Go East, America! Go East!

With the stroke of a pen, the value of a commodity exported by Australia went up 85%. Not even the oil market moves that fast! Dan Denning explains…

It happened about six days before I expected it, but at long last the hardball tactics of iron ore giant Rio Tinto resulted in an 85% increase in iron ore prices this year. It happened earlier this week, after eight months of intense and sometimes rather unfriendly negotiations. The consequences could be very friendly for investors, though. More on that in moment.

But let me just repeat that in case you missed it – with the stroke of a pen, the value of a commodity exported by Australia went up 85%. Not even the oil market moves that fast!

The Australian resource boom is rapidly becoming one of the biggest missed boats in American investing. There are staggering (and growing) numbers being posted by Aussie commodity exporters. Since it is an election year in America and your senses are being assaulted (and likely offended) by noxious fumes coming from politician’s mouths, let me remind you of the extraordinary story taking place here in the Lucky Country.

Just yesterday, the Aussie organization that tracks these things forecast 40% year-over-year growth in the value of Australian mineral, energy, and farm exports. Can you think of many companies that report 40% earnings growth year over year?

GM? Washington Mutual? Citigroup?

Led by 21st century blue chips like BHP Billiton, Rio Tinto, and Woodside Petroleum, Australian companies will export over A$212 billion worth of coal, iron ore, gold, crude oil, copper, and LNG (to name a few commodities) next year. These booming exports are evidence of the structural revaluation of global resources. And the booming stock prices of resource producers represent the structural revaluation of those stocks (once cyclical, now more like growth)

Gold to India. Coal to Korea and Japan. Iron ore to China. Copper, uranium, rare earth elements, and a host of other base metals and bulk commodities…they are all on big boats to points North and East. This is why American investors cannot afford to ignore the story any longer.

By the way, thanks to a huge spread in short term interest rates (2% in the U.S. and 7.25% in Australia) the Aussie dollar is nearly at parity with the greenback after rising 70% in the last four years. The strong Aussie currency derives much of its strength from the roaring commodities market. And it’s that commodities market that is lately under scrutiny from some investors.

The numbers above suggest that the commentators who are calling for a top in the commodity cycle are actually complete morons. But rather than name calling like a candidate for national office, let me suggest that the commodity market has evolved beyond a simple boom-bust cyclical analysis. It is still boom-bust, but with a twist.

No. I am not suggesting that, "This time it’s different." The basic economics behind the business (and/or credit) cycle are as valid as ever. Early business investment based on real demand leads to good times. Good times lead to easy credit. Easy credit leads to more investment (some of it very bad).

As money and credit expand, prices rise. Rising prices attract new investment from commodity producers. Eventually supply exceeds demand, credit tightens, and the cycle of growth ends in inflation in energy that destroys demand.

Is that where we are now?

Sort of.

There is a popular theory here in Australia – where I moved in 2005 for a front row seat to the resource boom – that China will suffer a post-Olympic slowdown. It’s what happened in Sydney after the summer games there in 2000.

This theory nicely fits another theory advanced by other analysts that China’s industrial boom is almost entirely reliant on American consumption. If the credit crisis sinks the American consumer economy in the second half of 2009, China won’t be able to sell anything to America. And if Chinese producers can’t sell finished goods to American consumers, they won’t need Australian raw materials!

Poof goes the resource boom!

The only trouble with that theory is that it’s complete hogwash.

American’s who believe that China’s boom is utterly dependent on unsustainable patterns of American consumption are sadly misinformed, or deliberately in denial about the changing structure of the global economy.

The facts are the facts. And what are the facts? The urbanization and industrialization in the developing world is hugely resource intensive. These people (in China and India and Brazil and the Middle East and Vietnam and Malaysia) are not building economies to service the whims and fancies of American consumers.

They are building sewers, bridges, factories, cars, roads, railways, airports, power plants, grocery stores, movie theatres and probably even Wal-Marts. The studies here in Australia by both the resource companies and analysts have shown that even Australian resource firms badly underestimated the intensity of demand for Australian resources.

Much of that demand comes from steel for infrastructure, residential, and commercial real estate. Australia has some of the world’s richest ore bodies, from the high-grade iron ore of the Pilbara, to the black coal in Queensland’s Bowen Basin, to Olympic Dam in South Australia (home to 17% of the world’s known uranium reserves).

In the 1960s and 1970s, Japanese and Korean companies were on the ground and in the Outback, looking for joint venture deals to secure long term access to Aussie resources for their post-war, industrializing economies. It is like that today, but on a much, much greater scale.

Today, the place is filled with Chinese, Russians, Indians, and even nomadic American newsletter writers. Australia is as big as the continental United States. Much of it remains unexplored. But there are plenty of investors on the ground from all over the world looking for their stake in key mineral and energy deposits.

Chinalco is looking to develop a huge bauxite deposit on Queensland’s Cape York peninsula. British-based BG has made an unsolicited $13 billion bid to get in on the coal-seam-methane business. A Saudi Arabian firm recently engineered the takeover of a small West Australian mineral sands company that makes titanium dioxide (key in the plastics industry).

My point in highlighting just a fraction of the activity that’s going on here every day is simple: this place is a bonanza for investors. There are far more intriguing resource companies than there are analysts to cover them. And remember, the market value of these company’s assets is generally going up (dramatically in some cases). The only other place on earth where you could find more uncovered stocks is probably the Indian Small cap market.

I was not willing to move to India in 2005, mostly because of my bad stomach, ruined by French cheese and room temperature English beer. But Australia seemed like the perfect place to follow the commodity and Asian booms firsthand, and gain a big edge on investors who weren’t here and accepted the conventional analysis of the resource boom. The meat pies are also excellent.

It’s a decision I have not regretted one bit. But let me clarify what I expect from here on out in the resource boom. In a word, I’d say you should look for "epicycles."

There are now cycles within cycles in the resource industry. There are five general categories to keep your eye on: bulk commodities, base metals, energy, agricultural commodities, and precious metals.

Right now, high energy prices are putting huge cost pressures on base metal producers. This, plus the first wave of new supply coming on line last year (especially for zinc, nickel, and cooper) resulted in a cooling off in base metal price last year. Meanwhile energy stocks took off, along with agricultural commodities.

My forecast is that high energy prices are about to knock everybody back a peg or two and result in reduced demand for energy for the rest of this year. Supply will remain tight in oil markets. But consumers (industrial and commercial) will roll back demand. Oil traders will take profits and we’ll probably see oil somewhere around $105 before the end of the year (barring geopolitical events).

Meanwhile, bulk commodities have already seen big year-over-year increases. Coking coal prices tripled earlier this year while thermal coal prices were up 75%. The iron ore price gain of 85% certainly won’t hurt Rio’s earnings either.

Ironically, many Aussie coal producers will make more money on lower production volumes this year. Bottlenecks with rail and port infrastructure on Australia’s East Coast mean that producers can’t fully take advantage of the big price gains this year.

This infrastructure problem itself is actually a great investment opportunity too. Not only are Australia’s top engineering and infrastructure firms making a killing on the local boom, they’re active in South East Asia, the Middle East, and Africa. For the coal producers – if they are not swallowed up by Xstrata first – earnings won’t start to benefit until the second half of this year or early 2009 (although stock prices have already begun to reflect the higher coal prices).

I would not be a seller of energy stocks at this time. However, it looks to me and my team of analysts here like base metals are due to take over the leadership in commodities for the rest of the year. Ag and energy may cool. Most of the bulk commodity prices are still negotiated, although there is a move afoot to base coal and iron ore prices on an index. This reflects the added liquidity in the markets: there are a lot more buyers and, increasingly, a lot more sellers.

It’s the new sellers we’re interested in the most in our Aussie research. You could do a lot worse than own BHP, Rio, and Woodside, and Worley Parsons for the next twenty years. BHP alone is like a mutual fund of commodities.

But the big earnings growth and the massive revaluation of ore bodies is taking place with the smaller and newer producers too. And this is where I believe it’s actually to your advantage that there are so few analysts covering smaller Aussie stocks. In fact, as one mining executive I spoke with recently said, "Even the analysts that are covering us don’t know how to value us. They are all using discounted cash flow models and don’t know much about geology or commodities."

In ignorance, there is opportunity!

Australia has an abundance of scarce resources. It’s a bit of a paradox. But then, the platypus is an animal native to Australia. That duck-billed, beaver-tailed, venom shooting, egg-laying marvel has DNA from both reptiles AND mammals. It’s one of a kind, just like the Australian economy, which has not suffered a recession in 17 years.

Regards,

Dan Denning
for The Daily Reckoning
June 25, 2008

P.S. Australia remains perfectly positioned to be a key resource provider of the developing world’s industrial boom, as long as that boom shall last. It will be much longer than you think.

Dan Denning is the editor of The Daily Reckoning Australia. He’s also the author of 2005’s best-selling The Bull Hunter (John Wiley & Sons), and spent five years as editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan draws on his network of global contacts from his new base in Melbourne, Australia.

The most boneheaded miscalculation of all time…

"Terrorism will be reduced…weapons of mass murder will be limited, people will be safer around the world, human rights and democracy will be unleashed in the Middle East, and the fragile outlook for world prosperity will be improved… The uncertainty tax on world growth will be lowered too, as will the energy tax from temporarily spiking oil prices."

This was Larry Kudlow writing in March, 2003.

The spike in oil prices he described took place on March 12th, 2003, pushing the price of a barrel of crude all the way up to $37.83 and the price of a gallon of gasoline to $1.72. Yesterday, oil closed at $137 and gas sells for $4.06.

But Kudlow was hardly alone in his hallucinations. Laurence Lindsey, then George Bush’s senior economic advisor, looked into his own crystal ball and saw nothing he didn’t like.

"Under every plausible scenario, the negative effect will be quite small relative to the economic benefits… The key issue is oil, and a regime change in Iraq would facilitate an increase in world oil," thereby driving down oil prices.

Paul Wolfowitz, then Deputy Secretary of Defense, went on to reassure the nation that Iraqi oil revenues would pay all the costs of reconstructing the country.

Today, we are talking about one of the most boneheaded miscalculations of all time. Almost with a single maladroit stroke, a relatively small group of world-improvers undermined the progress of 9 generations. Five years later, Americans are on the losing end of the "biggest transfer of wealth in history," as T. Boone Pickens described the oil market of 2008. George W. Bush has the highest disapproval ratings of any U.S. president in history. America’s most profitable industry – finance – has collapsed…its currency has lost a third of its value…and European, Chinese and Indian economists are wagging their fingers saying, "I told you so."

But here at The Daily Reckoning we always look on the bright side. And the sunny side of this story is that the United States needed to be humbled. After the Soviet Union fell to its knees in 1990, America had a monopoly on worldwide military force. Nature abhors a monopoly; she needed to take the U.S. down a peg. Who better to do the job than this group of neo-cons? They knew no history; nor did they understand economics. They were the perfect people to lead the nation to disgrace and bankruptcy.

Mr. Kudlow continued his miscalculation by referring to a survey, in which 69% of respondents said they would gladly pay $300 for the war.

So far this year alone, the price of crude has risen 40%. It’s now $100 higher than when the neo-cons took America into the Iraq War. Each American uses 25 barrels of oil per year. This is equivalent to a tax of $2,500 in additional energy expense per person…or $10,000 for a family of four, annually. In addition, the war itself is estimated to cost between $1 trillion and $2 trillion. Divide that by the number of U.S. families and you get a figure of $10,000 or more.

Ooops.

But the numbers are just the beginning. High energy prices are undermining the American way of life itself, such as it is. As colleague Byron King explains, below, we’ve spent the last 100 years building the wrong kind of world. Now, many Americans are doomed to live in the ruins of a civilization that no longer works.

"Rethinking the country life," begins an article in the New York Times. "Suddenly the economics of American suburban life are under assault," it continues. Then, it gets down to business.

When Larry Kudlow, Laurence Lindsey and Paul Wolfowitz were explaining how nice it would be to rough up the Middle East, the average suburban American household spent $1,422 on gasoline. Now, according to the Bureau of Labor Statistics, the sum has risen to $3,196. Another estimate puts the increase in energy costs to the typical family at $50 per month. Anyway you look at it, it’s a lot of money for people who don’t have much money. And the figure goes up the further you get out in the boonies.

"Life on the edges of suburbia is beginning to feel untenable," says the Times.

Like it or not, Americans are being forced to park their cars. This spring, they cut back on their driving at a sharper pace than anytime since 1942. But it’s hard to stop driving when you live far from work and far from shops.

Meanwhile, we got the latest figures on the U.S. housing market. According to the Case/Shiller survey, prices fell at their fastest rate ever in April, down 15.3% over the year before. This no doubt contributed to an enveloping funk in consumer confidence, which hit a 16-year low.

The confidence level of suburbanites falls with their house prices. We have no proof, but our guess is that no houses are falling more than those built most recently, most far out. That’s where homeowner equity is likely to be lowest…and where the increased price of commuting hits hardest. That is where house prices ought to be most vulnerable. Potential buyers will simply add up the costs of commuting – in time and money – and subtract it from what they are willing to pay for the house. The longer the commute, the lower the price.

"Prices in outer suburbs will get clobbered," concludes economist Mark Zandi.

The country will be turned inside out by higher energy prices. The suburbs are becoming less and less desirable…compared to concentrated, close-in developments near city centers. For the first time since the 1920s, the inner cities are ‘in.’ The suburbs, meanwhile, are ‘out.’ And the further out you go…the further ‘out’ they are. Over time, many of these out-lying suburbs are likely to become slums…or maybe simply abandoned, left to become ghost towns, with tumbleweeds blowing through the empty split-levels and burned-out neo-colonials.

In the fashionable inner cities, meanwhile, the middle classes will adapt and probably be better off for it. They’ll walk to restaurants, to school, and to shops. In the far out suburbs, consumers will regret every trip to the shopping mall…and rue the day they listened to Larry Kudlow.

But here we let Byron King pick up this point…

"The returns are coming in from the distant precincts of the oil patch, and the winner is… Oil!

"The price for oil has barely budged based on the Saudi Summit. There has been no summer sell-off, and I’d be surprised to see a significant pullback as the summer driving season kicks into gear. (Followed by hurricane season, and then the buildup for winter heating stocks, followed by winter.)

"What’s going on? Well, what the Saudis give – in proposed, future increased production…the Nigerians take away – with ongoing oil patch carnage that forces the likes of Shell and Chevron to close vast pipeline systems. Apparently the present trumps the future, even in the futures markets. Everything is connected to everything else, isn’t it?

"Here is my take on the exit polls from the Saudi Summit…

"Consumers and their representative governments are desperate for an oil pullback. This $135 oil is draining budgets. The poor and working poor are already marginalized in this cruel world of ours. Now it’s the turn of the middle classes to get kicked into the cellar of the modern age. People are working time-and-a-half just to put food on the table and gas in the car. Retirees and others on more-or-less ‘fixed’ incomes are impoverishing slowly. Unless they are impoverishing fast. Bankruptcy filings among the older and elderly demographics in the U.S. are soaring. The bottom line is that the conventional image of a ‘decent standard of living’ is rapidly receding for many tens of millions of households. The 20th Century is truly over. (I think this has much to do with the meteoric rise of Senator Obama as well… He offers nothing new – mostly just classic, populist Democratic Party bromides – but he offers it in such a sweet and beguiling, Teflon-coated manner…)

"And it will get worse before it gets better. To be perfectly blunt, it might not even get better. Over the next year, and into the foreseeable future, in the developed world people will go broke buying motor-fuel, heating oil and natural gas. (Wait until next winter… Sweet Jeeeezus!) In the less-developed world, people will go broke buying bread. And then the poorest amongst us will starve. Any way you look at it, it’s bad for business.

"Fast-rising energy prices are decapitalizing entire nations. Energy prices are destroying wealth faster than people can re-create it. Entire segments of the world economy have hit the iceberg and are filling with cold seawater. Some industries are becoming obsolete in a matter of months. Much of the airline industry is drowning in red ink before our eyes – almost every flight in the sky is losing money, no matter how much they charge to check your suitcase or how few peanuts they put in the small package.

"And down on the ground, most motor transport is just plain uneconomic any more… ‘Dead Rigs Driving.’ Farewell to the ‘Warehouse on Wheels.’ Sic Semper Globalization.

"Large swaths of the auto & truck building industry have become capital-wastelands. For example, GM is closing SUV factories and planning to ditch the Hummer brand. This cascades down to firms that make everything that goes into a set of gas-guzzling wheels. You name it: hot-coiled strip, axles & tires, wire bundles, paints & coatings, window glass and seatbelts, and so much more. Billions of dollars worth of past investment is just gone…bye-bye, poof! And the good-jobs-at-good-wages? History.

"So, is there room for optimism here? Yes, in the sense that high prices are concentrating many minds on energy. ‘Energy’ is the most important issue of our time, bar none. That is, people are finally beginning to understand the centrality of energy to our collective existence. Take away the cheap energy, and it becomes clear that mankind has spent the past century building the wrong kind of world.

"Another way of saying it is that we’ve collectively built ‘tomorrow’s ruins’ today. And I don’t mean just the physical structures, the bad architecture and stranded infrastructure that is worthless when energy is expensive. Think as well about the social structures that are beyond worthless when energy gets expensive. Tell me when you start to get worried…

"Much of what happens in our time only happens because energy is relatively cheap and abundant. So when energy gets expensive, a lot of what happens is going to stop happening.

"I leave the rest to your imagination."

Until tomorrow,

Bill Bonner
The Daily Reckoning