Riding the Bear & Deep Drilling in Australia

Gold and oil both traded down about 2.5% overnight in New York. The Fed is meeting in Washington, D.C. We'll know soon what, if anything, it plans to do. But does it really matter?

Higher U.S. interest rates would justify long-term dollar strength. But with house prices falling by an average of 12.7% in the last twelve months (according to the Case-Shiller survey of 20 U.S. cities), and with foreclosures up 112% year-over-year, do you really think the Fed will be raising rates any time soon?

The Fed is trying to soften the blow of falling asset prices by making it possible for homeowners to refinance into longer-term loans at lower rates, and then ride out the bear market in housing and credit. In other words, the Fed has kicked the dollar to the curb. It's on its own now.

That doesn't mean the dollar won't really from time to time. As a proxy for economic growth, there will be times in the coming years, let's call them false dawns, where the U.S. economy appears to be emerging from the slump, or is at least growing faster than Europe's sluggish economy. But the long-term trend for the dollar index is lower highs and lower lows. For gold and oil, it's just the opposite, higher highs and higher lows.

Speaking of highs and lows, our friend Dr. Joanne Nova at GoldNerds.com read our note yesterday about the challenges of deep-water drilling. But drilling deep is a challenge anywhere, even on land.

"Here's another perspective on the difficulty of drilling Brazil's new oil field a full 10km below the surface," Joanne writes. "Did you know the deepest hole ever dug reached down to 12km, but it took 19 years to get there? The Soviets started planning the Kola Superdeep Borehole in 1962 and began drilling in 1970 reaching the record depth in 1989.

"They initially aimed to reach 15km, but were forced to give up a few years after they set the record. Things were too hot, too strange, and too expensive. And this was not a hole designed to produce anything except interesting scientific papers. Twelve kilometers down, the rocks were under so much heat and pressure they behaved more like plastic than rock. The hole apparently kept flowing closed whenever they had to replace a drill bit. Makes production hard if the hole keeps disappearing."

Yes it does.

Incidentally, Australia's deepest on-shore drilling effort doesn't have anything to do with oil, gas, or mining. It is energy related though. Geothermal hopeful Geodynamics (ASX:GDY) finished drilling its Habanero 3 well in early February to a depth of 4,221 metres.

Even if you don't get all the way through the Earth's crust at that depth, it's still pretty hot down there, which is the whole point. Geodynamics hopes to be operating Australia's first commercial geothermal electric generating plant by the end of this year, with a capacity of 50 megawatts per year.

We know a bit about the project and the share because we tipped it in the Australian Small Cap Investigator. The credit crunch has not been kind to small-cap stocks in general or alternative energy stocks in particular. But if you look at these stocks in terms of their ability to generate future earnings, there is a lot to like. The assets should produce growing cash flows, and who doesn't like that?

We showed a chart a few weeks ago demonstrating that GDP growth and electricity are pretty well correlated. A growing economy needs its energy doesn't it? Australia's economy is growing and so are its energy needs.

Perhaps that's why Citigroup reckons Origin Energy (ASX:ORG) will grow its earnings by 16% a year for the next five years, according to Rebecca Keenan at Bloomberg. And perhaps that's why Britain's BG Group Plc. offered to buy Origin for $12.9 billion. That represented a 40% premium on yesterday's closing share price of $10.47. Proving that markets can sometimes be pretty darn efficient, Origin is up 37% in early trading.

As a trade, we might even consider shorting or buying puts. After all, Origin hasn't accepted the bid yet. But our interest isn't in trading these events, it's in anticipating them. BG's bid is based on asset quality and earnings growth. It's a stock picking story, not a China narrative, although the two are related. Take iron ore.

"Right now, I think this is the best stock picker's market in resources that we've seen for quite some time," says fund manager James Bruce in today's Financial Review. He could not be more right.

He was referring to today's breaking news that China's first-ever hostile takeover of an Australian company-Sinosteel's $1.37 billion bid for Midwest (ASX:MIS)-looks like it will go through. Midwest is in a trading halt this morning, suggesting an announcement could be forthcoming.

Sinosteel raised its bid for Midwest from $5.60 a share to $6.38 a share. This seemed to please the board of Midwest, which had been holding out for $7 a share. It probably doesn't hurt that, as Michael Vaughan reports in today's Financial Review, Sinosteel agreed to support the issue of 15 million options to two Midwest directors.

The exercise price on the options is $1.46. With the bid at $6.38, that means those 15 million options are worth about $73.8 million. That's a nice pay day, if you can get it. We've always said that owning your own business is the only real way to get wealthy.

"China was busy last night," writes Diggers and Drillers editor Al Robinson. "It closed the net around one little iron miner, and took stakes in a couple of others. It looks like Chinese steel mills are focusing on the leaders in the second tier of iron companies. By that, we mean the companies outside of BHP, Rio Tinto and Fortescue who have the best-developed assets.

The "other" company which Sinosteel appears to have set its sights on is Murchison Metals (ASX:MMX). Al has more details over at Money Morning. The entire mid West region of Western Australia is ripe for this sort of Sino-Japanese financing and takeover. The ore in the region is a little lower quality than the famous hematite of the Pilbara. The infrastructure doesn't exist yet, either, to move that ore from mine to port and on to points North.

On that score, keep your eyes on May 9th. That's the deadline for proposals to be submitted to the WA government for building out the iron ore infrastructure in the mid West. There are two major proposals, one backed by China and one essentially backed by Japan.

In the meantime, if you want to catch up on who the junior producers are in the mid West, you may want to introduce yourself to the Geraldton Iron Ore Alliance. Don't be shy. She's friendly.

There are seven firms in the alliance. Mount Gibson (ASX:MGX), MidWest (ASX:MIS), Gindalbie (ASX:GBG), Murchison (ASX:MMX), GoldenWest Resources (ASX:GWR), Royal Resources (ASX:ROY), Asia Iron Holdings (not listed), and Atlas Iron Limited (ASX:AGO).

Who will win? This is where we reach the limits of the free security analysis we provide in the DR. The heavy lifting and deeper digging goes on at Diggers and Drillers. We will tell you that valuing the companies comes down to looking at the quality of their assets and their ability to finance projects without a lot of debt.

Better hurry, though. "The Chinese invasion of corporate Australia is continuing apace with Chinese Iron and Steel Group announcing plans to lift its stake in outback prospector Apollo Minerals to 19.9pc, just short of the 20pc level that would require it to mount a full takeover under Australian law," according to David Litterick in Britain's Telegraph.

Dan Denning
The Daily Reckoning Australia

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