy the bank stocks, but meanwhile, what they had set off was a fire storm in the commodity area, and that was also helped by the Congressional investigations of commodity speculation.  A guy I had never heard of before named Masters with a small hedge fund based in the Cayman Islands as Senator McCaskill said, the most important man in Washington and there was a great foofaraw about making the big pension funds stop investing in commodities.  Well, I knew that wasn’t going to happen because Senator Dick Durbin who is the Democratic whip, and given the importance –this call is from Chicago – of the Chicago Board of Trade that wasn’t going to go through; but what they did do is they brought enormous pressure on some of the big ones with public participation – the CALPERS and funds like this – who had big exposure and were making a lot of money out of being passive investors in commodities. 

So they pulled their positions and that was a big deal with the unwinding by the hedge funds under duress, the unwinding of the big players under political pressure, we’ve taken oil from 147 down to 78 dollars, and we’ve taken copper down from 395 down to 212, and we’ve taken the grains as we’ve mentioned earlier down to just above 4 bucks for corn; so we’re no longer talking about food inflation.  So why was this so important for them to do this?  Because the Wall Street Journal and the right wing of the Republican Party were screaming at Bernanke to raise interest rates, to raise the value of the dollar which they said would bring down commodity prices.  Well, they did trigger a big rally in the dollar.  Now, whether that was what brought them down or not, you can’t say; I mean it certainly helped.  But the dollar was trading back in July at a 72 on the DX Index and it’s 82 now.  In dollar terms that’s a gigantic rally.  So they accomplished to rally the dollar, to rally bank stocks, to smash commodities, and to free Ben Bernanke up to be able to ease interest rates if he felt he needed to. 

I would argue this was the most brilliant and surgically managed government intervention in capital markets of all time.  When the government intervenes, capital markets always turn out to be somewhat bigger than the government.  And meantime, the full effects of the great sin of our time, as I call it, I call the Crime of the Century is Homicide – H-O-M-I-C-I-D-E – and homicide was the gigantic conspiracy between the Congressional backers of Fannie and Freddie, investment bankers on Wall Street who had these shining new formulas where you could put together houses that were sold at 110 percent of face value to people who didn’t have a job or any assets, mix them in with Triple-A borrowers who had only 50 percent in and you somehow or other you got a piece of paper that got a Tripe-A rating which you sold by the trillions and you sold most of it out of the country. 

And so what’s happened is the global banking system has been imploding ever since, and what is going on now is although that bailout that was announced – 700 billion – would be primarily aimed at US banks, the problems are even more acute in Europe.  And so what we have then is all over the world, the financial system is at bay.  I thought we would never see a worse crisis than say October of 87 when we were down 22.6 percent that day, but we’re down 22 percent so far this month in the S&P, and the month has still got quite a few days to run.  Now, what’s happened though is the good news is that the damage has been spread around the world.  It’s also the bad news.  What that means is all the central banks in the world are getting together, and we’ve got meetings in Washington this weekend, when we had that embarrassing day where Congress refused to pass the bailout bill and the Dow dropped 778 points and the finance minister of Germany said that this was the US’s greatest embarrassment and the US had given up its right to be capitalist leader of the world.  Well, since then they had to bailout a bunch of banks in Germany and the Germans aren’t so smug anymore. 

So what Milton Friedman and Ben Bernanke have always agreed on as brilliant economists is that there is no reason to ever have a depression because you can prevent a depression providing you grow the money supply rapidly.  What happened in 1929 was the Fed cut money supply growth – the government raised taxes and the Congress passed Smoot-Hawley.  Well, although we’re getting a lot of protectionism talked about in the Democrat primaries, I don’t think actually too much will happen.  And there might be some tax increases from Obama, but probably not a big deal there.  But what we’re certainly not going to have is a reduction of the money supply growth, but it wasn’t going anywhere for months.  And it wasn’t going anywhere for months because they couldn't get any growth in the banking system itself, now they’re doing it.  We’ve had rapid growth of the monetary base finally, and M2 is now growing at an acceptable rate.  This will be happening across the world.  The European central bank which had tightened rates in August cut rates this week and nothing concentrates the mind of a central banker so wonderfully as the knowledge that his banking system may collapse within a week.  So my view is that notwithstanding the scare stories that you’re seeing out here, that this one can be managed. 

What made the economic experience of the 90s so different than any decade before was because this was the first decade of true global liquidity where money flowed across borders relatively easily.  And by adding a new major currency – the euro – what we did is we finally had another currency with roughly the same market value as the dollar which meant you could flow money across these zones without friction.  Recently as 1980, the German bank wanted to send 10,000 Deutschmarks into buy dollars, they had to file a letter with the minister of finance.  Well, through the 90s, we got to the stage with technology and the breakdown of barriers, banks were able to flow 50 billion Deutschmarks equivalent now in euros, and just make a public statement of the transfers they were doing.  They weren’t held back.  So we used to have the term ‘global liquidity’ used to be used, but it was a series of lakes and oceans that had very small canals between them.  What we achieved in the 90s was remarkable.  We got the equivalent of the St. Lawrence seaways hooking up all of these, and therefore money flowed, which is a wonderful thing for the US because the US has had a negative savings rate for most of this decade.  And it would have not have been able to grow the US economy at all without being able to import from abroad.  The US lives by importing debt and this decade for every 100 dollars increase in debt that we've had total –that is with federal government, corporates and individuals – we’ve had 19 cents of GDP growth.  So we’ve been living way beyond our means, but we’ve been able to get the money easily.  What happens when you have a global banking crisis is you freeze up capital across borders.  Most importantly though, you freeze it between banks and their customers, so what we’re seeing is a situation where we were threatening to have a global recession or worse because banks weren’t able to make loans, so the mechanisms that they are using now to free up the banking systems should get this going. 

There are two different kinds of problems for banks.  One is liquidity, they’ve got very good investments on their balance sheets but they’re long term and they can’t suddenly raise when they need them to make a loan.  The other is insolvency; that they’ve got these long term investments on their balance sheets but they’re worth nowhere near what people say they are, or what their accountants are told they are.  And then you have what we've actually had in the US banking system for the last two years which is both problems.  They loaded up with this dreck, these complex computer created instruments and they kept assigning a valuation based on their own models.  But you notice when John Thain took over Merrill Lynch, he unloaded a lot of these complex instruments were shown at being valued at par on the balance sheet, they got 22 cents in cash but with a put option back which actually made the price six cents.  So if you applied that across the US banking system, all the banks would have gone bust. 

So it hasn’t happened, but the result of what is being done now with that 700 billion which has already been laid on, then with the possibility that the British remedy will be used, which is what Gordon Brown has done, where he’s actually buying preferred stock in British banks – that is the way that I think we’re to solve our problem.  The reason for that is that all banks are levered up heavily, so it doesn’t do that much good to take a piece of toxic paper off the banks’ books at the price that their auditor told them to claim for it because they just break even.  What you want to do is take advantage of leverage.  What’s killing the banks is leverage – 11 or 12 to 1, when they shouldn’t be levered up more than 10 to 1.  By the way, European banks are levered up 20 and 30 to 1.  They are in much worse shape.  You want to take advantage of it by putting in money via preferred stock the way Warren Buffett has done with Goldman Sachs, where he’s bought preferred stock and taken warrants.  If you do that then you’ve got the leverage working your way; you can write down a lot of bad paper if you've got that much equity.  So I believe that something like that is going to be done. 

I do not predict a US depression which some of the people who had predicted troubles are now saying.  See, once you get on the front pages as being an expert who’s been right, then your way to stay on the front page is keep coming up with forecasts that things are going to be even worse.  It’s intoxicating to be on the front page when you’ve been an obscure academic or an analyst that not many people listen to.  Therefore my view is that we are going to have a global recession that will last for a few months, but that’s in the OECD – the advanced industrial world.  Now, it’s hurting a lot of the Third World, but let’s take starting with the oil story.  We’ve broken 80 bucks on oil.  The bad news for the oil producing countries, bad news for Russia, or Venezuela, for Nigeria and for the Arab states; it’s good news for China and India.  It’s extremely good news for China and India – their biggest import bill is oil.  So what you’ve got to understand then is that although people are using this drop in oil prices as a sign that the whole commodity boom is over, the only oil producing states that are of any size that are up there, are Brazil will be an oil exporter when they bring on all this new offshore, but not at the moment.  So the oddity is that the drop in the biggest commodity – the one that’s worth more than half of all the commodity prices – is actually good news for the others because it will stimulate even more demand for food and for metals, and so therefore the fact that we’ve knocked these food prices down is that’s going to start to turn around I think a bit because we're going to have faster economic growth. 

Now, you say:  Well, how do they live off it if we’ve got recessions in the OECD?  Well, remember, even in China more than two-thirds of their economy is domestic.  Japan was able to grow through recessions that we had from the 70s and the 80s because, although they were an export powerhouse, over 80 percent of their economy was internal.  China has extremely high savings rate, and they are going to continue to grow and they need to continue their process of having a high protein diet.  I saw this when I took time off to travel in rural India and I saw that the young students going to school didn’t look as thin and small as their parents did.  The parents were using such money as they had to make sure that they got protein in their diet – either milk and cheese or through meat or both.  Now, if you do that, you’ve got a conversion factor from corn or soybeans or sorghum or barley that you’re using to feed the animals.  The figure is around six to seven times.  So we’ve got a shortage of protein that needs to be used to produce animal protein, and the more these countries grow, the more we’re going to have that shortage.  My favorite commodity group for the last two years has been the agriculturals.  I believe we have a global food crisis; I believe the willingness of people to go off a diet of just a couple of bowls of rice and a loaf of bread, a slice of bread a day, that’s gone; and I believe this is pretty much independent of the short term setback in the global economy that we’ve got.  Once people have learned to eat dairy products and/or meat, they’re going to continue to do so.  That leaves of course the metals and they are cyclical.  A recession here is going to cut down on metal demand.  But in this demand, copper demand in the OECD has only risen by one percent a year, but copper prices went from 68 cents to as high as four dollars, and even with the panic sell off that we’ve got, copper is still $2.16.  So what I believe will happen is that there will be a surprise by just how strong the demand will remain from the Third World because every time they want to build dwellings with indoor plumbing and electricity, what they do is create demand for copper and electrical wire – that’s 80 percent of China’s demand – both in the house and transmitting the electricity to the house.  They’re building one new coal plant a week there because of a growing electrical demand.  So I’ve always told people that this is the most significant historical development of our time. 

We’re living through what I call the greatest simultaneous efflorescence of personal economic liberty in human history.  Efflorescence is flowering and every time some poor family moves into a dwelling with indoor plumbing, electricity and basic appliances, acquires access to motorized transportation, what you’ve got is a form of miracle because that family is transformed.  Even if they’ve got no political power, what they do have is economic power beyond what 99 percent of humanity has had through history.  So that’s the process that I’ve told people they should be investing in – the great story of our time.  I’m a historian by training.  My pattern for 35 years as a strategist has been to say:  I want to pick out only a few big themes, and my choice has to be that there’s something that a future economic historian will be writing about 200 years from now.  They won’t be writing about a 22 percent selloff in the S&P, they’ll be writing about these big changes.  And the big change is this, that we’re moving leadership away from the First World to the leading Third World countries, and we’re doing it because we made a decision starting in 1971, we chose not to reproduce ourselves.  And ultimately what defines who are the strongest economic power is population, providing the population is educated and has access to tools.  And when we chose to collapse our birthrate from 3.4 for females, to 1.4, it means that each new generation is only 60 percent the size of its predecessor.  And that means for example, in the case of Japan, they project it, there will be no Japanese left on earth by the year 2500.  We’re not as extreme as that in North America, but we’re getting there.  You cannot have dynamic economic growth when you’ve got a collapsing birthrate, one, because you’ve got smaller generations.  The real estate boom was at all times was an act of monumental idiocy because it was based on earlier cycles where you always had so many new young people entering the workforce who needed a house.  That’s not the case now; it’s not going to be for the rest of the lifetimes of anybody who’s on this call.  Therefore the real estate boom  was idiocy almost on the same scale as the tech mania of the late 90s.  But we’ll work our way out of this because people still can use – a lot of people can use two houses, one up North and one in Arizona, that sort of thing.  But in the meantime, we’ve got to work our way through the folly of having created trillions and trillions of dollars in instruments that never traded in a public exchange, were never valued properly, done to models – I shared a platform with Professor Nassim Taleb in California last year – he wrote the book, Black Swan, which is a must read, and he wrote in this book that the models that were used for the building up of the balance sheets of the big Wall Street firms were fatally flawed because they didn’t make allowance for the possibility that house prices could go down.  Why?  Because house prices hadn’t gone down in 40 years, and therefore that meant forever. 

Well, as soon as house prices went down, the models basically blew up.  Now you might ask, why were people so stupid as to do that?  Well, Long Term Capital Management went bust with two Nobel Prize winners on its group in 1998, and they had a model which said they had everything covered in it, but it only went back to 1991.  It didn’t even include what happened in 1987 with the stock market crash.  Only hubristic Nobel Prize winning economists would be so stupid as to bet billions of dollars on a model that was so limited.  So what we had was the equivalent this time and therefore it was these mathematical geniuses that got us into this trouble, along with greedy investment bankers and with people like Countrywide and Congressmen promoting housing for everybody.  It was the worst display of collective chicanery in American history because on a bigger scale; lesser countries would be devastated forever by it.  Fortunately, America is too big, too smart, too strong, got too much going for it – but this will be more than a temporary setback.  The stock market is saying that this is “America’s era is dead” – that’s been proclaimed before, most recently by the emperor of Japan, not long before he was finished.  That’s it.  Are there any questions?  [22:41]

JIM:  Well, Don, what you just said is confirmed.  I have a friend who manages money, he’s in Hong Kong, he grew up in India, he’s been in Hong Kong for quite some time, we saw the economy around Beijing shut down for the Olympics as they tried to clear the air.  But yet I look at the PMI for China, which is moving up and again, and he is pointing out very much the same thing that you have said.  And it was interesting because we’re talking about demand destruction here for energy – auto sales here in the second quarter were down I think something like 7 percent, and yet if you take a look at auto sales in the BRIC countries, they were up 20 percent;  SUV sales in China were up 40 percent.  And one of the things that you have is if a Chinese individual trades in his bicycle for a motor scooter, or the individual who had a motor scooter buys his first car, all of a sudden now you have a consumer of energy; if a person from the countryside that used to live on rice and maybe vegetables moves to the city and he adds pork, chicken or even beef to his diet, now you have a consumer of protein. 

And I guess the story that I want to hear your comments on, you have areas that are in great demand around the world; our grain supplies, if I recall, are down to maybe 30, 40 year lows; gasoline inventories even here in the United States are down to 8 year lows.  In many cities you can’t even get gasoline.  Why don’t you comment on some of the areas that you’ve been very bullish on.  I mean I’m taking a look a look at the agricultural sector, and in the energy sector right now, you can take a company like Mosaic where they took out and shot in one day, dropped it by 40 percent because they’re talking about maybe reducing some of their inventories.  Here’s a stock that was up in the 160s, it’s now in the 35 level; it’s selling at 5 times earnings; you can take a stock like Conoco-Phillips which has large natural gas reserves which is selling at 4 times earnings, and has a very strong balance sheet.  What would you tell people who, let’s say, either own these stocks right now and are worried because people are saying, Sell, sell, sell, this is it, this is it for the commodity boom?  I just don’t buy that.  But what piece of advice or encouragement would you give to these people that own these stocks?  [25:17]

DONALD:  Well, I think that you have to understand that people such as you and I are still within the minority within the investment community, and I proclaimed that February of 2002 was going to be the greatest commodity bull market of all time, and I stayed with that.  At that time most people thought I was stark raving mad.  But gradually I made converts, particularly among hedge funds which realized this pattern.  But remember, there is only one mining stock in the S&P 500 – only two, Freeport McMoran and Newmont Mining, and that the weight of agricultural stocks is tiny.  So what you don’t have is the huge constituency on Wall Street promoting commodities.  As a matter of fact, they quite rightly realize that if commodities are going up, that some other sector of the market that they make lots of money on – investment banking and trading – are going down.  So that’s why the Toronto Stock Exchange outperformed the S&P for 7 straight years because there’s a weighting at the peak in May of 50% in commodities on the Toronto stock exchange as against 17 in the S&P.  Well, therefore when this bad news comes out like this, what you’ve got is all sorts of eager tub thumpers on Wall Street who are waiting for the commodity boom to roll over so they can get people to go back and buy tech stocks again.  So we don’t have enough depth out there of the believers. 

I developed four years ago the idea that the commodity story was going to be a great, great symphony; and I used the model of a symphonic form, a three movement symphony.  The first movement, which is maybe even allegro and cheerful; the second movement, slow movement in a minor key; and the third movement, very fast, maybe even presto – and that I believe is what we were going to have.  We are in that movement now of the largo movement.  We had six years of terrific growth and terrific speed, and of course a little froth came at the end of it, but what we’ve got is people saying, If the commodity prices aren’t going up, they’re going to collapse.  Well, even at 77 buck oil, that’s only taken us back to where we were two years ago and back then, since that was 200% higher than it had been three years before that, it looked pretty good.  I remember speaking at a mining conference in 2003, and I talked about the coming boom for the base metals and they asked me to give a forecast for where the base metals prices could reach.  And I said, Why don’t you use 2 dollar copper by the end of the decade.  The management of Phelps Dodge, as it was then, got up and walked out in disgust because they had told us before the luncheon that I spoke at to use 85 cent copper as the long term forecast. 

So the prices that we’ve got on this pullback are not the sign of a depression or are not the sign that you should give up on these because the reason for investing in mining and oil companies is what I call unhedged reserves in the ground in politically secure areas of the world.  We are running out of politically secure areas of the world, we’re running out of good ore bodies in them.  There’s not much point in having a politically secure ore body in Russia; if it’s a good one, it’s gonna get taken from you, or your management on the ground is going to be thrown in jail for taxes, or for environmental degradation.  So when you have secure ore bodies in Canada or Australia or in good countries in Latin America, those are worth a lot more money now than they were then and even with copper back at 2 bucks.  So the story is a great one.  It’s a story of a hinge in history where the economic power of the world gradually moves to the next great continent that has a bigger population of people who are educated and have the tools. 

Back in 1895, the British realized that as a result of immigration to the US, now those blasted ex-colonials of theirs had a bigger population and they were building bigger factories and had just almost as good technology as the dark, satanic mills of Britain.  That was when the industrial leadership shifted from Britain to the United States.  So because we chose to collapse our birth rate here, what we basically said is we’re not going to be number one by the year 2040.  We're still number one and will be for a couple of decades, but GDP is simply output per worker multiplied by the number of workers, so when abortion is the number one sort of election issue in the country, you know that’s a country that is just not going to keep on growing the way it did in the past.  But that’s the decision that we made; that’s not the reason for the Dow being at 8,000, but it is the reason why those who replace us are going to be able to keep on growing because they are growing for their children and they still have good size families.  They have all the things that drove American pioneers in earlier generations to suffer and save for future – Americans stopped saving years ago and have been living off the savings of countries abroad, and it’s working out pretty well.  We’re getting a bit of a payback time now, but we’re going to come through this; but the great commodity companies are in effect global companies.  That’s the point – they aren’t primarily dependent on the US economy for their growth.  So we are adding each year now about 100 million people to the total of the middle class who lives in dwellings with indoor plumbing, electricity, basic appliances and have a high protein diet.  So that’s the equivalent of adding two Canadas to the world’s population each year.  They didn’t count before, they weren’t on the radar of the world; and the number of companies there are out there that could find the resources needed to satisfy these new people is very limited.  They should be the core of any investment philosophy.  [31:12]

JIM:  Two final questions, Don, and this might help to explain what we've seen and I call it deleveraging on steroids, or hyperspace.  You've got the Dollar Index up, it’s up at 83, it’s had a tremendous move since July, you explained part of that.  I wonder if you might just comment on the yen as well, that this deleveraging of the carry trade, once that ends, what props do we have to keep the dollar up?

DONALD:  Good point.  This is something George Orwell would have approved of with the dollar rally which started in July 13th in what I call the midnight massacre:  Weakness is strength.  Which is that the hedge funds in particular had all these assets invested outside the United States in commodities and in emerging markets and so forth, and as they deleveraged they were bringing them in which meant they converted them into dollars.  European banks who’d bought up trillions of our bad mortgage paper were writing down, and as they did they had gone short the dollar because they didn’t want to increase their exposure to a weak currency, so as they were writing down their losses, they had to cover their shorts on the dollar, so the dollar had a huge rally precisely because a bunch of losing investors were pulling it in. 

Now, the carry trade on the yen is very different; the yen only costs half a percent to borrow, so the yen has been the favored currency for borrowing for investors who were levering up.  So the yen goes up at a time that people are unwinding their exposure, and it goes down when they’re borrowing in the yen and investing to do something somewhere else in the world.  So the fact that the yen has broken par would have been worth – if I’d known the yen was about to break par I would have had a fairly good forecast as to how much commodity prices would have gone down because knowing how they were levered.  But at the time of that big appearance – the midnight massacre – the yen was at 108, now it’s 99.78 and that’s another sign of blood being spilled among hedge fund borrowers.  [33:23]

JIM:  A final comment – as we're speaking right now, we've got gold – let me see – even in the after market trading it’s down about 70 dollars – and we’ve got silver down, it broke 10 dollars – in the month of August, when silver dropped down to 12 something, I bought a tonne of silver.  I was told at the time I could lock in my price; I paid a 6 percent premium to get it and I was told 8 to 10 weeks for delivery.  Checking in, it’s now turned to 14, 16 weeks; maybe I may get it by Thanksgiving.  I have no idea.  One of the largest coin dealers here in La Jolla, one of my clients called me up and went in and said, I have nothing to sell you.  I’m looking at EBay where silver Eagles are going for 21.25.  Isn’t there a big disconnect between the paper market and the physical market?  In other words, how long can you keep driving the price of paper gold and silver, and yet you can’t get it?

DONALD:  Very good question.  I recommended to the World Gold Council, now it’s set up that ETF because I said, first of all you would have it behaving like a stock because it’ll be in stock accounts and therefore when the stock market was selling off, the margin clerks would sell out the gold ETF along with it.  But I said it would also lose its exclusivity as being a hard asset because it would still be a paper asset.  Well, they didn’t listen to me.  And so what we see is gold futures are down 44 today, but as you say, the gold ETF is down 73 bucks.  And so we do have these disconnects.  So yeah, the Bank of Nova Scotia in Toronto as of last week told people it would be 8 days delivery to get bullion and they’re the biggest bullion dealer in Canada, and so, yes, the physical is indeed in short supply.  So at some point these things work their way out, but in my view on that is that I recommend to people that they have exposure to the good gold mining companies because then it doesn’t matter one way or the other, you know, they’re going to produce the actual bullion.  But today, those good gold mining stocks are acting as if they were copper stocks because you’ve got liquidation of, quote, commodity positions.  I’ve learned to live with it even if I don’t believe that there’s any rationale behind it.  [35:49]

JIM:  A final question, Don – as you have viewed the markets over the decades, or you mentioned earlier, you come at this from a historian.  What would you say is the most important lesson that you’ve learned watching markets in your investment career?  What would that be?

DONALD:  The most important lesson to learn is to find out really what you are.  Are you a true long term investor or are you somebody who can really not afford to sustain any significant short term downgrade in the value of your portfolio.  It goes back to the great poem of the 18th Century:  Know then thyself, presume not God to scan, the proper study of mankind is man.  Understand yourself first.  Secondly, understand what it is that is a reasonable expectation for what investments can do for you on the longer term; and third, realize that nobody that I know of has ever made money by being able to make money just in financial crises or runaway bull markets by short term trading.  They can do it once or maybe twice, but it’s like winning on black jack at Vegas, it is not the basis of a long term career.  So personally, I have not reduced my exposure very much in this market because I was cautious going into it.  But, no, did I think it was going to go down this much?  Definitely not.  But I believe the central bankers – this is another thing I learned was the central bankers need to understand better what’s going on in the world.  I was at a central bank conference.  I was one of the few outsiders permitted at a central bank conference on commodities – it was at the end of June.  And I really understood the collegiality of these – there were six central banks represented.  So I just tell your listeners that I believe that we’ve got an international group of people who are amazingly fine civil servants in the best sense of the word, and I have a feeling that they’re going to work something out here and it’s all going to be done behind the scenes.  But what you’re looking at in your screen is the second act of a three act, or a three movement symphony.  The third act is when we come to the happy ending.  [38:06]

JIM:  Well, Don, let’s end on that happy ending.  I want to thank you for joining us on the Financial Sense Newshour.  Great words of wisdom.  You say it so eloquently and put it in words that people can understand.  I appreciate you joining us on the program.  You have a great weekend, Sir.

DONALD:  Good luck to all of you.  [38:24]

 Frank Barbera, Gold Stock Technician

We're at the Bottom

JIM:  Well, joining us on the program is Frank Barbera – almost, Frank, it’s becoming a regular routine on Fridays, every week:  I’m standing on the ledge of a second storey building, Frank.  I don’t think a parachute is going to help me, but, you know.

FRANK BARBERA:  It’s been a really wild market.

JIM:  You know the funny thing about this, Frank, this has been I think if they were to go back and redo this again, I don’t think they would have let Lehman go the way they did because of what it has unleashed.  I mean here we are – I’m looking at a Bloomberg story – credit default swaps on Lehman has a payout of 91 cents on the dollar; look what it unleashed with the reserve fund, money market funds, AIG –

FRANK:  And then of course Ginnie Mae and Freddie Mac.

JIM:  Yeah.  And then you also have not only just Fannie and Freddie, look at the TED spread.  That’s the highest I’ve ever seen – let me just call up a graph here on the TED spread – and I’ve never seen anything like this since I’ve been in the business 30 years.  I mean we’ve got the TED spread 464 basis points above 3-month Treasuries. 

FRANK:  You know certainly what that speaks to is the incredible level of fear that there is, the fact that the TED spread being a very strong gauge of fear.  For those who aren’t familiar with it – the Treasury-Eurodollar spread – when that widens out you get a symptom of the credit markets that are basically not transacting.  That’s what’s happened – the credit markets have locked up.  You can see that in other indicators, some of the corporate bond – high grade corporate bond to low grade corporate bond spread has widened out tremendously.  We’ve seen some of the other spreads – with regard to LIBOR spreads, LIBOR OIS spreads have widened out.  All of that is abject terror in the credit markets and a sign of fearfulness in terms of one institution falling from another.  And we’ve just seen that contagion spread from the debt markets into the equity markets and now you see things like the Volatility Index – the VIX Index – breaking 70 for the first time on the upside.  I should caveat that.  The VIX Index – it’s the first time in many years.  If you go back long enough to 1987 there were different calculations, at one point in the 87 crash – this is more from memory than data – the VIX Index was up to around 140-150.  You can get very high levels of fear.  We may not be quite there yet but we have to be really close.  From a sentiment standpoint of view, I would say most of the gauges I’m looking at are showing markets that are basically terrorized.  This is the kind of an environment where it’s really ripe for a recovery of some sort.  I’m not going to go out on a limb and predict one right now, but I will say that right now looking at the tape – you know, Jim, I’ve been a bear for a long time, writing on Financial Sense going back to the highs in the stock market last July and October and then a whole series of articles in January of this year and March and April basically talking about a bear market and the risk of a crash; in my newsletter I’ve written about that quite a bit, with targets down to the levels that we’ve seen this week.  So there were a lot of big bells and whistles that were going off here for a number of months, that were sort of suggesting there was at least risk – if not the certainties – there was at least risk that the stock market could come down to these levels. 

I think this is the kind of an area where we have to pay very close attention to see if the market may find a bottom.  There’s a reasonable chance that this could be some kind of an important low that develops over the next few weeks; and I think that’s another point I should stress is that for people who might wake on Monday morning and see the stock market moving higher, folks there is no way the stock market has found a final low as of this point in time.  The momentum at this stage of the game down is still very high.  What you typically need to see is a nice rally attempt and a rally attempt that lasts several days or more – even two to three weeks would be great – and then a retest of the bottom, second decline that comes back down to the lows that you made, sort of makes a double bottom and at that point – at that point and only at that point would it be a conclusion where you could say, okay, this looks like an important market low and the kind of a low that may be able to launch a major bull phase.  So I think that type of outcome is potentially in the cards, and I think we’re getting very close to the kinds of readings that you would normally see that would signal a major market low, but I wouldn't want anyone to go out and try to aggressively buy stocks on Monday morning.  We’re still going to see some real volatility here over the next few weeks.  Sophisticated money, smart money is probably going to scale into the markets very slowly over time.  [43:53]

JIM:  You know, I’m looking at a chart, Frank, that takes a look at the spreads between what’s taking place in the XAU versus the price of gold.  I haven't seen these kinds of spreads – and this goes all of the way back to 99 – we’re almost at extremes on the gold area, and yet on the day you and I were talking – we were talking early in the morning – I watched gold last night, it was up 25-30 dollars at the 925 level and then we had almost a 75 dollar decline in gold in terms of when the markets closed in after-market trading.  What about the gold market?  I mean it’s almost like just extremes here.  Should we look at the gold market and the gold stocks as sort of a sign that reflation is beginning to take hold?

FRANK:  Well, I think that’s going to be a key barometer, Jim.  And I think, again, certainly that disconnect has been used; that was a concern of mine over the last few months. I voiced that on several occasions in the newsletter regarding the fact that gold stocks could be vulnerable in a bear market with the stock market.  That seems like that has basically played out.  At the moment, I think the first step is going to be to see if we can find some stability.  That’s the first key.  There are still a lot of credit default swaps that have to settle up in the next few days and we really need to see the stock market hold the 780 to 800 area – that’s critical.  I would define those 2002 to 2003 levels as pretty much life and death for the stock market over the next couple of weeks.  That may sound dramatic but it’s really hard to overstate how important that area is.  So I will feel better about things if the stock market hits 780-800 and then takes a really hard bounce off it, and then comes down to retest.  If that happens I would imagine there would be a good indication that we could be turning the corner into a reflationary environment; an environment where I would expect the gold stocks – and especially the junior gold stocks – to lead the pack. 

You talked about value, there’s probably nothing out there in the way of a market sector that has more accrued value built in than the junior gold, except possibly at this stage of the game some of the oil drillers and some of the oil senior oil stocks which are also badly depressed.  There is a lot of value out there when you look at names like Suncor, Chesapeake – I’m not to get into individual stocks, but TransOcean.  I look at the tape, I see these stocks as badly depressed and it definitely gets my attention in terms of, well, maybe we’re getting close to a spot to where these things are a good buy.  You have to restrain that a little bit right now because there’s this derivative overhang, and maybe if something doesn’t go well, who knows, maybe the market would break 780 to 800; that would be really negative if that were to occur.  I’m hoping that that doesn’t happen.  But again, we’ll know.  We’re going to let the market tell us a little bit, and if it can bounce towards 900 some time over the next couple of weeks having tested 800 first, that would be the kind of an indication I would say would be a good sign.  On some kind of a retest of the lows in the stock market, I would look for the gold stocks to not be as weak as the S&P and that would be a good indication; they have a pretty good nose for sniffing out an inflationary turn, and basically it seems like right now the deal that the federal government is making is let’s stop this deflationary trend in its tracks and throw a wall of money at it and now we’re going to see if that’s going to work. 

If that works, then we’re going to see a lot of different dynamics.  We’re going to see bond yields backing up, stock prices rallying in the recovery phase, gold and silver rallying right along with them, and of course probably all of the natural resources stocks especially with an underscore the gold stocks moving higher and spearheading a move back up.  That’s just simply a fact that the precious metals will react to the fact that you have the fed expanding its balance sheet at what right now is a record rate; something unprecedented.  And you’ve seen that chart, haven't you, Jim?  [48:10]

JIM:  Oh absolutely.  And you know, the other thing –

FRANK:  It looks like a data error.

JIM:  Yeah, it looks like not only a data error or something – a glitch in the computer system.

FRANK:  Something like that, exactly.

JIM:  You know, you and I were talking earlier this morning and we talking about and there was a story – there was one commodity firm that failed to deliver on their contracts and you’ve also had some deleveraging of a firm that could be in trouble.  And Frank, one of the stories that we’re seeing – we’re seeing a contraction of open interest and there’s a lot of talk here and I’ve talked to people around the globe on this – is a lot of people think that you could see a possible default in the commodity sector – another Refco where somebody has allowed a client to either go – I mean when anybody goes short an entire year’s production of silver, or like for example, remember, I think it was September 19th – it was a Monday – where we saw the price of oil spike from almost 95 to almost 130 and they had to close down trading in the commodity pits.  What happened is somebody had gone short a tremendous amount of energy and then somebody demanded delivery and they were forced into the market to go in and cover that position and the price of oil was up nearly 30 dollars on the day.  And what are the possibilities – I know you talk to a lot of people in the industry, but this is a story I’m hearing more and more often.

FRANK:  I’ve heard the same story, for what it’s worth.  And based on what I see happening with the lease rates, based on people that I’ve spoken to within the industry, right now you look at the metals and the metals are tight; it’s hard to take delivery of physical metal, the wait times are really substantial, inventories are low – some places are simply out.  So, I tend to think that wouldn't surprise me in the least.  In fact, I think the fact that we’re seeing the lease rates on gold tighten up the way they are, it’s a pretty good chance something like that could happen in the not too distant future.  That’s a positive.  I think we should point that out; that basically this would be some big player that has been shorting the metals and trying to hold them down who might be in the process of getting caught short and unable to deliver physical metal against that short position.  So that would be very bullish.

Jim, I think right now, other than in the very short term sense, if you look at the precious metals it’s basically a win-win situation.  If we end up with a successful stock market bottom over the next few weeks and a reflation, which certainly would seem to have a reasonable probability because the government is now involved, they’re basically waded into the pond, they’re in with both feet, they’re at a point where there’s really no turning back and if that can happen, I think you’ll see that inflation at the consumer wholesale level will begin to turn up a few months down the road, and maybe a year from now, we maybe looking at much more aggressive situation as some of this monetization that we’ve seen in recent days creeps into the broader economy.  You’d also be looking for a lower dollar and higher bond yields. 

To me, a big indicator was this week – the fact that you had heavy liquidation in the stock market, 700 point down days on the Dow Jones Industrials and the fact that the 10 year bond yield could not move lower in yield and bond prices higher and gain in that kind of situation – in the past, that would always have happened.  You would have had a flight to quality into government Treasuries.  That did not happen this week.  That tells me that foreign capital which I’ve seen in several charts has essentially pulled back from investing in the United States; and that means that we’re going to have to start funding ourselves; that means bonds are heading into a bear market; that means you’re going to be looking at much higher yields on the Treasury curve.  You’re going to see something that you haven't seen since the late 70s which is bond yields rising, gold prices rising and silver prices rising all in tandem against the backdrop of a lower dollar, which I believe is in the process of peaking right here.  Essentially, right here, right now – I think this is as good as it gets for the dollar and when we have this conversation maybe a year or two from now, we’re going to look back at the Dollar Index and say, remember when it was at 80 something.  My suspicion it will be a lot lower and that’s what happens when you increase the supply of anything, the value will fall.  [52:43]

JIM:  You know, it’s amazing, Frank, I’ve been in this business, what, about 30 years now and we’re publishing something that I wrote and we’re sending out to our clients on Friday.  I’ve got a graph and I showed this last week, but the graph has gotten even bigger, in the last five weeks the Fed has expanded its reserve assets by 688 billion – an increase of 76 percent in just five weeks.  We’ve gone from roughly 900 billion to almost 1.6 trillion in five weeks; and we’re just getting started.  Even when Arthur Burns was really ramping up the money supply in the 70s, Frank, I can’t find anything that even looks like this. 

FRANK:  Clearly off the dial.  There’s nothing that any of the history that would explain what’s happening now, and that’s why I think investors need to be very attuned because it’s easy to look at the stock market falling and say, Well, we’ve got a deflation, home prices are falling, equity prices are falling.  You know what, folks, that can turn on a dime almost literally in a period of a few short weeks; and the flip-side of that is first to reflation then inflation then runaway inflation and then maybe in the final analysis hyperinflation.  You hope not, but that can be a progressive sequence that is unleashed – you really won’t know the final outcome of a reflationary attempt right now probably for at least 18 to 24 months after this point in time, once some of that excess money starts slopping into the economy and prices start moving up.  We’ll find out exactly how long it takes for that to happen, but a big part of it is going to be to see can the US actually invite that foreign capital back and will it come back.  They may be interested in shares, but I’m really convinced that bond prices are going to be in for a very tough slide here and that means that we’re going to have to start watching the credit default swap rates for the US government as a whole.  So the risk is being transferred to the government – that’s a really big red flag for monetary inflation; that’s what it means.  It’s ultra-bullish for gold and it’s potentially ultra-bullish for the gold stocks, especially the small caps where if we get any sized money moving in that direction that could really be gasoline on a fire.  [55:16]

JIM:  And you know, the one thing that you’re going to have to look at which is these credit default swaps and this is one of Bloomberg’s top stories on Friday, Morgan Stanley stock drops a fifth day as Moody’s weighs downgrading the stock.  And Frank, you’ve got credit default swaps on Morgan Stanley going up to almost 1300 basis points.  That’s 13 percent a year equivalent.  But I don’t think after what they saw that they did with Lehman, you know, they made the decision to let Lehman go and then I think if they were to look back they would regret it because you had the reserve fund, a run on money market funds, the government had to come in and back stop these money market funds up until September 19th or whatever that date was; you had AIG disappear; they forked over 85 billion to AIG, now it’s another 35 billion, so there’s 125 billion; and then if you take a look at LIBOR spreads which a lot of mortgages and option ARMs are tied to, you had blow outs in TED spreads.  I mean you could almost go back and take a look at what you’ve seen in the markets, what you’ve seen in a rise in these blowouts.  And whether you’re looking at TED spreads, LIBOR, credit default swaps, it’s almost like it went into to hyperdrive with the default of Lehman – a primary government bond dealer.  And even though I’m looking at a giant jump in the default swaps –

FRANK:  Oh, that’s happening with General Motors and Ford as well as some other entities that have been under – and they’ve been essentially under siege for the last few days, but the question is can the US allow all of these companies to fail or is it going to try and unlock this problem with a sea of liquidity.  Jim, right now I kind of agree, I think we’re in that mode where you have to start thinking about that sea of liquidity.  It is really obvious that that’s the direction that they’re going in, and that’s what they’re trying to bring about.  I think we’ll have to see the stock market stabilize a little bit here over the next two weeks as a first sign that maybe that policy approach is gaining some traction.  Maybe within a couple of weeks we’ll have a bottom near these levels, and if so, that’s going to be something that people really need to pay attention to because that could be setting the tone for where things will be going over the next couple of years.  [57:42]

JIM: I was reading a story in the Wall Street Journal where you’ve got top policy officials at the Fed, the Treasury – even the White House – Frank, it’s weekend huddles.  Do you realize, ever since Lehman, every single weekend you know, now we’ve got the G-7 meeting in Washington, it’s almost like you want to turn on your television set Sunday night to get a preview of what it’s going to look like on Monday.  But that’s something new.

FRANK:  I think there are a lot of people out there who will say, Let’s just throw money at it so we can take a weekend off. 

JIM:  Okay, well listen, Frank.  I appreciate you coming onto the program and sharing your thoughts with our listeners.

FRANK:  Thanks so much.

JIM:  Hey, Frank, if our listeners would like to follow your work, tell them how they could do so. 

FRANK:  They can send me an email at FrankBGST@aol.com.  We’ve been really backlogged with incoming emails so please be patient.  Probably from maybe next week on we’ll try to catch up with it. 

JIM:  All right.  Listen.  Take care. 

FRANK:  Take care, you too. 

 Part 2

 Deleveraging at Warp Speed

And finally in our progress towards a resumption of work, we require two safeguards against a return of the evils of the old order.  There must be a strict supervision of all banking and credit and investment; there must be an end to speculation with other people’s money; and there must be provision for an adequate but sound currency.  Through this program of action, we address ourselves to putting our own national house in order and making income balance outgo.

JOHN:  Well, Jim, there you are, Franklin Delano Roosevelt’s inaugural address.  That was the same one where he said, The only thing we have to fear is fear itself.  But he said, number one, we have to have strict supervision of all banks, credits and other institutions such as that; we have to put an end to speculation with other people’s money; we have to have a sound currency and the government has to balance its budget.  Out of those four, which have we succeeded in doing?

JIM:  Was it Santayana who said that those who fail to learn from history are doomed to repeat it?

JOHN:  Right.

JIM:  You look at that, John, and you see what’s going on and the same mistakes that we make over and over again and it’s almost like each generation has to make the same similar mistakes.  Maybe it never happens and plays out like Mark Twain talks about, History tends to rhyme rather than repeat.  But here we are – and what was that, 1932

JOHN:  33.

JIM:  33?  All right.  So his inaugural address.

JOHN:  Maybe you’d call it a generational skipping thing because the generation that goes through it sort of remembers it, then they have children and their parents tell them about it.  By the time you get to the third generation out, they’ve forgotten it all; they don’t know what caused it.  And you’re right.  They go right back through the same cycle all over again.  If there is one thing we learn about history is that most people don’t learn from it.

JIM:  And you know, it was interesting because in the second hour in our interview with Don Coxe he comes at this from a historical perspective – he’s an historian – and my background is history as well – and it’s interesting because in the evening when I want to relax and I’m done reading, I’ll watch a documentary; and once again, I’m re-watching

The Roosevelt That We Never Knew – it’s a four part series on Franklin Roosevelt – I’m also watching a documentary on Winston Churchill – I kind of play the two off.  What I think was interesting about Churchill is he saw so many of the things that were about to unfold well before they took place, and so that he had seen these things unfolding so that when history was ready he was ready to assume the role; and thank goodness England had a Winston Churchill because they would never have made it without somebody of his caliber. 

But, you know, history does repeat itself – and just as people got leveraged in the 20s, just as we had naked short selling in the 20s, a lot of similarities to what we’re seeing today.  It’s amazing, but people don’t understand; and I think the government itself doesn’t understand sometimes when they set things in motion as they’re doing now.  For example, I think you can trace what you've seen unfold here with the TED spread, which is almost 463 basis points above 3-month Treasuries; if you take a look at LIBOR spreads, if you take a look at what we've seen unfold every single weekend – I think if the Treasury was to go back and take a look at when they let Lehman fail, I think they would take that back today and redo it differently.  [4:17]

JOHN:  It seems like the Saturday huddles now are becoming a way of life for these people.  And I have a feeling they have even bigger things planned for us in the future as we roll forward through this. 

JIM:  We always talk about that quote from Jens O. Parsson, The good kind of inflation.  And I think we addressed this last week.  We were talking about when all this stuff was going on we talked about last week where Paulson and five investment banks went into the SEC’s office in April of 2004 and said, you know what, we need to leverage up.  And up until that time there was a limit on leverage – 12 to 1 – and they said, We need to free up this capital.  And then not only did the SEC relent and give way to that, then they ceded supervision of these firms that were leveraged to themselves; and when you are leveraged 40 to 1, 30 to 1 and 20 to 1, people have no idea of what that means when the markets move against you.  For example, if you’re leveraged 40 to 1, if you have a drop in your portfolio of 2 ½ percent, it wipes out your equity.  If you’re leveraged 30 to 1, a 3.3 percent drop in your portfolio – and John, we’re talking about markets that go up and down almost 2 or 3 percent on a daily basis.  If you’re leveraged 30 to 1, a 3.3 percent drop in your portfolio wipes out your equity.  If you’re leveraged 20 to 1, a 5 percent drop in the portfolio wipes your equity; and if you’re leveraged 10 to 1, it’s a 10 percent drop.  And on the day that you and I are doing this Big Picture segment, we had a 900 point swing; almost a 1000 point swing in the market in just one day.  

And so when people deleverage and when the government staged their raid – Don Coxe calls it the Saturday night massacre – this basically took place on July 13th – it took place on the weekend, it hit the Asian markets and then it flowed through the European markets and then flowed all the way here to the United States – and at that time, as Don was talking about in the interview before that in the second hour, you had all these terrible things happening; you had oil prices – and you remember, John, when we were predicting 125 and then we blew through 125, I raised the forecast to 145 – we hit that in two weeks.  And so we were at 140 oil, we were at almost 1000 dollars gold again, we had every thing that you could think of in the financial sector from the bank and broker index breaking down, the dollar breaking down, rumors about Fannie and Freddie insolvency, you had the highest CPI and PPI numbers on record, the futures market were pricing in all these interest rate hikes by the end of the year which you’d never do with the system as leveraged as it was – and as Don pointed out in the interview in the last hour, they were very, very successful.  They not only forced short covering in the dollar, short covering in the banking sector, but also deleveraging because the leverage was on both sides; it was leveraged short the dollar, leveraged short the financials, it was also leveraged long the commodity sector.  And they completely did, you know, like we talked about last week, they flipped the teeter-totter around and people just don’t understand what we've seen unfold here in a period of probably about five to six weeks is deleveraging at warp speeds.  [8:03]

JOHN:  When people don’t really have a conceptualization – say you've got 9,000 hedge funds and you’re looking at a 40 to 1 ratio on deleveraging, what that really means when that all floods into the market?

JIM:  It means, John, that if you have to get liquid and you have to liquidate let’s say – and what you’re seeing right now is October 15th is sort of hedge funds have an open window once a year where you can liquidate – so if you’re leveraged 40 to 1, and it means that you get a million dollars worth of redemptions, if you’re leveraged 40 to 1 that means you have to sell 40 million dollars worth of assets.  Now, let’s say that you’re a hedge fund and you’re managing 10 billion dollars and you get a billion dollars worth of liquidations and I’m not going to talk about names but that is certainly what has happened to a couple of these hedge funds, that means you liquidate 40 billion dollars of assets.  And so all those things that people were doing well in – whether it was energy, metals, agriculture – all the things that were doing well because of the supply and demand issues – these were the largest holdings.  Now, Goldman Sachs has an index of the top 75 stocks owned by hedge funds and most of the big drop off in these stocks you’re seeing as well.  And it’s not only that, you have mutual funds’ year end; a lot of mutual funds have their year end fiscal year which ends on October 31st, and we had one of the largest months of liquidation in stock funds that we've seen – I would probably have to say, you would have to go back to maybe the technology market pullback that we saw between 2000 and 2002 to see the kind of numbers that we’ve seen now in the last month.  And I suspect if you take a look at what the numbers are going to turn out to be this month, you’re going to see the same thing.  I mean if you look at, for example, let’s just take one of the largest cap stocks you’ve got a large cap stock like Exxon – if you take the value of Exxon which has of this Friday has a market cap of let’s about 324 billion, and here was a stock that was worth almost half a trillion at the beginning of the year; this stock, as of May of this year, was at 96 dollars a share, it’s at 62 dollars a share now, so it’s down 33 percent.  It’s down almost 20 percent in the last five days.  And if you look at the credit default swaps on Exxon, they almost look as good as the US Treasury.  Now, they’ve gone up just a little bit lately because of the nervousness of the market, but here’s a company that has 40 billion dollars in cash on its balance sheet.  I mean it has more cash and has a bigger balance sheet than many countries in the world.  But this is what happens when you see this kind of deleveraging – and we’ve been talking about not only with some of our experts on the show this week – whether it was Gary Dorsch, or Joe Dancy or Don Coxe or Frank Barbera – is we're seeing the unwinding of the carry trade where these hedge funds could go to Japan and borrow at half a percent, less than one percent.  I mean how many people really would like to go to the bank right now and borrow at a half a percent?  I mean, think, John, what you could do if you could borrow money at half a percent, what would you do?  [11:36]

JOHN:  I would take the money and go put it in something that yields a much larger return and go back and pay off the one percent.  It’s just a cost of doing business. 

JIM:  You would continue to do that.  I mean if you were smart and you had risk control, you would probably want to do that.  But what has happened is as you were making these returns on these kind of investments, what happens is as you make these returns, your equity expands – in other words your net worth increases – as your net worth increases it gives you the ability to go out and borrow even more – so let’s say that you might have started out – let’s say you were a hedge fund and you started out leveraging 10 to 1; and all of a sudden the assets that you are investing in are going up 10, 15, 20 percent so your equity goes up.  That gives you the ability to go out and borrow even more money; now you’re leveraged 20 to 1; and then the markets continue to go up, you continue to find – I don’t care if you’re going in mortgage-backed securities, or you’re going into dividend-paying stocks, you’re going into resource-paying stocks – from almost the summer of 2002, it was almost relentless: a rise in almost asset classes.  It didn’t matter if you were in real estate, bonds, stocks, commodities.  And so you got to the point where a lot of these firms leveraged up, including many of these investment banking firms, which are now banks, are now leveraged – I think Bear Stearns was leveraged 33 to 1, I think Lehman was leveraged 40 to 1.  And it doesn’t take much for a run on the bank or the shorts to move against you; or another situation that they have that’s out of control right now is you have naked shorting of credit default swaps, where you have people that are taking out and buying these things and naked shorting these credit default swaps and they don’t have any reserves to back them up.   So, you know, on the day that we're talking you had Lehman credit default swaps settle for roughly for 91 cents on the dollar.  And so this is what deleveraging happens and in a world that is leveraged – and if anybody has read any of the writers on Financial Sense you've seen the leverage, whether you’re looking at debt to GDP, consumer debt to personal income – any of the yardsticks that we have in terms of measuring leverage, they got to be…

Here, John, here’s a flash as we’re doing this show – Paulson to announce to buy equity in a broad array of financial firms.  So now we're talking about recapitalizing the banking system.  So this is taking place as we're heading into the weekend huddle, especially as they’ve seen everything – in other words, the credit systems are clogged up as everybody tries to deleverage – and we’ll get to part of the solution that I think is coming here in just a moment, but that’s why you’re seeing the amount of asset selling that is taking place, and of course, just as we have this – just as people were giddy three or four months ago, it’s almost the opposite effect right now. 

Let me assert my firm belief that the only thing we have to fear is fear itself; nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.  [15:09]

JOHN:  Well, there’s FDR again, and it seems, Jim, when you get to this stage – and I know this from even to just talking to members of my family – there’s a fear factor that kicks in and people become downright weird and they begin reacting in very strange ways and quite frequently making very silly or stupid mistakes because of that.

JIM:  They almost regret – in fact, my wife on a plane flight back, she was reading USA Today and this is from the cover of USA:  Dow falls despite rate hint.  And it said: 

Planners acknowledge that the bear market has been particularly hard on savers who are nearing retirement.  But even those investors will probably need to make their savings last an additional 25 to 30 years, which means part of their savings should be in stocks.  Workers who ditch their stock funds and move their money to low risk investments also are making a mistake.  Those investors will lock in their losses permanently and can miss out on the big gains when the market turns around.  Emotionally it makes sense, but financially it makes no sense.

And we've seen this.  I think Frank’s right – we’re going to wake up one day and I think they’re going to throw everything but the kitchen sink.  And this flash that just came across our screen – and let me just go to this Bloomberg story here because this is just right off the wires and this is late Friday:

US secretary of the Treasury Henry Paulson said the US will buy equity in a broad array of banks and other financial institutions to restore market stability and ensure economic growth.  The Treasury is working to develop a standardized program that is open to a broad array of financial institutions, Paulson said today in a statement at the end of a meeting in Washington of finance ministers and central bankers from the Group of 7 countries.  The injection of equity is part of efforts to sustain banks and other financial institutions through the worst credit crisis in seven decades, including take over by Treasury of American International Group, Fannie Mae and the largest US mortgage finance companies.  The Treasury, under the equity purchase program, will not be involved in bank management, Paulson said.  Equity purchases would take place along side the Treasury’s coming program of “broad” mortgage asset purchases.  Such a program would be designed to encourage raising of new private capital to complement public capital, Paulson said.  Any equity the government purchases through a broadly available equity program would be on a non-voting basis, except with respect to the market standard terms to protect our rights as investors.  This will add liquidity.  The G-7 nations are committed to an aggressive action plan to expand liquidity.

And I think what you’re going to see next is you’re going to see – well, we've already seen it this week, we've seen the coordinated rate cuts – we’re seeing the Fed’s balance sheet and the monetary base expand at a level that we've never even seen before; we’ve seen the Fed balance sheet grow by almost 700 billion dollars in about five weeks and I think this just is probably the beginning – and I think you’re going to see more.  You’ve seen several commentators saying that unless they get behind and do what they’re doing, what they’re going to do is create a depression.  I think what the Treasury – this announcement coming late on Friday – is realizing what you need to do, you have several concerns in the markets – there are three of them:  You have liquidity, solvency and you have capitalization.  Liquidity is simply having enough cash when you need it; solvency means that you’re assets are greater than your liabilities; and finally, you have capitalization meaning that you have the capital. 

And what needs to be done is the problem with insolvency, the issue is so many banks right now are afraid to lend money to anyone – not to other banks, not to businesses.  Car leases – there was a story on Bloomberg, one bank is going to stop lending to auto dealers.  If auto dealers don’t have credit to go out and purchase inventory and run it on their lots and finance it and then don’t have inventory or financing to allow their customers to finance purchases, the whole economy begins to shut down without credit.  And so, you've seen this happen and what results is you don’t have mortgages available; if you’re trying to liquidate homes – this inventory or glut of real estate in the country that we have – how are you going to do that if homeowners don’t have access to credit or how are you going to do that if – or college students can’t attend college if they don’t have access to student loans; or the cancellation of home equity lines of credit.  So capital is a concern. 

Finally the message is getting through to these guys, as you go in and you perform triage.  You get rid of the bad banks; there are banks quite honestly that aren’t going to survive and the estimate is somewhere around 700 banks.  And you basically get rid of them – you euthanize them.  And so then what you do is you strengthen the good ones and you nationalize, take over the old ones, you prevent further liabilities and you next you recapitalize the banks that can survive by buying preferred stock.  And as you eliminate the bad banks, you recapitalize the good banks, then you’re going to see normal lending resume.  Defaults, insolvency are no longer going to be able to paralyze the system the way it is now.  This is basically what Sweden did to resolve the financial crisis in the 1990s.  So that’s what’s going. 

Now, there is a consequence to all of this.  [21:05]

JOHN:  What is really interesting here, Jim, is that the intelligence services have caught on to the meaning of this and they’re writing in a number of different areas, first in a geopolitical way how this will affect security and national defense issues.  But also, just what this bailout means because there is going to be a cost to this.  You know, we keep rolling all of this money into the credit pool and somebody, somewhere somehow has got to pay for it.  Here’s it said in Stratfor:

At the same time, the United States now has on the books a 700 billion dollar bailout program designed to pull dud subprime loans off the books, allowing banks to exchange them for cash.  That would in theory at least recapitalize the banks and remove the problem assets from the equation; that, plus the interest rate cuts, plus some other steps taken by the Federal Reserve and Treasury Department should again, in theory, succeed in unlocking credit and stimulate economic growth. 

Now, here’s the ‘but’.  You can hear this one coming.

The problem now is how to pay for all of this in a remotely safe way.  The United States already runs a budget deficit of similar size to the bailout plan, so this new 700 billion dollar program is going to have to be paid for entirely on the back of borrowed money.  And that can be done one of two ways.  First, the government can issue bonds.  The question is:  Who’s going to purchase them?  China and the Arab states of the Persian Gulf certainly have loads of currency reserves and would likely buy up a plethora of US T-bills without even being prompted.  They realize full well that a global recession torpedoes their own income streams and it is always handy for the global superpower to view you as part of the solution and not part of the problem.  All who participate would be certain to expect a certain amount of geopolitical back scratching for their efforts. 

It’s not clear however that their monies are the sort needed; selling any assets they hold in western markets is totally out of the question as liquidating 700 billion dollars in stocks to purchase 700 billion dollars in bonds only moves the pain from one sector to another.  It would be a wash.  And likewise, any of this money held in western banks – even if it’s held in cash – cannot really be made useful.  Pulling it out of those banks would simply intensify the credit crisis those banks already face.  That leaves for consideration raw currency held in East Asia and the Persian Gulf itself.  That is probably only a tiny fraction of the roughly five trillon dollars that these states supposedly hold in their various foreign exchange sovereign wealth and other funds. 

That leaves option number two, printing currency not simply as a part of managing the money supply, but doing so en masse to pay the bills.  Normally, this option is something that modern states scoff at as it can be wildly inflationary if it goes too far – like, think Zimbabwe and its 11 million percent inflation rate.  (Although Stratfor is not suggesting for a second that things will get anywhere near that bad) – in addition to crashing one’s currency.  But in a crunch it is an option albeit a distasteful one.  In a recessionary environment the likelihood of a strong inflation is somewhat less, luckily, because the demand is already suppressed.  But the risk of unconventionally high inflation remains and the system at present appears to be flirting with that risk. 

I mean, after all, lower interest rates are also inflationary.  Sharp interest rate cuts combined with printing currency is a bit like spraying a continual stream of gasoline on a dying fire.  You’ll certainly get warmed up, but if you keep it up too long, you’ll risk burning the house down.  [24:36]

JIM:  Couldn't have said it better.  It’s like problem, solution and then new problem.  And out of this – and I believe Don Coxe is right – the world is not going to end, I think you’re going to see another stage develop.  I think this is probably a severe correction in what has been a bull market in commodities and I will say this once again – and I’m not the only one saying this, but we’ll get into this in the next segment – as we are speaking here today, and as people are calling for the end of the bull market in commodities – you know, one of the things that we like to do, John, is check our facts.  And one of the things is that if there was certainly a glut in commodities, we would be hearing stories about excess supply of oil, grains, copper – whatever you’re talking about – but that isn’t taking place; and that is normally what takes place when you have a commodity bubble or an asset bubble.  You get too much of whatever the bubble was in – whether it was technology stocks in the 90s, or it was real estate in this decade.  And if this was a commodity bubble, I have yet to see anybody that has sent me charts or shown me any kind of proof that there is all this excess inventory of supply hanging around because that’s how bubbles end; you get prices driven up, the price of whatever the bubble is in; it inflates it – it might have been strong demand fundamentals behind it, but then eventually the price inflates to such an extent that you get all of this new supply that comes online and as a result of that new supply, eventually supply overwhelms demand and then you have prices go down. 

This has been an orchestrated decline and it’s caused by deleveraging; and as we said at the beginning of this segment, it’s taken place with deleveraging at warp speed because when you’re leveraged 40 to 1, 30 to 1, it is massive selling and that is exactly what you’ve seen.  Now, what you’re also going to see – the two remaining investment banks Morgan Stanley and Goldman have now converted to banks.  And as a result of being a bank they are going to have to deleverage.  I think Goldman is down to about 20 to 1 after Warren Buffett made a capital infusion; and then also Goldman raising money in the equity markets.  I think Morgan is much higher than that.  And so they’re going to have to deleverage over the next couple of years. 

But the most surprising thing I think, John, if I look at all of this –and you follow politics more closely than I do – I think it’s an important leg of our three-legged stool that we always talk about in investing:  fundamentals, technicals and the political side of it.  Because what happens in Washington, the decisions that are made in Washington and what politicians do, do have an impact on the investment markets; and we keep stressing that.  But when this problem first surfaced last year, and it actually first surfaced in February or March of last year was the first hiccup – but it really began to take shape as we headed into the summer months of last year.  And these regulators, from the White House to the Treasury secretary to the chairman of the Federal Reserve to leaders of the Finance and Senate Banking Committee, knew this problem was out there.  I mean they knew that there were bad loans, they knew because they drafted legislation and encouraged these bad loans to be made.  In fact, there was a cartoon that’s out that we’re making into a slide and it’s somebody sitting in a Congressional hearing chair, and he’s got his witness before him and the sign says the mortgage industry and the Congressman says, “Where did you get the idea that you should lend to people who can’t afford to pay?”  And then the mortgage guys looks up and he says, “You.”  And then the Congressman goes, “Other than that.”  [28:49]

JOHN:  That was the same thing, remember when we had the oil hearings that were going on before all of this most recent financial stuff hit it, and the Congressmen were grilling some of the heads of these oil companies and I thought, Oh, some of you just fight back when they’re talking about your outrageous profits.  Somebody say, Well, you Congressperson, make more money at the pump than we do. 

JIM:  You know, we’re going to confirm that because I’m going to go through sort of a statistical review of what’s going on in the public energy sector – not what’s going on with national oil companies – when we get into the next hour. 

But the thing that surprises me is there are a number of issues that they could have done.  First of all, why the SEC allowed investment banks to go from 12 to 1 to 40 to 1 is beyond me; why they allowed the industry to get this leveraged, I’m still having a hard time understanding.  Why they got rid of the uptick rule which made it easier to short – in fact, the FBI is investigating that right now.  That’s beyond me.  Why they did not enforce naked short selling, which is still taking place in the credit default swap market which is making it difficult because when the shorts drive up the credit default swap premiums on your debt, what happens then is it makes it much more difficult for you to go out and get financing.  You’re going to have to pay a much higher rate.  So, 1) Allowing the institutions to get leveraged; 2) getting rid of the uptick rule. 3) Failing to enforce naked short selling; 4) allowing mark-to-market accounting – and I believe one of the next remedies coming across is this mark-to-market accounting.  And there was a story done by Bloomberg that was out this week, and this is an article by Mark Pittman and he said the SEC, Christopher Cox’s regulators stood by as shrinking capital ratios and growing subprime holding led to the collapse of Bear Stearns.  And there’s a comment made here:  This is a report by Inspector General David Kotz, who was requested by Senator Charles Grassley to examine the role of regulators prior to the collapse in March.  And before it was released to the public, Kotz deleted 136 references – many detailing SEC memos, meetings or comments at the request of the SEC’s division.  “People can judge for themselves but it sure looks like the SEC didn’t want the public to know about the red flags that it apparently ignored in allowing Bear Stearns and other investment banks to engage in excessively risky behavior, said the Senator.”  And on Grassley’s he shows that Bear Stearns traders were using pricing models for mortgage securities that rarely ever mentioned default risk. 

And then Kotz goes on in his report to Grassley, he said, following Bear Stearns report with another request by Grassley, this one was covering the 2005 firing of Gary Aguirre, an SEC lawyer who claimed superiors impeded his inquiry into insider trading at hedge fund Pequot Capital Management.  The division failed to follow up on red flags raised by the New York based firms increasingly significant concentration of market risk of mortgage securities.  So you had a number of people within the SEC and here was a gross failure of an agency to fulfill its regulatory role basically taking a step back.  And this is the thing that, as you’ll hear in the Bud Burrell interview, this chain of events that we have seen raises some very serious questions.  And maybe this is just standard procedure with regulators; they get in a crisis and see that there is a crisis here and maybe naively they think that rather than deal with it and take the fall for it, or take the pressure from somebody because I do know for example, that several analysts were fired from investment banks in the 90s when they were calling into question the way companies were cooking their books.  We’ve interviewed a couple of them here on the program.  Or, when analysts were going to issue maybe a negative rating on a company, the investment banking division would get a call and say, You publish that report and we're pulling our banking business from the firm.  But you have to wonder why regulators – maybe it’s you don’t want to take the hit, you don’t want to stick your neck out, or maybe you just hope that if you wait long enough the problem goes away.  I mean you follow politics, but see if you can explain this.  [33:39]

JOHN:  A lot of it has to do with what the mood of politics is as far as what drives what they ultimately do.  And a lot of times, if the good times are rolling they don’t want to interrupt things and there’s a lot of other things under the table that, you know, who knows, you can only find out about some times in retrospect when it finally comes out.

JIM:  Well, at least it looks like they’re trying to get ahead of the problem.  But John, the most surprising thing I think once again, if they were to go back and redo it, I think they made a major mistake when they allowed Lehman to fall because it has triggered the chain of events that we have seen here in the last four weeks.  And as they’re huddling again this weekend, and like I said, and as you pointed out with Stratfor, we are going to fix this; you’re going to see massive monetary policy, you’re going to see massive fiscal policy that’s going to come in response to this.  And then I think that because this deleveraging has taken place at such a quick pace, they have basically brought themselves some time – maybe six to nine months before the aftershocks or effects of all this reflation starts beginning to show itself up in asset prices and also in higher inflation rates.  I can tell you this:  There are a number of things out there on the demand fundamentals – whether you’re looking at food, water, whether you’re looking at precious metals, whether you’re looking at the energy sector, which is going to be the topic of our next segment of the Big Picture.  [35:11]

JOHN:  Well, if we look back at the point by point history of how this came apart, July 13th began the process of deleveraging hedge funds caused by a government orchestrated perfect storm of intervention, by causing a dollar rally and short covering in the financial system and equally a selloff in the commodity sector because it was leveraged by those who went long.  So then we went from a positive position to one which forced the large, leveraged players there who were leveraged, what, 40, 30, 20 to 1, somewhere in there, to unwind their positions which really tripped off this cascading decline in commodity prices – which as you have pointed out, by the way, Jim, takes place on an accelerating basis – an almost exponential type of an acceleration. 

At the same time, by the way, I keep hearing people talk about the blow out in the commodity bubble; they’re still talking about commodity bubbles rather than a bull market in commodities, which the fundamentals are still pretty much there for them.  As prices came down and deleveraging played out, and as at the same time some policy mistakes were made, this whole thing just fed on itself and this carried over from the hedge fund sector then into the public sector as John Q. Public panicked and jumped out the window and they liquidated their mutual funds, further adding to the cascading decline.  And that’s where we are.  So, if you see all of this, Jim, your defense against it, what should you do?  [36:31]

JIM:  You know, if you understand why this happened and why this is so unusual, there are very powerful emotions that we have as human beings.  One is fear, one is greed.  And just as we’ve seen greed take place, now the dominating emotion in the market is one of fear.  If you understand the fundamentals, you own good quality companies, you don’t want to be sitting there throwing your Exxon and selling just because some hedge fund manager or some mutual fund company has to sell; you don’t want to be selling oil service companies, you don’t want to be selling good quality gold companies, producers, large deposit juniors because what you’re going to do if you sell, then what you’re going to do is you’re going to lock in your losses permanently.  And just as we saw in this week – and this is just a harbinger of what we may see going forward, in one day we saw the gold stocks go up 20 percent.  Had you gone to cash and taken your losses at current interest rates, it’s going to take you 9 to 10 years to break even again.  So that’s why emotionally right now it makes sense because your neighbors are fearful, the anchors on TV are fearful, the members of the press are fearful, and you’ve got to understand that a lot of this is being magnified because of the election as they always do.  But, emotionally it may make sense to jump out of the window right now, but financially it makes no sense.  Selling companies at three times earnings, four times earnings that have strong balance sheets – some companies that have better balance sheets than many of the countries in the world right now.  You don’t want to panic and you just – as Don Coxe said in the last hour – it’s during times like this that you really get to know who you are as a person and as an individual.  And you know what, if you can’t take some volatility and you don’t understand why these stocks went down, or you don’t even understand why they went up in the first place, if you don’t understand the fundamentals behind that, then maybe you don’t belong in this market.  Just settle for putting your money in a bank – and hopefully that bank’s safe or put your money in T-bill rates and stay there, but don’t change your emotions; you really get to know who you are as a person when you go through these kind of things.  But once again, if you understand why this took place, what was the story behind it, you hold the course.  [38:54]

JOHN:  You’re listening to the Financial Sense Newshour at www.financialsense.com. 

 Energy: Just the facts; the picture keeps getting worse

JOHN:  We’re back to one of our favorite topics here on the program and that is the subject of energy.  And Jim, we talk about cooked books as far as government is concerned – if we look at global statistics on oil, say for example, the BP Statistical Review, the numbers that are quite frequently quoted in there come from various governments and they’re not audited, so we have no way of knowing whether or not these governments are really telling the truth or if they’re fudging the figures for advantage or anything related to that; we have no way of knowing.  Now, we can look at what the international oil companies are doing because a lot of the information on them is audited.  So how do we derive some ideas about the oil or the world energy situation by looking at their activities?

JIM:  Well, you know, there are a lot of studies on the international oil companies, there are a lot of organizations that follow – and I’m reading from a report that I got this week from a major company that covers the energy sector – and it was amazing because when you go through this, once again, this is further I guess corroborating the information I got at ASPO.  If you take a look – and I’m talking about international oil companies that are publicly held companies and so they publish financial statements, they have regulatory guidelines in terms of how they file, how their financial reports – the industry struggled to increase production last year, which nudged up just one percent to 19.6 billion barrels of oil equivalent.  And basically, average prices were up 10 percent, increase in revenue to 931 billion dollars.

Another story that we've been commenting on in this industry was repeated last year is also being repeated this year is cost pressures have been unrelenting.  Lifting costs rose by 17 percent, driven by rising salaries, a continuing shortage of critical equipment and here’s a story that you will never hear in the press, equally governments continued to increase their take with income tax receipts up 5 percent to 253 billion or 51% of pretax profit.  So government is the largest shareholder of higher oil prices and if you watched the pundits on TV and the press, you know, you’d almost get the feeling that these oil companies are making this money and paying absolutely no taxes.  So as a result, if you take a look at the industry collectively the net income edged 2 percent to 246 billion – which is a record – but is far from the heady advances that we had seen in the prior three years. 

Furthermore, the key challenges that we are finding in the industry and are going to accelerate going forward is the industry is having difficulty in replacing their reserves and growing their production; and part of the problem is they are largely confined to these maturing oil basins as a result of restricted access to acreage where large resource potential lies.  In other words, we still haven't allowed drilling offshore the Pacific coast, or offshore Florida, or in ANWAR or in places where we know energy is.  And within this, energy companies increased their reserves by 0.3 percent to 263 billion barrels of oil equivalent; and most of that came from natural gas – in other words, oil reserves declined in the industry as a whole, but also natural gas reserves were up about 3 percent.  So you take barrels of oil equivalent, meaning that you’re taking the natural gas with the oil, it was barely up.  And it was up less than half a percent.  Also, cash flow was up on last year and it exceeded outlays by roughly about 7 percent.  Dividends were up, but one of the things that the industry is struggling with and especially when you see run ups like we did since the beginning of the year, or for that matter what we saw last year where we saw the price of oil go from 50 at the beginning of the year at 2007, to almost 100 dollars by the end of the year, or what we saw this year – oil going from the mid-90s all the way up to 147.  So what is happening now and then on top of that you add the credit crisis because remember the energy industry is a very, very capital-intensive industry.  You’ve got to tap the capital markets; you need credit lines, you need access to the bond markets and the commercial paper markets and when the credit markets start to freeze up at a time when you have a sharp pullback, as we’ve seen in energy, what happens is they just start pulling the rigs out of production and they start saying, “We’re pulling everything out,” which accelerates the process that we're already in. 

I think right now as of this Friday, we still have 40 percent of the Gulf that is shut in on oil and natural gas production; and so if you look at this, you’ve had production capacity constraint – part of that is by political factors; who has authorized in this country, yet, any company to build a refinery.  Meanwhile, growth in refinery capacity through – in other words, oil companies taking existing refineries and trying to enhance or enlarge them has barely kept pace with the incremental consumption that we have; and that is leading to tight supplies of transportation fuels.  And this is why it just goes to show you – whether you’re listening Barack Obama or John McCain, they talk about, “My plan to make us energy independent.”  We're going to drill our way out of it.  For part of the solution we need to do it, but we’re not going to drill our way out of it, we don’t have enough oil, but at least it can help.  But you’re not going to run, as we've talked about on this program so many times – you’re not going to run the ships the trains, the planes, the cars, the boats, you’re not going to run that on windmills, and that’s the problem.  This is simply a liquid fuels problem and right now the industry remains constrained by a shortage of opportunities because they don’t have access to where the oil is. 

And what was amazing is that if you take a look at this, despite huge capital expenditures, lifting costs were up 17 percent last year, and net income as a percentage of revenue fell to 27 percent, and income as a percentage of book value declined for the second consecutive year.  Almost 36 percent of production revenue accrued to government in the form of income taxes and related excise taxes.  So, John, if you listen to the pundits on the air, you would act like the oil companies are stealing and not paying any taxes, when in fact, the biggest profiteer from all these increases in energy has been the government themselves.  [48:00]

JOHN:  What’s typically lost in all of the chatter about who spends what, or who earns what, is exactly what is required for these companies to just replace what it is they are already producing for that matter – to keep it going. As a result, these are very, very capital intensive because of exploration and development, which is also high risk because it may or may not play out.  And that’s the environment we’re operating in for a commodity which is in growing demand now, if you look especially China and India in addition to the United States and the West.

JIM:  Yeah, I mean if you take a look at what the industry spent last year, the industry collectively spent 402 billion dollars; they spent 310 billion dollars in exploration and development and that’s a new trend change by the way.  In other words, they are back to exploration in existing areas and they’re trying to deploy that and build up their reserves through the drill bit.  They spent 51 billion more in exploration and development than they did the prior year; almost an increase of 51 billion dollars.  And even though the industry has record cash flows, they’re plowing back 80 percent of those funds into finding and developing projects – the highest reinvestment percentage in a decade. 

At the same time, you have oil field service costs and drilling rates are rising at an astronomical cost; they’re going up double digits a year.  I mean it costs millions and millions of dollars to drill a well today.  And you would never hear about that if you listened to these people – you’ve seen it, John, in the Congressional reports and the hearings and you know, “Gosh darn it, you guys need to reinvest and spend the money.”  I hate to tell you, Congressman, what do you call spending 80 percent of basically the funds into finding and developing projects.  They are reinvesting and here’s the sad part:  despite these mammoth efforts, 402 billion dollars, they only increased their reserves 0.3 percent, oil reserves actually dropped in volumes and they were only offset, as I mentioned earlier, by gains in natural gas.  Now, some of the oil properties were nationalized last year by Venezuela, so that did have an impact on things, but it just goes to show you how precarious this environment is in which these companies have to operate globally. 

And despite all of this, despite the advance in drilling, the production technologies, they are making large accumulations, but a lot of these reserve additions are coming from – in other words, higher prices and technology allow companies to increase their reserves on existing wells; meaning that with higher prices and technology, instead of maybe getting 40 percent of the oil underneath the ground, you might get 50 percent.  And so, as a result basically companies are back to using exploration and trying to find oil wherever they can and wherever they are allowed.  The good news – and this gets back to maybe an ad that we've seen – and I’m sure many of our listeners have seen at least here in the United States – is T. Boone Pickens ad about talking about maybe as a transition fuel we use natural gas because natural gas replacement in this country last year, or with these companies, was up nearly 200 percent. 

But the industry faces serious challenges – a 50 percent increase in the cost of an average well over the last two years; that is inflation and I think that’s something a lot of Congressmen – yeah, you hear about these profits and if you look at the dollar terms not in terms of percentage of sales or return on investment, it sounds like a lot of money.  But they have to spend a lot of money to find this stuff.  And when your cost of drilling goes up 50 percent in two years, that is a huge expense to a lot of these companies.  And it takes higher prices and it takes a lot more money to go out and find oil today.  [52:28]

JOHN:  Very much in the genre of what you were saying earlier on about emotions seizing control of the markets out there, the oil situation and the energy situation is likewise being driven by that; people upset and then trying to find a scapegoat to blame for why they are so high, rather than dealing with the actual energy issue itself.  And so far the US only in a limited way like Boone Pickens has been running these ads, and you are hearing some voices out there for what we need to do.  Senator Obama has been saying we need to become energy independent in a decade.  Well, that’s pretty ambitious, you know, you’re going to have to try to do quite a few things to be able to do that, but I don’t think it’s really sunk in to the people what this is all going to mean.

JIM:  No.  And you know, it was amazing too because I’ve checked with my sources overseas – you know, you keep hearing about demand destruction.  You might have some demand destruction in OECD countries, but you know what, it’s not happening in Asia, it’s not happening in India, it’s not happening in Russia, it’s not happening in OPEC countries.  And once again, this study which took a look at North America, Europe, the Middle East, Asia, the Pacific, South/Central America, Russia and the Caspian is once again demand continues to forge ahead in China and India and resource rich countries in the Middle East as it continues to do into this year.  And the one thing that they also talked about, no one credibly predicted the price behavior until it was well underway.  And demand growth has driven nearly all the events that we have commented on here on the program over the last couple of years.  What you have is you have these perceptions that develop, and one of them is demand destruction right now, which is really – you know, maybe there is a cutback, but I don’t know what it’s like where you are but any place I go here in California and you really get the impression – I mean California is the sixth largest or seventh largest economy in the world and it’s an economy built entirely on the automobile, and any place you go on the weekends or you try to travel here in California with, what, about 11 percent of the country’s population, we run into traffic jams.  And I don’t see any fall off.  You know, I do see it – like I do see that if I go sailing in the bay, there are less people out in the bay in motorboats because the price of fuel has gotten to be so expensive.  But at a time when the industry needs large amounts of money, when you’re seeing cost inflation of 17 to 25 percent a year, we're talking about calls for a higher taxes on oil producers which is becoming ever more strident in this campaign.  And if we learn anything, the last time we did this at a time when the industry needs this money to go out, we need to open and give them access to where the energy is, it’s going to reduce the industry’s ability to invest, which is going to result in lower production and that’s going to result in a major decline that will be magnified by the higher fiscal burden that is applied during a period of falling commodity prices, such as we have right now.  So you’re having a lot of people in the industry that are actually shutting down wells, they’re taking rigs out of service because they’re saying you know what, we just can’t do it.  And then all of a sudden this perception is going to change, and that’s one of the comments that you really get when you talked about people in the oil industry that this perception, demand destruction, demand destruction.  It’s almost like a propaganda campaign.  It has – and I don’t mean to tell people in the southeast coast of the United States, many cities are dealing with gasoline shortages, and there’s an interview that Richard Loomis did at World Energy with Matt Simmons and Matt was being interviewed by a reporter and that reporter in the Washington DC area was talking to Matt, and Matt was telling him about all the fuel shortages.  And Matt went to his computer and Matt just googled and started naming six areas close to the Washington DC area, Richmond, Virginia being one of them.  And the reporter said, How come I haven't heard about that.  And maybe that’s because you’re in the beltway.  And Matt directed him to many of these newspapers that were reporting these shortages. 

But once again, we’ve got the perception in the market – and John, as long as you and I have been doing this show, we've been talking about these misperceptions.  Just as the last major perception we had was in January of 2007 about either global warming or it was about demand destruction and about prices.  And that’s one of the problems that we have in this market today, the physical market and the paper market for commodities, there is a gulf or almost a chasm between the two of them that are so wide and it gets wider.  Unfortunately, we are going to be making very strategic blunders here in terms of allowing this course to go that it is; and bashing oil companies, wanting to tax more of what they take, heck, they’re already taking 51 percent, so they’re already making more than the industry does that goes out and finds it, refines it and transports it and sells it to the public.  And that’s why I think we’re once again – and we're also in that shoulder period right now where demand for energy slackens off, the summer vacation is over, the weather is nice right now.  But you’re up North, you were telling me earlier that, what, it’s getting ready to snow in your area?  [58:22]

JOHN:  Yeah, this year we’re starting to pick up snow, which is really early for us.

JIM:  You know, they were interviewing, gosh, it was an interview with somebody on C-Span, the people who put out the Farmer’s Almanac and they’re predicting a cooling spell beginning with this winter, and we’re transitioning into a cooling trend instead of a global warming trend and we've certainly seen that in China earlier this year, and their winter period; we’re seeing it in South Africa and we’re seeing it in other parts of the world and we can very well be facing those kind of conditions as we head into the fall.  Now, normally when it snows in your area, when does that usually begin?  The end of October or November?

JOHN:  Usually the end of November is when you usually see the first part of it.

JIM:  And they’re already talking snow in your area.

JOHN:  Yeah, we had some south of here last night, which shows you what’s happening here.  And also it goes by elevation too; remember, in the mountains it starts at the higher elevations and moves downward as winter progresses.

JIM:  Well, absolutely amazing.  Whether you’re looking at – and there’s another report by the way and hopefully when this report comes out I can get Matt or somebody to come out – the IEA is releasing a very key, strategic report that’s going to come out in November and they’ve been looking at the world’s major oil fields and studying – the same kind of work that Matt did seven or eight years ago – and taking a look at these oil fields because I think the IEA is now realizing we have a real supply issue here.  In fact, they issued a statement this week commenting on that; they’re very, very worried what’s happening on the supply front.  And the unfortunate thing, John, and I want to point this out, what we're seeing in this credit crisis right now – that’s the current fear or panic of the moment – but I’ll tell you one thing about credit markets and financial markets, the thing about paper money and the system the way it works today, the central banks can create dollars, euros, yen out of thin air and they can throw enough paper money to basically solve the problem.  If you throw enough paper money at something, you’re going to solve it.  And that gets back to Ben Bernanke’s speech – a central bank with a printing press at its disposal can always create inflation.  You know, those of you who are worried about deflation, you can put that worry aside, but the one thing that central banks can’t do – and this is the bigger crisis ahead is they cannot create barrels of oil, they can’t create nuclear power plants or clean coal plants or wind turbines or solar farms, and these are issues that we should have been addressing several decades ago when we went through the last crisis and we allowed this crisis to keep unfolding.  And what I’m afraid of is we’re going to commit the very same mistakes that we've committed in the past.  And once again, Santayana’s basic phrase; if you don’t learn from history, you’re doomed to repeat the same mistakes and I think that’s what’s going to happen here.  [1:01:15]

JOHN:  And you can always anticipate that a significant number of people will not do that.  You’re listening to the Financial Sense Newshour at www.financialsense.com.  Coming up next, we’ll take a look at the Q-Lines and the questions you have recorded for us over the last week.  We’ll be back.

© 2008 James J. Puplava, Financial Sense ® Newshour

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