Shale Gas-Published March 2012

             Last issue we showed a map of the natural gas shale basins located throughout the U.S..  It covers about half of the country.   This is also true for many other nations as well.  These shale gas reserves, and to a lesser extent shale oil, is about to change the marketplace. 

             For consumers, it could equate to savings that could last for decades.  Our local gas distributor, Fortis, announced that the average homeowner should experience a $100 cut in their annual home heating bill with the price of natural gas below $3.  With today’s price of $2.12, additional reductions should follow. 

             Unfortunately for governments, this will most likely be a  drop in tax revenue.  For the energy sector, only a few with deep pockets will remain in the gas exploration business.  Since there are huge gas reserves building, this should take pressure off rising oil prices. 

             For investors, money should be invested in those companies that build gas plants and pipelines only.  We recommend one avoid all gas shares.  Over the past month some small gas exploration companies have either cut or eliminated gas exploration due to low gas prices.  These actions make it obvious there are no profits to be made.  The next step will be to cap smaller gas fields.  Doing so will not make any difference to the growing world-wide supplies and falling prices. 

             It is estimated both China and the U.S. could have 200 years worth of reserves.  Qatar has one of the world’s biggest gas reserves, estimated to be up to 400 years.  One pool alone is expected to hold over 100 years supply.  This pool will not be touched for decades as existing fields are so huge that Qatar will not need any more gas to export. 

             Lower gas prices hurt Qatar.  Yet it should still make lots of money when prices fall to the $1.50 area within 2 years. Whether it is luck or foresight, the country has built gas plants, ocean tankers, and storage tanks in Europe.  Their infrastructure is already built and operating giving Qatar a nice competitive advantage. 

             There are huge shale gas reserves in Queensland, Australia. There is believed to be one of the world’s biggest unexplored shale gas reserves under the Mediterranean sea, between Cyprus and Israel and pockets near the Dead Sea.  Oil has been found there before, but only in tiny amounts.  If it is shale oil rock then Israel could possibly become energy self-sufficient. Eastern Europe may also be sitting on huge shale gas rock deposits. 

             If the latter is true, the political ramifications can be huge. Eastern Europe has relied on Russian gas for decades. As a result, the Russians have been blackmailing Eastern Europe for years, often slowing, if not cutting off the gas flow in the process. This will not happen anymore. In a few years time, Eastern Europe will no longer rely on Russian gas and Russia will be heading into tough times, and maybe even social unrest. Russia not only needs the foreign currency, but relies heavily on the political influence the commodity delivers. 

             Russia most likely has huge shale gas rock reserves.  Most of this will not be tapped for years for the simple reason there will not be a market to sell it. This is the case both internationally and domestically.  Natural Gas has been one of the main money earnings for the Kremlin. Now there will be little money left to bribe the Russian citizen and other countries. The Mafia is in trouble.

             China will most likely develop very little of it’s shale rock reserves in favor of cheap reserves from Australia and elsewhere. In 50 to 100 years gas prices will move up substantially as the West’s reserves are depleted. When this occurs, the West reserves will be very expensive to mine, while China will still be sitting on its cheap undeveloped shale gas rock.

             On the one hand, there are definitely some potential positives from shale. Specifically, if the auto industry can figure out how to mass produce cars using natural gas, the savings being passed onto consumers would be huge.  If this is the case, other industries will most likely follow.

             On the other hand, this gas will destroy solar and wind industries because they are not competitive with current prices. Established wind farms, such as those near Lethbridge, Alberta, off the coast of Copenhagen, and near Costa Del Sol, Spain, will survive.  But, as far as industry expansion is concerned, good luck!  It is most likely a dead industry for now.

             It will take anywhere from 3 to 7 years before the full effect of shale gas hits the marketplace.  New gas plants will have to be built, existing ones retrofitted, and more pipelines laid. Shale is going to alter many industries. We anticipate most new homes and buildings will be built utilizing gas.

             On the plus side, we are probably only 1 to 2 years away from oil prices moving below $100 and staying there for years, maybe even decades.  Similar to natural gas, there is plenty of oil available today. Currently in the U.S., there is the highest amount of surpluses since 2009 because oil production has increased by 1m b/d. The problem is that there are not enough pipelines to handle the increased production. Furthermore, no one talks about the potential of shale oil rock of which there is plenty. 

              Shale aside, both Canada and Russia are adding oil production on a monthly basis. Current supply is also being exacerbated by a massive oil field off the coast of Brazil; Iraq is producing the most oil in over 30 years; and Libya will soon do the same. If the glut was not real, Saudi Arabia would not be forced to shut in close to 4m b/d due to no buyers. Sorry Doomsayers, Peak Oil has been delayed by at least 50 years, probably much longer . 

               As more shale rock is discovered, the more downward pressure on oil will increase. We can see $70 to $80 being the new norm within 2 years, and bouts of $40 to $50 during world recessions. This is good news for the consumer because cheaper energy equals additional spending elsewhere which will also be good for stock markets. 

              The only threat to cheaper energy prices is government. Politicians might raise energy taxes to offset the falling revenue and hope the consumer will not notice. In B.C. and elsewhere, many energy taxes are based on a percentage basis, as the price rises, so does their take. Have you noticed not one government in Canada has spoken out about rising gasoline prices? Of course not. The politicians are making too much money from of it.

              If $70 to $80 is going to be the new norm it will hurt the Middle East, OPEC, and Russia. It could easily create social unrest in the latter. For China and Indonesia, this will be a bonus because  the economies will continue to grow and both will become more prosperous. If this turns out to be true, both will need Canadian and Australian resources.

              Interestingly, if Australia and Indonesia can agree on drilling in the disputed Timor Sea, which is believed to hold one of the world’s biggest untapped gas and oil reserves, it could make Indonesia self sufficient in both. Similarly, Australia can also become energy self-sufficient with shale rock.

             The only sure thing is the world will be a different place by 2015 than it is today. Energy prices will change the way many countries operate and governments will face shrinking energy taxes unless they raise them. There is no doubt about it, we are entering into interesting times.

China's Way of Thinking-Published February 2012

          It is common knowledge China is purchasing natural resources at an alarming rate. The most popular theory as to why is simple; a growing population, coupled with mass migration to cities as people demand a Western style of living. This is true. However, there is a high probability that the Chinese government is also planning long term, by this we mean 50 years down the road.

          Going over recent facts, it is becoming clear China is planning for the very long distant future. This bodes well for the Chinese economy for decades to come. However, everyone is missing one important fact about China; in many instances, the country is self-sufficient in most goods. Yet, it continues to buy resources from other countries when it is not necessary.  The most obvious reason is to stock-pile. 

          It has become apparent the Chinese government has decided to use other countries resources and leave most of theirs available for domestic use in the future. Coal is a perfect example, the country has over 200 years worth but they remain the biggest buyers of Australian coal. Plus, they buy from Canada, Brazil, and to a lesser extent, from America. In 50 years time Canadian, Australian, and Brazilian coal will be very expensive to mine. Meanwhile, China will still have plenty of cheap coal left in the ground.

          As mentioned in earlier issues, they have bought and are managing thousands of acres of rich farmland in Botswana. When my Father visited Botswana 5 years ago, he saw no Asians working the land. Wisely, the Chinese do not advertise what they are up to and employ only locals. This is a cheap form of insurance for years when Mother Nature is not kind to the Chinese farmer. For Botswana, this equates to investment, tax revenue, and more importantly, jobs.

          China is now buying up Australian farmland. It would not be surprising to find out they have bought land in Canada, the U.S., and France for their wheat. If they have made such purchases, they, along with the local politicians that govern the land, will attempt to keep it quiet as long as possible. Other nations buying large tracts of land could create a political nightmare amongst the people for both nations involved.

          China has signed long term contracts for Australian natural gas. Given the collapse in the price, we suspect they will demand, and most likely receive, a cut in the price they agreed to. Natural Gas is in a free fall and is likely heading to $1.50. If it came to crunch time, China will simply walk away from any contract they do not like. Similar to coal, China would rather buy cheap offshore natural gas and save their own for a future date. It is estimated that China has up to 200 years worth of gas stuck in shale rock.

          The Chinese have been forced to think long term. For the first time ever, urban population is at 51% of the total population. In order to control the growth and limit unemployment, they forced 20m people back to the countryside twice last decade. However, this did not slow the influx.

          Australians are basing their future solely on China being a major buyer of all their goods. Sadly, you can not trust the Chinese. They honor only contracts that suit their interests and do not care about the West. For Canada, Norway and a handful of others, no matter what, China will always demand our forest products. They simply cannot grow enough trees to meet their growing population.

          We are the only ones who think China is preparing for their own future.  When they decide, if ever, to go at it alone, as they did for over 50 years last century, many countries and businesses in the West will be hit very hard. They could easily drive some countries like Australia into recession. This, we believe, is why many large companies have been hesitant to invest directly in the country. If this was not the case, more large Western corporations would be investing directly in China.

          The one thing they have done, and will pay dearly for, was to redirect rivers that were flowing into the Yangtze River to help build the Three Gorges Dam. Some water soaked areas, especially within 100 miles of Beijing, have now turned into rock hard soil and is now unusable. It will take decades to clean up this mess, if ever. Water will be the biggest source of trouble for China. Without it, there is no future. China has time on its side, but as we all know, time goes by too fast. We have to assume China is currently working on this problem.

          China will be an ongoing story for years to come. It will unravel completely different from today’s thinking. They are planning long-term, something the West does not understand or do.

CRB Index-Forward Indicator Published April 2010

          Generally speaking, deflation is caused by a decline of currency or credit (money supply) in circulation, or as a result of an increase in the supply of a particular good.  A contraction in the supply of money drives prices for goods downward due to a shortage of available funds in the system.  Inversely, inflation can be created by a short supply of goods, and/or an increase in the money/credit supply (monetary inflation).  The latter is created exclusively by the central bank with the encouragement of the political party in control at the time.

          People rely on the Consumer Price Index for their insight into inflation.  While useful, the index, at anytime, can be, and often is, manipulated to skew the outcome.  The most often method is the stripping of core items.  Because of this, we find this measure to be unreliable.   Furthermore, any consumer can debate the relevance of the metric by simply comparing it to ones own cost of living which has increased much faster than the token 2-3% annual increase the index likes to deliver.  For example, house prices across the nation have doubled in the past ten years which implies a compounded annual return of roughly 7%.  Similarly, gas and food prices have also increased above the 2-3% range.  In most cases, we as consumers can avoid some price inflation by simply choosing not to buy goods, or settle for a cheaper alternative.  However, services such as power are usually set by government, leaving the consumer at the mercy of the price setter.

          While the CPI is indicating a general increase in the level of prices, it is the money supply that ultimately controls the movement in prices.  When the Bank of Canada lowers its lending rates, chartered banks are able to lower the amount of interest they charge on their loans.  As a result, the banks are able to lend more capital based on the debt-servicing equation.  This increase in availability of credit, also known as monetary inflation, raises the price of many goods.  For example, house prices in Canada have reached today’s levels only because of falling interest rates. If interest rates remained flat over the past decade, home prices could only have increased with wages, or 2% annually.  Conversely, the U.S. has experienced monetary deflation as lenders tightened their standards, resulting in less available credit circulating.  As a result, we have witnessed a melt-down in the U.S. real-estate market.
 
          Based on today’s movement in prices,  interest rates should be at least 4%.  However, given monetary deflation is still a strong threat, rates have remained at historical lows.  Today’s low rates have allowed governments around the world to borrow at non-existent interest rates.   What today's low interest rates are telling us is that the financial meltdown, which began almost three years ago, is still intact.     
 
          Japan has had zero interest rates for almost 20 consecutive years.  This policy continues to eliminate savings at a fast clip.  Japanese household savings have declined continuously from 16% of household income in the late 80’s, to 3% today.  At the same time, personal debt loads are climbing to maintain a life style that is not sustainable.  Japan provides ample evidence that low interest rates destroy savings and increase debt.    
 
          Today’s monetary deflation, while mild, is now into it's 33rd month, longer than that of the Dirty 30’s.   Furthermore,  there is very little evidence that it is ending.  People are borrowing and spending as never before, creating a false miniboom.  Considering the average household had a tough time dealing with their debts prior to 2007, how will they cope with today’s load?  Given the bulk of outstanding consumer debt is long-term (mortgage),  any future rate hikes will consume additional discretionary spending needed to fuel a true period of inflation.  Furthermore,  those living in B.C. and Ontario will realize a tax increase on July 1st (HST), resulting in less disposable income.   
 
          Too many people in the investment business are recommending buying all commodities to protect one's wealth.  The facts are there are surpluses of most commodities.  Furthermore, these assets have lost value to inflation over the past 200 years.  Over the past year the CRB Index (based on commodities) is up 22%.  When selling does come, as it always does, the sell-off will be substantial.  We cannot rely on the media’s illusion that China will consume any excesses. They are going to be more of a seller because they have huge stockpiles of most commodities.  Institutional investors will not be buying either.  In fact, I am willing to wager , since they are recommending commodities, they are net sellers, unloading their own positions onto their clients.   This is how the market makers operate.
 
          People have done everything to maintain their spending.  This is why the average sale price of houses in Canada have remained flat to slightly up, even-though there is plenty of housing available (5.8 months supply throughout Canada).  I took my son to Toronto at the end of March and visited the CN Tower.  I was blown away by how many new condo projects that have popped up since my last visit two years ago, not-to-mention those in the midst of construction.  My Grandfather’s Realtor told him there was an estimated 32,000 units being released on the market this spring alone.  It will be interesting whether the units will be absorbed or be turned into rentals, which from simply walking the street, is a saturated market.  “For Rent” signs where visible across the city.  Granted, the majority of the vacant units are in older buildings,  however, desperation is evident when buildings are offering incentives such as a free months rent or a flat-screen T.V. to anyone that signs a 1-year lease.

          House prices in Canada still bare no relation to family income.  After 3 years, American home values are down to around 3 times family income.  In Detroit, one can purchase a bargain at around one time household income.  Canada's average home price is at 5 times income, while Australia at under 6 times.  American prices are at or near the bottom.  Places such as Spain, Northern Ireland, Canada, Hong Kong, New Zealand, and Australia have plenty of room for sizeable price drops.  It should be pointed out that while the average sales price in Canada has rebounded, one is able to buy more house for one’s money.  This is deflation quietly at work.
 
          Once inflationary pressures do surface, central banks will be forced to create higher interest rates.  In a normal economy, rates should be substantially higher today because America is borrowing every cent it can find in order to finance it's $1.6t budget deficit.  Today, we are probably 2-3 years away from a banking prime rate of 4% or higher because deflationary pressure are still present.  Furthermore,  all politicians will complain that rising interest rates will hurt the housing market forcing the Bank of Canada to increase rates slower than needed.  
 
          Over the past 3 years, not one politician anywhere in the world has commented on how zero interest rates have punished savers, those on a fixed income, and all investors.  Part of the reason is few politicians have an understanding of basic economics, and fail to recognize that savers are the backbone of all economies.  It is their investment in shares and bonds that fuel all businesses and jobs, which in return, creates the surplus cash that buys cars and homes.  The investor/saver is the biggest job creator throughout any economy.   It is going to take trillions of dollars of investors savings world-wide to give the economy a solid, long lasting boost.  Yet those savers are getting poorer by the day due to government policies.  These policies will prove to be deflationary.

          We do not know which one will win out in the months ahead, deflation or government printing presses.  We give both an equal chance.  Deflation is usually short-lived, lasting 12-24 months.  However,  Japan has been the exception.  It is presently in its 3rd deflationary depression in the past 20 years. Once deflation gets a grip it is hard to eliminate it because spending slows since prices may be lower tomorrow. Governments will attempt to avoid deflation at all costs.  They tend to  love inflation because it devalues their outstanding debt. 

          Everyone in the investment business, except us, are surprised that the latest numbers from Japan show the deflationary forces are still at work and actually seem to be getting worse. We are the only people who believe the one variable that  is destroying Japan is zero interest rates.  Over the past 20 years,  Japanese household savings rate has deteriorated.  There will be no change in Japan until interest rates move up creating incentive for one to save.  A nation does not prosper by eliminating savings.

          The key to watch is the CRB Index.  Under 181 the world is heading into a period of deflation.  If it climbs over 300, it will warn inflation is coming.  Today it is bouncing between 250-275, a level the world can be comfortable with.  Hopefully it will stay in this range for sometime.  While The Streets are predicting rising inflation, few talk about the present threat of deflation.  History shows that when everyone is on the same wavelength the opposite usually takes place.  We are not out of the deflationary woods yet.

Hedge Funds-Published May 2007

                 At the start of this decade there was around 4000 hedge funds world-wide.  At the beginning of 2005 there was nearly 7000. By May 2006 there was 8,100 hedge funds, double the number of mutual funds.  Today, there are over 9,100. Once the financial industry saw such a profitable gold mine via commissions, service fees, and profit sharing coupled with an unregulated environment, they all raced to jump in.   Last year there were two fund managers who earned over $1b and another 8 that received over $240m in pay. 

                 As a group they control an estimated $1.4t.  Including borrowing potential, the amount jumps to over $2t.  The world offers about 150 different investments.  There are the metal markets in London and various other commodity markets scattered across the globe,  most stock exchanges,   currencies, and government debt.  However, roughly  40 investments are liquid enough to allow for  large dollar volume trades on a regular basis.

                 Since there are too many hedge funds and not enough investments available they are now investing elsewhere.  The past year has seen many hedge funds throw stupid amounts at already over-valued real-estate.  The most famous deal to date was the purchase of  Equity Office Properties Trust by Blackstone for $39b, $31b of that being financed via debt. 

                 A strategy growing in popularity is the leveraged buyout (LBO).    Last year, $450b worth of public companies were purchased in the deals, up from $50b only seven years ago. In this scenario, borrowed money  is used to purchase a public company. In most cases the debt issued to purchase the company becomes senior to that outstanding.  As a result, the current bondholders end up taking a hit because the debt being used to acquire the company increases the debt service ratio of the organization and will ultimately lower the credit rating of the company.  

                BCE is the most recent high profile takeover target in Canada.    Investment bank and Hedge Fund operator Kohlberg Kravis Roberts, has shown an interest in buying a majority position in BCE for $40 a share.  While its shareholders are enjoying a nice capital gain on the news, many of its bondholders-representing about $7.5b of BCE’s $11.9b in long-term debt– have been hurt as their holdings have fallen by 10%-20% with spreads widening 300 basis points  above Canada’s 30 year bond.   This spread reflects the higher risk the current outstanding bonds would carry if the LBO firm rolled its takeover debt into BCE.  This will inevitably leave BCE debt holders  “ ...subject to higher risk, higher leverage and lower credit ratings,” according to Dominion Bond Rating Service.

                 In the process, the hedge fund pays itself a huge commission for arranging the deal.  Once the hedge fund collects its fees and bonuses, the purchased company declares a huge one-time dividend that  eliminates much of the company’s cash holdings by passing it onto the shareholders (the hedge fund).  With stock markets around the world doing well, the hedge fund, with help of Wall Street and Bay Street, will then take the company public again, at a higher price than what they paid in addition to passing the debt back to the average shareholder.  This strategy is the perfect legal pyramid scheme.

                  Hedge Funds are one of the main causes of  price inflation.  Forget about blaming China and India, they are responsible for exporting deflation via lower labor costs being passed onto the consumer.  By investing too large of sums into small markets such as many commodities, the hedge fund pushes up the price of the commodity which still must be used as an input into a value added process.  The company that must use the commodity is faced with higher input costs that will be passed onto either the consumer via higher prices, or the shareholders in the form of falling profits due to increasing input costs. 

                  There has yet to be a shortage of oil in the world, nor will there be for at least one hundred years.  It is interesting to point out that, as the number of hedge funds increased so did the price of oil.  Similarly, the price of gold has increased with the number of hedge funds as well.  If there was even half as many hedge funds, both would be roughly 50% below today's prices.  Copper is another metal that is trading far beyond fundamentals.  During May 2005, there was a shortage of above ground copper, as a result the price of the metal increased to $1.52 per pound.  Today, with supplies up over 300% and ample, the price is up 129% in London and up 122% in Chicago.  Gold, oil, financial instruments and copper are the most traded assets by the hedge funds. 

                  While there lacks any meaningful evidence, I am certain that the following strategy is also being practiced by some hedge funds.  Since it is impossible to track a metal once it is received by its buyer, it is possible for one to continue to buy a certain commodity and corner the market.

                  In 1973, the Hunt family of Texas, one of the richest families in America at the time, decided to buy precious metals as a hedge against inflation. The Hunts, together with some wealthy friends, formed a silver pool  and began to buy silver in enormous quantity. In a short period of time they had amassed more than 200 million ounces of silver, equivalent to half the world's deliverable supply.

                 When the Hunt's had begun accumulating silver in 1973 the price was in the $1.95 per ounce range.  By the early eighties the price  peaked at $50.50.  Typical of most investment manias, the retail investor joined the party at the peak.  Unfortunately,  changed trading rules on the Metals Market (COMEX) and the intervention by the Government put an end to the game.  Specifically, the price collapsed because the elite in Washington and on Wall Street started shorting silver in the low teens.  Meanwhile the Hunt clan rightfully called for delivery and the short sellers could not supply the silver.  Since the short sellers controlled the various government positions they easily changed the laws making it illegal to hold the metal.  As a result, the price began to slide causing a 50% one-day decline on March 27, 1980.  Silver plummeted from $21.62 to $10.80.  By 1987, the Hunt’s liabilities had grown to nearly $2.5 billion against assets of $1.5 billion.  Consequently, the Hunt brothers declared bankruptcy in addition to being convicted of conspiring to manipulate the market.  Unfortunately, the only mistake the Hunt clan made was not inviting both Wall Street and Washington to join into their lucrative plan.

                 At the start of the this decade it was believed many funds were making 20% or better.  However, no one knows for sure since no accurate reporting is done, let alone necessary.  It is mathematically impossible for all hedge funds to make their investor’s money. There are rumors that many funds are juicing up their performance.  Some are believed to be reporting profits today, based on future revenue and capital gains.  This is very easy to do.  Enron did the same thing only with gas and electricity futures.   Again we will never know what is happening since they are not made to disclose any financial information to anyone.  The latest numbers for 2006 show that hedge funds supposedly produced returns of 6.7% annually, on average.  If true, they did outperform many stock markets and real-estate, however, it is still not a stellar  record.

                 Because there are so many hedge funds with no shortage of money, we are in the midst of a new financial bubble.  Today’s actions, and the excesses they are creating, are exactly the same as in the late twenties and the late nineties. There are surpluses of most food.  We are overbuilding real-estate, vehicles, and many consumer goods, so, many asset prices today are unwarranted.  The bottom line is hedge funds are creating a huge world-wide financial bubble.  No one knows how much more it can expand.  We do know that one day it must revert to the norm in order for the economy to come into balance.  When this occurs it will aid in pushing the global economy into a multi-year recession.   At least half of all hedge funds will  disappear. Those left will be holding depreciating assets tied to huge debts. 

                 Under no circumstances can we afford to see house prices fall by more than 10% and/or stock markets fall more than 5%.  We cannot afford higher interest rates, yet the global trend is in place.  Stock markets cannot afford cheap oil, yet it will fall to below $40.  This is the longest period on record  without a true economic pullback.  The last occurred in the early eighties.

                 Hedge funds are popular, however, they are past their peak.  There are too many chasing the same thing and are now in the midst of the Greater Fools Theory.  This new segment of the global economy has not once been tested as a whole on the downside.  Since no accurate reporting is mandatory, when trouble comes, investors will be caught by surprise and will feel the pain after the fact.  Most investors will not be able to get out since most exercise a minimum holding period. Stay away from all hedge funds, they are about to disappoint many people.