Big Aussie blue chips like Commonwealth Bank, Telstra, and BHP Billiton report their annual results this week. It is a contention of this version of the Daily Reckoning that corporate cash flows have been unusually high for the last fifty years - a combination of an explosion in credit and debt markets and the real economic activity the credit boom kicked off in the industrialised world and, lately, emerging nations like Brazil, China, and India.

The emergence of those economies as producers of capital goods and consumer goods puts pressure on prices for Western manufacturers. Meanwhile, legacy costs for Western firms (taxes, pension, healthcare etc) rise. All of this eats into cash flows, forcing them to revert to the mean (lower).

And let's not forget the credit boom has ended. Sure, global capital markets are not as broken down and frozen as they were last year. But trillions of dollars in capital has been wasted in speculation or sunk into bad investments (residential American real estate).

National governments are demanding a larger portion of global savings. Government welfare transfer schemes and bailouts have to be funded from borrowing (unless from money printing), which also makes capital harder for private companies to get. Corporate cash flows will revert to the mean in the absence of huge infusions of credit to finance the growth of the balance sheet.

So yes, the cash flows are coming, and in some cases, going. They will reveal which companies emerged from the last eighteen months of chaos with sound capital structures...and which are still vulnerable (not enough equity, too many dodgy assets not valued correctly). It may sound kind of boring. But for investors, taking a microscope to the balance sheet and income statement has never been more important.

Housing finance data for June is out tomorrow. That will be worth a look. Remember that the Reserve Bank has cut the cash rate by 425 basis points since last October. They remain at a 49-year low. By the way, what do you get when you cut rates by that much that fast? You get yourself a bit of a bubble in the housing market.

"Are we agreed that the proposal is crack-brained, absurd, could prove incalculably expensive, and violates every dictate of financial prudence?" writes Robertson Davies in "The Lyre of Orpheus." We picked up a copy in Fitzroy Street and ran into that line. It could apply to a great many things.

Speaking of crack-brained schemes, the Australian is reporting that credit unions are looking to the superannuation industry has a source of liquidity for making home loans. "If the fund gets the green light, it will give credit unions an important alternative source of funding to expand their market share in home lending, now at 7per cent," reports Adele Ferguson.

It's another example of forced speculation. The Big Four banks source their home loan funding from capital raisings (guaranteed by the government) both domestically and overseas. The borrowed money goes into commercial and residential property. Banks make a mint, and the liquidity drives prices up which drives more people into property, keeping up demand for more bank loans (and keeping stamp duty coffers full for state governments).

The credit unions want a piece of that action. And why wouldn't they? If the government, the banks, and the regulators rig the housing market so that it's the preferred destination for foreign capital, smaller competitors can't be blamed for wanting to get in the game. It's where the easy money is made.

Of course this could be the mother of all bad capital allocation decisions for Australia. You'll have a larger share of superannuation money going into the housing market. An increasingly large share of the nation's income will be tied up in residential housing. This confirms what Dr. Steve Keen said recently at our Debt Summit. "Americans traditionally speculate on stock prices. Australians speculate on houses," he said. (By the way, the transcript of the Summit should be available this week).

What made the housing boom so unusual in America, he pointed out, is that it was one of the first time's Americans speculated so wildly on houses. Prior to the last twenty years, house prices never went up much faster than the rate of inflation. They were consumption assets. Not financial assets.

The lowering of interest rates by the Fed and the explosion of non-traditional mortgage lenders changed the financial incentives just enough for Americans to abandon prudence and start gambling with houses. It ended - is still ending in fact - in what we once called the total destruction of the U.S. housing market.

As we told a Diggers and Drillers reader last week, "A report from Deutsche Bank reckons that by 2011, nearly half of all U.S. mortgages could be underwater with negative equity. Further price falls, the Bank reckons, will wipe out the little equity that large swathes of the market currently have. Once the equity in the house is gone, there's no reason for the borrower to hang on. In the States mortgages are non-recourse loans, which means the lender cannot chase up the borrower if the borrower decides to walk away."

"Why does this matter to junior resource stocks? It was the original fall in U.S. house prices that kicked of the credit crisis. The fall in home values wiped out bank collateral and rendered into junk a lot of the securities that were made up of subprime U.S. home loans. That episode brought the global financial system to the brink of ruin."

"The market is telling us that the system has recovered from its near-death experience. In fact the market is obviously pricing - in a robust recovery in earnings, which itself implies a return to normal economic life. No one, apparently, is considering the possibility that further losses in U.S. real estate could again trigger a capital collapse in global financial institutions. But it's a real threat!

"Australia's banks appear to have minimized their exposure to losses from U.S. real estate. But what did happen in the last year is that the capital crunch led Aussie banks to be a lot more conservative in their lending to the mining sector. The mining sector responded by tapping the equity markets directly and bypassing the banks. But some companies were left exposed an unable to fund their projects or roll over loans."

"That's exactly the situation that could happen again. At least it's something you have to consider. The supply of capital to the mining sector looks stronger. But Australia is a net importer of capital. Its strategic weakness has been exposed and not fully repaired."

Dan Denning
for The Daily Reckoning Australia

• Equity Premium Will Be Replaced With a Tangible Asset Premium
• Negative Equity Becoming the Norm in U.S.A.
• More Money in Cash Right Now Than Equity in U.S. Companies
• The Coming Oil Back Draft
• Irish Govt Pledges Bailout, Who’s Next?

That is quite some feat. We write of course, on the subject of the BHP Billiton/Rio Tinto story.

Aside from all the benefits that a takeover would have brought to BHP, the big point to take from it is that even mega companies are reluctant to add debt to their books at the moment. And it also gives an indication that if it is troublesome for the likes of BHP and Rio to raise money in this market, think about the smaller companies and how they must be faring.

An example of this is one of the companies in our Australian Small Cap Investigator (ASI) portfolio. Last week it released details of a new joint venture deal it had entered into. Three days later the window closed for shareholders to pick up more stock in a capital raising.

The result was that the company raised less than 40% of the capital is was hoping for. If it was twelve months ago we are sure they would have raised the full amount. Fortunately, the company in question does have a Plan B. But many small companies out there don't. If they can't borrow from banks and can't raise additional capital from shareholders, it makes it very hard for smaller companies to invest in growing their business.

On the other hand, that is one of the reasons why rather than stepping back from looking at new investments for ASI, we are actually ramping up the coverage in the New Year.

The credit markets will eventually recover, but it may be slow. However, even before this becomes obvious to the market many small cap companies will have already taken advantage and should surge ahead in price.

In our view, we believe the next six months will be the best time in years to pick up undervalued small cap companies.

Kris Sayce
for The Daily Reckoning Australia

• The Fourth Biggest Iron Player in Australia
• Normally Small Businesses Lead the Economy Out of Recession
• One of the Biggest Humbugs in Capitalism is Private Equity
• Assets Race to the Bottom
• Why an Energy Crunch Could Lead to Booming Profits in “Solid Electricity”

The government wants people to understand their money is safe in the banks. That's why that last bit is in there. It's designed to keep foreign holders of Aussie dollars from engaging in a run on the dollar and bringing their money home, wherever home might be (Japan, for example).

The Australian dollar is up in early trading. But its huge slide in just a few months is remarkable. It's good for exporters (especially farmers). Aussie agricultural goods now become relatively cheaper on foreign markets. It's not as good for consumers, who could see higher prices on imports (and there are a lot of imports in the consumer goods sector of the economy).

The big question, of course, is how shares will react to the weekend's events? So far so good. They're up 6% in early trading.

Polling the crowd this weekend and the Melbourne Investment Expo, we got the impression that there was a bit of capitulation on Friday. Investors who could not afford to lose anymore capital may have exited the market during the big 8.3% slide. Fear gave way to abject terror.

There may also be another reason-aside from the panic in the banking market-for Friday's frenzied selling. When Lehman Brothers was allowed to fail, it defaulted on some US$130 billion in senior debt. Against that debt, hedge funds and other Wall Street investment banks had sold some US$400 billion in credit default insurance.

Remember, anyone can sell credit default swap (CDS) insurance. It's a little like writing options. You collect the premium and hope you never have to pay out on the policy. So firms like Goldman Sachs (NYSE: GS), JP Morgan Chase (NYSE: JPM), and Morgan Stanley (NYSE: MS) sold huge amounts of credit insurance against default in Lehman bonds.

One theory making the rounds last week was that those investment banks and hedge funds were selling assets and hoarding cash in preparation for judgement day on how much of that insurance they would actually have pay out. An auction was held last week to determine the value of the outstanding Lehman CDS.

Based on the results of the auction, it looks like anyone who sold default insurance on Lehman bonds will have to pay out around 90.25 cents on the dollar to the holders of the CDS. Obviously, that could be a huge number, based on the gross value of the CDS outstanding ($360 billion). But if the banks and hedge funds have already hedged against their risk in writing these credit default swaps, it won't be any big deal.

If, on the other hand, you were a hedge fund selling CDS on Lehman's debt without making any provision that you'd actually have to pay up, well you, my friend, are in a sorry state. And you were probably selling assets like cheap underwear to raise cash last week. What does any of this have to do with the Aussie share market?

Blue chip Aussie mining shares like BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) and OZ Minerals Limited (ASX: OZL) have been the darlings of hedge funds wanting to own commodity stocks. The Aussie dollar has also been a popular commodity currency and yield play. If hedge funds and investment banks were liquidating commodity positions to raise cash for the Lehman CDS auction, it would most likely hammer Australian stocks.

That's one reason Aussie stocks fell much harder on Friday than stocks on Wall Street. Australia has a high percentage of stocks that were attractive to leveraged speculators when commodity prices were high. Now, those assets have seen a large amount of selling. With the Lehman CDS auction behind us, will the selling end?

We'll see. Beyond Lehman, there are the larger issues in the global financial system. On that score, politicians in Europe raced against the opening of global markets this morning. They announced a package of reforms that would: guarantee interbank lending, guarantee debt issued by banks until 2009, give government's permission to buy preferred shares in banks, make provisions to directly recapitalise any banks that were deemed "systemically critical."

While the Euro nations try to unfreeze the banking sector by effectively guaranteeing all lending, regulators in the U.S. and the U.K. are taking similar steps. The British government will take controlling stakes in the Royal Bank of Scotland and HBOS Plc. The Brits have also decided to inject about A$125 billion in capital directly into the banking system.

We covered the big-picture implications of this policy response in yesterday's special Sunday edition of the Daily Reckoning. If you missed it, you can find it here (Australian Resource Shares, What's Next). But it's not hard to see what's going: government guarantees to all bank lending, and direct, unsecured government lending to anyone who asks for it.

Will putting more money (credit) into the hands of those who created the problem in the first place actually help? Probably not. As Jim Rogers told CNBC, it's setting the stage for an 'Inflationary Holocaust.' It's hard to believe at first that the current deflation in financial assets will give way to astonishing inflation. But that's just what we expect to happen.

Specifically, governments will boost lending to the private sector via central banks. You can also expect direct stimulus for households via rebate packages and tax breaks. In the long-run, big government spending programs on public works, infrastructure, and energy are a certain political winner.

And where will the money come from? Good question. It will be printed or borrowed into existence. Money supply will rise. And with the banking sector effectively nationalised, private investors will look for a real hedge against the inflation being unleashed.

We would take a strong look at over-sold Aussie oil stocks right now. Not only are they over-sold from a technical perspective, but the oil price has nearly halved from its highs earlier in the year. You may not get a better chance to buy them at this price.

Of course, if the market gets any worse than it got last week, it will no longer be the worst financial crisis since the Depression. It will be the worst financial crisis of modern times, full stop. If that is the case, it marks the end of one era and the beginning of another.

In the meantime, however, you could do worse than build a "Robinson Crusoe" portfolio. That is, when his ship ran aground and all his colleagues were lost at sea, Crusoe spent three days salvaging anything from his ship that would be of use in living on his deserted island. His misfortune was severe. But he had enough sense to realise the ship contained items that would be essential for his survival after the shock of his shipwreck.

The stock market offers you a similar opportunity, once the selling abates. You will get an excellent chance to buy Australia's best shares at very low prices.

Dan Denning
The Daily Reckoning Australia

• The Asian Banks Have Finally Been Heard From
• Short Selling Ban May Kick Off Market Liquidation
• $4.1 Billion in Investor Funds Have Been Frozen Overnight
• Big Australian Resource Stocks Up 24% in 2008
• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?

First, the big fish. "With iron ore prices rising explosively," says China's National Development Reform Commission (NDRC), "many domestic firms are very enthusiastic about investing in overseas mines, which needs strengthened macro guidance from the country."

Macro guidance is about what you'd expect from a nation that has methodically and with stunning success, pulled itself from centrally planned poverty to centrally planned prosperity (at least for some). But what does 'macro guidance' mean? GPS? RFID?

Today's Australian has all the intriguing details on China's Grand Strategy towards Australia in a story titled, "Beijing takes over BHP raid plans." The comments from the NDRC are a fascinating take on how at least some Chinese officials think capitalism works. "Globally, iron ore mines that are of high quality and easy to exploit are basically in the hands of major multinational companies. Our firms need to pay a high cost to mine iron ore resources abroad. Their exploitation risks and costs are increasing."

Is it really 'exploitation' to pay the market price for natural resources? Or is that just the language of socialism? Perhaps a crash course on free market economics is in order for the NDRC.

Not to sound too condescending (this coming from someone who uses the royal We), but you have to wonder if there is some wishful thinking going on in Beijing. Or maybe, after having lost money in Blackstone and Bear Stearns, state backed firms are wary of buying equity chunks in public companies. Maybe they want a different arrangement.

Either way, it is clear the Chinese have woken up to the fact that the century is theirs for the taking. But there seems to be some confusion about what rules the century is going to operate under: will it be mostly free market rules...or other rules. The market price for the resources China wants is rising. So it would prefer to not pay the market price.

By the way, we reckon free markets are headed for a bit of a bear market. Globalisation, in the bastard form we find it (where trade isn't really free and currencies are manipulated regularly) has produced US$114 oil, massive inflation, the worst credit crisis since 1929, food riots, and a growing popular backlash. Expect more direct government intervention and regulation in financial markets and, perhaps, resource markets. That should play right into China's hands, actually.

This latest line of probing rhetoric coming from China is not exactly a new line of attack. After all, the resources are there for the taking on the public markets. There's no need to attack at all. But it does feel like an attempt to flush out Australia's politicians and get them more involved in China's plans for Australian resources. The government is already involved, of course, with the Takeovers panel quashing the bid by Shougang Steel and APAC resources to take a 40% stake in iron ore up-and-comer Mt. Gibson (ASX:MGX).

Let's put this whole affair in the context of steel and GDP. We found the chart below yesterday while preparing for a radio interview with a Canadian business show. The host wanted to know how steel companies could afford to pay a 300% increase in coking coal prices and a 75% increase in iron ore prices. We asked him to picture the chart below.

Steel and GDP, Marching Hand in Hand

Source: Mining and commodities exports, Angelia Grant,
John Hawkins and Lachlan Shaw, 2006

The chart shows that world steel production leapt ahead of GDP growth during the two big periods of Asian industrialisation of the last 50 years, in Japan and Korea. With China now industrialising, and coming off a much lower base in steel production, a period of growth in steel production that exceeded world GDP would be quite the spectacle. It would also mean China's consumption of base metals is just now hitting high gear.

From an Australian perspective, what's so flabbergasting about the chart is that both Korea and Japan have been devoted customers of the black coal from the Bowen Basin that is so well suited for coking. They've also been tied up for years as customers of Rio Tinto and BHP for the iron ore that comes from the Pilbara. Now you add China to the queue.

Despite its surge to the top in terms of global steel production, China's individual steel firms are still smaller, at least according to the latest figures from the International Iron and Steel Institute, than Japan and Korea. Nippon Steel, Posco, and JFE are all bigger producers than Baosteel. Keep in mind, however, that as recently as 2002, China was a net steel importer. It's now a net exporter.

Source: International Iron and Steel Institute

You could argue that Japanese and Korean steel production might decline as those economies age and become more service oriented. Yet major industries in both countries, including ship building and heavy equipment, are massive users of steel. And as of 2005, Japan ranked behind the EU as the world's second largest exporter of steel.

More likely than declining steel production by Japan and Korea is that they will compete for market share with Chinese producers. And the producers in all three countries don't seem to have batted an eyelash at higher input prices. That may be because they'll simply pass those higher prices right on customers. Steel prices are up by about 10% this year already.

But if you're wondering why steel producers don't seem panicked by rising coal and ore prices, there's probably a simpler explanation: there's a bull market in steel. When you combine the industrialisation going on in India and China with the massive commercial, residential, and industrial build-out in the Middle East (rebar prices are up 65% in the UAE this year), you get a pretty bullish case for steel producers. Consumption is rising at an enormous rate.

Australia ranks 22nd in terms of global steel production. Despite having an abundance of the two main inputs (coal and ore), the country, alas, has only 20 million people. Its demand for steel is low, which is why no single Aussie firm dominates the global steel-making stage. And so Asian steel producers have essentially outsourced their raw material requirements to the Pilbara, the Bowen Basin, and the Hunter Valley.

If you want to keep tabs on this three way competition for Aussie resources, watch the battle for infrastructure project at Geraldton. This projects brings rail and port access together to open up the lower-grade iron ores in the Mid West.

One project, put together by Yilgarn and Midwest (ASX:MIS), is embroiled in all sorts of intrigue. But with Sinosteel as the main JV partner of Midwest, this can be viewed as the Chinese project. The other proposal is backed by Murchison Metals (ASX:MMX) and Mitsubishi. It's the Japanese project. Korea is not represented, as far as we know.

To what lengths will Rio Tinto (LON: RIO) go to fend off the BHP takeover offer? Rio shares were up in London overnight by 6% on rumours that BHP would raise its share offer to 4-1 (currently 3.4 for 1) or ad some cash into the pot.

Rio and BHP keep quarreling over whose assets are better. With crude oil futures in New York cresting US$114, BHP is playing up its oil and gas assets. Rio managing director Tom Albanese is having none of it. He presented production figures from Rio's first quarter poured a cold latte all over BHP's oil story.
"I've seen numbers that would indicate to me that BHP Billiton's oil business is about 60th ranked in the world in terms of size...I would certainly rather be the leading player in the aluminium sector than the 60th ranked company in the oil and gas sector."

That's a nice quote. But it's a bit disingenuous isn't it? Size doesn't matter so much in terms of production. It's what you're getting for what you make. Just ask the coal producers on the East Coast. They're actually producing less coal for export this year due to infrastructure bottlenecks and flooding. But with higher contract prices, export earnings will go up on declining production volumes. That's not exactly how you'd draw it up. But you'd take it, wouldn't you?

Rio is even talking up its zircon assets in an effort to bolster its defences. The company revealed it found a big deposit of zircon-rich material in Victoria in East Gippsland. We laughed at this because we joked around the office yesterday about rising zircon prices. Mineral sands are intriguing, not least because James Packer and his lot have recently sold off their position in Iluka (ASX:ILU).

We are not so much interested in zircon as we are in rutile, titanium, tantalum, and lithium. We've been digging through the juniors in our research at the Australian Small Cap Investigator and have found the pickings slim, although there are a few plums there. Rio rightfully calls itself a world class explorer. But we doubt its zircon assets are going to fend off a persistent BHP.

The real bombshell from Rio's announcements yesterday is that it will sign a deal with Saudi Arabian Mining Company to build a giant aluminium complex in the Kingdom. The complex will include the whole aluminium chain, a power generation facility, an alumina refinery, and an aluminium smelter.

As we argued in a recent newsletter, aluminium is the most energy-intensive of the metals. Its production is migrating from cheap energy-challenged areas (China and South Africa) to energy-abundant areas (the Gulf States). The Saudi smelter will produce 617,000 tonnes of the metal each year, making it one of the world's largest. It will cost US$7.5 billion to build.

Rio didn't say how much it would get of that US$7.5 billion. But between Rio, Worley Parsons (ASX:WOR), Leighton (ASX:LEI), and a host of other Aussie mining services and infrastructure companies, the move by the Saudis into minerals and metals production should be good news for Aussie firms. Our preferred play on aluminium continues to be bauxite, the ore from which alumina is made, which later is smelted into metal.

The votes are running 20-1 in favour of more technical analysis. Ask, and ye shall receive, only it will probably be over at Money Morning. We want to make a home for Gabriel Andre's analysis of global indices, Aussie indices, and individual shares. But after careful thought, we believe that kind of approach is more suited to our sister e-letter, Money Morning.

The DR will stick with its skeptical end-of-the-worldism while Gabriel and Al Robinson over at Money Morning track money flows, moving averages, and the technicals (which are often described as the 'language of the market'. Watch this space for further details and feel free to write in with your suggestions to dr@dailyreckoning.com.au

How do you become a Decamillionaire? Easy! Move to Zimbabwe. Maybe it should be called a "Zimmillionaire." Reader Luke in WA recently came into possession of a paper currency note from Robert Mugabe's fiefdom. It had no watermarks and an expiration date. Luke placed it next to a gold coin to show DR readers the difference between real money and government fraud. Thanks Luke!

Dan Denning
The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Chinese Foreign Mining Acquisition Equal to All of 2007
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• BHP Billiton (ASX: BHP) to Report Second Half Results Today

Rio Tinto (ASX: RIO) out-punched BHP Billiton (ASX: BHP) in the half-year-results contest. Rio Tinto reported $8.3 billion in "underlying profit." Diggers and Drillers editor Al Robinson looks at BHP Billiton side-by-side with Rio Tinto and says, "Both had negative earnings growth at the bottom line (BHP Billiton -2.8%, Rio Tinto -1%). Both had positive earnings after strategically removing a few significant items (2.8%, 2%).

"Rio Tinto's result was slightly above expectations, and BHP Billiton's slightly below," Al says. "The two 'slightlys' add up to a 'significantly', as Rio Tinto will tell you. Rio Tinto says it has a much a better future growth profile than BHP Billiton and will profit more quickly from rising iron ore and aluminium prices."

Albanese says Rio Tinto's "stellar" year comes from the "three pillars" of its business: iron ore, copper, and aluminium. Rio Tinto reached production records last year for ore, copper, bauxite, aluminium, copper, and gold.

Everyone knows that the contract price for iron ore will probably go up by at least 50% this year. Rio Tinto increased production in Western Australia. It also recently announced its plans to develop the Simandou deposit in Guinea. The company says mineralization there indicates 8-11 billion tonnes of high grade hematite ore, with targeted annual production of 70 million tons per year year.

Look on a map and you'll see that Simandou, on the West Coast of Africa, is a long way from China, where Rio Tinto's chief ore customers are. "Over the long term," Albanese said, "we have outlined our capability to produce 600 million tonnes... annually, based on an unrivalled and unconstrained Pilbara port and rail infrastructure and our extensive global resource and mineralisation position."

Hmmn. There's a big difference between capability and actuality. But Rio Tinto's point is well-taken. It's more leveraged to an increase in ore prices than BHP Billiton and thus, BHP Billiton should, you know, sell its oil assets already and pay more cash for Rio Tinto's ore assets. At least that's what Albanese seems to be saying if you read between the lines.

Here's a thought, though. Maybe Rio Tinto's choicest assets aren't its iron ore assets but its bauxite and aluminium assets. Hold your scorn for a moment.

We know that aluminium has lagged (badly) copper, zinc, lead, and iron ore prices (see chart below). But we reckon that could change in the next 18 months.

Source: International Monetary Fund (IMF)

Aluminum has trailed the other metals thanks to massive increases in Chinese production of the metal. A fall-off in U.S. demand from the housing bust has been more than compensated for by rising Chinese demand. To meet that demand, China has ramped up domestic production. Increases in China's smelting capacity have flooded the world with cheap aluminium and held prices down.

Granted, the main material for ingredient, bauxite, is abundant and usually pretty easy to find and mine. It's not like finding and digging for gold. But there's a catch.

It's power. The big cost for aluminium is electricity. Aluminium is sometimes called "solid electricity" because of the amount of juice it takes to smelt it.

Producing an energy-intensive metal in an energy-scare world is not a long-term strategy for mega profits. You can see where we're going with this. The Chinese electric grid is already strained. With rising thermal coal prices, China is paying more to keep its fleet of coal-fired plants operating. It is already cutting back aluminium production to divert electricity to other industrial and retail users.

Our point?

This year, we may a shift in global aluminium production away from places where electricity is generated by coal (China) and TOWARDS places with cheaper, or even renewable sources of energy (North America and the Middle East). In the interim, however, it makes sense to us that reduced Chinese production may favour the share prices of some North American and Australian producers.

That's a very short list, mind you. Right at the top is Rio Tinto, which looks to have another card to play in its game of poker with BHP Billiton. Another beneficiary will be Alcoa (NYSE:AA), the Pittsburgh-based producer.

Everyone thought that BHP Billiton would bid for Alcoa after Rio Tinto bought Alcan. But BHP Billiton went straight for the bigger prey, leaving Alcoa out alone in the cold North American winter, looking for a little love.

Because its Valentine's Day, let us speculate that Alcoa may soon receive some love from a larger bidder (Anglo-American, Vale, or Xstrata). Actually, looking at the chart below, it's clear that someone fell in love with Alcoa yesterday. The stock was up 6% on the day and closed within kissing distance (a chaste kiss, mind you) of its 100-day moving average. Hmm.

Smooch! Alcoa (NYSE:AA) Moves up towards 100-day Moving Avearge

The other part of this story is more complex and more strategic, so we'll have to save it for another day. But the short version is this: if China is cutting aluminium production because energy is getting more expensive, it could mean aluminium production is migration to parts of the world where energy is cheaper. And where could that be?

Try the Middle East, where over US$20 billion worth of aluminium smelters are being built by the likes of Dubai, Saudi Arabia, Qatar, and Oman. The Saudi's say aluminium could become the "third pillar" of an industrial base built on oil, gas, and petrochemicals. Remember, Saudi Basic Industries Corporation paid US$11.6 billion last year for GE's Plastics Unit.

Say what you want about the strategy of diversification away from oil and energy towards metals and plastics. But doesn't that seem like a better investment than recapitalizing American financial institutions?

Everyone has known that plastics are a great business since Mr. McGuire tells Benjamin (played by Dustin Hoffman) to get into them in "The Graduate." That was 1967. Mr. Mcguire was just thirty years early. But the Saudis as aluminium makers? Think about it.

And while you're at, think about how much closer Saudi Arabia is to Guinea than China. Guinea is home to some of the world's richest untapped bauxite deposits. For now.

And how goes the bear in credit? Add the "auction securities market" to your list of toppling credit dominoes. "A collapse in confidence in a $330bn corner of the debt market has left US municipalities and student loan providers facing spiraling interest rate costs. The implosion of the so-called auction-rate securities market is the latest incarnation of the credit crisis," reports today's Financial Times.

"Its slump this week has pushed interest rates as high as 20 per cent for bodies such as the Port Authority of New York & New Jersey to a Minneapolis hospital. 'The auction securities market is falling apart,' said David Cooke, chief financial officer at Park Nicollet Heath Services in Minneapolis. Municipal borrowers are scrambling to seek letters of credit from banks and other new sources of finance, but anxiety in the credit markets and uncertainty about the stability of bond insurers is making this difficult."

Just what the banks needed. Credit is tight already. But hey, that's what happens in a bear market in credit. During the boom, financial institutions grew earnings by expanding their balance sheets through leverage (borrowing money cheap, lending it dear).

In the bust, everyone downsizes, retreats, retrenches. The only things that grow in a bear market are fear and volatility and the list of mistakes made by central bankers. Asset-based wealth generation... not so much.

Dan Denning
The Daily Reckoning Australia

• None Found

BHP Billiton Podcast

----------

Podcast Transcript: This is Al Robinson from the Daily Reckoning in Australia.

Resource investors world-wide eagerly awaited today’s release of annual results from Melbourne-based BHP Billiton (ASX: BHP), the world’s second largest diversified mining company.

BHP Billiton's U.S. listing (NYSE: BHP) climbed by 18% in the last two weeks on a rumour that the company would upgrade its gold resources at its Olympic Dam mine in South Australia enough to make it the largest gold mine in the world.

What exactly did the company reveal in its annual report today? Specifically, how large was the upgrade in the resource base, will those resources become reserves, and what is the short-term and long-term impact on earnings and, more importantly, the stock price.

BHP upgraded resources at Olympic Dam to 7.7 billion metric tonnes from 4.4 billion, a 75% increase. The resources in question are uranium, gold and copper.

The more important number may be 6.7%. That’s the increase in the amount of material that can be economically mined at the site. On face value this may seem like a modest increase when compared to the 75% boost in resources.

But mining companies are required to scrutinise ore samples more closely when determining economic feasibility, as opposed to the mere existence of material.

As BHP conducts further drilling at the site, its reserves will gradually increase as Olympic Dam approaches full production in 2013.

It’s too early to quantify precisely how much of the new resource base will translate into actual reserves. That said, analysts here expect reserves to increase by as much as 3 times.

What is the short-term impact of the official announcement?

The upgrade isn’t likely to significantly affect earnings. Business earnings are a function of revenues and costs, but at this stage nobody even knows for sure if an expansion at the site is feasible.

BHP is in the process of conducting testing to determine whether it’s worth investing more cash in the mine to increase production.

If it does so, the positive effect on earnings will accrue as the company increases infrastructure and capacity. The outlay involved would be AU$6 billion; this would have a negative effect on profit growth in the short term. However, in the long term, higher production will mean greater sales.

BHP’s planned expansion at Olympic Dam could increase copper production two-fold, and uranium production three-fold. Copper uranium and gold are at historically high price levels. But the real benefit from the mine is to the bottom line of BHP’s base metals unit.

The stock price should continue to follow the long-term increase in earnings. But investors will also attempt to anticipate the future. As BHP makes more resource and reserve announcements, its share price will adjust to reflect greater probability from higher future production.

Ignoring short-term volatility, we believe the company’s long-term market value will increase as the mine is expanded and as the pipeline of new projects enters production.

While the upgraded resource base at Olympic Dam may not begin benefiting BHP’s bottom line for a few years, the company has an impressive portfolio of producing assets and new assets in the pipeline that investors may not be aware of.

The company has 33 projects either in the execution or feasibility phase. Those projects represent US$20.9 billion in capital investment. The company reports another list of medium-term projects requiring $50 billion in investment.

BHP’s long-term price forecasts for commodities are clearly bullish. What may surprise some investors is the diversity of BHP’s asset portfolio and the composition of its earnings.

The base metals group—which includes copper, lead, and zinc—generated $6.9 billion pre-tax earnings in the last year. Stainless steel—driven by BHP’s Ravensthorpe and Yablu nickel operations in Western Australia—contributed $3.6 billion.

Oil from the Bass Strait in the South and BHP’s share of the LNG project in North West shelf contributed $3 billion in pre-tax earnings for the company, and makes BHP a beneficiary of rising oil prices.

The Iron Ore group in West Australia—which represents BHP’s direct connection to demand for steel-making materials in China—generated $2.7 billion in pre-tax earnings. The other operating groups, Aluminum, Metallurgical Coal, Thermal Coal, Maganese , and Diamonds and Specialty products produced a combined $3.9 billion in pre-tax earnings.

While Olympic Dam gives BHP potential gold assets going forward, its chief assets are its iron ore deposits in West Australia, the Cannington silver, lead, and zinc mine in Queensland, and one of the world’s largest copper mines in the world with the Escondida mine in Chile, where BHP is a 57% stakeholder.

BHP’s quality assets and long-list of development projects are indicative of an even larger boom taking place in the Australian Resources sector.

The Australian Bureau of Agricultural and Resource Economics estimates $43 billion in capital spending for new resource projects in the next twenty four months.

For continuing coverage of that story, stay tuned to http://www.dailyreckoning.com.au.

Al Robinson
The Daily Reckoning Australia

• None Found