Baltic States Oil

Baltic States Oil: Red Storm Rising
by Kevin Kerr
The Daily Reckoning
Ouzilly, France
Wednesday, July 27, 2005

Kevin Kerr discusses the Oil problems between Russia and the Baltic States of Estonia, Latvia and Lithuania and what this means for the economies of all concerned.

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• Nobody ever lost money underestimating the intelligence of the public…nothing seems to rattle homeowners…
• Universal and cyclical illusions…a $24,000 a month apartment in London - and it's not even that fancy!
• We'll all be so rich that we'll go broke…the two-headed monster in the financial market…and more!

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"Mortgage rates hit record lows!"

That is not a news headline, but the beginning of an ad that popped up on our computer this morning. Beneath it were rows of smiling, goofy birds carrying the initials of the 50 states. The significance of the birds surpasses our imagination, but the significance of the headline is familiar to us all.

As long as mortgage rates remain low, we are told, everything's gonna be alright. People will be able to buy…to refinance…to 'take out' equity…and to buy more.

Nobody ever lost money underestimating the intelligence of the public. People will believe anything - so long as it is flattering. Americans flatter themselves with the idea that there is something so great about their society - it will make them all rich! It does not worry them that the "wealth" comes in the form of higher house prices. They lose no sleep when they read that 35% of private investment is going into residential housing…and 40% of new jobs in the last two years have been in the housing sector. Their palms do no sweat when they think of how their neighbors financed their houses - and now have no equity in them. It does not concern them that wages are stagnant - while the cost of housing soars. Nothing seems to bother them at all!

The Financial Times reports that wealth in Britain rose to 5.8 trillion pounds last year - equal to about 20% of the total wealth of the United States. That's how much everything in the nation is worth - houses, offices, roads, companies…everything. The amount went up last year by 404 billion pounds - or more than $10,000 for every man, woman and child in the country. The increase was led there, as in our own fair land, by residential real estate, which rose 12%.

You see, dear reader, Americans are not the only ones who think they can get something for nothing. The illusion is universal, and cyclical. It comes and goes. But it comes in joy…and leaves in sorrow.

The average Brit believes the same fantasy as the average American - as long as his house is rising in price, why should he worry? His statisticians and economists tell him he is getting richer. He sees the evidence of it himself - a guy down the block sold a similar house for a lot more than he paid for his. As long as rates stay low, he can refinance…trade up…sell out… He has real money.

We are looking for a house in London. Next year, the whole family is moving to the city. Yesterday, Elizabeth looked at a nice, but not extravagant, house for rent for 3,000 pounds per week.

"THREE THOUSAND POUNDS PER WEEK?!" exclaimed her shocked husband, in all capital letters. "Why would you look at a place so expensive?" He quickly did the math…that's about $5,500 per week…about $24,000 per month!

"Well, everything is expensive," came the reply. "Besides, I wanted to see what you got for that kind of money."

"Well, what….?"

"Not much…it's fancy…but not that fancy…."

Of all the mad, mad real estate markets in the world, South Kensington, London, must be among the maddest…as least to a modest scribbler who earns his modest salary in modest dollars.

But, we do not bring it up to whine…or wince…dear reader…we bring it up to warn.

More news, from our team at The Rude Awakening:

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Tom Dyson, reporting from Baltimore…

"In the midst of war, one of the world's potentially wealthiest countries had been reduced to one of its poorest."

For the rest of this story, and for more market insights, see today's issue of The Rude Awakening:

The Spoils of War

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Bill Bonner, with more opinions:

*** The popular idea - as long as rates are low and prices are rising, we're okay - is dangerously wrong. Imagine that all Britain's property doubled in price. Or, in America, imagine that the house worth $500,000 suddenly became worth a million. Everyone would be twice as rich.

The average new mortgage would double. Property taxes would soar, too. People could take out the additional equity until the weight of additional debt crushed them. What could they do but sell their property? Or declare bankruptcy?

Since 1996, $5 trillion in additional "wealth" has been added to the U.S. economy - from increases in house prices. Now, the burden of the accompanying debt is becoming a drag. Bankruptcy rates are rising. House prices on both coasts may be reaching their apex.

Forbes magazine: "Get out now because house prices on the urban coasts have peaked. That's the consensus of experts, based on ratios such as house prices to local incomes and mortgage payments to local rent prices. While I'm usually skeptical of expert consensus, this smells right. Rising interest rates have started to put the brakes on house appreciation. The number of "for sale" signs in California is exploding like spring pollen."

And these headlines from CNN:

"Bankruptcy filings climbing."

"Workers Raid 401(k)s."

Soon, we will all be so rich, we'll go broke.

*** "It is conventional wisdom that without a sharp rise in real interest rates, everything will be hunky dory for the economy, writes Dan Denning.

"No increase in debt service costs. No outright falling house prices. No problem.

"What's more, it's asserted that long-term U.S. rates probably won't go up because there isn't much inflationary pressure in the economy, whether that's because of China and its overproducing machine of an economy or not is debatable.

"But if you accept the premise that China (or something, like other central bankers) can keep a lid on U.S. inflation, then how about this question: can an economic collapse occur when interest rates are low?

"I'm being painfully obvious because…that's how I am. But it seems like economic collapses almost have to be preceded by low rates. Excess and waste aren't possible without low borrowing costs.

"Hmm. So maybe it's not rising rates that cause the collapse. It's the collapse that causes rising rates.

"By the way…in the depression rising rates killed business investment and thus employment…leading to the huge bread lines. The scary two-headed monster today is that business investment is already in the toilet AND there are even larger massive deflationary pressures in the labor market."

[Ed. Note: Dan Denning will be sharing more of his insights tomorrow, on FOX News' Your World with Neil Cavuto at 4:20 pm (EST), and on Bloomberg television at 11:00 am. And no, he probably won't be wearing a sarong. To find out all the details of his media appearances, see our site:

Dan Denning's television appearances

*** Yesterday, in London, the Millennium Bridge was closed - for fear of a terrorist strike. The city seems normal to us…but a little edgy. Plainclothes police chased a Brazilian man through the subway the other day. He did not stop; he must have thought thugs were after him. They shot him dead. The cops said they thought he was getting ready to detonate his jacket. Mistakes will be made, they said, announcing that they were continuing their "shoot to kill" policy.

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The Daily Reckoning PRESENTS: Energy price hikes are a major problem for the Baltic states - which could mean trouble for American investors as well. Kevin Kerr gives us the whole story…

RED STORM RISING
by Kevin Kerr

Since the end of the Soviet Union, the Russian government has scrambled to shore up its eroding power base. As a result, the surrounding Baltic states are being slapped with energy price hikes they simply can't afford. The situation is truly desperate… and that could mean trouble for you.

At first glance, there doesn't seem to be a lot of reason to care about what's happening in this corner of the world. The three countries that make up the Baltic states - Estonia, Latvia and Lithuania - don't produce any oil or gas. In fact, they depend on imports for much of their natural resource needs.

But these tiny nations do play a role in the global energy markets. They are home to ports that transport oil overseas.

Baltic States Oil: Ventspils and Butinge

In fact, up until 2002, there were only two Baltic ports connected to Russia's massive oil pipeline system - Ventspils in Latvia and Butinge in Lithuania. (Estonia's Tallinn port gets its oil by train.)

Ventspils was the largest port on the Baltic Sea, too, until Russia completed its Primorsk port in 2002. And that's when the trouble began.

At the heart of the problem is Transneft, a holdover from the Soviet Union that controls all of Russia's pipelines. After Primorsk was ready to start operations, the company saw no reason to keep pumping oil to Latvia's Ventspils port. It shut off the spigot.

Now if Latvia wants to ship oil, it needs to get it to port by train. Obviously, that's more expensive and less efficient than using a pipeline. The higher costs and loss of volume cut into the port's profit margins - and by extension, the country's wealth. Today, Ventspils is shipping only a third of the oil it used to.

The situation at Lithuania's Butinge port is a little less grim. The country has retained better relations with its Russian oil suppliers than Primorsk did. In fact, the port was able to ship more oil than its larger Latvian neighbor in 2003. But that amount is still tiny compared to the oil coming out of Primorsk. And Russia still holds the keys to the pipeline… so it could choose to shut off Butinge's supply of oil at any time.

How likely is that? Who knows? The fact is the region is a mess, and things can turn on a dime. Right now, Ukraine and Russia are in a struggle for control of the pipeline system. Meanwhile, a border dispute between Russia and Estonia has flared up again, just when it seemed like things were settled. And shutting off Latvia's oil pipeline hasn't helped relations there, either.

All the Baltic states are having problems working with Russia to secure borders and fair prices for energy supplies. And as if things weren't bad enough already, Russia recently fired another shot over the already struggling Baltic states…

Baltic States Oil: Raising the Prices

In early June, Russia's gas monopoly, Gazprom, announced plans to raise the price of gas supplied to the Baltic states over the next three years.

Now, to be fair, the Baltic states were getting a pretty good deal before. Latvia was paying around $92-94 per thousand cubic meters of gas. Lithuania paid $85 and Estonia $90. Meanwhile, Western European customers pay about $150 per thousand cubic meters. Gazprom is saying that will be the new price for the Baltic states too.

It may seem like a common-sense move. But the truth is the company is probably raising rates just because it needs the money.

A Russian investment fund with a stake in Gazprom publishes a yearly audit noting the firm's shortcomings. The report states that Gazprom has at the very least stopped the wholesale looting of assets that it used to allow through the sale of gas reserves to joint-venture partners at knockdown prices.

But this company still has many, many problems. The report points to wasteful tax-payment schemes, seeming nonchalance about unpaid bills, disproportionately high wage costs and extremely costly pipeline projects. As a result, Gazprom's market value in relation to its reserves is miniscule compared with the likes of BP or Shell. And Gazprom's gas output in 2004 was no higher than in 1999.

So the rate hikes might help Gazprom, but they're not doing the Baltic states any favor. The average worker in the region earns between $400 and $600 a month. (My own mother-in-law is a doctor in Estonia and earns around $700 a month.) With such low wages and the region's notoriously cold winters, the next several months are going to be tough for the people. The Baltic states may truly discover the price of independence.

Of more concern to us, however, are the oil exports. On average, Russia's Primorsk port is iced in 155 days out of the year - putting a damper on exports. Higher prices could bring Ventsils' imports to a complete halt. And no one knows what effect prices and events will play on Lithuania's exports.

With a total of 1.5 billion barrels of oil per day on the line, investors will do well to pay close attention to this region.

Regards,

Kevin Kerr
for The Daily Reckoning

Editor's Note: With 15 years of experience, Kevin Kerr is a true veteran of the commodities markets. A licensed commodities trader since 1989, he's worked the trading pits in Chicago and New York with legends like Paul Tudor Jones, and he's even traded commodity derivatives in London. Over Kevin Kerr's career he's dealt with everything from cotton to currencies to oil and natural gas.

Kevin Kerr's unparalleled expertise in futures and commodities has made him a regular contributor to news outlets like CNN fn, CNBC and Marketwatch, where he's been quoted in over 500 articles.

The above essay has been adapted from this month's issue of Outstanding Investments, for which Kevin is a regular contributor. To read this month's full issue, see here:

Outstanding Investments

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