Let's hope Obama recognizes the need for incentives, profits, and capital investments in the economy. The economy cannot be taxed and regulated without potentially severe consequences. Former Fed Chairman Paul Volcker (and the last Fed chairman to provide adult supervision for the banking community) is an Obama adviser. So Obama should be apprised of the consequences of Carter-era deficit spending and money printing.

At the very least, Obama must act as a check on the potential for a Democrat-dominated Congress to turn a recession into a depression.

For example, some in Congress are floating a proposal to steal your 401(k), sell the proceeds, and invest in "government-guaranteed" retirement accounts. The only thing this Marxist idea would guarantee is a depression. Call or write your congressman if you feel that your 401(k) is in danger. We shouldn't allow them to steal more from prudent savers than they already have.

Keep in mind that presidencies rarely resemble campaigns. President Bush campaigned on limited government and a humble foreign policy, and we got the opposite. To top it off, we had the illusion of real growth, with credit and housing bubbles that led to the greatest misallocation of resources in history.

The free market has been falsely accused for this financial crisis. But the free market didn't get us here; a combination of government spending and crony capitalism did. Much ink is wasted on how we need to re-regulate Wall Street, but the fact is that the problem would never have grown so large without agency conflicts and a banking system built upon on a foundation of paper money.

The agency conflict on Wall Street is the mentality of "heads I win, tails you lose. " CEOs, traders, and mortgage-backed security factories were paid more for taking more risk. So it shouldn't surprise us that they overdosed on leverage to magnify returns, without considering risk.

Performance pay should be based on creating long-term shareholder value, not on meeting next quarter's earnings estimate. A good place to start would be bonuses in the form of restricted stock that does not vest for 10 years. I doubt Lehman would have blown up if employees were paid modest salaries with the potential for sizeable ownership stakes in the future.

If every employee were paid partially in restricted stock of his or her company, even a small amount, most agency conflicts would be eliminated.

Much of our current mess resulted from totally complacent, incompetent boards of directors. Carl Icahn has good ideas for how this can be addressed without excessive regulation. Icahn explains how most corporate boards behave like government bureaucrats in this post. In my view, we need an economy in which everyone acts like owners, rather than CEO pillagers or union extortionists. For example, look at how decades of management and union looting brought General Motors to its state of current crisis.

A banking system built upon on a foundation of paper money also contributed to this crisis. The Treasury and Fed allowed institutions to grow "too big to fail. " Without taxpayer subsidies (i. e. , Fannie and Freddie - two of the worst crony capitalist institutions in history) and the subsidy of Fed rate cuts, housing prices would have kept growing in step with household income. Instead, house prices went to the moon. Precious capital was thrown into a black hole when mortgage-underwriting discipline went out the window and homebuyers deluded themselves with bubble psychology.

As Albert Einstein noted in the quote above, our problems "cannot be solved by the same level of thinking that created them. " If the federal government proposes "solutions" to this crisis with the same type of thinking that got us here, we could be in for a very long period of economic pain. America's status as a destination for foreign capital is at stake.

If the new government fails to act wisely and understand how we got here, the only "government guarantee" we'll have is depression.

Regards,

Dan Amoss

For The Daily Reckoning Australia

• Ghost of the Great Depression
• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?
• U.S. Government May Default On Its Debt
• Making Bad Investments in a Rising Market
• U.S. Presidential Election

And few got the memo from Wall Street strategists that they are supposed to stop driving because oil is over $100 per barrel. Americans love their mobility, and they will pay a premium to keep it. I expect the resilience of energy demand to surprise many.

I checked the markets at the end of each day as the list of bear market casualties grew: Fannie, Freddie, Lehman, Washington Mutual, and now, AIG. It's amazing how well the financial stocks we're selling short in Strategic Short Report are holding up, since they're all loaded with leveraged exposure to credit risk. But I'm confident our patience will be rewarded in the coming quarters.

My week off allowed plenty of time to think about the future of this credit crisis from a much broader perspective. Driving though Vermont's scenic Green Mountains and New Hampshire's White Mountains, we had plenty of time to listen to audio books.

One in particular - David McCullough's excellent book 1776 - offered perspective on how far the U.S. has strayed from its founding principles. 1776 is a historical narrative of the American Revolution, with a focus on the early military engagements between General George Washington's Colonial Army and the powerful, yet overconfident British Army.

Two themes from the book seem to parallel recent financial market events:

First, in one scene, British soldiers express their surprise at what motivated the colonists to revolt. Most Americans enjoyed a high standard of living, and nearly all were better off than British regulars. Why did they risk life and limb in a fight against British rule, when they had such material wealth and a decent amount of sovereignty? With historical perspective, we can appreciate even more just how much freedom most colonists enjoyed; taxes in particular were a pittance compared to today's U.S. tax burden.

Despite their many sins - most notably slavery - the colonists had amazing sense of sacrifice and honor. Their willingness to fight for freedom from government abuses stands in stark contrast to the attitudes of most modern Americans. Now, politics focuses on wealth redistribution, rather than harness the American entrepreneurial spirit and human capital to compete effectively in the global economy. It's gotten so bad that most Americans hardly seem to care when the federal government virtually takes over the mortgage industry - and most don't even understand how we got into this mess in the first place.

Will my one-year old son Ben apply directly to the federal government, a.k.a. "Frannie," for a mortgage when he grows up? Will politicians now directly manage the mortgage industry? After this week, it's far more likely to happen. We are watching the slow creep of socialism. That holds enormous long-term consequences for financial markets.

The second interesting point I drew from 1776 concerns leadership. George Washington didn't posses the brightest mind, or the best oration skills, but he quickly learned how to lead through success and failure while maintaining great humility.

After a stinging defeat at the Battle of Long Island, Washington engineered a brilliant overnight retreat that salvaged the awkward, inexperienced Continental Army. Rather than gamble his army on a low- probability recovery of lost ground, he swallowed his pride, and retreated to fight another day.

Washington's humility in retreat stands in stark contrast to the type of leadership we've seen in the boardrooms and executive suites on Wall Street. In nearly every big financial blowup of the past year, executives have failed to make tough choices that might have salvaged shareholder value, and instead gambled on a miraculous future turnaround.

Think about how much better off Lehman Brothers would be if its management hadn't put off the process of reporting losses, dumping impaired assets, and raising new capital. Would its stock be $4 today? Probably not.

While all of those decisions would have been painful at the time, they could have salvaged much more shareholder wealth - just as a successful retreat preserves an army's ability to fight another day.

The speed of Lehman Brothers' deterioration is shocking even to its skeptics. Despite my already low opinion of Lehman management, expressed several times in this space, I'm amazed at its failure to structure a deal or asset sale to salvage a respectable amount of shareholder value. Lehman even had the advantage of immunity to a "bank run," thanks to the Federal Reserve's lending facilities. Bear Stearns wished it could have used the same; it was finished as soon as creditors lost faith in its solvency. Lehman shareholders and its 25,000 employees deserved better.

These are tumultuous times - times that show us all the importance of good leadership. The importance of management leadership skills is never greater than it is in a crisis.

Best regards,

Dan Amoss
for The Daily Reckoning Australia

• Lehman Brothers (NYSE: LEH) Is Not Dead Yet
• The Asian Banks Have Finally Been Heard From
• Congress Berates, Rebukes and Ridicules Executives from Five Major Oil Companies
• Americans Celebrate Independence Day but Have Never Been More Dependent
• The Crime of Central Banking

But by the time you entered the workforce, you realized that the Soviets were only good at building conditions for shortages and black markets. With no prices or profits, the economy was destined to collapse, and everybody would become equal - equally poor. Finally, in 1991, the Soviet Union officially dissolved. Your suffering continued as you bartered your way through the economic chaos of the 1990s. Economic productivity kept falling until the 1998 financial crisis brought your country to the brink of failure.

But ever since then, things have been getting better. Since 2000, President Vladimir Putin has been a strong, yet controversial force behind restoring Russian pride and power. You don't have a problem with Putin's tough tactics, thinking that Russia's turnaround required bold action. But it's hard for the West to relate to your experience. They don't realize how hopeless the Russian people felt before Putin came along.

Regardless of what the West thinks of your president, Putin is a hero where it counts - in his own country. He's so popular and powerful that TIME Magazine named him "Person of the Year." The currency is strong, the stock market is soaring, and Putin wants to keep the boom going.

The Financial Times reports that the Russian government is pushing a plan to invest $1 trillion, roughly the size of its entire GDP, in modernizing its infrastructure over the next 10 years. Most of this investment would come from private sources, a clear reversal from the Soviet days.

Russia will follow the lead of other emerging economies in establishing its own "sovereign wealth fund." Export earnings that the Russian government had parked in U.S. Treasury bonds will start flowing into infrastructure and natural resource projects with higher long term returns. It's likely that some of this money will find its way to Gazprom, the state-controlled natural gas monopoly.

Lately, Putin has been setting the stage to consolidate his political gains. He's endorsed his protégé, Dmitri Medvedev, in the upcoming March 2008 Russian presidential elections. Putin's endorsement means certain victory for Medvedev, who also happens to be chairman of Gazprom.

As part of his consolidation strategy, Putin will be prime minister in Medvedev's administration. There's even a legal precedent for Putin to return to his current post - president Yeltsin resigned in December 1999, handing Putin the top job. Medvedev could do the same thing.

Some suspect Putin's stake in the future of Gazprom extends well beyond his relationship with chairman Medvedev. In November 2007, the Moscow Times described Putin's alleged personal holdings: "Stanislav Belkovsky, the well-connected insider who initiated the Kremlin campaign against Yukos in 2003, made specific claims about Putin's wealth. He alleged that Putin owned... 4.5 percent of Gazprom, [a stake worth $13 billion]."

Whether or not the rumors are true, Gazprom will likely remain the world's most politically influential corporation well into the future. Gazprom will get what it needs, and what it needs right now is to accelerate its drilling activity.

The International Energy Agency projects Gazprom's natural gas production will decline rapidly through the year 2020, and it tends to issue optimistic supply forecasts. Gazprom management knows production is too dependent on a few large, mature gas fields, so they greatly expanded drilling activity from 2001 to 2006.

Thus far, it has yielded disappointing results. As you can see in the first chart, Gazprom expanded its drilling activity at a 30% compound annual rate from 2001 to 2006. Industry sources estimate this was the fastest drilling growth rate among all national oil and gas companies over this period.

Gazprom will probably try improving its supply shortfall by acquiring smaller independent gas producers, and try to strike deals to transport Central Asian gas to its European customers. But eventually, the company will not be able to ignore the need to redouble its drilling activity. Morgan Stanley oil service analyst Ole Slorer agrees, and described the amazing growth in the Russian rig fleet since 2000:

"Activity in Russia is now shifting from rig-less activity towards more drilling intensive services. According to the MI-Swaco rig count, there were only 40 active rigs in Russia in 2000 or about 4% of the U.S. onshore activity. This stabilized at about 75 rigs in operation over the 2001 through 2003 period (about 7% of average U.S. activity), before escalating by 70% to average 128. The growth has continued unabated and rig count averaged 246 rigs in 2006 although exiting the year at a 300 run-rate. In our view, we are entering a period of double-digit drilling growth."

Gazprom management is on record with a goal of quadrupling the company's market value to $1 trillion within a decade. "We'd like to be the most valued and most capitalized company in the world," said Deputy CEO Alexander Medvedev in an April 2007 interview. He expects Gazprom's market value will double in five years. To achieve this goal, there's no question the company will have to drill heavily to stem its gas production declines.

Gazprom isn't the only Russian energy company with aggressive growth plans. The December 2007 Lehman Brothers E&P Spending Survey estimates that the six largest Russian oil and gas companies will spend $28.5 billion on exploration and production in 2008, up 21% from 2007 levels. Out of all the Western oil services companies, Schlumberger has the largest chunk of this business - with Baker Hughes, Halliburton, and Weatherford contending as well. Russian companies still perform most oil service work. But they use inferior technology and equipment, so Western oil service companies should keep winning contracts.

On the equipment side, our own National Oilwell Varco (NOV) has repeatedly cited Russia as an enormous growth opportunity. Once NOV's acquisition of Grant Prideco (GRP) closes, the combined company will be even more of a "one-stop shop" to retool and supply the Russian rig fleet. Tesco (TESO) has a huge opportunity to outfit this antiquated fleet with top drives, which improve productivity and efficiency. Natco Group (NTG) is a major player in wellhead gas processing equipment. As more oil and gas wells are completed, the opportunity for Natco equipment sales grows. Chart Industries' (GTLS) equipment will play a key role in building LNG liquefaction plants to process the huge untapped gas resources under the Barents Sea and on Sakhalin Island.

Dan Amoss, CFA
for The Daily Reckoning Australia

• None Found

Clean Energy Fuels (NASDAQ: CLNE) is one of these companies. It's leading the charge to promote natural gas as a transportation fuel. It builds the infrastructure necessary to store and dispense natural gas at fueling stations. It's also backed by billionaire investor T. Boone Pickens.

Pickens is a great energy investor. He made his fortune investing in oil and gas. He's often been right about the big picture in energy, spotting trends long before the crowd. Today, he expects a future in which oil and diesel prices remain very high and consumers will use natural gas to fuel many more types of vehicles. He controls 60% of Clean Energy's stock, a stake worth $400 million. That's a big bet, even for a billionaire.

But there's one big hurdle to his vision. Pickens knows the U.S. natural gas market as well as anyone, and he says he expects it will remain tight. Domestic gas drillers are working as fast as possible to meet demand from power plants, chemical plants, and homes. A growing fleet of natural gas-powered vehicles would propel natural gas demand to another level, spurring huge investments in liquefied natural gas (LNG).

Most of the world's natural gas reserves are located far from major population centers. When gas is too expensive to transport by pipeline, it's called "stranded" natural gas. The only way to get stranded gas to market is to cool it until it reaches a liquid state and transport it on ships designed to carry LNG.

Pickens' vision of the future, along with continued global growth in gas demand for industrial uses, sets the stage for a massive boom in LNG infrastructure. Douglas-Westwood, a leading industry authority, forecasts investment in the LNG supply chain to grow dramatically over the next four years and beyond.

The importance of natural gas extends well beyond its role as an emerging transportation fuel. It's a vital feedstock in electricity and chemical production. Synthetic nitrogen fertilizers, which use natural gas as a feedstock, greatly enhance agricultural productivity. Other chemical compounds created from gas are the building blocks for electronics and plastics. Gas is also becoming a popular fuel for home heating. Natural gas furnaces are much more efficient than oil or electric heat furnaces. Without natural gas, many businesses would simply have to close their doors. Reliance on natural gas is a weak link in the global economy.

Because of its importance, governments and industrial companies will keep favoring policies that secure reliable natural gas supplies. Since the industrialized world no longer includes just North America and Europe, many more countries have entered the competition to lock up the most promising stranded gas reserves.

For decades, LNG has not been cost competitive with oil and coal. But continually rising oil prices are heightening the sense of urgency to develop a tradable LNG market. Also, climate change activists will keep pushing to tax, regulate, and eventually banish coal. This benefits LNG because natural gas electric power plants can replace coal plants. The financial and political incentive to develop the world's stranded gas reserves is strong and growing. Energy companies are responding.

Even Exxon Mobil - a consistent optimist about plentiful future oil supplies - doesn't assume the United States has enough domestic natural gas to meet growing demand. "Energy independence [within 20 years] is just impractical, and we will have to rely on additional imports of natural gas," says Ron Billings, Exxon's vice president of Global LNG.

The Wall Street Journal recently reported on Exxon's plans to build a huge LNG re-gasification terminal 20 miles off the coast of New Jersey:

"Exxon said it expects demand for gas to rise in North America, outstripping the ability of gas drillers and producers to keep up. Globally, it said, LNG demand could more than triple, to 500 million metric tons a year, in 2030, from 150 million metric tons a year today. About 20% of gas consumed in North America could be imported by then, up from 3% today."

Like the U.S., China produces almost enough natural gas to meet its needs. Both countries rely on LNG to satisfy the extra 2-3% of domestic demand not met by local production. China's use of LNG is small, but it can grow dramatically. China is an underserved market. It's consuming as much gas as its limited pipeline and LNG capacity will allow. Supply constraints and high costs force many Chinese provincial markets to use coal for electricity when they'd rather use gas.

Residents of Beijing and Shanghai would certainly prefer gas-fired power plants to the coal-fired plants currently ruining air and water quality. Until now, China has constructed coal-fired plants at a maddening pace simply because they were cheap. But the health costs resulting from coal-based pollution are growing to a critical level. As Chinese wealth grows, the country will look to secure a leading position as a consumer of LNG - much in the same fashion as Japan. It may be more expensive, but China will weigh the extra cost of gas over coal against the benefit of lower health care costs and better social stability.

Chinese land drillers are pushing very hard, yet still cannot satisfy demand. China's onshore oil and gas basins are fairly mature. State-controlled oil companies have been scouring the country for decades. Offshore drilling may eventually bring more gas supplies online. A few promising underexplored basins exist in northwestern China. But the pipelines necessary to deliver this gas to coastal cities will take years and tens of billions of dollars to build.

Chinese leaders have signed long-term gas supply agreements with the leaders of Turkmenistan and Kazakhstan, two Central Asian countries endowed with plenty of untapped reserves. But Gazprom, the Russian gas monopoly, also wants access to these reserves. The pipelines required to transport this gas would be very expensive and risky from a geopolitical perspective. The Chinese would probably find it easier to safeguard LNG supplies sourced from emerging exporters like Qatar, Malaysia and Australia.

I expect China will increasingly turn to LNG to satisfy growing natural gas demand. But it must compete with the rest of Asia, the U.S., and Europe to invest in the most promising LNG projects. Many European countries are looking to diversify away from politically risky Russian gas supplies. They're investing in LNG projects that strengthen connections to longtime suppliers like Algeria.

Since natural gas provides the building material for so many modern products, its consumption grows as living standards improve. According to the BP Statistical Review, the entire Asia-Pacific region consumed just 3% of global natural gas in 1975. This figure expanded fivefold, to 15%, by 2006, and this trend should continue on its current course.

Japan was the first Asian country to invest heavily in LNG facilities. After suffering through the oil market disruptions of the 1970s, Japanese leaders decided it was wise to diversify supply of hydrocarbons. South Korean gas demand accelerated from a low base as its industrial machine matured in the 1990s. There's an interesting aspect about the natural gas market in these two economic powerhouses: Neither of them has a viable domestic gas resource. They both rely on imports. Japan relies on LNG for 97% of its gas and South Korea relies on it for 100%.

Japan consumed 39% of the world's LNG supply in 2006. South Korea came in second, at 16%. Both countries have a huge stake in LNG, so they will keep expanding their LNG re-gasification and storage infrastructure. LNG equipment companies have the opportunity to meet this demand over the long term.

Recent events have caused Japanese LNG demand to accelerate. Japan suffered a powerful earthquake in July 2007. It reignited fears of radiation leakage from nuclear power plants, forcing the shutdown of a major nuclear reactor. Ever since the shutdown, Japan has had to make up for the lost electricity with gas-fired power. Utilities have been importing as much LNG as storage facilities will allow, paying premiums of about 50% over benchmark U.S. natural gas prices.

After this scare, it appears that the Japanese government is rethinking its commitment to new nuclear reactors. In a recent research note, Bernstein Research described this important policy shift, which remains below the investment community's radar screen:

"As a result of new [Japanese government] guidelines, nuclear plant operators will now have to analyze seismic events over a 130,000-year period, in stark contrast to the current mandated 50,000-year period. Geological faults screened to be active... would nullify greenfield site proposals, and could lead to closures of operating nuclear capacity..."

Nuclear power supplies 30% of Japan's electricity. Regulators may delay or cancel some of the 10 gigawatts in new nuclear capacity slated to come online by 2015. If this happens, Japan's LNG and gas-fired power facilities must expand.

Dan Amoss
for The Daily Reckoning Australia

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Three weeks later, Citigroup (NYSE: C) announced that its third-quarter net income would fall roughly 60% from a year earlier, blaming “dislocations in the mortgage-backed securities and credit markets, and deterioration in the consumer credit environment.”

Apparently, “pretty good” in the current environment is “pretty dismal.”

Additionally, Citigroup disclosed that its securities and banking unit would be writing off $3.3 billion worth of losses – a large figure for even a megabank like Citigroup. This loss stems from its LBO-related leveraged loan commitments and the frozen CDO market.

The most troubling part of this preannouncement was the $2.6 billion increase in credit costs in Citigroup’s global consumer business. Of this figure, nearly $2 billion was an increase in Citigroup’s loan loss reserve. (The loan loss reserve account is a bank’s estimate of the losses it expects to take on its loan portfolio). This large write-off was a clear message from Citigroup that the credit quality of its loans is deteriorating much faster than expected. To put Citigroup’s $2 billion allocation to loan losses in context, during the first and second quarters of 2007, Citigroup added just $646 million and $545 million, respectively, to its loan loss reserve account.

We should expect many, many more dismal pre-announcements from the banking industry over the next few months. Just yesterday, for example, Thornburg Mortgage (NYSE: TMA) said its subprime losses will be 27% higher than expected. As our colleagues at the 5-Minute Forecast explained, “Thornburg Mortgage will throw another $1.1 billion on the mortgage carcass pyre.”

Once a major asset bubble pops – and the housing bubble was one of the largest asset bubbles of all time – the companies at the center of the mess usually try to take their lumps in a single quarter, often referred to as a “kitchen sink” quarter. By cramming losses and write-offs into a single quarter, they try to give Wall Street the impression that the bad news is out of the way and nothing but blue skies are ahead.

This game works very nicely sometimes… especially among gullible investors.

But “kitchen sink” quarters have an inconvenient way of recurring. It is improbable to believe, for example, that banks will be able to cram five years of reckless lending into a single quarter of writeoffs. More likely, this quarter’s write-offs will begin a long-running trend.

“Kitchen sink” quarters will occur repeatedly in the financial sector, just like they did in the tech sector after the dot-com bust of 2000. Cisco, Intel and Corning reported a series of disappointing quarters.

The homebuilders are also playing the “kitchen sink” game, as Lennar and KB Home demonstrated in their most recent horrid results. Both of these homebuilders sliced large chunks off of their book values by writing off $848 million and $690 million worth of shareholder equity, respectively.

These massive write-offs illustrate how much raw land inflation and irrationally priced finished homes were hiding in the homebuilders’ inventory accounts. The most indebted homebuilders will likely experience some form of bankruptcy.

A little over a year ago, I wrote a Whiskey & Gunpowder article entitled, “Are Homebuilder Stocks Actually Cheap" in which I warned that low price-to-earnings and price-to-book multiples were deceptive:

“After major declines, [homebuilder] stocks are trading for an average trailing P/E ratio of 4.7. This is incredibly cheap in the current market, but trailing earnings represent the very peak of the most speculative housing market in history (in other words, 2007 earnings are likely to decline significantly, making the forward P/E ratio potentially double or triple the trailing ratio). Your macro outlook for the housing market over the next couple of years will determine whether you think these stocks are bottoming or just pausing before another round of declines…

“The measure of book value for most homebuilders will be a moving target in the future, as further inventory charges and margin compression is very likely. So the argument that homebuilders are cheap rests on shaky accounting and extrapolation of the past into the future. That adds up to a ‘value trap,’ in my opinion.”

I see a similar value trap unfolding among the bank stocks. Most of the analysis I read doesn’t extend much beyond the parroted mantra: “Bank stocks are cheap on a price-to-earnings and price-to-book basis.” Citigroup’s earnings preannouncement reminds us that earnings and book values only reflect past results, not future results.

But for the moment, very few investors seem to fear the uncertainties of the future. So financial stocks are rallying on the garbage rationale that “bad economic news is cause for celebration because it will bring more interest rate cuts from the Fed.”

Unfortunately, negative surprises on bank balance sheets will far outweigh any benefits they receive from Fed rate cuts — benefits that tend to re-stimulate the credit creation process only after a very long time lag.

Finally, on the subject of further Fed rate cuts, the financial markets are flashing many glaring signs that monetary inflation is spiraling out of control. So Fed Chairman Bernanke will receive ample opportunities to establish his credentials as an inflation fighter…or not.

With gold and commodities soaring, and most global stock markets either approaching or blasting through July peaks, he may decide to put further rate cuts on hold for the time being.

Indeed, if the dollar continues sinking – and commodities continue soaring – rate cuts may be on hold permanently…and that’s when the real carnage in the finance sector might begin.

Stay tuned!

Dan Amoss
for The Daily Reckoning Australia

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During this particular credit cycle, investors might suffer even more pain than usual. That's because there was nothing "usual" about this particular credit cycle. In fact, the world has never known anything like it.

In the modern financial system, the ability to create credit extends far beyond the reach of the traditional banking system. A labyrinth of credit contracts and derivatives provides sources of financing that never pass through the door of a traditional bank.

This labyrinth is known as "Securitization."

Every imaginable stream of future cash flow - from car and mortgage payments to the loans that fund private equity deals - can be "securitized" and sold to the highest bidder. Securitization is simply the process whereby a stream of future cash flow becomes pledged to a separate legal entity, which then divvies up the cash flow among different "tranches," or classes, of creditors.

Like everything in life, the securitization revolution has its positives and negatives. One negative consequence is that securitization creates a vast expanse between borrowers and lenders. The two sides never know each other…or care to know each other. But obviously, the further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender. Very bad loans tend to be made when this is the case, as those who've dabbled in subprime mortgages are discovering. On one end of the lending chain are plenty of fraudulent "liars' loans" yet to default, and on the other are plenty of lenders who don't fully understand the risks they were taking.

Bill Gross, the most accomplished bond fund manager in the world, recently published his views on the subprime debacle. In his July Investment Outlook, Gross acknowledges that securitization and derivatives diversify risk and "direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets…

"The flaw, dear readers, lies in the homes that were financed with cheap and, in some cases, gratuitous money in 2004, 2005, and 2006," Gross concludes. "Because while the Bear [Stearns] hedge funds are now primarily history, those millions and millions of homes are not. They're not going anywhere… except for their mortgages, that is. Mortgage payments are going up, up, and up… and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable-rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises, with nearly $700 billion ARMS subject to reset, nearly three-quarters of which are subprimes…"

The housing market will remain sluggish far longer than most expect. $800 billion of ARM resets can only add to the supply of distressed sellers in 2008. This will further depress an already sluggish housing market that's having enough trouble working through a huge supply overhang. To say the least, this scenario will weaken demand for securities backed by residential housing.

Until now, hedge funds have been creating a great deal of the miraculous "liquidity" sloshing around the globe. By buying the highly leveraged equity and mezzanine tranches of collateralised debt obligations (CDOs), the buyers provided the cash to make new loans and create new CDOs. Liquidity surged; share prices soared; everyone was happy… until homeowners began defaulting on their loans in record numbers. Suddenly, CDOs were not providing the returns the buyers expected. Instead, they were providing the large losses the buyers did not expect. Indigestion resulted.

Indigestion tends to suppress an appetite. That's where we are today - in the indigestion phase. Institutional investors' appetite for mortgage-backed securities is spoiling just as Wall Street tries to serve them heaps of new portions.

Get ready for the days of expensive credit.

Dan Amoss
for The Daily Reckoning Australia

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Opinions differ about future capabilities of oilfield technology. Some argue that technology will allow us to unlock trillions of barrels worth of oil out of unconventional and not-yet-discovered resources. Others argue that every technology in use today was developed twenty or thirty years ago; not only that, but growing service industry bottlenecks could halt several desperately needed development projects in their tracks. While both sides in this debate have valid points, I think it's important to remain focused on progress underway at major projects and depletion of large existing fields, and not argue about potential resources thirty years into the future.

Resource owners usually want to produce a hydrocarbon reservoir as fast safety and engineering limits allow, so it makes sense that most oilfield technology was developed to accelerate the process. The concept of "time value of money" doesn't end on Wall Street; it extends to the oil patch. Producers are under pressure to satisfy the demands of employees, bankers, tax collectors, and shareholders so the sooner oil and gas arrives, the better.

This picture of working to beat the clock not only applies for newer discoveries, it also applies for projects that strive to extend the lives of older fields. Oilfield equipment and services have become very expensive and are likely to become even more expensive in the coming years. The free market is the driving force behind oilfield technologies. If there's thought to be a few million more barrels of oil left in an old well, an operator will go ahead with an enhanced oilfield recovery project if the return on investment is high enough. But if oil and gas prices fall and service prices remain high over the course of this project, it can lose a lot of money. So timing is of the essence.

Low-viscosity, or "sticky," heavy crude and sour crude with high levels of impurities like sulfur require extra steps in both wellhead processing and refining. The initial step in crude oil refining really occurs at the "wellhead," or the site where it's first pulled from the ground.

The trend toward heavier, sourer crude oil will directly benefit manufacturers of specialized wellhead equipment. These lower grades of crude make up a steadily rising share of global oil production because just as you'd expect, the sweetest, lowest-hanging fruit in the oil patch tends to be picked and consumed first.

More barrels of crude will require upgrading, particularly the abundant, yet barely accessible heavy crude from sources like the Orinoco belt in Venezuela. Technology is what the Venezuelans, the Russians, and the Saudis need, and they will pay up for it. Some of the biggest wealth-creating companies of the next generation will be those that can unlock the value these politically unstable resources - without committing billions in capital to projects that can be seized overnight.

Odds are, the next few years will look like the last few - a period of growing resource nationalization not unlike hoarding. Leaders of countries sitting on vast reserves are taking actions in the best interest of their people (or their personal Swiss bank account) and telling major oil companies to "get out."

Most of their remaining reserves are difficult to produce, so Vladimir Putin and Hugo Chavez wouldn't have kicked the big oil companies out if they hadn't planned on granting major development projects to big service companies like Schlumberger, Baker Hughes, and Halliburton. Yet despite having access to the best oilfield technology in the world, most big projects still suffer from bottlenecks, delays, and cost overruns. This phenomenon is widespread enough that it supports the core ideas behind the Peak Oil theory - most notably that the "easy oil" has already been consumed.

Chris Skrebowski, editor of Petroleum Review, became a leading Peak Oil theory proponent after initially setting out to prove that it was nothing more than worrywarts seeking to make headlines. With decades of international oilfield consulting and research experience, he ran the numbers and concluded that data on both historical production and future projects was not precise enough to assume ample oil supply as far as the eye can see.

So Skrebowski started a "megaprojects" database to track the projects widely expected to satisfy growing demand. He's noticed an undeniable trend of delayed startups and shortages of everything from drilling rigs to qualified personnel. Assuming that the current backlog of projects proceeds without a hitch, he expects that " 24.8 [million barrels per day] of new capacity [is] due to come onstream between January 2007 and December 2012."

An extra 24.8 million barrels per day of new capacity may sound like plenty for the world's 2012 production needs. After all, it represents a little over 4% annual growth over the next 6 years. But this ignores depletion of the existing base, the elephant in the room that most Peak Oil critics either overlook or avoid. Skrebowski warns that the data behind the existing base, especially from national oil companies like Saudi Aramco, is not transparent enough for us to make happy assumptions about long-term supply. If average global depletion is running a little over 4% per year - a fair estimate - the world is likely to have the same oil production capacity in 2012 as it has today.

Skrebowski draws two conclusions from his latest megaprojects analysis. "First, data on production, project performance, and depletion rates is wholly unsatisfactory, particularly for the OPEC producers. Second, the large volumes of new capacity being added between 2007 and 2012 may not translate into the sort of increased production flows the world economy needs to underpin economic growth."

Regards,

Dan Amoss
for The Daily Reckoning Australia

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These pumping units toil without fanfare. Up and down, day and night, most draw less than a dozen barrels daily from wells long past their prime. Yet combined, they account for a shockingly high percentage of the oil produced in a country that was once the world's top producer.

This is a picture of a country 37 years past its peak in oil production. Yet our reliance on this army of machines to produce the most precious commodity in the world remains a little-known secret.

It is a picture of the United States of America.

The United States - the world's most voracious energy consumer - now heavily relies on an army of worn-out machines to supply much of its oil and gas.

Yet as far as the public is concerned, oil and natural gas reserves float around in giant swimming pools a few hundred feet underground, and if only those greedy oil executives would turn up the production nozzles, we'd have all the affordable energy we need.

The challenges posed by declining oil supply and rising prices are not as simple as most imagine. Entrepreneurs have scoured nearly every square inch of promising hydrocarbon basins since Col. Edwin Drake successfully drilled that famous Pennsylvania well in 1859. We are now in a situation in which small independent operators are responsible for maintaining older wells - and they increasingly rely on this month's recommended company to keep their wells from drying up.

As far as the big oil companies are concerned, it's pretty telling that they're exploring in harsh, remote environments like offshore Kazakhstan and Sakhalin Island, rather than right here in the good old U.S. of A. This is a very clear signal from the free market that the size of potential future U.S. oil discoveries are not worthy of large-scale investments.

In The Future of Global Oil Production, Roger Blanchard explains how the U.S. has reached this state:

Once oil production starts declining in a mature oil-producing region such as Texas, the easily extractable oil has been extracted, and it requires an increasing amount of work to extract the remaining oil. Wells that once required no pumping because high reservoir pressure forced the oil out ultimately require pumping as the reservoir pressure declines. Over time, the wells pump less and less oil. A substantial increase in the price of oil will have little effect on the declining production trend unless there are previously undeveloped oil fields to exploit. The U.S. now has approximately 500,000 low-production stripper wells (wells that produce less than 10 barrels/day) with an average production rate of ~2 b/d.

You read that figure correctly. That's 500,000 "stripper wells" currently in operation. Even more shocking is the fact these mom and pop wells account for about 18% of U.S. oil production. Tiny natural gas wells provide about 10% of U.S. gas supply. Moving a little further up on the size scale, the latest EIA numbers show that about 50% of U.S. oil supply originates from wells producing less than 100 barrels per day. No wonder so many nodding donkeys dot the landscape!

You might say that a couple of states would have to go without modern transportation or winter heating if not for the industry that supports this production. This is an industry that will hardly blink an eye as an estimated USD$1.5 trillion worth of mortgages rolls past the "teaser" stage, or flinch at the growing glut of chips in the electronics supply chain.
This industry will go about its business through bull market and bear market, through boom and bust. I'm talking about the well service industry.

A well service rig generally has fewer capabilities than a typical land drilling rig. They are normally smaller and more mobile, mounted on trucks operated by three-four man crews. Most well service rigs also typically don't have the drill pipe, mud pumps, and rotary tables necessary to drill new wells. But these rigs can perform workover drilling, recompletions, and horizontal re-entries - all drilling-related tactics an operator may use to offset depletion after a well has passed its peak production rate. Service rigs are truly the "workhorses" of the oil patch, often the first to arrive and the last to leave the well site.

Well service companies charge by the hour. During the last industry downturn, in 2001-2002, the drilling rig count contracted by 37%, but well service hours declined only 25%. Each newly drilled well creates an annuity for the well service industry; maintenance work must continue to some degree, even through the worst industry slowdowns (see "Typical Oil Well" chart).

Here's the key difference between the traditional land drilling business and the well service drilling business: Exploration and production (E&P) companies will acquire drilling rigs only if they are optimistic about oil and gas prices. But if they want to remain in business for more than a couple of years, they need to spend on well services. Otherwise, their production would fall off a cliff. As you'd imagine, rates earned by well service rigs are far less volatile than rates earned by exploration-focused rigs.

Another reason why pricing in the well service business is less volatile than pricing in the drilling business is a more consistent balance between supply and demand. When investing in companies supplying services with a fleet of capital-intensive assets, capacity utilisation is the most important factor to monitor. This applies for oil tankers, offshore drillers, land drillers, and well service drillers. Competition is not limited to existing competitors; it includes new equipment coming online in the future.

In the well service industry, business was horrible in the late 1980s. Bankruptcies eliminated about 65% of well service capacity over the following 20 years. The industry is now operating with only about 2,800 well service rigs left in working condition.

Now that the industry has worked through the huge glut of well service rigs, service companies are finally starting to order new rigs. However, even after this long, painful attrition process, the average age of the well service rig fleet is still about 25 years. This gives us reason to expect that for every two new rigs constructed and put to work, roughly one old one will be scrapped.

Dan Amoss, CFA
for The Daily Reckoning

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Contrary to popular opinion, paper money is not wealth. Paper money is a claim on wealth. It only has value to the extent that it can be exchanged for things — a bushel of corn, a gallon of gasoline, a dental cleaning, or an Intel microprocessor.

When the government prints more money, it gives a public fixated on asset prices the illusion that they are growing wealthier, when, in fact, they are growing poorer. As paper money becomes more and more plentiful, the producers of valuable products will eventually demand more units of money in exchange for their product or service.

Daily celebrations of new Dow records fail to recognize the inflation behind this index’s move upward. Dr. Marc Faber is on public record talking about a potential “Dow 100,000” scenario. This scenario is possible if current trends continue. But we must remember that under this scenario, the price of everything will be increasing dramatically, leading to lower living standards.

A stark example of consumer price inflation leading to declining living standards is the recent tripling of corn tortilla prices in Mexico. Protesters have marched on Mexico City, demanding that the government do something about it.

Mexico’s fairly socialist economy has produced a situation in which many citizens’ incomes rely heavily on the government’s entitlement spending. Mexican monetary policy must remain loose to keep the system afloat. The supply of pesos in circulation has been growing 15-20% over the past year.

Misjudging the root cause of tortilla price increases — an exploding money supply — populist politicians have blamed “monopolistic” tortilla companies like Grupo Gruma and have enacted price controls that will only worsen the future supply picture.

Once the stage for easy pesos was set, the final catalyst that sparked the Mexican tortilla price explosion was the U.S. government’s boneheaded policy of subsidizing corn-based ethanol. Demand from dozens of new ethanol plants has stretched the U.S. corn market to its limit. High corn prices have attracted all excess supply away from international markets, causing a shortage in Mexico’s regular imports from the U.S.

Paper money inflation is not confined to Mexico. Loose U.S. monetary policies and ethanol subsidies are combining to form a future perfect storm in the price of basic food ingredients. Those holding their breath for imminent Fed rate cuts will probably have to hold it beyond this year’s corn harvest.

The average Mexican citizen facing spiraling food costs doesn’t seem to care about housing prices or rallies in the Mexican stock exchange. Will Americans be facing this situation at some point in the future?

Over the past decade, a few billion new capitalists began their quest to achieve Western living standards. They will demand energy and industrial metals on an unprecedented scale, and the best way for investors to benefit from this trend is to own shares in the companies fulfilling this demand.

This capitalist revolution is well under way and nothing short of an economic meltdown will stop it. Just in case the economic machine that funds mortgage payments and all other manners of debt begins to sputter, central banks will slash interest rates yet again.

But unlike the 2001-2003 series of rate cuts, long-term rates are more likely to increase as CPI fears mount, causing demand for long-term bonds to dry up.

If that were to occur, the U.S. Federal Reserve would implement Chairman Bernanke’s well-outlined “unconventional monetary policies.” This would involve a new role for the Fed: buyer of last resort for bonds of any maturity. And lest you think the Fed could ever run out of money, check to see what institution guarantees the value of the “Federal Reserve notes” sitting in your wallet. If necessary, the Fed can use its ability to create an unlimited amount of this paper to keep the debt pyramid solvent.

If this scenario were to develop, the U.S. dollar would quickly be added to history’s long list of worthless paper currencies. Under the status quo, the U.S. dollar’s rate of decay will depend on public perception of inflation, and perceptions are likely to worsen after this year’s corn crop.

Thanks to corn-based ethanol subsidies, a huge portion of the country’s corn-derived food supply — everything from sweeteners in packaged foods to chicken and beef — will suffer from shortages and price increases. Much of this will be passed onto the consumers who can least afford it. So investors should expect the current momentum behind populist political movements to grow stronger. This will be bad for longer-maturity bonds and the overall stock market, but good for gold prices.

The global economy now floats on a sea of paper money. This grand monetary experiment has been in place for only a few decades — a mere tick in the clock of civilization. We know how this show ends, having seen previews in Weimar Germany and several banana republics.

Will the price of gold ultimately increase from its current $620 to $3,000 per ounce? I expect that it will. A better way to frame this large number is to flip the ratio from dollars per ounce to “ounce per dollars.”

Regards,

Dan Amoss
for The Daily Reckoning Australia

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These predictions of consumer retrenchment have not appreciated or fully respected a key tenet of human nature: When given the option to consume without producing (via credit cards), most people will choose "yes," and most people are reactive adjusters, rather than proactive planners. Instead of keeping in mind the odds of a job loss or a slump in the housing market, most consumers wait until they run into the proverbial budgetary brick wall before they adjust spending habits.

Though it's generally a bad idea to speculate on the possibility that consumers will reverse their habits overnight, drastically cutting back on spending, the odds shift in your favor if you selectively bet against the consumer. Referring to short sale candidates, J. Carlo Cannell of Cannell Capital asked the audience at this year's Value Investing Congress West, "Why should I go hunting in the rainforest for a puma when I can shoot a sick pigeon at the side of the road?"

There are many "sick pigeons" at the side of the road, waiting to be put out of their misery. They routinely consume far more capital than they will ever return to shareholders, and should be liquidated in order to allow capital to be diverted to more productive uses.

Using the past three years of hindsight, this means selling short Pier 1 rather than J.C. Penney, Krispy Kreme rather than Panera Bread, or Gateway rather than Apple. Whether it's due to obsolescence, fads, end market saturation, dumb acquisitions, or misguided corporate strategy, the reasons for 50-99% of crashes in a stock are numerous. So when the market gives you an opportunity to sell short a stock with several of the aforementioned characteristics (and is quite expensive relative to its earnings power), it's an opportunity you should take advantage of.

Specialty retailing is a market segment littered with "sick pigeon" short sale candidates. While a recession may signify little more than an inventory adjustment and a 30% stock correction for the Wal-Marts of the world, it represents a death knell for some specialty retailers counting on a critical mass of consumers continuing to overspend on very discretionary items.

While it's not reasonable to assume that consumers will change their habits overnight, it's reasonable to assume that most are a) fickle and b) too addicted to the "doorbuster" type of sales that are becoming mandatory in order to draw foot traffic. It's the marginal consumer that keeps dozens of specialty retailers afloat. Miss one fashion trend, or allow the competition to poach your customers, and it could mean lights out in a hurry.

Retailers usually declare bankruptcy when traffic and cash flow slows to the point where they can no longer repay suppliers for inventory on loan, make payments on their revolving debt, and make the contractual lease payments that they owe to their REIT landlords.

How did specialty retailing reach this point of saturation? The top reason is the incredibly easy credit conditions of the past generation. Consumers have been given every opportunity to overspend, and private entrepreneurs have been more than willing to oblige.

Craft and fabric retailing has leapfrogged from cottage industry to logistically complex nationwide empires - all with the intent of fulfilling demand for an eye-opening array of slow-turning merchandise. Lenders with more focus on fees than on risk have fallen over themselves to finance store openings and inventory builds, much of which will be liquidated at an economic, if not accounting, loss.

Now, the tide should reverse, or at least stagnate, favoring the retailers with the strongest balance sheets, best management teams, and most loyal customer bases.

Fiat monetary systems without the checks and balances of the gold standard allow credit creation to run out of control. It has greatly diminished lenders' need to accurately price risk and ration credit. Therefore, a great number of loans made to  specialty retailers over the past few years were made with poor assumptions about sustainability of the underlying business.

In the latest issue of The Richebacher Letter, Dr. Kurt Richebacher writes:

"It is one of the key postulates of Austrian theory that the most harmful effects of credit inflation are not in the price indexes, but in the misdirection of resources that it causes. For American economists, lacking any understanding of this part of the inflationary process, all these structural distortions are irrelevant.

To be sure, over time, they impinge on economic growth in various ways. The lowest interest rates in half a century and the biggest fiscal stimulus in U.S. history during 2002-2004 have given the economy a one-off boost, but the resulting recovery plainly lacks any self-sustaining and self-reinforcing traction."

The housing boom that ended last year was fueled by inflation. An "asset-based" economy is simply not sustainable over the long run. Since the housing boom promoted a "one-off spending boost," the profits of retailers that benefited the most from this boost should be viewed as artificially inflated.

Regards,

Dan Amoss, CFA
for The Daily Reckoning Australia

Editor's Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

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