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From Dan Denning at the Old Hat Factory:

--Well, that's it. Apparently the commodities boom is over. The folks at Deutsche Bank told clients to get out of commodities. They say China is slowing. The whole world is slowing. Oil will return to its "marginal cost of production," somewhere between US$60 and $80 and gold will settle around $650.

--Of course it's possible they're right. You have to take each one of these predictions from the investment banks for what they're worth, though. Sometimes they're late to the party (Goldman Sachs calling for an oil 'super spike' to $200 in March). Sometimes they miss the part altogether. And most of the time they're just morons who are making it up as they go along.

--That said, it's pretty clear the institutional infatuation with commodities as an asset class is over. It's not at all clear the case for resources has been defeated. Remember, the up-trend in resource prices that started in 2003 came at the end of a period where resource prices declined in real terms...for nearly two hundred years.

--Two-hundred year down-trend...three year up-trend...resumption of down-trend? Does that make sense to you?

--Remember, the world's population has doubled since 1960, from three billion to well over six billion. The first two great periods of industrialisation in Europe and North America brought more resources on-stream, and thus, lower prices for tangible goods.

--There was a lot of coal in Newcastle and West Virginia, and a lot of farmland in Kansas. But now, the latest period of industrialisation begins with more people than ever chasing scarce resources. China is not Kansas.

--It could be that demand for resources will fall (as it appears to be doing simultaneously all over the planet). It could also be that in some sectors, supply will finally catch up (this appears to be what's happened with base metals). But what's really changed in the last month is that investors are simply demanding fewer resource shares. That's it. It's important to distinguish investment demand from real demand.

--The trendy investors who want to own the latest "It" sector will be back. Let them go trawl for beaten down financials and retail stocks. If you missed out on the first phase of the boom, this will be your next best chance to get into long-term positions at much lower prices. Those prices may not go anywhere for a year, mind you. But at least it won't be so crowded in the aisles while you browse through firms, projects, and management.

--What we have in the commodity and credit markets now is what the geopolitical crowd calls a kind of "durable disorder." Things can remain disorganised a lot longer than a neat freak would prefer. Replacing one global currency regime with another isn't easy, is it? Yet we still believe that's what you're witnessing and living through: a grand changing of the economic guard. More on that below and why it's bullish for resources.

--First, there was clarification yesterday-but no real resolution-to the Queensland government's policy on underground coal gasification (UCG) and coal seam methane (CSM). Mines and Energy Minister Geoff Wilson apparently told the Australian yesterday that there was no three-year moratorium on production licenses for UCG operators.

--But it wasn't exactly a ringing endorsement for would-be UCG firms, either. Wilson said, "These projects are in a pilot phase which is why they have a conditional tenure and that gives no automatic right to a production tenure at a later point...We're not about to give the green light to underground coal gasification projects, especially where any of them may affect the Great Artesian Basin, unless we're convinced it's in the best interests of Queensland."

--Hmm. What is the Minister up to? The apparent trouble is that the UCG companies and the CSM companies may be after the same coal. The government is in the position of choosing one industry over the other. Do you think the CSM players are lobbying the government?

--We're not sure what kind of future UCG has in Queensland. That appears to be up the government and not the marketplace. But we're pretty sure it has a future anywhere you find a country has coal but needs transportation fuel. Much more on this story in today's update for Australian Small Cap Investigator readers.


--Here is a thought for you to consider this weekend: the Great Moderation was a fraud.

--Central bankers round the world pointed to the period of high-growth and low inflation in the late 1990s and early 2000s as the so-called "Great Moderation." They essentially declared victory over inflation, after whipping it in the early 1980's and sowing the seeds for an 18- year bull market in equities. But they were not being truthful.

--It turns out inflation is a double agent and has been living among us these many years. You can imagine how the conversation with central bankers must have gone in the wee hours of the night in the early '80s. It was clear to them that de-linking the world's currencies from metal wouldn't be acceptable to the man in the street if it led to consumer price inflation.

--A man will tolerate a little inflation in his life, as long as it isn't noticeable. Or, in economic terms, the great fraud of fractional reserve banking and fiat money is tolerable so long as the decline in real purchasing power doesn't cause people to notice their declining standard of living.

--The oil shock of the 1970s-itself a response to the U.S. dollar being cut loose from gold-was just the kind of inflation even an idiot would notice. How could he not? You have plenty of time to notice things when you're waiting in line for gas.

--So under the banner of Paul Volcker, interest rates were put up and the forces of inflation retreated from consumer prices. But our point today is that they did not march home, disarm, and go back to doing whatever they do in peace time. Not at all.

--Instead, you can imagine the central bankers looking out over the global landscape in the late 1990s and noticing a wonderful thing: globalisation. Cheap labour in Asia would lead to years of low prices in manufactured goods and textiles. Consumer price inflation would be well and truly whipped! And what people couldn't afford to buy with savings, they could be induced to buy with the provision of massive amounts of tempting credit.

--"Dam the martinis, full greed ahead!" the credit peddlers must have thought. And so inflation, like a mob hitman in the witness protection program, was cautiously let loose back into the economy. He was redeployed with the same mission in a different market. Only this time he'd had some plastic surgery done and a makeover so that he would blend in with the locals. He would look respectable, desirable even, and be welcomed into American, Australian, and British homes with loving arms like a long lost prodigal son.

--Why? The central bankers realised that while people hate inflation in the things they buy, the love it in the things they own. If the central bankers could just get all the new funny money they'd been creating to get into asset prices, well then their lifelong project of enslaving the common man to debt would be so much easier. Wall Street was eager to help, and a powerful machine to impoverish the average punter was born.

--Boy has it succeeded. As credit grew faster than GDP in the entire Western world, it seemed to make people richer day by day. First stocks went up. And then when they stopped going up, Alan Greenspan lowered U.S. interest rates so much they were negative in real terms. That kicked off the housing boom. Eventually, in response to all this bustle of activity in the U.S. housing market, and also in response to the huge increase in global population, much of the new money printed by central banks found its way into the commodity market.

--Everything went up everywhere. The trouble is that no one is really any wealthier today. The inflation in asset prices (houses and shares) is giving way to debt deflation. There are two reasons for this.

--By creating money out of thin air, the central bank stimulates unsustainable patterns of consumption. Production is increased too. But it is based on a bogus price signal. Consumers spend money they don't have. When the money runs out, or debt levels get too high, consumption must fall. All the money poured into productive assets based on unsustainable patterns of consumption becomes misallocated capital. That's why so many retail stores are going bust in the States, and why global factories are closing shop, and why mortgage lenders and homebuilders are dying off faster than T-Rexes.

--The second reason no one is wealthier is that the rise in asset values was just inflation in fancy clothes. Houses weren't suddenly worth ten times more than they used to be worth. They weren't ten times more useful. They were just ten times more expensive.

--The cause of all this is the same: government issued money not backed by any real asset, like gold or silver. But lest you think we're a nutcase, we're happy to suggest it can go on even longer. How long?

--The logical conclusion of a fiat money system where the government has a monopoly on the medium of exchange is, of course, one world currency. As confidence in particular national currencies fades (due to the mismanagement of politicians) it probably won't be that hard to encourage people to take up a new currency.

--People instinctively know that paper money isn't real wealth. It's just paper. But it IS awfully convenient, isn't it? And if you've ever tried to burn a note of currency in front of someone, you see how easy it is to convince people that money is wealth.

--It isn't. But it may not matter. We are moving closer and closer to cash-less society. Pretty soon, the government may just issue everyone debit cards and price everything in arbitrary units. The deception that everyone can get rich by having access to credit will be complete.

--But something cannot come from nothing. Production of goods and services has real costs, things like land, labour, and capital. This is why the price of tangible goods will increase relative to paper and digital currencies in the coming years. People will prefer to trade what they know to be worthless bits of paper that are declining in purchasing power for real goods. This has always been the case in hyper-inflationary melt ups. It is why shelves in stores are empty in the rush to get rid of the declining paper junk as quickly as possible.

--But aren't we a long way away from that, you may be wondering? Not as far away as you might think. Flawed money regimes can last for quite some time. They only truly begin to falter when two things happen. First, people notice a decline in purchasing power for everyday things. This has begun to happen in the Western World, although the benign effect of globalisation on consumer prices and the existence of credit have helped mask it.

--The crucial issue for a banking system based on garbage money is confidence. Lose it, and the game is up. That is, as long as depositors don't rush to the bank en masse to get currency, and then trade currency for tangible goods, then the fractional reserve banking system can go on its merry way for many years, just as it has been doing.

--Yet we reckon you'll see more and more smaller banks go under this year in America and around the globe. Why? The banks have a lot of debt-based assets and not much capital (in the form of deposits). This is already happening in the U.K. and the U.S. It does not take a terribly imaginative person to figure out where it might go from here.

--The banks take losses on the worthless assets (mostly residential and commercial real estate, but perhaps corporate bonds, GSE bonds, and ultimately the sovereign debt of the U.S. government). The losses on the assets wipe out the already-thin capital base (which wasn't much of a base to begin with).

--Of course the government may at some point decide to simply give the banks a holiday. This is a handy way of cutting of panic at the pass. Franklin Roosevelt did this a lot in the 1930s, to prevent serial bank runs in America. But this did nothing to improve the confidence of people that the financial system was sound. Indeed, they realised that the whole system was based on bogus premise, that money could be created from nothing have value as a medium of exchange. It made them more eager than ever to preserve as much of their wealth in things that could not be eroded away by inflation.

--But here we are eighty years later dealing with the same problem. How will it end this time? Which will come first, the Depression, or the War? Hmm. We'll get back to you on that next week. Until then, enjoy the Olympics. One world. One dream.

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And now over to Bill Bonner in London, England:

The next big trend, dear reader...

It's coming. Consumers - especially the baby boomers - are about to change their way of looking at things. And when Bernanke & Co. realize what is happening, they will greet the new trend like the citizens of Atlanta welcomed Sherman.

"War is hell," said the yankee general, before burning the city down. So is a correction.

Wednesday's news brought more details. The Dow rose 40 points. Oil remained where it was. Gold lost $3. And the dollar seems to be strengthening a little against the euro. You can now buy a euro for only $1.56.

"Retail sales stall," is the word on the street, coming from Bloomberg. Of course, we already knew it. Restaurants are serving fewer meals. Malls are losing tenants. U.S. automakers are desperate to move their vehicles off the lots.

"Big three face bankruptcy fears," is the headline from CNN/Money.

There are two ways to play a correction, as we mentioned yesterday. (Or forgot to mention?) You can look for bargains as investors sell off their losing positions. Or, you can take a vacation. Read War and Peace...in Russian.

Here at The Daily Reckoning, we'll take Option #2. We like doing nothing. It gives us time to think.

Many investors, on the other hand, are sure they are looking at the Opportunities of a Lifetime. They see Fannie and Freddie, for example, and remember when the stocks were trading over $60. "What a bargain they are now!" they say to themselves. Or look at Wall Street. J P Morgan, Lehman Brothers, Bear Stearns...they're all selling at big discounts.

And don't forget the nail bangers. The housebuilders were the first to get nailed. Their stocks got sold off; investors lost billions in just a few months. But take a look at the builders now - hey, maybe they're coming back! 'No guts, no glory!' 'Go for it!'

Yesterday, one of the biggest builders, DR Horton, reported a $400 million loss for the third quarter. While it is possible that we've seen the worst in the housing sector, it is also possible that the sector will never bounce back - at least, not in our lifetimes. Nor will Wall Street. The bargains, in other words, could turn out to be traps for the unwary.

How could that be? We'll explain.

Over most of the last century, housing prices followed GDP growth and inflation. Nothing more. And it makes sense that they would. Housing is the number one consumer item. Consumers buy as much housing as they can afford - but not more. What happened in the 10 years - 1997-2007 - was an aberration, an unnatural freak caused by a rare conjunction of various absurdities. The dollar-based financial system...the collapse of the dotcoms...9/11...Asian export-mad economies...Alan Greenspan - all conspired to bring about a huge run-up in housing prices and consumer debt.

The two circumstances - like Butch Cassidy and the Sundance Kid - worked together. One kept his firearm on the bank manager, while the other cleaned out the vault. Consumers were able to borrow vast amounts, because their major collateral - their houses - was rising in value. And with the extra credit, they were able to buy more houses!

But the two desperadoes met their end, it is said, like Che Guevara, gunned down by the federales of Bolivia. And once they were dead, they were dead forever.

So too, our guess is that the bubble in housing and lending is over. If not forever, at least for a long time. Credit or interest rate cycles tend to last a long time - about as long as an investor's career. High- grade yields reached a peak in 1920 and then retreated until after WWII. Then, they rose again...for the next 35 years. Since 1981, they've gone down...at least for 22 years...maybe longer. One generation is convinced that interest rates always go up. The next is sure they always go down. One thinks credit gets easier and easier. The next knows it will never be able to borrow another dime - and doesn't want to. One generation forgets what the generation before it just learned. That's the credit cycle.

But what did U.S. consumers learn during the last great credit cycle? What are they learning now?

One of the surest ways to make money in the last 10 years was to buy a house. The baby-boomers, especially, saw home ownership as equivalent to saving for retirement. Houses always went up in price; everyone knew that. If you had enough houses you didn't need any money in the bank. A popular retirement planning technique was to buy a second house at the beach in your '40s or '50s. And then, when you were ready to retire, you could sell the main house.

But this is where the Next Big Trend comes in. The baby boomers are suddenly realizing that houses are not the same as savings. And they're suddenly facing up to the idea of financing their retirements in a world of declining house prices...and rising costs.

"Home energy prices are expected to soar," reports the New York Times.

What will they do? First, they will be forced to go back to saving. They won't like it. But they will have no choice. They need money for their retirements. And the only way they can get it is by reducing their spending and saving more.

We know what you're thinking, dear reader. You're thinking - "it's about time!" We're thinking the same thing. Americans desperately need savings...capital...resources.

But we're thinking something else too - that the U.S. economy of the last 20 years was built on excess consumer spending. Savings rates went from around 9% of GDP down to zero. Now, if they go in the opposite direction - and they must, in our opinion - the drop in consumer spending will cause the worst recession since the '30s. We're not just saying that to be provocative. We can add two and two. Subtract 9% from an economy that is growing at, maybe, 2%. Do that over a period of 10 years (the boomers don't have to save just one year...they have to save every year). Of course, it isn't quite that simple. When money is saved it doesn't disappear. Some of it is re-invested in the real economy, leading to more jobs...more output...and growth. But it takes time to convert a consumer economy into a more balanced economy. And it takes time to pay off debts...and write-off mistakes. In the meantime, you have an economy walking backwards for a long time. And probably tripping over something along the way.

But wait. Will the Bernanke Fed allow it? Will the Obama administration permit a serious, multi-year recession? How will they try to prevent it? What will happen when they do?

Ah...we're glad we don't have time to answer those questions today. Stay tuned for tomorrow...

*** Japan says it is in recession. China says it is trying to avoid a slowdown, by loosening credit restrictions. The United States is probably already in a recession; its central bank is giving away money to try to get out of it. So is the U.S. government. Britain is falling into recession too; the IMF warned Britain not to cut rates to try to save itself. Europe must not be far behind...with the lowest consumer confidence numbers in memory.

The whole world is slowing down.

But commodity prices, while retreating, are still up for the year. Copper is 14% ahead of last year. Gold is up 5%. Aluminum is 23% more expensive.

Tanker rates are falling; tanker captains have been told to go more slowly to save fuel. And the oil producers are selling oil forward in order to lock in today's prices. The industry seems to have little faith in today's prices - even though oil has come down about 15% from the peak.

*** Another farcical chapter in the history of the War on Terror seemed to come to a close this week. It turned out that the 'terrorist' responsible for practically shutting down the U.S. postal system - closing mail rooms across the nation, and frightening old ladies to the point that they were afraid to open letters from their grandchildren - was most likely working for the U.S. government. Bruce Ivins cost the nation millions, maybe billions of dollars, when he sent the anthrax spores through the U.S. mail. But at least he had the good grace to save the country the few bucks it would have spent putting him on trial. After threatening to kill his co-workers and adversaries, he decided it was time to exit the stage.


Until tomorrow,

Bill Bonner


THE WAR FOR OIL
by Marin Katusa

In the blustery winter of 1950, U.S. Major General Oliver Smith and his elite 1st Marine Division were surprise attacked by some 3,000 Chinese troops as the Americans attempted to take control of the mountainous eastern coast of North Korea. Suffering 1,500 casualties and over 4,000 wounded, Smith withdrew his force and delivered his now-famous quote: "Gentlemen, we are not retreating. We are merely attacking in another direction." Smith then reassessed strategy, regrouped, and, with fresh supplies and ammunition, drove the Chinese off in one of the most heroic struggles in military history.

There's a powerful lesson investors in today's volatile market can take away from Major General Smith. Namely, that when the going gets tough and you feel backed into a corner, there is a way to come out on top. But, like Smith, you need to continually reassess your approach and have the conviction to go in a new direction.

Some might say the U.S. now finds itself backed into a foxhole when it comes to meeting its energy needs. Although it has the highest rates of energy consumption in the world, it's no big news that America's traditional sources of oil are either tapping out or have become "No Trespassing" zones, leaving the U.S. dependent on foreign sources for 70% of the oil needed to keep the lights on. It behooves us, then, to better understand the nature of the foreign sources. To do so, we are going to use an approach usually found in a military context, dividing the sources into Allies vs. Axis - an appropriate model given the current war being waged for global resources.

With Friends Like These...

To better understand the reliability of America's oil imports it's helpful to see who America's faithful oil-suppliers are - and who they aren't. The chart shows that 54% of U.S. crude imports come from countries we consider Allies willing to work with the United States (shown in black and grey). Some 31% of imports come from Axis countries (shown in shades of red) that have demonstrated hostility to America. Another 15% are from Saudi Arabia, a Wildcard we believe could go either way. It's unsettling to note that almost half of U.S. imports come from countries that are either unfriendly or have the potential to be.

The Allies

"A faithful friend is a strong defense; And he that hath found him hath found a treasure." - Louisa May Alcott

First, let's take a look at the good half. Although these oil exporters have been willing enough to work with America, they face their own internal challenges. For example, the U.S. has powerful competition for both Canadian and Mexican oil; and it's from these countries' inhabitants themselves. Canada already consumes 90% of the crude it produces, while Mexico consumes a growing 60% of its production. Further, both face challenges with their reserves. The only abundant reserves Canada has are the oil sands - expensive and difficult to extract. And Mexico, with its reserves dropping quickly, is likely to become a net importer of crude in about six years. Read that last sentence again, because right now Mexico is the third largest source of oil to the U.S...just after Saudi Arabia.

Shifting farther away from the continental U.S., the stability of exports from Nigeria and Iraq is challenged by internal unrest. Nigeria is destabilized by ethnic battles, ongoing supply scares, kidnappings, sabotage, clashes with militants and election unrest. In addition, resource competitors, including China and India, are both making inroads in that country. Meanwhile, Iraq's reliability is largely dependent on a long-term U.S. presence in the area, a presence that is in doubt.

And these are the good guys!

The Axis

"Keep your friends close, and your enemies closer." - Sun Tzu, 500 B.C, author of The Art of War

Now, let's touch on the almost-50% of imports that come from considerably less reliable sources.

The stability of U.S. relationships with both Venezuela and Russia is questionable. Venezuela, under Hugo Chavez, has already reduced exports to the U.S. And Russia has shown dubious motives. Its recent tap- twisting with natural gas exports to the Europeans reinforces that it sees energy as a tool for gaining geopolitical power.

Angola, Algeria and Ecuador are very willing to sell oil to the US right now, because they need the money. But, they have also ramped up exports to other countries. Over time, they may pick and choose to whom they sell their increasingly precious commodity.

The Wild Card

Saudi Arabia - source of an impressive 15% of exports to the U.S. - is holding its dance card close to the chest. It either could supply the U.S. reliably over the next few decades, or, through its OPEC power, increase the price of crude even more. Despite the relatively stable relationship between the U.S. and the Saudi family, rising regional tensions, increased Islamic militarism and ongoing Israeli-Palestinian tensions could threaten exports. And, the U.S. presence in Iraq has implications for the stability of Saudi Arabia's supplies, too. Should the U.S. pull out of Iraq, any implied chance of U.S. troops supporting Saudi Arabia, should push come to shove, disappears. (How likely would the U.S. be to send troops back to Vietnam?) This could leave the Saudis looking elsewhere for security guarantees - guarantees that would invariably be purchased with a realignment of oil sales to suit the new benefactors.

"...We're Advancing in a New Direction"

With such vulnerability in our supplies, America's quest for new oil is vital. The single most important conflict of this war will be replacing declining reserves. But for war profiteers - or investors - profiting big starts with betting on the right army. The unexpected victors of one early American military conflict come to mind as an example of the right type of regiment to back. Remember that famous 1775 battle of Lexington and Concord, the "shot heard round the world" that kicked off the Revolution and culminated in our freedom to pursue our way of life? It wasn't the British Redcoats, trained to fight the old-fashioned way, lined up and advancing in unison, who won that one. They ended up scrambling for cover, tripping over their coattails as they hightailed it all the way back to Boston Harbor.

It was the Minutemen, the rebellious, nimble scrabblers, who knew the terrain, left business-as-usual behind and, sniper-like, came out on top. So it will be in the search for new oil today. This time, the major oil companies are wearing the red furry helmets and buttoned up uniforms and are ending up the casualties of war. That's because the old world army, including players like ExxonMobil, Royal Dutch Shell, BP, Chevron, ConocoPhillips, must cost effectively replace their flagging oil reserves and maintain production or face a quick retreat...in their share prices. And these days, finding large new pools of oil that can be cost-effectively developed is no easy task. Plus, they're facing stiff competition from China, Russia and others who are cashed up with plenty of fresh ammo - namely trillions of U.S. dollars thanks to the historic trade deficits of the last decade or so. These new, nationally-sponsored competitors, who aren't constrained by prohibitions against handing over suitcases of cash to win concessions, are quickly signing long-term off-take agreements where price is hardly discussed in the negotiations. In the war for new oil, the business-as- usual army has little chance of advancing in the right direction.

So, if not "big oil", where should an energy investor look to deploy their capital? We'll place our bets on the Minutemen, or the small, more agile oil explorers targeting under-explored areas in the U.S., Canada, and more remote areas of the globe. Rather than being caught up in layers of bureaucracy, and hindered by the negative associations of big oil, these smaller companies can act swiftly and have grass-roots connections with local politicians to help push their projects forward. Plus, they can operate in areas that are less populated by environmental protest groups that can challenge progress.

Most importantly, when a small company makes a large discovery it can have a huge impact on its share price...where even a large discovery, by today's standards, will barely move the dial on a multinational giant.

Investing in one of these companies early is one of the best ways to not only insulate yourself against the personal inconvenience of steadily increasing energy prices, but also to make you one of the few real winners in the war now being waged.

Marin Katusa
for The Daily Reckoning Australia