Strong-Arming the Seesaw

The Daily Reckoning
Bill Bonner
London, England
Tuesday, January 24, 2006

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OK…today, we give it to you straight. No metaphors. No jokes. No irony. No sarcasm. Today, you're going to get the story unvarnished, unadulterated, unsweetened, unsullied…like a shot of Old Overholt Pennsylvania rye whiskey without the branch water…oh, never mind.

There are four macro-trends, all related, and all affecting the world at the same time:

1.) The world is running out of cheap oil. Yes, there will always be energy, but it will be harder and more expensive to get. American oil production peaked out decades ago. Britain's North Sea production is declining. No one knows how much oil the Saudis have, but probably less than they say they have. The entire world's oil production is expected to peak out in a year or two. Cutbacks in supply couldn't come at a worse time; more people want more oil than ever before. The Chinese bought two million new cars in 2004. They're buying nearly twice as many each year. Currently, the average Chinese consumes less than 1/10th as much energy as the average American. Wait until they consume just half as much! Gasoline prices in the United States jumped last week - the biggest increase in 11 weeks. Three dollars for gasoline now seems certain. In a few years, it will seem cheap.

2.) The world's wealth is shifting to the East. General Motors, recently America's largest company, is worth $12 billion. Put it together with Ford and they are still worth less than half of Honda, and less than a fifth of Toyota, with a market cap of $172 billion.

"In 1970," says Marc Faber, "IBM alone had a bigger market cap than the entire Japanese stock market. Over the next 10-20 years, Asian markets, including Japan, could have 25% to possibly 50% of the world market cap, from 14% currently."

A friend of ours just returned from Shanghai:

"It is unbelievable. They've built a whole new city. The hotels are the nicest I've seen anywhere in the world. The bars are fabulous. It is so exciting. If I could live anywhere I wanted, I'd live in Shanghai, at least for the next 10 years or so. It must be the place where more growth and innovation is taking place than anywhere else on the planet. There's so much money…so much energy…so much life. It must be like New York was in 1910 or 1920."

Globalization has wrought competition. Now, faster, lighter competitors in the East are eating America's lunch and kicking its derriere - just as New Yorkers did to Londoners a century ago.

3.) The U.S. Empire is peaking out. From the get-go, the U.S. Empire has always been a slippery grog of Wilsonian moonshine and Custerian military hooch. Those two intoxications have come together in an explosive and disgusting concoction: The Iraq campaign - a war that is both strategically incompetent and operationally ruinous. The most splendid attack force ever created has been put to service patrolling gas stations! But what is really sapping the empire's strength is money, or more precisely, a lack of it. Americans would rather have granite countertops and free pills than have a costly empire. They can't afford both…not with globalization marking down the American workingman's daily rate.

So, their debts rise. The Washington Post reports:

"U.S. household debt hit a record $11.4 trillion in last year's third quarter, which ended Sept. 30, after shooting up at the fastest rate since 1985, according to Fed data.

"U.S. households spent a record 13.75 percent of their after-tax, or disposable, income on servicing their debts in the third quarter, the Fed reported."

Drenched in easy money, a decadent mildew spreads. "Get it while you can," say the corporate hustlers, lifestyle gurus, and money shufflers. Wall Street, for example, is enjoying another year of record bonuses. Henry Paulson, Jr., CEO of Goldman, will get $38 million.

4.) With the decline of the empire comes the decline of the empire's money - the dollar. When the dollar was cut loose from gold on August 15, 1971, thinking men posed themselves a question: How long would the dollar last? The answer is still unknown, but the day of its demise gets closer all the time. Yesterday, the euro jumped above $1.23. Gold headed for $560. This experimental drama with paper money as the lead role has a few acts to go, but we all know how it will end. The dollar will go down; it will fall like Macbeth at Dunsinane.

There is also an important cyclical trend to consider. Markets go up and down…even while the great macro-trends work their wills and their ways. A major expansion of credit, and an increase in asset prices, began in the early '80s. In terms of real money (gold),prices for stocks, bonds, and real estate all over the world rose. That inflation of asset prices came to an end in July of 1999. Since then, gold has gone up against almost all asset classes. The trend has just begun. And since most people only look at prices in nominal, local currency terms, few people have noticed. But asset prices are deflating. In terms of real money (gold), stocks, bonds and property are going down.

This, too, couldn't come at a worse time. U.S. credit market debt is more than twice what it was when the expansion began in 1980; it has gone from 130% of GDP to more than 300%. That debt - especially mortgage debt - rests on inflated asset values. When asset prices go down, so will the debt itself. And then, the struggling householder…the poor yeoman consumer…the purchasing prole…what will he do?

Pinched between the Scylla of debt and the Charybdis of declining real, spendable income - with all the costs, illusions of a decaying empire to sustain, with his dollars losing value (and his Fed chief dropping them from helicopters) pumping three-dollar gasoline into his gas-guzzling land barge, and making monthly payments on a mortgage that towers over his house like the Washington Monument over a bum's cardboard box - what will the poor man do?

We almost think we know the answer. He will turn to the left. But that is another story for another day.

More news from Aussie Joel and The Rude Awakening…

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Eric Fry, reporting from Nicaragua:

"In last Friday's Rude Awakening, Matt Badiali, the editor of the S&A Oil Report presented a short list of independent oil and gas companies that are likely to catch the fancy of a corporate suitor. Today, Matt concludes his analysis by presenting an even shorter list: the three independent oil companies most likely to attract a takeover bid from a major oil company. Details below…"

Bagging Texas Tea, Part II

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Bill Bonner with more views from London…

*** Over the past few days, we've been examining Greenspan's 18-year stint as Fed Chief - as he's passing the economic torch to Ben Bernanke next Tuesday.

Many are speculating over what kinds of measures Helicopter Ben will assume when he takes the helm at the Federal Reserve. We told our friends at American Conservative Magazine:

"Greenspan's real legacy [is that] he has finally made central banking work. And his successor, Ben Bernanke, pledges not to mess it up. By targeting inflation, he says, he will be able to make the financial world even more stable and predictable. And if the party ever starts to wind down, he has told fellow economists that he will drop money out of helicopters, if necessary, to keep it going.

"…But of all the twisted concepts that came out in 2005, the explanation of the world's international financial system offered by Alan Greenspan's replacement, Ben Bernanke, is perhaps the most elegantly preposterous. Americans are not spending too much, said Bernanke. The problem is that Asians are spending too little. As a result, they have a 'savings glut' that Americans helpfully recycle into granite countertops and home entertainment systems.

"Bernanke managed to condense a whole universe of lies, misapprehensions, and conceits into two short words. Yet as compact as they were, they covered up a grotesque system of global finance so out of whack that even congressmen are appalled: One nation buys things it doesn't need with money it doesn't have. Another sells on credit to people who already cannot pay-and builds more factories to increase output."

You can read our whole article, "Eat, Drink, and Buy Merrily" on American Conservative Magazine's site:

Greenspan's Punchbowl

*** "Don't give me any of your theories; I need practical advice," said Elizabeth yesterday…perhaps speaking for many dear Daily Reckoning readers. "I've got some money and I need to do something with it. What do I do? I don't want to lose money. But I don't have time to follow stocks. And I'm afraid the dollar is going to fall."

"Simple," we replied. (We had had dinner recently with Frank Trotter of EverBank.)

"Open an account with EverBank and put the money in euros. Besides, you're going to need euros when we go back to Paris."

We don't know whether that was good advice or not. Will the euro go up against the dollar? We can't say. But Elizabeth sold a house in Baltimore and now wants to use the money to buy an apartment in Paris this year. The worse thing that could happen to her would be a big drop in the dollar while she is waiting.

Most readers are not in that situation. They pay their expenses in dollars. The fall of the dollar wouldn't hurt them - at least, not directly. Still, they would probably like to protect themselves from a falling dollar, as well as the other macro-trends discussed above.

"The current shift in wealth from the U.S. is unprecedented," writes Ray Dalio, "and will go down in history as one of the great financial events."

But what can you do about it?

"In this environment, you have to emphasize international investments," says Marc Faber, "largely in Asia."

Faber revealed his portfolio to readers of Barron's. He is short the dollar, short 30-year Treasuries and short the Philadelphia Housing Sector index:

"Short the U.S. dollar. It is pegged to asset inflation, namely the U.S. housing market. The Fed will stop tightening when the housing market no longer goes up. Until then, it will be willing to increase interest rates by baby steps. When the housing market and the Dow Jones Industrials decline by 10% the Fed will flood the system with liquidity. The dollar will become very weak. Some sectors of the global economy, such as PCs and cellular phones, are in oversupply. But the biggest oversupply in the world is the U.S. dollar."

[Ed. Note: Our friends at EverBank offer many different investment prospects to help diversify your portfolio…and one of their best, in our opinion, is their 5-Year MarketSafe Gold Bullion CD. It's the easiest (and safest) way to cash in the gold rush. But you have to hurry - today's the last day to take advantage of this opportunity…

EverBank's 5-Year MarketSafe Gold Bullion CD - Last Day!

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The Daily Reckoning PRESENTS: Accompanied by his new Estonian wife, our favorite resource expert, Kevin Kerr, spent the holidays sharing Christmas cheer with his in-laws. But being a commodities fanatic, he, of course, also jumped at the chance to check out new trading opportunities in one of Eastern Europe's busiest seaports. Read on…

STRONG-ARMING THE SEESAW
by Kevin Kerr

Diminutive and beautiful, the Republic of Estonia has always been an easy target for the region's bullies. Suffering a long history of heavily armored invaders such as Germany and Russia, the tiny republic has endured as a colonial territory for nearly a thousand years.

Estonia's main attraction to invading armies is its seaport, Tallinn. Extremely deep and ice free, Tallinn has been a major hub for shipments between the Baltics, Russia and the West.

Even as Estonia tries to grow a high-tech industry, the port continues to serve as the primary source of economic growth. Through it flows 30 millions tons annually - some 75% of it cargo. And the thing you really need to know is that the biggest moneymaker is oil.

And Estonia's biggest oil carriers are Pakterminal and Estonian Oil Service (EOS). Bringing up the rear as No. 3 is Eurodek. All of these heavy fuel oil operators are headquartered in Muuga Harbor, which is part of the Port of Tallinn.

By posting record profits, Pakterminal, EOS and Eurodek have attracted a slew of regional competitors. As the shares of the pie grow smaller, we can expect this market to sustain growth of approximately 7%.

Originally, the railroads carried crude from the Russian oil fields. Since then, the facilities have evolved with the times. Today, Estonian oil terminals handle more profitable shipments of refined products.

The lone holdout is Lonessa AS. It is owned by Nordic Terminals BV, which in turn is a holding of Taurus Petroleum Ltd. Unlike other regional terminals that are connected to the Russian pipeline system, crude shipments are carried by rail through Estonia to Tallinn. That has not deterred Lonessa from building a new $30 million oil terminal in Tallinn, however, in February 2005.

Quoted in InternationalReports.com, of The Washington Post, Lonessa's director John Madsen said: "We decided two years ago that it would be an extremely good idea to go through Estonia… Tallinn has the best port in the Baltic States; it's deep, ice free and accessible. Access for big ships is, of course, extremely important. This is a very competitive business, and big ships means lower transportation costs per ton. Every cent that we can gain is important. Our terminal will be dedicated to crude oil, because that's the Taurus business. However, having said that, we will build the terminal according to the most modern standards and make it flexible, which means we will install the tanking capacity so that it could take fuel. Maybe Russia cuts off the supply one day. We are preparing for that as well."

While a $30 million expansion for a U.S. oil giant would barely draw a second glance, Lonessa's current project makes it one of the five biggest investments in Estonia - ever! What Lonessa will get for its money is a terminal with a 3 million ton annual capacity, most of which will be fuel oil. That amounts to 12.5% of Estonia's 24 million tons shipped through the port last year.

Seesawing oil prices have impacted global profits, but it's surprising that among the Baltic countries, Estonia fared better than most. Estonia's oil transport industry, and economy in general, have stood up well against market forces.

Unfortunately, other former Soviet states are getting hit hard by geopolitical shockwaves. The bare-knuckled fight between Russia and the Ukraine over natural gas prices has dominated oil-industry headlines. And the consensus is that Russia is trying to pound the Ukraine into submission after it elected pro-Western President Viktor Yushchenko last year. The Ukraine finally threw in the towel to Russia's price gouging - leaving it vulnerable to a major economic meltdown. By ending subsidized natural gas prices to the Ukraine, Russia stands to extract an extra $1 billion in lieu of political influence.

Now we can expect similar Kremlin strong-arm tactics in other former Soviet states that have turned pro-West, pro-NATO and pro-European Union. Among them are Estonia, Georgia and Moldova.

Taking it straight from the horse's mouth, Russia's Finance Minister Alexei Kudrin recently told the RIA Novosti news agency, "The time when we built relations by quasi-subsidizing neighboring economies is gradually passing. We must think about our own interests."

As with many things Russian, subtlety takes the form of a baseball bat on the negotiating table.

In its negotiations with the Ukraine, Russia's nationalized Gazprom proposed that natural gas should jump from $50 to $160 per 1,000 cubic meters, which would pile on nearly $1 billion to Ukraine's annual bill for heating homes and powering factories.

Finally, in December, Gazprom said that it was sick and tired of what it characterized as foot-dragging. It said that if no deal were reached, Jan. 1, 2006, would see an extreme form of capitalism at $200-230 - the same price Russia obtains in Western Europe.

As I tuned into the news the other night here in Estonia, my wife Katrin translated for me. "Ukraine has wasted time in these talks, and now there can be no talk of $160," Alexander Medvedev, deputy chairman of Gazprom, said on Russian television. "The market situation has changed, and it's continuing to change."

In short, the message is that any pro-Western Baltic country still lives in the shadow of the Kremlin - just the way Russia wants it.

Unlike the Ukraine's spanking, Gazprom plans to continue subsidizing natural gas prices for Belarus, for which it charges $47 per 1,000 cubic meters. Russia's party line is that prices are kept low because Belarus has allowed Gazprom to own a gas pipeline there and to lease the land it uses long-term. Many political analysts, however, attribute the friendly pricing to the country's firm political alignment with Moscow. The leader of Belarus is a puppet dictator himself, whose strings (or chains) are pulled (or yanked) by the Kremlin.

But puppetry aside, the real market force here is bartering. The Ukraine pays most of its natural gas bill by allowing Gazprom to use Ukrainian-controlled gas pipelines for about 80% of Gazprom's exports to Western Europe. This gives Ukraine potential leverage in the negotiations; Ukraine's Yushchenko has ruled out any interruption of gas to Europe. Still, the battle is just warming up.

For example, radical Ukrainian politicians and analysts have suggested pressuring Russia into renegotiating a lease for Ukrainian bases used by Russia's Black Sea naval fleet. A lunatic fringe has gone so far as to remove Russia's early-warning radar systems from Ukrainian territory. Given that such a move is possibly illegal, a more businesslike approach to the negotiations would likely prevail.

In fact, Yushchenko has said he would accept a gradual transition to market prices, but not the kind of sudden, drastic increase proposed by Gazprom. We wait to see how this saga further unfolds.

In the meantime, a $1 billion increase in natural gas could nearly cripple the Ukraine's slow-growing economy. The country's chemical and metal industries, which are heavily dependent on natural gas, would be particularly devastated.

The Kremlin has no reason to be charitable or cooperative. It knows quite well that a backlash to higher home heating bills could undermine the Ukraine's parliamentary elections in March. In the end, "comrade" could be the new operative word in the Ukraine later this year.

Regards,

Kevin Kerr
for The Daily Reckoning

P.S. The one thing that resource traders can be certain of is that this region is the new hotbed for commodities and this is where the battleground is being set for resource profits. Not just in energy, but in all raw commodities.

As Russia and the Baltics seek out more Western investments, opportunities will abound for saavy and informed investors. I, for one, plan to bring you all the information you can use from here to help grow your own resource wealth…you can start with my free special report:

Get Rich Trading Real Resources

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.

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