Market Review: War Games

It’s called operation "North Sword 2005," China’s largest war game exercise ever, with over 16,000 troops. Not that the operation itself is anything unusual or threatening. It’s simply interesting to see how the Chinese operate. One day, the government announces new restrictions on the Internet to prevent subversive content. The next day, war games. Is it all part of a larger strategy, and one that may fail eventually anyway?

And along those lines, how will China fit into the unfolding contest for the world’s cheap and easily available energy? One thing is clear: The production of cheap, high-quality petroleum is declining. This will unleash a series of geopolitical and domestic economic consequences.

All this means energy is getting more expensive for everyone. It also means that we’ll have to accept lower Energy Returned On Energy Invested (EROEI) ratios. It’s great to get 30 barrels of oil using only one barrel of oil as energy. But as we move to other sources of energy, that ratio is going to drop.

There’s another aspect to the word "economic" that we’re not even considering, however. We aren’t accurately calculating the "energy invested" portion of the ratio, because we are not including the accumulated political and military cost of dealing, coddling, and aiding oil-rich and unfriendly nations for the last 50 years.

I wouldn’t know how to begin to count this cost. But I’m sure it’s…well…really high, and getting higher. We’ve invested a lot of political as well as real capital, not to mention lives, in that part of the world. Surely that has to be figured in the net petroleum yield we get from the Saudis. By this math, oil isn’t nearly as cheap as we’ve been making it out to be.

And if the last 50 years have proved more energy intensive on the cost side than first meets the eye, they may be nothing compared to the next 50 years. This week, China puts its first blue-water warship to sea, no doubt just the beginning of its effort to secure the sea-lanes through which China receives its oil and other commodities. And Iran, with its huge energy reserves, is developing a nuclear insurance policy to prevent an eventual American attack.

Does the oil price include these costs? If it did, maybe Middle East oil wouldn’t be as "economic" after all. There are no mullahs in Utah, hurricanes in Colorado, or communists in Wyoming.

Regards,

Dan Denning
for The Daily Reckoning

October 02, 2005 — Baltimore, Maryland

P.S. But you will find a lot of gas, coal, and shale in the Powder River, Green River, and Piceance basins. That’s the subject of the October issue of Strategic Investment

— Daily Reckoning Book Of The Week —

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by Dan Denning

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THIS WEEK in THE DAILY RECKONING: There is an overlooked asset class in India – and Sala Kannan explains how to profit from it in Thursday’s essay, below…

God*mmit, I’m An American 09/30/05
by Bill Bonner

"Is the toilet paper soft…just like it is at home? Do the shops take credit cards, just like they do in Flagstaff? Are the roads paved as well as they are in Michigan?"

Big, Big Pockets 09/29/05
by Sala Kannan

"In just four decades, India will be the most populous nation on Earth…India’s demographics alone will be its greatest asset. This is a young and increasingly wealthy nation."

Reality Bites 09/28/05
by Puru Saxena

"Let’s face it; our world now depends heavily on Saudi oil. The Saudis claim that they have 260 billion barrels of proven oil reserves and their oil fields are capable of pumping 15-20 million barrels of oil per day. "

When To Expect the Unexpected 09/27/05
by Erin Beale

"I did not expect to find Irish bars on every corner. I did not expect to get an incessant parade of curious stares because of my blond hair and American clothes."

The Bonds of Interest 09/26/05
by The Mogambo Guru

"What happens if you buy a bond today, one that yields that real 0.67 percent that we were laughing about earlier? When interest rates rise to that long-term average of eight percent, the market price of the bond that you are now holding will plummet!"

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FLOTSAM AND JETSAM : One can’t help but notice the abundance of levitation recently – even as the consumer crumbles, surprisingly other sectors of the market have gone up, and stayed up. Justice Litle explores…

LEVITATION
by Justice Litle

A recent Wall Street Journal cartoon depicts four flamingos. Three of them are standing on one leg in the shallow water, as flamingos tend to do. The fourth is floating in midair, both legs folded under, contented expression of enlightenment on his face. The third flamingo, intensely irritated by this lack of respect for gravity, demands that his levitating brother, "Stop that."

That cartoon reminded me of recent market action for some reason. Making demands of the market is pointless – but one can’t help notice the strange abundance of levitation these days. As the consumer crumbles, a surprising number of things have gone up and stayed up, in seeming defiance of gravity.

For example:

– Crude oil, natural gas and energy stocks across the board
– Gold and gold stocks
– The U.S. dollar index
– The Amex Securities Broker/Dealer Index (XBD, as noted last week)
– Speculative bellwether Google (and various Internet indexes).

This invites the old Sesame Street song, for those of us who remember the mismatch game: "One of these things is not like the others/ One of these things just doesn’t belong." How can these competing areas, traditionally hostile to each other, be displaying strength at the same time?

The bullish explanation is to say that energy’s strength is temporary — and to argue that gold’s vigor will be sapped too as energy prices ease and inflationary pressures recede. Indeed, the cheery liquidity and speculative fervor chasing Google and the dollar higher depends on some version of this argument – the belief that energy will back off and the economy will pull through and everything will turn out OK. But that belief is resting on an increasingly shaky foundation.

While the markets mostly shrugged off the effects of Hurricane Rita, the
Financial Times reports that Rita "has caused more damage to oil rigs than any other storm in history." Meanwhile, the full extent of Katrina’s damage remains unknown. Our infrastructure problems are still building, and cheery scientists report that more hurricanes of Katrina and Rita strength are likely in October. Whatever the reason, we are living in an age of extraordinary storms.

Combine extensive infrastructure destruction with the news of domestic resurgence in Japan, and you have a potential double-edged sword keeping energy prices high. Japan has had many false starts over the past decade, and Japanese consumers have long remained in the dumps. But growing trade with China and the positive effects of painful reforms are finally starting to bear fruit. If Japan can sustain this burst of economic energy — and create a virtuous circle in terms of Japanese domestic demand and China trade – then energy demand from Asia may not fall significantly, even if the U.S. consumer falls by the wayside.

For the past few years, the United States has enjoyed the trump card of being the only game in town for producers of consumer goods. If the seeds of growing domestic demand have finally been sown in Asia, that advantage could quickly erode, even as energy remains stubbornly high.

Data suggest the dollar is still under heavy accumulation by the world’s central banks. Mutual fund legend Bill Miller, who runs $52 billion for Legg Mason out of Baltimore, is confident that the dollar’s status as the world’s reserve currency will save the day. And he may be right, in the short to intermediate term. We may well see the powers that be pull off a managed transition to whatever comes next.