Shots Fired in the Ore Wars The Daily Reckoning Australia London, England - Melbourne, Australia Friday, 16 May 2008 In This Issue: China's earthquake reverberates... Is dollar devaluation deliberate? Why the oil price will correct itself... ---------------------------------- From Dan Denning at the Old Hat Factory: --There are four fronts in the battle for pricing power in the iron ore market: BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO), Fortescue (ASX: FMG), and spot market for iron ore. It's hard to tell who is winning...or what losing really means. --The Australian reports this morning that, "Chinese interests have approached a major Australian superannuation and investment fund to be their partner in a multi-billion-dollar swoop on 9 per cent of BHP Billiton." This proposed deal involves three parties, the Chinese Party, an Australian fund, and a global private equity firm. --That's pretty clever. Under that deal, reports the Oz, China gets a 4.5% stake in BHP. That's would be worth about $12.15 billion, using yesterday's closing price. The Oz also reports that under the terms of the proposal, the Chinese could buy back the fund's stake in BHP in five years at an agreed upon price. --That sounds like a call option to own another 2.25% in BHP in the next five years. Given the earnings BHP may generate from its iron ore and oil divisions, that could be a handy little capital gain. What do you think the intrinsic value of an option like that would be? The Aussie fund better stipulate a high price for that future agreement. --But remember, this is just one front in the ongoing Kabuki dance/cage match/strategic resource game playing out. The second front is Rio Tinto. In March, Chinalco's Xiao Yaqing said he would like to eventually increase his stake in Rio Tinto from the 9% he picked up in the late January over-night raid with Alcoa (NYSE: AA) (which has made a nice little move in New York, by the way). --Since then, China's interest in Rio has taken a back seat to China's interest in Fortescue and BHP. But could the Rio pursuit revive? Aluminium prices are likely to rise with the shut-down of some of aluminium smelters in China (more on that below.) What will commodity will generate the most earnings growth in the next five year: iron ore, aluminium, or oil? --The third front is Fortescue. Yesterday was a milestone for Andrew Forrest's mob in the Pilbara. They went from being an iron ore explorer to an iron ore exporter. Take away an "l", add a "t" and you have a whole new ballgame. Fortescue loaded 180,000 tonnes of iron ore from its Cloudbreak mine on to a Cape-sized Baosteel ore hauler. It's on its way to China. --What are Fortescue shares really worth? Charlie Aitken at Southern Cross Equities reckons they are worth more than today's price. The company aims to produce 100 million tonnes per year by 2010. If the company averages $50/tonne, that's $5 billion pretax. After 30% corporate taxes, you're still looking at $3.5 billion in earnings for shareholders. --Andrew Forrest says he'd welcome Chinese investors on the Fortescue share register. But spots on the register are already at a premium. Over 70% of Fortescue's issued capital is owned by just five major shareholders (including Forrest himself). If China Inc. wants in, someone else is going to have to sell out. Fortescue's top 5 shareholders own 70% of issued capital --Joel Steinberg's holding company Leucadia (NYSE: LUK) which some people call a mini-Berkshire Hathaway, owns just under 10% of Fortescue. Aussie institutional investors shunned Twiggy Forrest when he went looking for extra capital to cover cost blow-outs in 2006. Steinberg ponied up over $400 million, $300 million for the 10% equity stake and another $100 million in unsecured notes paying a 4% royalty on Fortescue's production. --At the time, Fortescue wasn't producing anything, and no one was sure it ever would. And because Leucadia's offer valued Fortescue at $15.20 a share (a 35% premium to the share price at the time), it looked like Steinberg had overpaid. But maybe not. --A 4% royalty on production of 100 million tonnes per year at $50/tonne is about $100 million a year. And over ten years, that's about $1 billion in royalties (not a tough sum to calculate)-and remember that's on just the $100m in unsecured notes. With that kind of return, Steinberg could sell some of the equity to, say, China, and still come out well ahead on the deal. --If Steinberg doesn't sell to Baosteel, will Harbinger Capital Management? That's the firm run by Phillip Falcone in New York, and rumoured this week to be shopping its 16% stake in Fortescue to potential buyers. Harbinger's stake is held in trust by its Australian representatives. --All we know is that Aussie institutions are on the outside looking in when it comes to the Fortescue registry. Existing shareholders might make the Chinese pay a pretty penny. But the Chinese might be happy to do so. --The final front in the ore wars is the negotiation for this year's contract price. It's going nowhere. In fact, the China Iron and Steel Association ordered all its steel mills and traders to boycott Rio Tinto's sales of ore in the sport market, according to today's Financial Review. Yikes. --Earlier this year Rio threatened to sell more ore into the spot market-while still fulfilling all its contractual obligations and the pre-agreed price. With spot prices nearly double the contract price, Rio was both taking advantage of the higher spot price, and indirectly pressuring China to agree to the 85% rise in contract prices that both BHP and Rio are asking for. --China's move to ban the purchase of Rio ore in the spot market is the negotiating counter punch. Whap! Pow! Bam! --Will the ore wars spread beyond these four fronts? They already have, of course. While these big battles are entertaining, real ground is being gained at the junior level as Chinese companies get on to the registers of many smaller ore companies. That's the story we're on at Diggers and Drillers. [Editor's Note: The next issue of Diggers and Drillers will be out early next week. Take out a trial subscription now to make sure you get the latest share tips.] --By the way, thanks for all the feedback on the Penny Stock Prospector idea. There seem to be two camps. One camp wants very specific trading tips on mining juniors. The other prefers more of a tip-sheet, with research and analysis of smaller players in the mining industry that don't get analyst coverage. We're debating the merits of both approaches before we launch. Any additional suggestions can be sent to dr@dailyreckoning.com.au --In addition to the massive human tragedy from the earth quake in China, base metals prices are jumping in the futures markets as China shuts down zinc and aluminium smelters. Bloomberg reports that, "Bosai Minerals Group Co.'s 120,000-metric ton aluminium smelter has halted output since the 7.9-magnitude tremor hit western China three days ago. Sichuan Hongda Chemical Industry Co.'s 100,000-ton zinc plant also stopped production." --As we wrote a few months ago in the Australian Small Cap Investigator, China's days of being a large aluminium producer are probably numbered. Aluminium is energy intensive, and we production migrating to the Middle East, closer to sources of abundant energy (and increasingly abundant demand). --In any event, look for an increase in alumina prices (Rio reckons demand will grow by 8% this year). And look for the bauxite market to heat up in Australia and Guinea, the two biggest owners of bauxite deposits in the world. --And keep an eye on Alumina (ASX:AWC) shares, too. We asked Gabriel, back from a sicky, to take a look this morning. If the stock can summon the energy to beat resistance at $65, it would establish, perhaps, some new bullish momentum. The old momentum is visible in the old trading channel. But this is old news, DR technical analyst Gabriel Andre says. The stock has traded out of it for so long that a break through $65 means a new kind of dynamic altogether. --By the way, if you thought China was slowing down, Bloomberg reports that factory spending was up 25.7% in the first four months of the year. "Fixed asset investment in urban areas rose to 2.8 trillion yuan (US$400 billion)." That figure reminded us of the chart below, taken from Rio chief Tom Albanese's recent presentation in London. --Not to beat a dead horse, but the Reserve Bank did publish the 2007 Bank Fee figures yesterday. They were good...if you're a bank. Bank fees on you and your family were up 9% last year and borught banks about $4.3 billion. --In total, bank fees grew by 8% to over $10.5 billion. If it's any consolation, though bank fees on business grew a full 2% slower than fees on individuals, busines fees still make up 58% of total fee income. Household fees are the other 42%, though this is a high for the last eight years (household fees were 33% of the total in 2007). --Finally, here's a question: is the U.S. dollar devaluation is a deliberate attempt to drive global food and oil prices higher? Why would the U.S. do that? --Unorthodox but total economic warfare, is the answer. Unable to compete with low wage manufacturing economically and unable to secure Middle East oil militarily, and paying high prices for energy domestically, U.S. strategists rely on two of the oldest strategic weapon in the book: inflation and famine. --Hey. It's not our idea. We've just seen it in a few e-mails from readers who believe U.S. monetary policy makers could not deliberately wanty to bring about the destruction of the dollar. Maybe that's right. And to be fair, competitive devaluation of your currency is a common from of currency manipulation, especially among Asian exporters who want to keep their goods cheap in America. --Faced with the seemingly inexorable rise in global energy prices, the theory goes, America decides to price out the developing world by crashing the dollar and unleashing inflation on large holders of dollar currency reserves (nearly everyone). Hmmn. --The downside to this policy is that it trashes the dollar standard that's been in place for years. That dollar standard has delievered Americans unprecedented prosperity. The upside is that the dollar standard is broken anyway, undermined by America's vast accumulation of debts. And in that circumstance, crashing the dollar on purpose inflates away the debts owed to others. --The U.S. Treasury need not default on its bond obligations. It just uses the dollar as a weapon, only in a rather indirect way. --Sounds unlikey? Probably so. Implausable? Hardly. --If you view history as a series of continuous cycles between trust and suspicision...boom and bust...overweeing pride and abject humiliation...then things get clearer. Globalisation reached a kind of apex with the fall of the Berlin wall. -- It kicked off a whole decade of technological and economic integration. For most of that period, between 1989 and 1999, oil was incredibly cheap. Prices for consumer goods fell. The world was flat. --Then money got cheap everywhere after the Nasdaq bust, thanks to Alan Greenspan and the Great Moderation. The price of labour went down globally as China began its long climb out of rural poverty and into urban living and higher per capita GDP. --At the peak of the cycle, there was zero economic gravity, like the apogee of a swing in motion...that split second where the swing is neither rising nor falling but perfectly still at its peak. --And then the falling. And if you see the falling coming, if you see the competition for economic ascendance as one you cannot possibly win (owing to your low savings rates, your lack of energy reserves, and your huge accumulated debts) how do you win that kind of war? --Do you just surrender? Or would total economic war include using your own currency as a weapon...even if it meant destroying the currency. Is it first neccessary to destroy the dollar before it can be saved? --Who knows? Sometimes the simplest explanation is the best. The dollar is falling because the supply of dollars is growing faster than the supply of tangible goods, and the demand for tangible goods is growing. Americans got used to charging the good times on the next generation, or on their credit cards. That kind of spending excess became a habit, both at the Federal and personal level. --"We are what we repeatedly do," wrote Aristotle. "Excellence, therefore, is not an act, but a habit." If you repeatedly spend more than you earn, as a nation or as a household, your habit becomes a vice and your vice becomes your undoing. On that cheerful note, have a great weekend. Until Monday. ---------------------------------- This Tiny Prospector Could Become the World's Next "Super-Metal" Giant... It's the metallic equivalent of superman... strong, tough, resistant to extreme conditions, and incredibly versatile. It's what you might call a 'super metal.' And the worlwide energy industry uses A LOT of it. What is this metal and why could NOW be the best time to buy? In the just released issue of Diggers and Drillers we take you to a huge mine perched atop the left shoulder of Western Australia where one tiny prospector is poised to become the world's 'super-metal' giant. Not a subscriber to Diggers & Drillers, no worries! Simply click here to accept our trial offer and get instant access to this just released share tip. ---------------------------------- And now over to Bill Bonner in London, England: "One market bubble may be an accident;" begins an article in the Financial Times , "two in the space of a decade begins to look like carelessness." In our view, the bubbles in housing and debt were the result of neither accident nor carelessness. They were the result of Fed policy. The Fed thinks it has two mandates: to preserve the value of the U.S. dollar...and to maintain full employment. The two are as incompatible as a sanctimonious governor and the Emperor's Club. At some point, you have to choose. What're you going to be - a governor or an emperor? Fed governors chose the easy path - they chose to try to boost up the economy...and let the dollar go to hell. That's why the greenback has lost half its value against major foreign currencies since the beginning of this century. And it's why we have had two major, related asset bubbles so far this decade - one in housing and the other in housing debt. And it's why we have also had a credit crisis...from which we now seem to be emerging. People are beginning to put two and two together - to make the connection between the Fed's aggressive attempts to put more money and credit in circulation and the asset bubbles. And now that they've got their slide rules out...they're wondering about the oil price too...and gold...and food...and consumer prices... ...and now, in this moment of high anxiety, the whole world turns its weary eyes to Paul Volcker. Like France recalling the old Hero of Verdun - Marshal Petain - in '42, the press goes to Volcker and asks his opinion. The latest Bloomberg report: "Volcker, who engineered a surge in interest rates to 20 percent when battling consumer price gains 18 years ago, said 'there is some resemblance to where we are now in the inflation picture to the early 1970s.' The Fed failed to contain a pickup in prices at that time, spurring the acceleration of inflation later that decade, he said. "'If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary pressures' and buttress the dollar, 'we will be in real trouble,' Volcker said. 'That has to be very much in the forefront of our thinking. If we lose that we are back in the 1970s or worse.' "Consumer prices rose 3.9 percent in April from a year before, compared with an average rate of 2.7 percent over the past decade, a Commerce Department report showed today. Volcker said there's 'a lot more inflation' than reflected in government figures." Yes, dear reader, the battle between inflation and deflation has been noisy and indecisive. But the real cost of this war hasn't even begun to register. Unbeknownst to most observers, almost a whole generation of wealth building has been wiped out. Wages are back to levels of the '70s. Stocks have gone nowhere in 10 years. And houses are headed back to levels of the mid-'90s. On this last item, we have some news headlines. Foreclosure filings rose 65% in April, from the year before. In California, foreclosures hit a new record high. And land prices in Las Vegas, away from The Strip, are down 24% from a year earlier. Toll Bros. says its sales will go down 30% in this quarter. Mortgage fraud cases are up 31%, says the FBI. And in England, realtors say the market is the worse they've seen in 30 years. How cometh these things to pass? Fed governors have been enjoying their own emperors' club, if you know what we mean. They've had their cake - and eaten it too. Until now, they could cut rates and increase the money supply, and still hold their heads up look Americans in the eye: "Do you see any inflation? We don't see any inflation." Alas, the rumors are out...the receipts are turning up...and people are appalled. They're turning on Alan Greenspan, in particular. We opined years ago that Greenspan's reputation was inversely correlated to the price of gold. As gold rose, Greenspan's stock went down. As you will see, below, this trend probably has further to go. Even Ben Bernanke has disavowed his former boss - saying that the Fed can and should spot bubbles and lance them before they get too bad. But while Bernanke talks tough...he has shown himself unwilling to make Volcker's tough choice. Between protecting the dollar and keeping the bubble pumped up, Bernanke has chosen the pump, not the lance. *** Yesterday, we mentioned the oil market. Today, we slide in deeper. You'll recall, dear reader, some time ago we guessed that the feds' efforts to keep consumers consuming were essentially inflationary...and that the inflation they caused would tend to go more into gold and oil than into economic growth or asset prices. Since then, the price of oil has shot up over $100. Yesterday, it hit a new record at over $126, before falling back to $124. Gold, meanwhile, has traded above $1,000 - and now is correcting in the mid-800s. This is already a major adjustment. It comes along with a major adjustment in the purchasing power of the dollar, generally. Americans' global purchasing power has been cut in half. The value of their assets - on the world market - are only half what they were during the Clinton years. And the value of their most precious asset - their time - has also been greatly reduced. This is why you see so many Europeans in the United States...America is a cheap place to visit. It's also why U.S. export industries are reviving; the country has become a low-cost producer for many things; it is now a place where richer nations can consider outsource production. All of this has gone almost 'according to plan' - that is, it is pretty much what we guessed would happen. But now, we have to ask: are these adjustments enough? You're expecting us to say 'no,' aren't you? Instead, our answer is 'maybe.' In the case of America's 50% pay cut, (the U.S. dollar is only worth about half as much as it was compared to other major currencies) we think it should do the trick. Now comes a long period in which people come to realize it and begin living not quite as large as before. They lose their houses. They cut back on their spending. They relearn an old word - thrift - and find they like it. They downsize their lives - with smaller houses, smaller cars, and littler expectations. The economy goes into a long slump - as 70 million people, facing retirement, begin to save money. In the case of gold, our guess is "probably not." Gold has still not come near the inflation-adjusted peak it set 28 years ago. Considering all that has happened during those years, we bet that there is another peak to come - even higher than the last. In 1980, the United States still had the residual financial integrity to stand up to inflation. Paul Volcker could push the yield on the 10-year Treasury note up to 16%; he caused a recession, but not a revolution. Most importantly, he protected the dollar. We don't see any Volcker around now...and we don't see how anyone - even Paul Volcker himself - could "pull a Volcker" now. The country has twice as much debt per person. It has a hugely negative current account. It has the biggest government deficit ever (think what would happen to it in a real recession...the deficit would go to $1 trillion). No, we don't think gold is in danger of a sudden attack of monetary propriety. Instead, we think the gold bull market has much further to go - probably above $2,500 an ounce, before the dollar-based financial system collapses completely. But it is oil we set out to reckon with today. And what we reckon is that oil is getting close to its near term peak. If we were holding major positions in oil, we would sell them. Here's why. While gold is nowhere near its record high - oil is above it. In today's money, the top price ever paid for a barrel of oil, until recently, was only about $79. Today, oil seems to be headed to twice that level. And a few experts think it will go much higher. Goldman's oil expert predicts $200 oil. But why should it go so high? For all the talk about China's insatiable demand, it is still true that prices and demand must worth themselves out. When the price goes up, people grumble...but they use less. We filled our tank in France last weekend. The total price came to more than $150. We had been thinking about driving down to the South of France next weekend. Instead, maybe we'll take the train...the trip would have cost us more than $300 in gasoline alone. Everything happens at the margin, said a dead economist. Americans alone probably drive millions of marginal miles - to places they really don't really need to go...when they don't really have to be there. At over $3.50 - they'll drive less. Already, the Financial Times reports that U.S. demand is falling more than expected. There's so much shifting sand in the oil market - usage, new discoveries, distilling capacity, storage facilities, OPEC policy, inflation, drilling technology, emerging market developments, the dollar, U.S. economic growth - its impossible to know how big the dunes will get. But oil demand - and prices - should generally stay in line with GDP. The more growth, the more oil. Plus, if you measure GDP and oil in dollars you eliminate both inflation and currency depreciation as variables. Well, at $100, reports Martin Wolf in the Financial Times , "the annual value of world oil output would be close to $3,000 bn. That is 5% of world gross product. The only previous years in which it was higher than that were 1979 to 1982." Those were not good years to enter the oil business. The price subsequently collapsed. Yes, you could make a lot of money in oil...many people already have. But sure as fleas come with stray cats, success leads to excess. As the price rises, more and more people imagine that it will keep going up. Some take measures to avoid using it. Some find substitutes. Some increase production. Markets still work, in other words. Every bubble eventually finds its pin. The day can't be too far off when the price of oil will fall back under $100. [Editor's Note: Bill Bonner & Lila Rajiva's new book, Mobs, Messiahs and Markets, is now available in Australia from The Educated Investor. Order here for a 15% discount.] ---------- Advertisement ---------- The Fossil Beaches of the North Perth Basin Could be Australia’s Next Big Mineral Winner These 'fossil beaches' may be next in line for Australia’s biggest resource boom ever. What lies in them already allows Australia to supply as much as 40% of growing world markets. Yet there are only on a handful of publicly traded companies competing for a piece of the action. This month's Australian Small-Cap Investigator share tip is one of them. The latest issue of Australian Small Cap Investigator was just released, along with this share tip. To make sure you get the issue simply click here to accept our 3 month trial offer. ---------------------------------- The Daily Reckoning Presents: There exists what might be termed the Volcker Consensus that inflation has returned as the real threat to world economic conditions. There are a few 'notable' holdouts on this consensus however. Lord William Rees-Mogg explains... THE VOLCKER CONSENSUS by Lord William Rees-Mogg The American electoral system has never been designed to protect sound finance, and it has become more dangerous as Federal Governments and the Fed itself have become more skilful at manipulating the economy of the United States. The process of running before every gust of wind reached its limits under Alan Greenspan, who always chose to inflate rather than deflate a bubble. His successor, Ben Bernanke, is more cautious than Greenspan but has made no attempt to reverse the Greenspan policy. There has not been a Chairman of the Federal Reserve Board with sound monetary instincts since Paul Volcker resigned in 1987. It was Paul Volcker who brought the dollar back from the brink of hyperinflation in 1987. On May 14th, Paul Volcker testified before Congress. Scattered around the monetary world, and particularly influential in Europe, there is a group of Central Bankers who admire Paul Volcker, as I do myself, and share his analysis of the present situation. The Volcker analysis is very similar to that of the European Central Bank, and to that of Mervyn King, the Governor of the Bank of England. Paul Volcker testified that the Fed ought now to tackle the threat of inflation more forcefully. He is particularly concerned about the danger of a return to the conditions of "stagflation" of the 1970s. The Bank of England also expects that the next two yeas will see the pressure of rising inflation combined with low rates of growth. In the 1970s this unpleasant combination of economic trends resulted from the loose monetary conditions of the early 1970s and the oil shocks of the mid 1970s. Those who experienced the 1970s were taught a painful lesson about the negative effects of inflation. In standard monetary theory some emphasis is given to the initial phases of inflation in which an increasing money supply funds economic expansion and tends to cause booms, bubbles and speculation. Less attention is usually given to the second stage of inflation in which prices rise, interest rates are increased and economic growth rates, after an acceleration, begin to slow down. There is an illusion that inflation is good for growth; that is true of the first stage, but only of the first stage. Staglation, in which rising prices are accompanied by reduced growth, comes as a second stage. Paul Volcker warned Congress that he saw a "resemblance" between present monetary conditions today and those of the early 1970s, when the economy had an overall tendency towards rising prices, including big increases in energy and agricultural prices. He observed "if we lose confidence in the ability and the willingness of the Fed to deal with inflationary presses and sustain confidence in the dollar, we'll be in trouble". On the same day, the Bank of England published its latest quarterly forecasts and came to much the same conclusions. The Bank's inflation projections will not return to the 2 per cent target figure until early 2010, which suggest that it will have no room for rate cuts until then. Britain and the United States have different political cycles. The next Presidential election in the United States will come nearly two years earlier than the next British General Election; the latest date for a General Election will be June, 2010. The Bank of England's economic forecast suggests that there is little chance of interest rate cuts much before that time. The Government's reluctant tax cut on the lowest income tax band will strengthen the Bank's hand in keeping interest rates at their present level. Mervyn King observed that "the consequences of price increases would be a squeeze on real take home pay which will slow consumer spending and output growth, perhaps sharply." There exists what might be termed the Volcker consensus that inflation has returned as the real threat to world economic conditions. This consensus includes Paul Volcker himself, the Bank of England and the European Central Bank. It does not include Ben Bernanke, the Fed or the current President of the United States. After November we may find out whether it includes the next President of the U.S. Lord William Rees-Mogg for The Daily Reckoning Australia Editor's Note: Leading political editor William Rees-Mogg is former editor-in-chief for The Times and a member of the House of Lords. He has been credited with accurately forecasting glasnost and the fall of the Berlin Wall – as well as the 1987 crash. His political commentary appears in The Times every Monday. His financial insights can only be found in the Fleet Street Letter, the UK's longest-running investment newsletter.