Below is another great article from John Mauldin via his weekly newsletter.

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:http://www.frontlinethoughts.com/learnmore

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

–Old Scottish Prayer

Where the Wild Things Are is a beloved children’s book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve’s low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let’s quickly set the background.

It Is Not Just Japan

Let’s look at today’s interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can’t make money in this environment, you need to quit and find meaningful employment.

And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.

But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.

The Euro-Yen Cross and the Dollar Carry Trade

I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.

A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.

But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is "discounting" a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4^th quarter 2009 estimates so as to not have to take into account the disastrous 4^th quarter of last year.)

Worrying about a dollar carry trade is not just a preoccupation of my friends Nouriel Roubini or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:

"China’s Liu Says U.S. Rates Cause Dollar Speculation

"Nov. 15 (Bloomberg) — The decline of the dollar and decisions in the U.S. not to raise interest rates have caused "huge" speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission."

"The continuous depreciation in the dollar, and the U.S. government’s indication, that in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation," he told reporters in Beijing today at the International Finance Forum.

"Liu said this has ’seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.’

"His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve’s policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis."

"’I'm scared and leaders should look out,’ Tsang said in Singapore Nov. 13. ‘America is doing exactly what Japan did last time,’ he said, adding that Japan’s zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown."

It is not just China. Brazil has moved to impose a tax (or tariff) on investment money coming into the country on a shorter-term basis, as they are worried about both a bubble in their markets and in their currency. Russia is openly considering similar policies.

I have been doing a lot of speaking in the last month. In almost every speech, I warn of the significant imbalance in the dollar. I walk to the very end of the stage to help illustrate that the world now has on a massive ABD trade. By that I mean Anything But Dollars. Everyone is now on the same side of the boat. They have borrowed dollars to buy other risk assets, assuming that the dollar, like the yen in the glory days of the yen carry trade, will continue to fall. Dollar bears are everywhere.

Explanations abound for why the dollar is a trash currency. It is Fed policy, or the Obama administration’s willingness to run massive deficits, or the trade deficit or our health-care policy or (pick any number of issues). But I wonder.

Global trade collapsed last year and well into this year. Global trade was essentially done in dollars. If global trade is down 20% or more, then there is less need for companies in various countries to hold dollars and more need for local currency because of the crisis. Thus, after a rush to safety in the credit crisis, there is a rational selling of dollars by business.

Look at the above chart. Notice that the dollar is roughly where it was 20 years ago. And notice the recent jump during the credit crisis. We are not even back to where we were before the crisis.

What happens if world trade picks back up, as it appears to be doing? Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars. And dollars which are being borrowed (and probably leveraged!) on the assumption the dollar will continue to fall.

And I agree that, over time, the case for the dollar is not as good as I would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because it would be a major short squeeze.

Barron’s just did a survey. It revealed that the bullish sentiment on stocks is quite high and almost everyone hates US treasuries (graph courtesy of David Rosenberg of Gluskin, Sheff)

Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears. And the irony is that a recovering world economy could be the catalyst.

The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.

Source

Where the Wild Things Are – John Mauldin

Related posts:

• Chart of the day: Aussie – Yen cross
• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• Japan’s easy money policy was the trigger for the tech wreck
• Mea culpa on the need for a new currency
• The dollar is rising against floating currencies

Gold hit a record high of $1,044.30 an ounce, beating the previous record of $1,032.35 set back in March and up a monster $26 on the day. The impetus is the crashing dollar, brought down by a report (later denied) that OPEC states and the Chinese were organizing a secret abandonment of the US dollar (see story here).

It is still rising.  In fact all commodities are rising sharply against the dollar. WTI Crude is up 2%, oat futures are up 3%, wheat futures are up 4 1/2%,  and corn futures are up almost 7%. And, we are seeing parabolic moves in silver (up almost 6%) and copper (up over 3%) as well.

But, of course, the Dow is up over 160 points despite this news of dollar revulsion. A little gallows humor over at Zero Hedge captures the mood amongst the shorts (hat tip Scott). This rally is absolutely turbo-charged. Can nothing take it down?

Sources

Spot gold – Kitco

Commodity futures – Bloomberg

Related posts:

• The dollar collapses
• The dollar rally spells trouble for some investors
• Has anyone noticed the Dollar has gone into freefall?
• US Dollar rising dramatically
• Chart of the day: US Dollar

Below is a wide-ranging interview with Marc Faber over four videos on CNBC TV18 in India explaining view on inflation, currencies, commodities, stocks and more.

Asset-based economy. In general, he thinks we are in an inflationary environment, whereas I think that deleveraging is secular and means any inflation is only cyclical. But he shares my belief that zero interest rates induce money balances to move into consumption or into higher yielding assets. He believes this is a boon over the medium-term (if not the short-term or long-term) for financial assets, whether they be stocks, bonds, commodities, real estate or art. And it is something that will continue, he says. Faber believes Bernanke will be loath to raise rates aggressively given his prior statements and writings.

Currencies. Faber takes the view with which I agree that the Fed’s easy money policies after 1998 flooded the global economy, especially emerging economies with liquidity. This has led to asset bubbles.  Hong Kong residential real estate is one example he cites.  As a result, Faber thinks the U.S. dollar is no longer overvalued at present levels. A snapback rally for the dollar resulting from oversold levels would be bearish for asset markets. But, longer term, Faber thinks the dollar is weak.

Equities. There has been a huge rally everywhere.  He says he is not a buyer at these levels. However, as central banks are going to continue to print money, stocks could continue higher – but he would not bet on a blow off rally from these levels.

Commodities. Faber thinks zero rate levels makes it extremely difficult to value anything.  Pose the question: which would you rather own – the “US dollar at zero interest rates or a ton of gold or a ton of copper or a ton of crude oil?” Of course, commodities are supply constrained, whereas dollars are not, so there is a justification for buying them. But, he anticipates the commodity hoarding by China is about to end and that is bearish for industrial commodities as well as precious metals. As with other commodities, he thinks the huge run up in oil could induce a setback. Long run, he is an oil bull because of limited supply.

 Financial Crisis. He is disturbed by the fact that a crisis caused by excessive debt growth, especially as a result of Federal Reserve policy has been allowed to pass with the same players in control. He says enjoy the ride for now. Longer-term, this necessarily means the same bad policies will follow and it will lead to a system-wide financial collapse.

India. Faber is bullish longer-term. Short-term, there could be a correction. India is one of the best protected countries because of less vulnerability to the export sector. He also believes the Reserve Bank of India has one of the best monetary policies in the world – supervise the financial system closely, relatively tight, and mindful not just of core inflation but other price levels like asset prices.

(videos embedded below)

Related posts:

• Marc Faber says avoid financials and buy gold
• Marc Faber: "I don’t think that you’ll see gold below $1,000 per ounce probably ever"
• Marc Faber on CNBC: bearish on oil and India
• Marc Faber: I advise every American to hold his gold outside of the United States
• Marc Faber: “A huge move is coming in the dollar, in bonds and in equities” but…

The bloggers at bloggers at UMKC’s economics blog have been making the case that California’s IOUs are a currency.  Randy Wray’s entry last Monday was particularly provocative because he suggests a movement to loosen national government power is supporting similar moves in other jurisdictions. Wray writes:

Some commentators have argued that the proposed California "warrants" are similar to local currencies (see, e.g., Mark Thoma). In this piece I discuss experiments with local currencies and continue my argument that if California were to accept its own "warrants" in payment to itself, it could turn these into a functioning currency free of the defects of local currencies.

Interest in local currencies has soared in recent years, with nearly 100 U.S. communities experimenting with them. While proponents offer a variety of arguments in favor of local currencies, they share three common themes. First, there is concern that the use of a national, monopoly, currency creates a variety of economic, social, and environmental problems. Second, local currencies are said to improve regional communities, again across several dimensions including economic, social, political and environmental spheres. Third, many proponents want to reduce the power of national government, recognizing a relation between the monopoly of currency issue and centralization. They believe that decentralized money would shift power back to the communities.

However, previous adventures in local currencies have failed miserably as Wray later attests:

As discussed, most local currencies have failed (of the 82 created between 1991 and 2004, only 17 remained by 2004). Those that succeeded shared some combination of the following characteristics: an exchange rate pegged to a strong national currency by a trusted institution; substantial supplies of unemployed or underemployed workers; businesses operating below capacity; and a strong community spirit, led by liberal, middle class residents. These characteristics are not always easy to replicate nor are they necessarily desirable. If the goal is to displace the national monopoly currency, linking the local currency to it appears inconsistent—especially if one fears national government policy is inflating away the value of the nation’s currency.

So I have another idea, which I got from a knowledgeable reader nicknamed aitrader.  How about a Gold-backed IOU system.  In response to a recent post I wrote on the similarities in the troubles in California and Ireland, he wrote:

Now here’s a curve ball for ya: what would happen if a state or even a private bank were to issue currency redeemable in gold or silver? What would the implications be for the US Federal Reserve? This was the situation for many years in the US. Private banks often issued their own paper currency redeemable in gold and silver. There is nothing illegal about this, though one would assume a new law would be crafted and passed to prevent this from occurring. On that note here is what happened recently to a private currency issuer, http://en.wikipedia.org/wiki/Liberty_Dollar#Fed….
Interesting times…

So, let me explore his idea using Ireland instead of California.  I want to use Ireland as the example here because, in discussing my California-Ireland post, the Economist pointed out that Ireland is the place where true problems lie. The Economist says:

There is a problem with Mr Harrison’s thesis in the fiscal policy department, however. California has faced credit downgrades, but only because it is legally prevented from running deficits—it must default if it cannot make all its payments out of pocket. But California has a relatively small debt load, so far as nations go. If the state were allowed to run annual deficits, it seems highly unlikely that it would face pressure to balance its budget amid recession.

Ireland, on the other hand, is confronted by actual market pressures to prove that it can meet its obligations; it’s in trouble in an absolute sense. Ironically, both have fiscal difficulties that are not rooted in their federal status; Irish borrowing is limited by markets while California’s borrowing is constrained by the state constitution.

Point taken. So Let’s solve this problem.

Say Brian Lenihan is dispatched to consider how to prevent the government from sacking tens of thousands of workers in order to prevent the Irish from defaulting on its debt. 

He suggests that California’s IOUs are a model for Ireland, but he goes one step further adding a redemption in 5 years at a 40% premium to the present spot price for gold, which represents a 7% annual return.  Today, spot gold is trading at $950 an ounce. So, a 40% premium is about $1330 an ounce for gold.  Lenihan would offer this deal to any and all creditors of the State in lieu of cash.  The IOUs would be tradable in standardized amounts of 20, 50, 100, 1000, 10,000 and 1000,000 euros in order to facilitate a secondary market.

I got this idea from the high yield market where often bonds are issued with an embedded option to convert to equity at a premium or with PIK preferred shares thrown in as a kicker.  The point of these options is to provide a sweetener to investors in order to get the deal done.  These are the same kinds of deals that Warren Buffett did with General Electric and Goldman Sachs in 2008, and that he has previously done with USAir (now US Airways) and Salomon Brothers (now a part of Citigroup). If the embedded option increases in value significantly, the debtholder can make a lot of extra money.  For Buffett’s options in Goldman, this has already occurred.

Here’s what the ‘investor’ gets in the case of the Irish IOUs:

1. Bonds backed by the full faith and credit of the State paying a rate of interest that I suggest be a slight premium to the official 5-year bond.
2. A 5-year out of the money European option to buy gold for the full face value of the bond at today’s price.  Obviously,if you think gold is going up you would be willing to pay a lot for this option.
3. An IOU that is not just backed by the full faith and credit of the sovereign like most currencies, but that has a tangible link to a real asset, gold.

What does the sovereign get?

1. Ireland conserves cash without having to issue bonds.  Ostensibly this would mean interest rates on Irish bonds could remain lower. That’s a huge deal, especially since these IOUs would not be considered legal tender.
2. Ireland removes the restriction imposed by the Maastricht treaty as the IOUs are not cash and reduce the budget deficit.  In effect, the government is free to add fiscal stimulus without those restrictions.

Obviously, the Irish government would have to hedge their gold commitment by buying Gold futures. But, the Irish could then legitimately claim that its IOUs were more than just a piece of paper.  And, they would remove some of the constraints now impose upon it by foregoing their own currency.

Related posts:

• Pre-payments are reducing value of mortgage-backed securities
• Ireland: government blew the boom
• Gold hits all-time record high
• Spain and Ireland ‘thrown to the wolves’ after ECB move
• Ireland gets deflation

This comes via the Sydney Morning Herald:

A year ago, after Stern Hu had survived 20-odd rounds of negotiations and won Rio Tinto and Australia an extraordinary 87 per cent price increase for its iron ore contracts, I asked him if he was being too aggressive.

He said he had no qualms with driving as hard a bargain as he could on price. But he had misgivings about whether Rio Tinto should risk its integrity in China by claiming "force majeure" to wriggle out of long-term contracts to chase higher prices elsewhere.

"We acted in accordance with the letter of the contracts, but not the spirit," he said.

One of the ironies and tragedies of Mr Hu’s incarceration, together with his senior staff, is that he is widely known in China and at Rio Tinto for his integrity and quietly spoken good judgment.

He is reputed to know exactly how far to push China without breaking the relationship.

He is said to understand how relationships work, the importance of face, and almost everything that is worth knowing about the Chinese steel industry and the government and industry bureaucracy that tries to manage it.

It was notable that Chinese steel managers spoke up for Mr Hu yesterday even though he stands accused of one of the most serious crimes.

More here

Related posts:

• Should we expect a protectionist China?
• China detains Rio executive on suspicion of espionage
• China cutting overcapacity
• China’s skyscrapers will be ten times New York
• China: we “will take steps to protect the interests of our domestic industries”

Here is a Marc Faber interview from March. It is well worth watching because he calls things perfectly through June: economic news, equity markets, and commodity markets.

This is billed as a Czech TV interview.  But the audio is pretty bad. So, the interviewer may be a Czech with halting English, but this is hardly a TV spot (notice the cigarette in Faber’s hand). Given the photo flashes, it may be for a newspaper or magazine. What you get is fifty minutes of Marc Faber unfiltered.

I call it Marc Faber Raw.

Enjoy.

Related posts:

• Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation”
• Marc Faber says avoid financials and buy gold
• Marc Faber on CNBC: bearish on oil and India
• Marc Faber: “A huge move is coming in the dollar, in bonds and in equities” but…
• Marc Faber makes bullish comments on Bloomberg

The real worry right now should be deflation, as we have not yet beaten back all of the ill deflationary effects of the financial crisis.  Nevertheless, a growing number of market participants see inflation as a longer term worry.  With unemployment high, a cost-wage push will not be part of that equation.  Nevertheless, increases in food, oil and commodity prices could create problems down the line as this Bloomberg News video on milk prices attests – they are talking about a doubling in milk prices in 2010.

And, remember, before 2007, $70 was an unheard of, recession-inducing price for a barrel of oil.  Yet, in the midst of a deep, deep global recession, we have $70 oil.  What does that tell you about likely prices in a recovery?  Is it too early to worry about inflation?

Sources
Dairy-Cow Kill to Double Milk Price on Biggest Slump Since 1980 – Bloomberg

Related posts:

• George Soros warns UK on economy, oil and inflation
• Oil to sink to $100
• Oil breaks out above 2009 high
• Quote of the day: William White and inflation
• Oil down below $138

During the Great Depression, it was the Smoot-Hawley Tariff Act, which in hindsight is blamed for triggering a wave of protectionist actions globally.  Protectionism was a major contributor to the downward spiral that created depression.  So, have we avoided this kind of outcome this go around?

At this juncture, it is pretty unclear we have. Simmering disputes with China in particular are creating anger in Beijing.  First, there was the U.S. steel industry complaint over the dumping of cheap Chinese tires in the U.S.  This dispute has received little press.  However, the International Trade Commission(ITC) has just sided with U.S. steel interests. I reckon the issue will now become more important.

Then, there was the link between Rio Tinto, the Australian commodities producer and Chinalco, the Chinese commodities company. Rio got itself in a bit of a mess when it leveraged up only to see commodity prices tumble. As a result, the company was forced into the arms of Chinalco.  But, Australians and Rio shareholders did not like the concept of the Chinese having such a huge stake.  So, BHP Billiton came to the rescue and Chinalco was stuffed (and received a hefty breakup fee).

These types of things are really getting the Chinese sour.  And the China of 2009 is akin to the United States of 1930 as Alpha Creditor to the world economy. So, when just days ago Beijing started a ‘Buy China’ policy, we should realize that a Smoot-Hawley outcome is still something we need to act vigorously to avoid.  It is protectionism in China as retaliation that we must worry about.

Now that the U.S. has received a green light from the ITC to restrict Chinese tire imports, it will be instructive to see what the Obama Administration does.

Related posts:

• China detains Rio executive on suspicion of espionage
• China launches retaliatory investigation into U.S auto subsidies
• China: we “will take steps to protect the interests of our domestic industries”
• Tariffs: Other industries may line up for sanctions against China
• Jagdish Bhagwati: Obama is a protectionist

For the time being, I am more worried abut the potential inflationary effects of quantitative easing than about the deflationary impact of deleveraging.  But, the latest news from Ireland shows us that deflation is alive and well. This comes via the Irish Independent:

Consumer prices recorded a second annual drop in April as the cost of energy, clothes and food declined amid a deepening recession.

Prices based on a European Union measure dropped 0.7 percent from a year earlier after falling at the same rate in March, the Cork-based Central Statistics Office said today. The decline in March was the first annual drop since the data were first collected in 1996. Prices rose 0.1 percent in April from the previous month.

Crude oil has dropped around 60 percent since reaching a record $150 a barrel in July. At the same time, waning consumer demand as unemployment rises has prompted stores to cut prices.Tesco this month said it will reduce prices at some Irish stores by as much as 22 percent.

Rising unemployment and tax increases have “heightened consumers’ reluctance to spend,” Lynsey Clemenger, an economist at Ulster Bank in Dublin, said in an e-mailed note today. “Prices have further to fall, as the consumer strike continues.”

The EU measure excludes mortgage interest payments. Based on an Irish gauge, prices fell 3.5 percent in April from a year earlier, the biggest decline since 1933.

In my opinion, the ECB’s recent announcement that it was getting into the covered bond market has a lot more to do with Spain and Ireland than it does with Germany.  Spain and Ireland suffer from their joining the Euro to escape the impossible trinity of free exchange rates, independent monetary policy and free capital movement.  Having sacrificed monetary policy for a fixed exchange rate, the Spanish and Irish are seeing some horrific debt deflation dynamics.  The ECB seems to have awoken to this and is now engaged in quantitative easing via the covered bond market (although Trichet denies this). See Edward Hugh’s take on this from a Spanish perspective.

So, Ireland has joined the deflation camp along with Spain, the U.K., Switzerland and China, to name a few.  If you think this deleveraging cycle is too powerful for the money printers to override, you’ll see the increasing number of countries with deflationary numbers as a bad harbinger.  However, if like me, you are equally concerned about the upturn in commodity prices and the steepness of the yield curve, you will also see inflation as a looming threat.

To be continued.

Related posts:

• Germany gets deflation
• Irish unemployment gaps up by most in 40 years
• Spain gets deflation
• Switzerland gets deflation too
• U.S. CPI: Lowest since 1954 – deflation here we come

If you have been folowing the commodities market, you would have noticed that most commodities have been rallying of late.  This includes oil, silver, gold, base metals and agricultural commodities.  Oil has gone from the low 30s to threatening to pass $50 a barrel.  I had predicted a decline to $25 before oil rose to $55 a barrel.  It’s looking like the bottom is in for oil.

The question is whether this rally has legs. Looking at the Baltic Dry Index it may well do.  The index is a common measure for shipping costs and it is at its highest level since October.

On the whole, I tend to believe the economy will remain in the doldrums throughout 2009. The International Monetary Fund has recently predicted that the global economy will register a decline in GDP for the first time in 60 years. However, that is not a foregone conclusion. If the commodities trend holds, it may signal an uptick in the global economy.

Update 11 Mar 2009:  Below is a good link to more on The Baltic Dry Index, from an article which appeared today.

Understanding the Baltic Dry Index – The Daily Angle

Related posts:

• Commodity prices are dropping across the board
• Have commodity prices peaked?
• Oil now over $144
• Soros says commodity bubble echoes ‘87 climate
• Oil to sink to $100

Jim Leng, the new Chairman of troubled mining giant Rio Tinto has quit abruptly despite having been employed by the company for only one month.  This does not bode well as the company’s mountainous debt is at the core of why Leng is leaving the firm.

Bloomberg quotes Leng as saying “there has been a difference of opinion over which option the company should pursue.” Rio has “‘a financial issue to resolve in terms of its debt and repayment. I am hopeful that my resignation will enable the board to reach a consensual decision.”

Now I mentioned Rio’s problems in a December post which was very skeptical about Rio’s prospects going forward.  However, skilled investors like Marc Faber have come out in Rio’s favor.  In his January 2009 newsletter, Faber listed Rio along with Newmont Mining (NEM) and one-time Rio suitor BHP Billiton (BHP) as major mining firms which should see a rebound.

Indeed, Rio shares, bottomed at just under 1000p in UK trading. When I mentioned them, they had already risen to over 1500p. After falling to 1350 in mid-January, shares have soared to just short of 2000p. But this is a company in trouble.

Leng clashed with Chief Executive Officer Tom Albanese over plans to sell a stake to Aluminum Corp. of China, known as Chinalco, to reduce Rio’s $38.9 billion of debt, the Financial Times reported today.

“When you get that dramatic a turnaround in events, something has gone wrong,” said Shaun Giacomo, who helps manage $2.5 billion at SG Asset Management Pte. in Singapore. “They are under pressure, they are under siege and investors like myself are basically unhappy with the board.”

Rio said last week it was in talks with Chinalco to raise cash by selling debt and stakes in some units to reduce the loans taken to buy Canadian aluminum maker Alcan Inc. in 2007. The U.K.-based company plans to sell assets, cut jobs and reduce spending to lower debt by $10 billion this year.

Debt, Equity

The dispute “shows which way the wind is blowing in the Rio Tinto boardroom — speeding the ship to China,” Evolution Securities Ltd. analyst Charles Kernot, who has a “sell” recommendation on Rio, wrote today in a report. “Selling growth assets, or stakes therein, to repay debt reduces potential returns. Rio Tinto loses full control of cash flow.”

Rio is also in talks to sell $5 billion of assets to Japan’s Mitsui & Co., the Wall Street Journal reported Feb. 6.

BHP Billiton Ltd., which in November dropped a $66 billion takeover bid for Rio partly because of its debt, would also be interested in buying stakes in some Rio assets, BHP CEO Marius Kloppers said last week.

The long and short of this is that Rio Tinto loaded up on debt in order to take over Alcan. Shortly thereafter the commodities bubble burst spectacularly and prices have yet to recover. Given the Depression in major economies, it is not clear that commodity prices will re-assert themselves over the short-term. Therefore, Rio is cutting headcount, reducing capex and shedding choice assets into a depressed market in order to stay alive.

Now the new Chairman has quit as well. With shares having doubled in the last two months, I see Rio’s shares as being extremely overbought.

Source
Rio Seeks New Chairman as Leng Quits a Month After Appointment – Bloomberg.com

Related posts:

• Rio Tinto: all kinds of trouble
• Should we expect a protectionist China?
• GM offers a debt for equity swap to bondholders
• Glencore: credit default swaps suggest something amiss
• Who is the Rio executive arrested by the Chinese?

This is the time of year when everyone tends to look back and sum up the year in one way or another. I have been doing much of the same.

In keeping with that theme, I have taken a good look through my nearly 1400 posts to get a better sense of what I got right and what I got wrong and how knowing that can help me going forward. Call it an exercise in intellectual honesty. This exercise has given me a good understanding of where things went wrong in the past year and why.

It may also give me some thoughts as to where we need to go in 2009. Let me share a little of what I learned with you. This is a long but thoughtful post, so take a few minutes. It should be worth it.

On the whole my predictive powers were working pretty well this year. But, I made a few lousy calls and some controversial ones along the way. Below is my view of how the year went, on some of those calls and links to the relevant posts. At the end, I’ll wrap it up with a few thoughts about where that leaves my thinking for 2009.

Recession in 2008

I started the year (actually it was March when I began) blogging about recession. It was my belief at the time that we were already in a recession that would prove much deeper than widely acknowledged. I tagged this recession as having begun in December 2007 or January 2008. This has turned out to be right on the money. Relevant posts:

• The Economy Is Definitely In Recession (Mar 2008)
• Recession: How Long and How Deep? (Mar 2008)
• Last week’s GDP numbers (May 2008)

Easy Money as the problem, not the solution

My thinking at the time was that a recession,while deep, did not have to lead to deflation and depression if policy makers made the right calls. That meant following an Austrian prescription of appropriately high interest rates in conjunction with liquidity at penalty rates if needed and liquidating excess capacity where appropriate.

Until Lehman’s collapse, I stuck with the basic Austrian school belief: easy money is the problem and not the solution. I felt the Federal Reserve was a bubble blowing, easy money central bank that created the housing bubble because they did not have the regulatory wherewithal to stop the madness. I lay much of the blame for this malaise at the feet of the Federal Reserve. Relevant posts:

• Has anyone noticed the Dollar has gone into freefall? (Mar 2008)
• Is the Fed reckless? (Mar 2008)
• The US Economy 2008 (Mar 2008)

The Fed creates a commodities bubble and inflation

As the Spring progressed my worry was easy money. My logic was that an easy Fed was stoking a commodities bubble which, by seeping through into consumer price inflation, was going to cause a much harder landing when the bubble popped. My view was that inflation needed to be kept in check because it would set off demand destruction and create a hard landing that all but guaranteed deflation.

Ultimately, I believe this to be the correct interpretation of events but it is controversial because many see the Fed as having made the right calls in gearing up for deflation from the word go. You decide. Relevant posts:

• Liquidity trap of a different sort (Apr 2008)
• Oil price rise is accelerating May 2008
• The Fed is on the easy money trip (May 2008)
• George Soros warns UK on economy, oil and inflation May 2008
• What is Inflation? (Jun 2008)
• Peak oil: are we there yet? (Jun 2008)
• Bernanke is responsible for the market meltdown (June 2008)

Credit writedowns will be much worse than expected

Meanwhile the financial services sector was imploding. I was very concerned that policy makers were underestimating the severity of the writedown and loan loss problem about to come ashore. No one was chronicling the writedown problem comprehensively.

So I started the Credit Crisis Timeline on April 15th as a modest post called Global Bank write-offs and failures. Later that same day it later morphed into a post called Articles: Bank Writedowns & Failures before becoming the Credit Crisis Timeline in May.

As April hit us, I saw the credit crisis fanning out far beyond the U.S. and big bank exposure to subprime. This was NOT a subprime crisis and it was a global in nature. The U.S., U.K., Ireland, Spain and Denmark all suffered popped housing bubbles that weakened their banking system. Global banks like UBS were writing off tens of billions in exposure to mortgage backed securities. The U.S. regional banks were starting to look weak. So I started to write a lot about anticipated European bank writedowns and regional bank exposure.

My best call here was in predicting that many more writedowns to come and that the financial sector and its credit writedowns would be at the center of this downturn. My favorite call was on HBOS and its exposure to loan losses. My worst call was on Santander, which I thought was going to take down a lot of writedowns. I got that 100% wrong.

All in all, this was the most sickening time throughout this crisis in my view. The problems were mounting and the Bush Administration, The UK Government, The Federal Reserve, all of them, they were asleep at the wheel. Relevant posts:

• Finding a bottom (Apr 2008)
• RBS takes an enormous hit (Apr 2008)
• Where’s HBOS? (Apr 2008)
• Santander: US, Spanish and UK mortgage exposure (Apr 2008)
• HBOS to raise new capital (Apr 2008)
• The UK is ground zero in the credit crisis (May 2008)
• British Banks are underestimating losses (May 2008)
• Regionals are exposed to credit crisis (May 2008)
• Bradford & Bingley to issue profit warning (May 2008)

Oh no, debt deflation is the problem now

Then, in about June I made a controversial switch to a deflation-only perspective. Most everyone else was concerned about inflation at this point. Yes, I worried about the Fed’s easy money, but I figured the damage was done and now we were going to have to live with the consequences of easy money in the form of crushingly high food and oil prices. That meant a major, major recession. Meanwhile, it was very obvious that the banking sector was getting sicker by the minute Debt deflation became my main only concern starting about June. This was starting to look a lot like Japan.

This inflection period between having to worry about inflation to having to worry about deflation was perhaps the crucial moment for monetary authorities. You can see my angst in the post “What’s a central bank to do?” From where I sit, my seminal piece in all this was the post “The ECB is right and the Fed is wrong,” which I wrote on July 4th. Basically, I still felt that the inflation genie could be put back into the bottle before we suffered an extra-hard deflationary landing. The ECB was looking to do this, but the Federal Reserve was not. In my view, the Fed had been easy all along and it was this easy money that created the oil and food inflation monster.

In retrospect, it was probably too late by July. The extremely hard landing was baked in the cake. So, I was wrong here. I was still worrying about inflation as late as July 18th (post: Has the inflation damage already been done?). By July I should have realized deflation, or at least unwanted disinflation, had already begun. Relevant posts:

• De-leveraging (Jun 2008)
• De-leveraging redux (Jun 2008)
• Forget Inflation, debt deflation is the real threat (Jun 2008)
• The Japanese Problem is now ours (Jun 2008)
• Credit deflation and the Japanese problem (Jun 2008)
• Is the Fed going to raise rates? (Jun 2008)
• Deflation has already arrived (Jun 2008)
• BIS warns of worsening credit crisis and deflation (Jun 2008)
• Inflation or deflation? (Jun 2008)

Things fall apart

So that gets us to the IndyMac blowup. And we later get to the nationalization of Fannie Mae and Fredie Mac which I correctly predicted in April ( post: Question: How is Fannie Mae a AAA company?). Honestly, I didn’t see IndyMac coming. I knew that things had gone beyond subprime into Alt-A already but I was blindsided by IndyMac like most everyone else.

In retrospect, I see IndyMac as the unexpected event which changed psychology toward fear. No longer were Sovereign Wealth Funds ponying up billions into the financial services sinkhole. Investors started to flee the financials in droves and that spelt the end for Fannie and Freddie and later Lehman about whom chatter had already begun even befre IndyMac went bankrupt. Just my opinion.

Below are my warnings in April and May that buying financial services stocks was like catching a falling knife followed by investor revulsion in June and the blowups of IndyMac and the GSEs. I also said the true bloodletting would not begin until people stopped throwing money at the financials which were clearly headed down. One thing you might notice is that I was way too early on commercial real estate. Back in May, I was saying that Commercial Real Estate was the next leg down. It was not.

• Finding a bottom (Apr 2008)
• Carlyle: Expect protracted credit crisis (May 2008)
• What’s different about 2008? (May 2008)
• UBS warns on non-US property losses (May 2008)
• Regionals are exposed to credit crisis (May 2008)
• Regionals have CRE and Construction exposure (May 2008)
• Investors in Financials lose $10 billion (Jun 2008)
• Investors finally balk at giving banks more capital (Jun 2008)
• Financials: catching a falling knife (Jul 2008)
• IndyMac: Another Banking Bankruptcy (Jul 2008)
• Freddie and Fannie taken over by US government (Sep 2008)

The missed opportunity for a comprehensive solution

In jumping forward to Fannie’s bankruptcy, I am skipping July and August. I do that in part because I think the GSE bankruptcies were pretty much guaranteed post-Indy Mac. This was a lull where policy makers should have been looking for a comprehensive solution. We saw what happened in Japan and Scandinavia in the early 1990s. Why not use these as test cases? Instead what we saw were policy makers asleep at the wheel yet again. Did they not see the severity of the problem?

• Lessons from Japan’s Bank Crisis (Aug 2008)
• The Swedish banking crisis response – a model for the future? (Aug 2008)
• A cautionary tale: story from 1994 Japan (Aug 2008)
• Japan circa 1996 – forgotten already? (Jul 2008)

Commodities tailspin means hard landing

Meanwhile, I predicted commodity prices would collapse and we would have a brutal downturn. I never envisaged $35 oil. I thought $70 was reasonable and gave $100 as a bogey, but $35 is frightening. It speaks to the depth of deflationary forces.

Below are my posts on predictions about commodities, which would lead to deflation and recession.

• Oil to sink to $100 (Jul 2008)
• Have commodity prices peaked?
• Ten predictions for 2008 (Jul 2008)
• Refiners as a canary in the coalmine (Jul 2008)
• Commodity prices are dropping across the board (Jul 2008)
• The inflation – deflation debate redux (Aug 2008)
• What happened to peak oil? (Aug 2008)

The Lehman debacle: completely mishandled

I have been very critical of US economic policy makers and their handling of many aspects of the present financial crisis. But, the Lehman Brothers bankruptcy was the critical event in the whole daisy chain. It unleashed a tidal wave of panic and crushed the global financial system. Before Lehman Brothers went bankrupt, there was considerable wiggle room for the global economy. Yes, there would have been a sharp downturn, but recession is a necessary part of the business cycle. After, Lehman, it was game over.

I wrote this the day after Lehman’s bankruptcy and i think it is the most relevant post I wrote all year:

• Lehman’s bankruptcy: putting the cart before the horse?

Deflation is going to happen. Stimulus is needed

Before Lehman was allowed to go bankrupt, the right medicine would have been liquidating bankrupt institutions – financial and otherwise- before their zombie corpses pulled down good companies with them, whilst the central bank remained a ready lender of last resort in the event of market turbulence. That is the Austrian prescription.

But Lehman’s bankruptcy and the attendant market dislocations brought with them the absolute certainty of debt deflation, a downward deflationary spiral, and a deep recession. (For what it’s worse, I was blindsided by the depth f AIG’s fall, while I foresaw WaMu and Wachovia). After Lehman, Depression became more probable than not. This will be the worst economic event 95 of humans on the face of the earth will ever experience. Now suddenly, Keynes has become the man of the hour.

I have felt pretty conflicted by my about face. If you read any of my posts before Lehman Brothers’ bankruptcy, you’ll see that I take a hard Austrian line toward easy money and the solution to crisis. Granted, I have always had a sot spot for Galbraith, but I do not believe in fine tuning the economy, fiat money, or any of that.

In reading through my posts, I have tacked hard to the Keynesian side since about October. Why? In a word: Depression. Economic hardship of the magnitude we are about to face is the bedfellow to famine, war, disease, dictatorship, and economic nationalism. It is the breeding ground for fear and we have never experienced the type of hardship and fear that we are about to experience while in the possession of weapons of mass destruction. There are very bad scenarios to be avoided here. And there are no good choices. To ‘let them eat cake’ is not the way forward. I summed up my thoughts in four posts in mid-December.

• Confessions of an Austrian economist
• What does Mises say about trying to stimulate the economy out of recession
• Nouriel Roubini: Will massive stimulus ward off stag-deflation?
• A brief philosophical argument about the role of government, stimulus and recession

The Outlook for 2009 and beyond

So where does that leave us going into 2009? In my view it leaves us in a semi-depressionary state. There are many ills to overcome: commercial real estate, Alt-A mortgages, the unwinds of the banking sectors in the UK and Ireland, and the Eastern European debt crisis, a potential dollar crisis. Most of these things have yet to fully materialize but they are coming. Below are my predictions as made in posts in October and November following the market panic.

• The U.S. banking crisis: where are we?
• History shows US bank lending will be soft for years
• Europe is in for a rude awakening
• The Europeanisation of the Credit Crisis
• Where is the global economy headed?
• A shift to Eastern Europe and emerging markets too
• Dollar strength is an illusion
• Currency crisis is gathering storm
• Subprime good, prime bad
• The emerging markets crisis
• Iceland: a cautionary tale for small nations
• Is Ireland the next Iceland?
• Why I am bearish on the U.S. Dollar

Make no bones about it, we are in a very tough economic climate. It will get much worse before it get better.

The key, however, is the policy response. Are we going to stick our heads in he sand and act like these things will never happen or are we going to face the challenges head on? I say we forge ahead and take on the difficult decisions, work our way through this mess and make sure we reform the system so that it never happens again. It will be a long road to the kind of place we really want to be in – perhaps a decade – but we have done it many times before. All we need is the courage to do it again.

I am ever hopeful.

Related posts:

• Bank consolidation and getting positive about the credit crisis
• Danish banking crisis the worst in Europe
• Another look at my 2008 predictions
• Additions to Credit Crisis Timeline: 02 June 2008
• Structured Credit downgrades

I am going to post a BBC article here that gives an anecdote about western Canada and how the boom in oil and commodities is causing economic problems there. Make of it what you will, but my bottom line is that Canada is neither immune from global pressures or from the commodities savaging.  This type of thing will com to an end.

Marshall Auerback has said to me that the Canadian economy is much less dependent on commodities than it once was. However, in my recent consulting experience there, it seemed very leveraged to commodities especially as regards employment, with many young people moving out west to take advantage of the high wages. One Canadian company executive told me last year that they were struggling to get entry level personnel because McDonald’s was paying $14 an hour in Alberta. I wonder if that’s the case today.

I meet Jaz at the Centre of Hope homeless drop-in centre in downtown Fort McMurray, Alberta, on a freezing cold morning.

She comes here during the day, but says she spends the nights in the woods and offers to show me where, for a fee. I explain that BBC policy forbids it, but she takes me anyway.

We stomp through the snow along the Athabasca River, past apartment blocks. She leads me through some thinly spaced trees to a campfire. A bit further on is the tent she uses to store food, and a second tent she sleeps in.

Jaz, 34, originally from the neighbouring province of Saskatchewan, is fairly media-savvy. With a smile, she describes being photographed for National Geographic magazine a few months ago. That was not her first media encounter.

Fort McMurray has attracted a lot of attention as the boomtown at the heart of Canada’s oil sands rush.

Established as a trading post in the late 19th Century, by the 1960s Fort McMurray had grown to a modest town of about 6,000.

With the commercial development of the oil sands industry in the late 1960s, the town grew to 32,000 in 1982.

Its current population is more than 65,000, with an extra 18,500 people in the so-called shadow population – oil workers who live in hotels or residential camps on the outskirts of town.

Population growth has averaged 9% a year for the past six years, and soared to 16% last year. Local police say they are working on the assumption that the population could reach 250,000 by 2030.

“We’re bursting at the seams. We’ve got this massive population growth, and we don’t have the infrastructure to accommodate it or service it,” says Fort McMurray’s mayor, Melissa Blake.

Working town

Ask any newcomer what brought them to this remote part of northern Canada, and the answer is always the same: money.

“People come here for the work, the whole town runs on the plants,” says John Keegan, an oil worker who arrived from Ireland almost 30 years ago.

The workers come mostly from other parts of Alberta, and from depressed parts of eastern Canada such as Newfoundland.

To attract and keep workers in a remote community where the jobs are often dull and repetitive, wages are high. Truck drivers can make C$175,000 ($146,000, £95,000) a year with overtime.

Teenagers working at a local fast food chain can make C$14 a hour – almost twice the minimum wage.

Housing costs are among the highest in Canada, with a small bungalow costing from C$550,000, about C$100,000 higher than in large urban centres such as Calgary or Edmonton.

Rent for a small apartment can range from C$1,800 for a one-bedroom flat.

“A lot of people do come here thinking the streets are paved with gold and that they’re going to walk into the big paying jobs,” says Mayor Blake.

“But the housing market is inaccessible to those that don’t have the highest income.”

The article goes on to recount from a very personal level how everything is expensive there and that things have become quite “stressful.” Alcoholism and cocaine are a problem. While this is merely an anecdote from one BBC reporter it describes an economy that is severely strained by events tied to commodities.

I think this type of thing is going to end soon. What effect this will have in Canada overall, in provinces like Quebec and Ontario, I don’t know.  Either way, if I were from Fort McMurray, I would not be happy with the picture the article paints of my town.

Source
Canada boomtown under pressure – BBC News

Related posts:

• Canada: Boom in progress
• Canada joins the list of housing busts
• Canada’s largest province on road to recession
• Canada is furious about U.S. protectonism
• Canadian housing crisis warning

Just months ago, Rio Tinto was a behemoth swaggering from the huge run up in commodity prices.  This is a company that had revenue of nearly $30 billion and net income of nearly $8 billion in 2007. It was worth over $160 billion by May as the commodities boom took shape.

They were everywhere: building projects in Saudi Arabia, resisting a takeover by BHP Billiton and operating across the globe.  Most of that is history now, except for the debt.

Rio Tinto Group, the world’s third- largest mining company, had ratings on $5 billion of its debt cut by Moody’s Investors Service after failing to meet asset sale targets.

Rio’s earnings may also be affected by falling metal prices, including expected declines in iron ore next year, Moody’s said yesterday in a statement. It lowered London-based Rio’s rating to ‘Baa1’ from ‘A3,’ and has a negative outlook on the company.

Rio plans to eliminate 14,000 jobs, more than halve capital spending and sell mines to reduce debt by $10 billion by the end of 2009 as demand for metals sinks. Its needs to sell assets over the next few months to help clear debt, the ratings service said.

“A key factor in the company’s rating will be its ability to execute on its divestiture program and reduce debt over the next 12 months,” Moody’s said. That includes $8.9 billion due next October and $10 billion due a year later, it said.

Rio declined 1.2 percent to A$39.80 on the Australian stock exchange at 11:55 a.m. Sydney time. It has declined 38 percent since BHP Billiton Ltd. scrapped its hostile $66 billion takeover bid on Nov. 25, citing Rio’s $38.9 billion of debt, slumping metal prices and global turmoil on financial markets.

Ed here. You will notice that BHP Billiton made a $66 Billion offer according to this article by Bloomberg. That was the value of the offer after share prices had already cratered. Originally, the offer was much higher and would have created a mining juggernaut worth $252 billion when it was made in November of last year. Rio is now worth $31 Billion.

But, it gets worse. Rio is firing people left and right and pulling out of projects and selling assets in order to save cash. That’s the profile of a company in trouble: high debt, plunging stock, plunging prices, cutting staff and capital spending. Maybe they shouldn’t have loaded up on debt in acquiring Alcan.

Citing the “unprecedented rapidity and severity of the global economic downturn,” the company said it will slash as many as 14,000 job roles globally, including 8,500 contractors.

In addition, the Anglo-Australian company will cut in half capital expenditures for next year and sell further “significant” assets.

Analysts cheered the downsizing, saying it shows the degree of conviction that Rio Tinto’s management has in reining in expenses.

In all, the measures are intended to cut the company’s net debt by $10 billion by the end of 2009. Rio Tinto said it will also trim operating costs by at least $2.5 billion a year in 2010.

The reduction in debt will be on top of the $3.2 billion already paid down since the end of June. At Oct. 31, net debt stood at $38.9 billion.

Rio Tinto also effectively abandoned its policy of progressively higher dividend payouts, which has been in place for 30 years. Instead it said the total dividend payout for 2008 will be held steady at $1.36 a share.

“This is one quick way to shore up the balance sheet and put confidence back in the company,” said Jonathan Barratt, managing director of Commodity Broking Services in Sydney. “When you are looking to offload so many people around the world, it goes to the bottom line quite quickly.”

Here’s a blurb from the Sydney Morning Herald today showing how desperate things have become.  Rio Tinto took on too much debt in acquiring Alcan at the top of the market. Now they are selling assets.You should note the reference to Xstrata. It is owned by Glencore of Switzerland, another commodities company I don’t particularly like.

Mining giant Rio Tinto is hiving off assets to pay down $US40 billion ($57 billion) in debt after BHP Billiton withdrew a $US66 billion bid, but in these turbulent times, who’s buying?

Bankers and analysts say the world’s largest miner BHP, Brazil’s Vale, Switzerland’s Xstrata and China’s aluminium giant Chinalco, parent of Chalco, are all eyeing Rio’s diverse collection of assets.

Most have the cash to pounce on any near-term opportunities.

“The two with the most cash, BHP and Vale, they’re definitely looking at the situation,” one Hong Kong-based resources banker at a Wall Street firm said.

“Xstrata is still highly leveraged. Its stock has taken a beating – it’d be interested, but has less ability to do a big deal,” the banker said.

Now you’ll remember I posted a blurb in August about this company’s CEO Tom Albanese making ridiculous predictions about commodity prices and skyscapers in China.

Rio Tinto yesterday shrugged off talk of an impending collapse in the commodities market, pointing to recent research that suggested China will build up to 50,000 skyscrapers in the next 20 years, the equivalent of 10 New Yorks, creating sustained long-term demand for steel and other raw materials.

The mining group reported half-year profits of $5.5bn (£3bn), a 55% increase on the same period a year earlier, providing the company with ammunition in its battle to see off a hostile bid by BHP Billiton valued at about £70bn.

Rio’s chairman, Paul Skinner, said the board’s view was unchanged since BHP increased its bid in February. “The offer on the table is still short of what we would consider full value for Rio Tinto and its prospects, and these results emphasise that,” he said. “We are demonstrating what Rio Tinto is really capable of.”…….

By 2025, the report predicts that China will have 221 cities with more than a million inhabitants, compared with 35 in Europe today. As well as the need for huge spending on infrastructure, McKinsey projects that China will build between 20,000 and 50,000 skyscrapers, many of them in less developed interior provinces far from Beijing and Shanghai.

The company’s revenue from China in the first half more than doubled on the previous year, from $2.4bn to $4.9bn. Group revenue topped $30bn.

“There is no question that we are living in an era of unprecedented demand for minerals and metals,” said Rio’s chief executive, Tom Albanese.

hmmm…. Houston, I think we have a problem.

Sources
Rio Tinto pulls out of $10bn Saudi project – Telegraph
Rio Tinto to cut jobs, pare debt and capital spending – Market Watch
Moody’s Cuts Debt Rating on Part of Rio Tinto Debt – Bloomberg
Chinese skyscraper builders to put up equivalent of 10 New Yorks, says Rio Tinto – Guardian
Rio’s selling, but who’s buying? – Sydney Morning Herald

Related posts:

• Rio Tinto’s Leng quits after a month on the job
• Who is the Rio executive arrested by the Chinese?
• Should we expect a protectionist China?
• China’s skyscrapers will be ten times New York
• Question: How is Fannie Mae a AAA company?

You have probably never heard of Glencore. Well you have heard of its founder Marc Rich, the man infamously pardoned by President Clinton before he left office. And I suspect that you will soon hear a lot more about the company as well.

Glencore is a metals production and trading company based in Switzerland. It is one of the largest privately-owned companies in the world and a very large employer in Switzerland. The problem is that commodities prices have been absolutely decimated. So, the secretive Swiss company’s credit default swaps are trading at huge premiums, something we alluded to last month.

The obvious question is: why is that? Unfortunately, the answer is: nobody knows. But rumors of financial problems are mounting.

Glencore announced on Tuesday that it was considering a debt buy-back after the cost of insuring against its default rose to a level that did not reflect its financial situation, the world’s largest commodities trader said.

The decision by the secretive Swiss-based group came hours after Standard & Poor’s, the rating agency, downgraded Glencore’s long- and short-term credit rating to BBB-minus and A-3 respectively, down from BBB and A-2. The outlook is “stable”, S&P said.

Glencore’s credit default swap spread reached a record high last week. From a level of less than 200 basis points in early September, it rose to more than 3,100bp, meaning it cost more than €3.1m ($4.1m) annually to protect €10m of the firm’s debt over five years.

“Glencore strongly believes its current credit spreads do not reflect its underlying credit profile, and has therefore decided to utilise part of its strong liquidity position to selectively consider debt buy-back opportunities,” it said in a statement.

The company did not say how much debt it planned to buy back.

Glencore said that its current liquidity, both cash and undrawn banking facilities, exceeded $3.5bn. It added that lower commodities prices were reducing its working capital needs and estimated that this natural deleveraging would result in another $2bn of spare liquidity by the end of the year. S&P estimated Glencore’s short-term debt for 2009 at about $2bn.

This seems like a case where the external business environment is declining rapidly, yet the company paints a pretty picture of its finances. But, no one really knows what’s happening inside. They can only speculate based on publicly available data. And that data is not good.

Glencore, which is controlled by its employees, trades base metals, minerals, oil and agriculture commodities. It also owns smelters and stakes in mining companies, such as 35 per cent of miner Xstrata.

S&P said it had cut its view on the Swiss trader because of “metal prices’ unprecedented fall and weak near-term outlook” and “the related significant drop in the value of Glencore’s industrial investments portfolio, which has resulted in weaker asset-debt coverage levels”.

The market value of Glencore’s 35 per cent stake in Xstrata has, for instance, shrunk to about $3.7bn from around $22bn at the end of June.

Stay tuned.

Sources
Glencore considers debt buy-back – Financial Times

Related posts:

• The latest on Glencore
• Glencore: A Swiss giant on the edge
• Rio Tinto: all kinds of trouble
• Lehman Brothers: a primer on Credit Default Swaps
• Treasury credit default swaps rise dramatically

I caught a post today on the Swiss Blog Zeitenwende about Glencore, the Swiss corporate giant, which should reinforce the fact that this credit crisis is far from over. As the original post was in German, I have translated it into English below:

If Charts could speak, what would the following one tell us then? This concerns five-year Credit default Swaps of the company Glencore. In case you have never heard of this company, then now is the critical time. Glencore is the largest enterprise by turnover in Switzerland, recording record sales of 142.3 billion USD in 2007. According to its own data, Glencore directly or indirectly employs 52,000 employees. And obviously some of it has gone pear-shaped

The company, which is active in raw materials, was originally founded by notorious Marc Rich and has always been completely in private ownership.

Today Glencore ranks among the leading raw material companies world-wide and deals with, among other things, production, processing and trade of aluminum, alumina, bauxite, ferrous alloys, nickel, zinc, copper, lead, coal and oil, as well as agricultural products. Right now, things are looking bad for raw materials. Apparently, bad is how things are going at Glencore, if this Chart reflects the reality of the company. Only – one does not know the details. Concerning the rumors that Glencore could be having liquidity problems, an analyst at BNP said that the company has more than 3.5 billion USD of cash and open lines of credit as of the end of of Octobers.

The chart speaks volumes. While you may have never heard of Glencore until now, I suspect it is a company that will become very familiar to us in due course.

Source
Was ist nur mit Glencore los? – Zeitenwende

Related posts:

• Glencore: credit default swaps suggest something amiss
• The latest on Glencore
• Swiss Franc at Dollar parity?
• Swiss citizens think a large Swiss bank will fail
• Steve Keen: On the Edge with Max Keiser

Last week, I posted an article on why the recent rally did not look anything like a bull market titled “An amazing market rally. What’s next?“o, it seems like I was bullish for all of two weeks. Yet, the truth is I was never bullish on the market as a whole. But, I do think there are many stocks trading below fair value due to the fall in stock prices.

I mentioned energy as a sector to watch. In that, I would actually include utilities – a related industry. Most people see utilities as boring — the beta on a typical utility stock is far less than one. Yet, these companies pay fairly high dividends and have relatively low price-earnings ratios. To my mind, that looks like a very good defensive play.

Apparently, Warren Buffet thinks so as well because he has been on a shopping spree buying up utilities. You’ll remember that there has been a push toward deregulation worldwide, which has hit the capital intensive utilities business particularly hard. But prices have dropped too low, meaning some companies are well worth buying. The hard part is figuring out which ones.

Jim Jubak at MSN Money has a good post on this issue today. There, he says:

First, let me try to reconstruct some of the logic behind Buffett’s liking for the sector:

• Because utilities need so much capital, they’re a good match with an investor who has billions and billions in cash. Berkshire Hathaway finished 2007 with $44.3 billion in cash and short-term investments. That year the company generated $12.5 billion in operating cash flow. At the start of 2008, Constellation Energy had planned for a capital budget of $2.4 billion.

• Because utilities need so much capital, their stocks have been hit hard by the financial crisis of 2007-08. Constellation sold to Buffett for such a bargain price because chaos in the markets made it impossible for the company to raise the money it needed for everything from its capital spending to its day-to-day operations. (It didn’t help, of course, that Constellation had jumped whole hog into trading energy. That gave the company even bigger exposure to the problems at Lehman Bros. (LEHMQ, news, msgs) and other Wall Street financial companies.) MidAmerican Energy was able to strike such a great deal for itself because it promised to inject $1 billion in capital immediately into Constellation.

• Because utilities, even financially stressed ones such as Constellation, generate so much cash, Buffett can buy these shares without worrying too much about when the bear market will end. In many of his recent deals, Buffett has looked to combine the upside potential of stock appreciation with the insurance of a high current dividend. In his investment in Goldman Sachs Group (GS, news, msgs), for example, Buffett got warrants to buy stock at a fixed price in the future, so that if the stock goes up, he profits. And he got preferred stock paying a 10% dividend, so he collects even while he waits for the stock to go up. (By the way, Buffett’s preferred stock pays twice the 5% yield taxpayers got on the preferred stock we received when we put money into Goldman Sachs.) In 2008, while Buffett waits for Constellation to recover in the stock market, the company will generate $1.4 billion in cash from operations, according to projections by Deutsche Bank.
• And finally, Buffett likes the rising future returns in the utility sector. In the next 20 years, the utility industry will need to invest about $1 trillion in new power generation, including nuclear, clean coal, natural gas, wind and solar power, in new transmission lines and grid enhancements, in new forms of energy storage and in environmental solutions to problems such as global warming. Companies that can raise the cash will have almost unlimited places to invest it — at rates of return that are guaranteed by state utility regulators. So the industry is looking at a scenario where it can put all the cash it generates — and all it can raise — to work at a rate of return guaranteed to exceed the cost of capital. Each year, utilities will be able to reinvest their cash flow in new plants and equipment that will, in turn, generate a guaranteed rate of return. And so on and so on, compounding over the next decade or two.

My reconstructed version of Buffett’s scenario is pretty much what led me to invest in Edison International in July. So why did that pick turn into such a disaster? Because there are a few minor differences between you and me and Buffett.

First, Buffett can buy a strapped utility such as Constellation and in one fell swoop make sure that the company can fund its capital projects. If you and I buy a few hundred shares, the company still has to go out to the capital markets to raise the money it needs.

And if it can’t — and plenty of utilities can’t right now — then it has to cut back on plans to invest. And power plants, transmission lines and solar modules that aren’t built don’t generate revenue. If you own shares of a utility now that can’t raise money now and has cut capital spending now, the fact that you, like Buffett, are right about the long-term positive trends in this industry is irrelevant. The stock tumbles.

Second, Buffett gets deals when he buys shares of Goldman Sachs or buys control of Constellation that none of us can get. If I were getting a 10% yield on my shares, I’d be a lot less worried about how long it was going to take for the bear market to end and stocks to start going up again. If I gained control of a company when I bought into it, I’d fret less about the possibility that in the near term management would do something — like selling at a bargain-basement price — that worked against my interests in the long term.

I can’t think of anything to give me control over as many billions as Buffett can direct — at least not in the short run — but I do think there’s a strategy that will compensate for these differences between you and me and Buffett. That strategy has three parts.

1. Pick and be patient

You want to find utilities that, before the credit crunch, had big plans to expand power production using a combination of sources — wind, solar and nuclear — and had existing investments in those areas to build upon, and that were making significant investments in upgrading the transmission grid and the system for delivering power to customers. Right now those utilities are also announcing cuts to their capital budgets.

You’d like to buy these utilities at a point as close as possible to the moment when they’ve made their last capital spending cuts. With a potentially long and deep recession ahead, we’r
e likely to see more capital spending cuts in 2009. Wait. The two utilities I like most for the long run are FPL Group (FPL, news, msgs), with its mixture of conventional nuclear, and wind power, and the one I sold in October, Edison International, because this is a utility that really understands how important upgrading the grid is. Right now, though, you’re at least six to nine months early on these. I’m adding them to my watch list with this column (see the list on the left-hand side of this page).

I recommend reading Jubak’s article in full. However, I would point out that Jubak recommends proceeding with caution given that we do not have the funding advantages of Warren Buffett and capital spending has yet to hit a bottom in the industry. And I agree that one needs to understand the finer points of the industry before jumping in wholesale. After all, we are still in a bear market.

Related posts
An amazing market rally. What’s next?
Valero crushes earnings: I was wrong
Bullish

Related posts:

• Buffett to invest in General Electric
• Quote of the day: Warren Buffett
• Quote of the day: Warren Buffett
• Warren Buffett backs Goldman
• Even Buffett hit by higher funding costs

For the second day in a row we are basking in the glow of an up market (update: or at least we were until the last 12 minutes). Everyone’s happy. But, some people are happier than others. And the happiest amongst the bunch are those people who are long commodities.

Take a look at these charts from Bloomberg for commodities. The gains are mouth-watering. I will have more to say on this snapback rally in stocks, bonds, currencies and commodities later.

Related posts:

• Japanese stocks, Asian real estate and commodities
• Chart of the day: Japanese Yen
• Chart of the day: Dow 1914-1929 vs. 1982-1999
• Chart of the day: Dow 1928-1932
• Panic Time at the Fed

The markets are having a very bad day today. After we saw the Europeans were also vulnerable to this credit crisis, stock markets worldwide sold off, with many European markets seeing their largest drops since 1987. For Europe, today is as bad as last Monday’s 777 point fall was for the U.S.

Sectors being hit include oil, mining, commodities, and financial services as recession is widely anticipated and investors flee the banking sector. Signs of increased volatility include VIX, LIBOR-OIS Spread, and the TED Spread.

European currencies are getting slammed with both Sterling and the Euro down multiple big figures against the dollar and the yen. Investors are fleeing riskier assets and putting their money into relative safe havens like bonds and gold and silver. Below are links to commentary on the turmoil and charts of the various markets.

Articles
European Stocks Tumble, Stoxx 600 Has Biggest Slump Since ‘87 – Bloomberg
Euro Falls Most Since 1999 as Credit Crisis Deepens in Europe – Bloomberg
Government Bonds Rise Worldide as Credit Freeze Prompts New Bank Bailouts
Money-Market Rates Climb as Banks Hoard Cash, Crisis Deepens – Bloomberg
VIX Jumps to Record, Topping 50, on Concern About Global Growth – Bloomberg
Brazil’s Bovespa Plunges 10 Percent, Trading Halted; Vale Sinks - Bloomberg
Mexico’s Peso Plummets to Record Low as Investors Fall Into `Fear Mode’ - Bloomberg

Charts
World Indexes – Bloomberg
Benchmark Currency Rates – Bloomberg
Commodity Futures – Bloomberg
CBOE SPX Volatility Index – Bloomberg
TED Spread – Bloomberg
S&P 500 Index – Bloomberg

Related posts:

• TED spread signals better conditions
• Rough day in the markets
• High yield is back in business in Europe
• The TED spread is still too high
• Even Buffett hit by higher funding costs

A few weeks ago, I said I thought the volatility in commodity and currency markets smelled like panic. I found it very hard to believe that we could have such violent moves without a significant shakeout in the hedge fund world. We are now beginning to see that shakeout.

Ospraie Fund has just collapsed, losing nearly 40% on the year. At least it wasn’t 100%. But, this is bad news for Lehman Brothers, which had 20% of the company as of 2005.

From Portfolio.com:

Crash Landing

Another one bites the dust.

The Ospraie Fund, a commodities hedge fund that was worth $2.8 billion at the start of August, is winding down after suffering a brutal blow during the month. According to a letter to investors from the Ospraie’s founder Dwight Anderson, the fund lost 26.7 percent during August, bringing it to a 38.6 percent loss year-to-date.

“The losses were primarily caused by a substantial sell-off in a number of our energy, mining and resource equity holdings during a six-week period characterized by some of the sharpest declines in these sectors in the past ten to twenty years,” Anderson wrote to investors.

Anderson, 41, got his start in the business working under Julian Robertson at Tiger Management. In 1999, he moved to John Paul Tudor’s hedge fund firm, where he started managing his own fund and in 2004 he spun out Ospraie Management as an independent firm. Anderson didn’t have a losing year until 2006, when his flagship fund lost 19 percent in the first five months of the year. It took another hit in mid-2007 as the credit markets began to freeze.

While this fund’s closing will come as a blow to all of its investors, it comes at an especially bad time for Lehman Brothers, which took a 20 percent stake in Ospraie Management in 2005. One of the ways Lehman has recently tried to raise capital is by seeking a buyer for its asset management business, which would include its stakes in hedge funds as well as its Neuberger Berman unit.

So far, no one has stepped forward with an offer, however. And this news certainly won’t help Lehman’s negotiations on that front, although Lehman also has a 20 percent stake in D.E. Shaw, which is doing exceptionally well during this credit crisis.

The demise of the Ospraie Fund, which was named as an “eclectic spelling of osprey” according to a Bloomberg profile on the firm last year, underscores the extreme volatility in today’s commodities markets.

According to the Bloomberg article from last year, the Ospraie Fund makes long and short investments in commodities such as oil, copper, and corn. It also trades shares of companies in the energy, mining, and agriculture industries. August was a tumultuous month for commodities in general, as their prices plummeted after soaring since the beginning of this year.

Related articles
Ospraie’s Anderson forced to shut flagship – Reuters

Related posts:

• Hedge Funds
• Hedge funds collapsing
• Reflation watch hedge fund edition
• RAB looks to halt redemptions for three years
• Hedge Fund Panic

I always feel a bit sceptical when I read a report about unending growth and prosperity. Rio Tinto thinks that the metals and mining boom will continue unabated for years. That certainly puts him in the same camp as Jim Rogers. Rio CEO Tom Albanese was quoted as saying,

“There is no question that we are living in an era of unprecedented demand for minerals and metals.”

He sounds a lot like Irving Fisher on the eve of the Great Depression — “Stock prices have reached what looks like a permanently high plateau.” But, I really liked the Guardian’s picture of the China’s tallest building, Shanghai World Financial Centre, so I’ll link to that article (see the link below) and a few others I caught on this particular theme. (The Independent has the most sceptical article).

Definitely check out the website skyscraperpage.com, it’s pretty cool. It has pictures of a lot of different skyscrapers around the world.

Here’s what the Guardian said:

Rio Tinto yesterday shrugged off talk of an impending collapse in the commodities market, pointing to recent research that suggested China will build up to 50,000 skyscrapers in the next 20 years, the equivalent of 10 New Yorks, creating sustained long-term demand for steel and other raw materials.

The mining group reported half-year profits of $5.5bn (£3bn), a 55% increase on the same period a year earlier, providing the company with ammunition in its battle to see off a hostile bid by BHP Billiton valued at about £70bn.

Rio’s chairman, Paul Skinner, said the board’s view was unchanged since BHP increased its bid in February. “The offer on the table is still short of what we would consider full value for Rio Tinto and its prospects, and these results emphasise that,” he said. “We are demonstrating what Rio Tinto is really capable of.”

Metal prices have come off their highs after five years of strong growth, but Skinner said the credit crunch had had only a “modest” impact on Rio’s markets.

The company said that North America and Europe were becoming decreasingly relevant to the setting of metals prices, as demand is driven by China, India and other emerging markets – Chinese imports of iron ore are running 20% ahead of the same point last year. In the first half of the year, Rio lifted prices of iron ore by an average 86% compared with 2007, even as economies in North America and Europe were weakening. The average copper price charged by Rio in the first half was 20% higher than last year, gold was 38% higher and aluminium prices were up 2%. The company said 2009 was likely to be the sixth successive year of higher prices.

Profits were also boosted by the company’s $38.7bn acquisition of aluminium producer Alcan last year, though the brokerage Numis estimated that it accounted for only 5% of the gain in earnings.

Some analysts had been forecasting a dip in Chinese investment after the Olympics, but Rio is predicting that there will be a post-games boom. The company cited research from McKinsey, the management consultancy, which said the scale and pace of urbanisation would continue at an unprecedented rate.

By 2025, the report predicts that China will have 221 cities with more than a million inhabitants, compared with 35 in Europe today. As well as the need for huge spending on infrastructure, McKinsey projects that China will build between 20,000 and 50,000 skyscrapers, many of them in less developed interior provinces far from Beijing and Shanghai.

The company’s revenue from China in the first half more than doubled on the previous year, from $2.4bn to $4.9bn. Group revenue topped $30bn.

“There is no question that we are living in an era of unprecedented demand for minerals and metals,” said Rio’s chief executive, Tom Albanese.

The BHP offer is conditional on it gaining regulatory approval. A merger has already been cleared by Washington, Europe gives its verdict in December and Australian regulators are to rule in October. If it receives clearance, BHP will then send out the offer document and the bid will go live.
Another obstacle was thrown in the path of BHP’s bid over the weekend when the Australian government gave its approval to the acquisition of a 12% stake in Rio’s London shares by the Chinese state-owned company Chinalco.

-Guardian, 27 Aug 2008

Sources
Chinese skyscraper builders to put up equivalent of 10 New Yorks, says Rio Tinto – Guardian
Rio Tinto expects post-Olympic Chinese boom – Times Online
David Prosser’s Outlook: That 20-year commodities super-cycle is in need of a puncture repair kit - Independent

Related posts:

• Rio Tinto: all kinds of trouble
• Who is the Rio executive arrested by the Chinese?
• Should we expect a protectionist China?
• China detains Rio executive on suspicion of espionage
• China wants all of Repsol’s Latin American oil assets

The Financial Times Deutschland is reporting that China and Iraq want to revive a Saddam-era oil contract between the two nation that is worth billions of dollars. The contract, an obvious economic coup for China, secures Beijing exploration and development in the south of Baghdad situated Ahdab oil field.

The Iraqi government looks to be doing everything it can to thumb its nose at the Bush government and define its sovereignty outside of the U.S. sphere of influence. If the United States entered the war in Iraq to gain secure access to oil, spending over $1 trillion in the process, it has not been successful.

My translation:

“Iraq and China are working hard to demonstrate their cooperation through the conclusion of a development agreement for the Ahdab oil field,” it was noted in a statement by the Iraqi Oil Ministry. The agreement will have a value of approximately $ 1.2 billion. It was agreed to in 1997 under Saddam Hussein and was to enter into force after the end of the then-UN sanctions against Iraq.

The agreement would be the first oil contract from the Saddam regime, which the new government has upheld. Despite claims by foreign oil companies, Baghdad had so far refused to benefit firms with pre-war arrangements for the allocation of oil contracts. The contract with the state-owned Chinese oil group CNPC was closed, although UN sanctions forbid direct transactions with the Iraqi oil industry. It was worth about $700 million at that time. After its development, the Ahdab oil field development should yield approximately 90,000 barrels of oil per day.

Source
China greift nach irakischem Öl – Financial Times Deutschland

Related posts:

• Is China avoiding using US dollars?
• Bush Overstated Iraq Evidence, Senators Report
• China is now America’s largest creditor
• Iran finds huge billion barrel oil field
• China issues bonds to “promote the RMB in neighbouring countries”

One reason I believe inflation pressures will slow going forward is that the global economy has already slowed enough to have a measurable impact on oil demand and all commodity prices across the board. As July comes to an end, the month is shaping up to be the worst in commodities for 28 years.

Tumbling prices for natural gas, nickel and corn are turning July into the worst month for the Reuters/Jefferies CRB Commodity Index in 28 years.

The CRB Index of 19 commodities slumped 9.7 percent since June 30, the biggest decline since a 10.5 percent drop in March 1980, when the U.S. economy was mired in recession. Natural gas plunged 31 percent to lead July’s biggest losers. Corn and nickel slumped 14 percent.

The dollar’s rebound from a record low against the euro eroded the appeal of raw materials as an alternative to stocks and bonds, especially for investors who snapped up commodities earlier this year and sent prices to records. Demand also is easing in China, which expanded at the slowest pace since 2005 in the second quarter, Lehman Brothers Holdings Inc. analyst Edward Morse said in a report on July 23.

-Bloomberg, 31 Jul 2008

It will be interesting to see what happens to commodities demand after the Olympics in Beijing have ended.

Related posts:

• Have commodity prices peaked?
• The Fed wants inflation
• Have commodity prices bottomed?
• Chart of the day: U.S. Consumer Price Index
• I was wrong on inflation

I certainly believe they have. Price action speaks to this. The Wall Street Journal’s Market Beat had this quote about the price action in commodities:

The price of many commodities and commodities stocks — from gasoline to coal to fertilizer makers — rode up on the coattails of crude oil. So oil’s moves are pivotal. Ryan Detrick, senior technical strategist at Schaeffer’s Investment Research, said there’s good reason for a technician to believe oil’s retreat will continue in the near term.

“Since the peak, the down days have been on really heavy volume,” Detrick said. “The only day we had a bounce since the peak on July 11 was on July 21, and that was a very light volume day. You can almost make that statement for all commodities. There’s been a bounce here and there, but the selling without question has come on higher volume.”
-Market Beat

Ultimately, if oil continues to lead the rest of commodities lower (see the U.S. oil fund ETF above), this will be a huge shot in the arm for the global economy. It will certainly get the U.S. Federal Reserve off the hook, as accelerating consumer price inflation was constraining policy action. But, more than that, a decline in commodity prices would offer relief to consumers squeezed by higher inflation and deflating asset markets. And it just may end up leading to a milder downturn.

Related articles
Commodities boom may be coming to an end: economist, Financial Post, 23 Jul 2008

Related posts:

• Commodity prices are dropping across the board
• Oil to sink to $100
• Have commodity prices bottomed?
• Oil down below $138
• Soros says commodity bubble echoes ‘87 climate

Oil at $100? That’s certainly my call and I’ll stick to it. So far my call of oil peaking at $150 is holding.( We’ll see for how long). On July 9th, after oil’s first pullback to $138 I said:

Yesterday, oil fell the most in one day since the start of the Gulf War in January 1991 to close at $136.03 in New York trading. Now is the time to evaluate whether we have seen the top in oil prices? On Thursday in my post “Oil close to $146” I said,

The price action makes me think we are nearing the top here. I’d call $150 a peak. Many have called a peak before so let’s see what happens going forward.

I would like to reiterate that sentiment here with oil still being quoted below $138 in overnight trading. As I see it, a tight supply due to low Iraqi output from the war in Iraq, refiners’ inability to process heavy sour crude, and peak oil production led to a super spike in oil prices. The response has been demand destruction in the North America and Europe coupled with a reduction of oil subsidies in Asia.

Ultimately, the oil-induced inflationary spiral combined with the financial crisis has brought the world to the brink of recession with economies slowing markedly in Europe, North America, ANZ and South Africa. Demand for oil is lower, so prices will soon follow.

This begs the question whether inflation is still anything to worry about. My answer is yes — but not because of actual commodity prices, rather because of much higher inflation expectations getting embedded in the economy. There is always the worry about a confrontation with Iran bringing oil prices back up again (and way up potentially). But on the whole, demand destruction has set in and I expect to see oil prices lower.

If oil prices continue to fall down below $100, we can see the super spike as over. I see oil collapsing to well below $100 in the not too distant future.

Then we can move past inflation to the real worry, deflating credit and asset prices.
- Oil down below $138

Now, on July 22nd, oil has even dipped below $127. I think it’s on its way to crashing below $100 as demand collapses, with a global recession on the horizon. Marc Faber recently said the same.

Commodities and investment guru “Marc Faber, who told investors to bail out of U.S. stocks before 1987’s so-called Black Monday crash, said oil prices may fall to $100 a barrel as demand slows in a global economy at the “tail end” of its expansion.

Accelerating inflation and rising interest rates worldwide are likely to dent the value of commodities including oil, said Faber, who publishes the Gloom, Boom & Doom Report, at an investment forum in Sydney today.
-Commodity Online, 22 Jul 2008

So far, so good in my predictions of a $150 peak and a collapse toward $100. It can’t happen soon enough, as inflation is strangling the global economy.

This might save us from 1970s style inflation, but unfortunately it won’t save the global economy; the massive price decline is only a response to recessionary demand destruction from the previous high oil prices. The damage is already done.

Related posts:

• Oil down below $138
• Japanese stocks, Asian real estate and commodities
• Marc Faber says avoid financials and buy gold
• What happened to peak oil?
• Have commodity prices peaked?