Economic Outlook for Australia in 2007

"What's your economic outlook for Australia in 2007," we've been asked a lot recently. The more we think about it, the more the year is shaping up around two themes, resource nationalization (especially energy) and the debt-driven private equity binge. One is driven by the geopolitical race for control of scarce global energy assets. The other is evidence of late-stage, credit-driven speculation on financial assets.

In the case of the energy/resource race, it means consolidation within the mining and energy industries. For example, yesterday Zinifex (ASX: ZFX) decided to divest its smelting operations from its zinc mining operations. The smelting operations in Hobart and South Australia will be merged with Belgian outfit Umicore (EBR: UMI). That leaves the company with a core group of mining assets, which, not coincidentally, make it a potential takeover target from larger mining outfits like BHP Billiton Ltd. (NYSE: BHP), Rio Tinto (ASX: RIO), and Xstrata (LON: XTA).

Today's Financial review reports that, "The zinc price has risen 150 percent in the last year and is set to be one of the top performing metals in 2007, as demand for galvanized steel continues to increase and new zinc mines come on stream." Our belief here at the Old Hat Factory is that consolidation (or rationalization) in the industry should help smaller zinc companies too, one of which we recommended in Outstanding Investments.

But in the race for scarce resource assets, the energy story will continue to be front page news in 2007. Yesterday we learned that West Australian Environment minister Mark McGowan has cleared the way for the $15 bill Gorgon LNG project on Barrow Island off the cost of the Pilbara. These is good news for Chevron (NYSE:CVX) and ExxonMobil (NYSE: XOM), who have a big stake in exporting Gorgon gas to Japan and Korea. It's also really good news for Royal Dutch Shell (NYSE: RDS.A), still smarting from the boot to its backside in Russia's Sakhalin-2 gas project.

Much of Gorgon's gas is already spoken for in Japan and the United States. And the project joins the North West Shelf as Australia's strategic asset in the global energy market. Yesterday, the North West Shelf Venture signed a fifth agreement to sell liquefied natural gas (LNG) to Tokyo Gas, Japan's largest gas utility. The eight-year deal which commences in April 2009, will send 530,000 tonnes of LNG to Japan each year.

All of this seems like good news for Australia. Our only quibble would be that the only genuinely Australian partners in the North West Shelf Venture are Woodside Petroleum (ASX: WPL) and BHP Billiton. We're sure the other companies in the deal-BP, Chevron Australia, and Shell Development-all employ Australians. And we know, according to today's Financial Review, that Western Australia has "reaped $6.7 billion in royalty revenues, including from the North West shelf venture, over the past five years."

But here's a questions,  if Australia's gas is making Japanese household's warmer, and multi-national oil and gas companies (and their shareholders) richer, what is it doing for Australia? Creating new jobs? New industries? We're just wondering…and watching.

And what about that other potentially enormous story in the economic outlook for Australia in 2007, what we like to call Pirate Equity? Well, with Qantas (ASX: QAN) rejecting the $10 billion plus bid from Macquarie Bank Ltd. (ASX: MBL) and U.S. firm, Texas Pacific, the eye-patch wearing bean-counters in the world of pirate equity have been set a temporary set back. Don't expect it to keep them quiet for long.

Today's Australian reports that Australia's private equity industry is set to raise nearly $6 billion for operations in the second half of the financial year. This is an addition to the vast sums of leveraged booty foreign (especially U.S. firms) have at their disposal. And it raises the possibility that Australian economy of 2007 will be marked by a wild-eyed, guns-a-blazin' free for all on the capital markets.

Stepping back for a second, a private-equity fuelled bidding war for public companies in 2007 is really the next sensible step in the credit-driven global asset boom. Property, up. Commodities, up. Equities, up. And then, equities, up, up and away! Private Equity is the latest last frontier for financial engineers and innovators to deploy their leveraged tactics and ramp up values.

It will be great theater. And in some ways, it is a theater in the warfare sense too…in what we like to call the border wars of globalization….who will own and control what kind of assets? If the Russians and the Chinese are making bids to secure ownership of real assets, the counter-attack of private equity forces is to use leverage to secure control of publicly owned companies and their underlying assets. It's a war of ownership.

But we recall the old idiom that possession in nine tenths of the law. And if it came down to it, we wonder what we'd rather own in 2007…a claim on the future cash flow of a public company…or a zinc mine and a lead smelter. Hmm.

Reserve Bank Governor Glenn Stevens seems to recognize the crucial role leverage plays in this, our modern world. Regarding the housing boom, he said last night, "If we are seeking an explanation for why the prices of the 8 million existing homes across the country have increased so much, we surely have to give a very prominent role to the halving to the cost of debt and its easier availability."

"But in a real recession," he continued, "there always comes a point at which many people are not confident of recovery, and that affects their behaviour. It is not unknown for lenders to be sufficiently lacking in confidence that they are reluctant to take on the risk of new borrowers. That would feed back to the economy, deepening the decline and slowing the recovery."

It is just at this point-when other investors lose their nerve and their confidence-that you want to be a buyer. But we aren't there yet. According to Stevens, the flamboyant appearance of swashbuckling private equity firms on the stage of global capital markets may just be the thing that marks the beginning of the speculative end.

Stevens says, "Looking ahead the increasing prominence of private equity and leveraged buyout activity will be a point of interest. To date, this trend has probably caused a bit more excitement than the straight numbers would suggest is warranted, since LBOs accounted for a relatively small portion of corporate mergers and acquisitions of Australian companies in 2006."

"In essence, many of these transactions are based on two fundamental premises: the return on equity is high, and has in recent years been unusually stable as well; and the cost of debt is low. Those offering high prices for businesses are essentially betting that, over the next several years, they can enhance the returns by increasing leverage. To some extent, they may also feel that in a private-ownership structure they can do some things to improve long-run performance of the company that current shareholders would not tolerate because of short-term damage to earnings and share prices."

"But mainly, the strategy is one of leverage. If this analysis is correct, then corporate leverage, and the associated exposures around the financial system, could be rather more prominent as an issue over the next five years or so than it has been for a couple of decades."

Does this mean, as we quoted an American homeowner saying yesterday, we are all "rather screwed?" We shall see. Stevens advises us that we must be alert, "to the shift in the wind in the area of corporate leverage that seems to be occurring. I suspect we will be talking about that for some time to come."

Will the shifting winds make the future any more visible for investors? Doubtful. But they may increase rainfall!! The CSIRO reports that shifting winds are blowing the smoke from Asia's smokestacks over Australia…increasing rainfall! Pray for rain Australia, but in the meantime, encourage the Chinese to burn coal just in case.

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