The Consequences of a Blistering Summer

The Daily Reckoning PRESENTS: We may have had a relatively mild summer here in the United States, but in Spain, the summer of 2006 brought wildfires and drought. Chris Mayer reports on the effect this water shortage has had on the European lifestyle – and the possible solutions to this widespread problem…

THE CONSEQUENCES OF A BLISTERING SUMMER

Crops withering under the blistering gaze of the sun. Cracked mud flats curl along the edge of shrunken waterways. Fish lie dying on the dried riverbeds. And in the evening, the orange glow of wildfires pulses against the dark sky like the glow of a torch. This is not some eerie scene from a science fiction movie. This is summer in Spain in 2006, victim of drought.

Spanish water reservoirs were at only 45% capacity in August. In the tourist-heavy southeast, they were as low as 8%, getting close to the sludge at the bottom. Spanish farmers face severe water restrictions and the prospect of a much smaller harvest. They will lose hundreds of millions of euros as a result. Fires peppered Spain’s parched forests. In the first week of August alone, there were over 100 forest fires in northern Spain, killing at least three people. But it’s not just Spain that is parched. Much of Western Europe suffers from unyielding drought.

Drought has even touched the normally deep and powerful Rhine, the busiest waterway in Europe. The proud old river is a shallow and feeble portrait of its old self. Ships must carry less cargo than they once did. And shipping companies recently imposed surcharges of 50% to make up the lost revenue.

The hot dry summer has a ripple effect on European life. According to the Financial Times: “Desperate to conserve water, Paris has for the first time decided not to dampen the dusty paths of its public gardens. English gardeners are banned from using hosepipes, while swimming pools remain empty in many Spanish towns.”

The tight water constraints also threaten livestock, as favored lush meadows and cool watering holes are now dusty fields and clumpy mud puddles. Harvest of beets, rice and corn will approach record lows.

Some may think that this is all just temporary. After all, occasional drought is part of life on this unpredictable little planet – like rain on summer barbeques and clouded-over picnics. But it is more than that. The record high temperatures expose deeper problems in how we manage our precious water resources.

Among those lying exposed are farmers. Farmers waste a lot of water. They would probably prefer not a lot of people know about this habit (as don’t bed-wetters). But it is impossible to ignore.

In Spain, agriculture uses about three-quarters of the country’s water. Yet according to Spain’s environment ministry, at least 80% of that water is wasted. Some is lost through leaking infrastructure or inefficient irrigation techniques. Heavy farm subsidies also discourage efficient use of water resources and lead to waste.

The solution is apparent. Europe needs more investment in water infrastructure, such as reservoirs and improved pipe systems. It needs more efficient irrigation systems and greater reliance on market incentives to encourage smarter water use. It’s a tale told in hundreds of other places.

The irrigation angle is really the cake frosting to this story. It is the most appealing part, because the need for greater efficiency is so widespread. And there is actually an investment idea buried in here.

In most countries, agriculture is the largest consumer of water. The less developed the country, the more agriculture tends to consume. As I’ve said, much of this is wasted. By some estimates, half of farmers’ water use does not produce any food at all.

Therefore, minor changes in use can have a dramatic impact on the supply of water. As Fredrik Segerfeldt writes in his excellent book Water for Sale: “A 10% improvement in the distribution of water to agriculture would double the world’s potable water supply.” Using drip irrigation to grow tomatoes, instead of traditional irrigation, for example, lowers the amount of water used by about a third.

Improved irrigation is a crucial component of better management of water resources. The most telling statistic of all is this: Irrigation waters only about 17% of the world’s farmed acreage. Yet that irrigated acreage produces 40% of the world’s food supply. That is astounding productivity. It also shows why irrigation technology will figure prominently in solving water supply problems.

One company I recommended in Mayer’s Special Situations makes irrigation equipment. Though its headquarters are deep in the American Midwest – in Omaha, Neb. – this company is a global player. Farmers use its irrigation systems to water crops, nurseries, turf, pasture and much more. Their products improve water efficiency and boost crop yields.

About a third of its sales come from overseas. This piece of the business has a bright future. Management estimates that international sales will make up half of the company’s sales in the next five years. They are in all the hot spot markets you would want to participate in – China, Africa, Brazil, Australia and, of course, Europe.

And the business is booming. Revenues were up 34% last quarter. Profit margins are up. Earnings nearly doubled. The backlog is up 73%. The company is in great financial shape. It’s got lots of cash and marketable securities – more than $4 per share on a $27 stock – and no debt. Finding companies with all these attributes these days is a rarity – like pitchers who hit home runs.

It may seem expensive at 31 times trailing earnings. But earnings are growing rapidly. Next year, this stock could easily earn well over $1 per share. Backing out that extra cash gives you a multiple of around 23. Not bad for a company ramping up earnings as quickly as they are.

Regards,

Chris Mayer
for The Daily Reckoning
September 14, 2006

P.S. Though there are always choppy ups and downs in the ag markets, I like the long-term story with this company. And every time we have drought and water constraints, practically anywhere in the world, it will be hard to ignore this company’s solution.

Editor’s Note: Christopher Mayer is the editor of Capital and Crisis and Mayer’s Special Situations. Chris began his career in corporate banking after earning an MBA with a concentration in finance. He later started Capital & Crisis, a monthly newsletter that gave Chris’ unique brand of financial commentary a more regular and expanded format.

Yesterday we posed a question from the classics:

“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?” asked Adam Smith. It was a rhetorical question in the eighteenth century.

Today, we have a real answer. Or rather, an unreal one.

A bubble!

Twenty years ago, the total notional sum of derivatives in the entire world was close to zero. At least that is the impression you get from looking at a chart showing the growth of derivatives in the years since. From nothing, the global supply of derivatives has risen faster than the NASDAQ…faster than oil…faster even than prices of Mayfair apartments. Other market bubbles were soap bubbles compared to the Hindenburg of derivatives, which the latest estimates judge to be worth some $236 Trillion – or about eight times the GDP of the entire planet. In other words, derivatives make up a bubble larger than the old globe itself.

What a jolly time to be alive. There in front of us is the fattest, juiciest bubble that has ever existed. If only we had a long sharp pin in our hand!

But what are these derivatives, readers might want to know.

They are debt. Packages of debt. Bundles of debt. Piles of debt. Rocky Mountains of debt.

Debt that is stuffed into hedge fund portfolios as an investment. Debt that is laid away at insurance companies and pension funds…as an asset. Debt that is traded, extended, extruded, pressed, bolted, wrung out and wadded up. It is debt for all seasons…all people… all times and place…it is Urbi and Orbi Debt…

There. We have given you the technical description of it. What follows is an answer to the question: what do all these bubbled up derivatives really mean?

Derivative contracts are sometimes so difficult to understand that it takes teams of dusty mathematicians to keep an eye on them. That gives financial institutions comfort, but it shouldn’t. Long Term Capital Management of Greenwich, Connecticut had two Nobel Prize winners among its quants when it managed to blow itself up after placing a few bad bets.

Why? Because behind the arcane complexity of derivative contracts are the simple-minded human beings who are at any moment in only one of two positions: long or short. Every contract is a bet. And every bet can go either way.

You might think that this means the whole shebang is a zero-sum proposition. Let them blow up, you might say; the longs and the shorts will offset each other. For every winner there will be a loser…and for every half dozen fools separated from his money there will be a new billionaire with peculiar art in a monstrous mansion in Greenwich.

Alas, that is not the whole story. Derivatives are not a zero-sum game…but a game in which the actual odds themselves follow long patterns of boom and bust. There are, for example, trillions of dollars worth of securities whose value is derived from the housing market. Fast-talking lenders write adjustable-rate, payment optional mortgages for slow-witted homeowners. Then, they sell the contracts on…whence they are packaged with thousands of others into a mortgage-backed security (MBS). The mortgage backed security is backed by a mortgage. But who backs the mortgage? That would be those sad sacks you read about in the papers, who stretched too far to buy too much house with an ARM far too long and too complicated for them to grasp.

Most of the time, and especially during the long bull market in housing – roughly equal to the bull market in credit derivatives – the payers are ready and able to pay. Sometimes they are not. When they are not…the security of mortgage-backed securities disappears.

America’s average mortgage payer has not had a real wage increase in 34 years. Instead, he has become upwardly mobile by proxy… piggy-backing on the shiny surfaces of bubbles…in credit…in debt…in housing. But there must come a day when the bubbles take a bath…when the poor homeowner must find another money-tree or miss his mortgage payment. And when he misses, what a hit he will take. And that will be the day all the bubbles blow up at once – including the mother of them all, the bubble in derivatives.

More news:

————–

Byron King, reporting from Pittsburg…

“…Chevron’s effort is illustrative of the future of the petroleum industry over the next decades, and I think that the effort is worth dissecting some more…”

For the rest of this story, and for more market insights, see today’s issue of Whiskey and Gunpowder

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And more views:

*** Gold and crude oil have fell to their lowest prices in months this week, which poses the question: is the bull market in commodities over?

Hardly, according to Strategic Investment’s Dan Amoss. “Over the next several months, it will be crucial to maintain a multi-year investment focus with energy and commodity oriented stocks,” he advised.

“Bull markets are prone to periods of overheating,” he continued. “Greed and fear overwhelms rationality on the way up and on the way down. There is no doubt that we are undergoing a consolidation, but this should be viewed as an opportunity, not a reason to panic.”

*** As empires age, all their institutions get hollowed out. The old institutions are still there, but they serve new masters – the parasites who have taken control of them. Today, we look briefly at America’s defense institutions. Of course, we still have a Department of Defense, but its major activity is no longer defending the nation. Instead, it has been taken over by its suppliers and the world-improvers. That is why we have a war in Iraq. No one can know the future, but even we cannot stretch our imaginations far enough to see how Iraq ever presented any military threat to the United States of America.

Why does the War on Terror go on? It has been five years since a tiny band of fanatics brought down the World Trade towers. Since then, hundreds of billions have been spent to protect the homeland – but we wonder, from what? Since 2001, terrorists have caused fewer deaths in America than allergic reactions to peanut butter. We are awaiting a War on Peanuts….

But the spending…the searches…the bullying…the scare-mongering continue. Why? Because it pleases the parasites.

Since 9/11, reports The Observer in London, “a highly lucrative industry” has arisen in the United States of America – protecting the homeland from terrorists. Not since Lucky Luciano teamed up with Meyer Lanksy has there been such a protection racket in the United States. In the entire fifty states, there may not be enough terrorists to fill a small county jail, but that doesn’t mean there isn’t any money in homeland security. In fact, since the dawn of the 21st century, almost half of all new jobs have come, directly or indirectly, from two booming industries – housing and homeland protection – one a delusion, the other a diddle.

“Seven years ago, there were nine firms with federal homeland security contracts. Now there are 33,890. Since 2000, $130 billion of government contracts have been dished out.”

“There is a powerful economic incentive,” continues the report, “to exploit the terror threat – even government officials are leaving office to join the gold rush. John Ashcroft, former Attorney General, controversially extended state surveillance powers before leaving to set up the Ashcroft Group, which lobbies on behalf of technology firms aiming to capitalize on the new powers.”

The Observer wonders whether the money was well spent. It mentions one contract, for example, to provide bullet-proof vests for dogs in Ohio. Is that a worthwhile expenditure? We don’t know. But we will take a wild guess: from now until Hell freezes over, not a single American Homelander will be saved from terrorists by a dog from Ohio wearing a bullet proof vest.