We were thumbing through the transcript last night over some sashimi and a beer and highlighted this passage from Dr. Steve Keen: We are told that for example debt doesn't matter because if a company takes out a certain level of debt, say a very low level of say 10% debt to equity, that's irrelevant to the company's value because the person buying shares in that company can take out 90% debt to equity ratio."

"Therefore you're told the Modigliani-Miller proposition, after the two morons who got the Nobel prize for it, was that the level of debt that a company takes out does not affect its value. And those sorts of propositions are strewn through conventional economic theory, and of course people like Alan Greenspan and Ben Bernanke are experts in that very same theory."

See? Bernanke...Greenspan...morons, all of them! Debt does matter. And so do deficits. Just this morning we read that U.S. President Barack Obama will ask the Senate to lift America's statutory debt limit to $13 trillion. It's at $12.1 trillion at the moment.

The lower legislative body of the Congress, the U.S. House of Representatives, passed a measure lifting the debt ceiling earlier this year. But it used a parliamentary trick to do it in a manner which did not require a roll call vote. No jack asses had to go on the record.

The Senate is different. There are just 100 of the grumpy old men and women. And to increase the debt ceiling to accommodate annual deficits of over $1 trillion for the next ten years (it's $1.6 trillion this year) the Senator will have to go on record. Spending other people's money is generally easy (and probably kind of fun). But not when you have to publicly commit to it and "own" the debt. No one wants to own it, even though everyone wants to benefit politically from the spending (sound familiar?)

The investment fallout from the record U.S. debt and deficits is continued pressure on the dollar and $1,000 gold. Old yeller metal dragged itself up $2.50 in the futures markets to close over the $1k in New York trading last night. Gold has done this despite a 50% rally in stocks. We reckon once the punters catch a little gold fever - which they will if it can hold the line at $1,000 for a few days - higher highs will follow.

And let's not forget large owners of dollar-denominated assets like stocks and U.S. Treasury bonds. Do you reckon they're getting a touch nervous? Cheng Siwei, a Chinese official attending a conference at Lake Como in Italy, said he was worried about the Fed's indefinite policy of credit easing.

"If they keep printing money to buy bonds it will lead to inflation," Chen said. "And after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies... Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets."

In the meantime, why not try iron ore and uranium? Reuters reports that, "Chinese state-owned firms expanded their footprint in Australia's mining industry on Tuesday, agreeing to help fund two iron ore explorers in return for supply contracts and taking a controlling stake in a uranium prospector." The iron firms involved were FerrAus United Minerals both of which formed relationships with China Railways Materials Commercial Corporation. The uranium deal was between China Guangdong Nuclear Power Holding Co. Ltd and uranium prospector Energy Metals.

These deals are probably both operational and strategic. They're operational to the extent that in exchange for capital, Chinese firms get long-term supply contracts (price certainty) for key minerals and bulk commodities. They're strategic to the extent that State-owned firms can channel U.S. dollar reserves into tangible assets. This slightly reduces China's risk to the inevitable devaluation of U.S. debt securities through inflation.

Getting back to Cheng, he seems to understand exactly what happened over the last five years. Loose credit is the problem. "This is where Greenspan went wrong from 2000 to 2004," he said. "He thought everything was alright because inflation was low, but assets absorbed the liquidity." He's talking about real estate and stock markets.

He's also talking about the psychological and moral attitude in a country that's obsessively focuses on preserving its immediate lifestyle at the expense of future investment and growth. "The US spends tomorrow's money today...We Chinese spend today's money tomorrow. That's why we have this financial crisis."

Of course whether your Chinese, American, or Australian, it's everybody's crisis now. So what should you do?

Inflation has yet to really rip through the commodities sector. As Bill pointed out yesterday, the U.S. dollar has yet to really crash. It may do so only gradually. U.S. creditors are not exactly easy to cause a run on the dollar. They have a lot to lose. And we know the Fed and Tim Geithner and Barack Obama want a gradual devaluation, not a dollar crisis.

Will they get what they want? We don't know. But we reckon the Law of Perverse Outcomes applies here: people get not what they expect, but what they deserve.

For investors, we'd say again that markets are priced for earnings growth that we think won't materialise. It's wishful, almost nostalgic thinking. That means you should be on your guard for locking in paper gains since March with trailing stops. We're pleased that Gabriel Andre is just about ready to debut his new ASX 200 blue-chip timing service this week. The aim is to track the chart patterns and technical trends on the biggest Aussie stocks in order to avoid buying at the top.

But the big benefits - he hopes to prove - are the ability to take profits on long-term holdings and avoid the big declines we've seen over the last two years. Then, using the same analysis, Gabriel believes you can time your entry back into the same stocks. It's quite a proposition.

Of course, anything that looks or sounds like market timing probably makes a buy-and-hold investor really nervous. But it's time to question the conventional wisdom that buying and holding blue chip stocks is a guaranteed retirement strategy. It's not.

If we've learned one thing in the last two years, it's that the stock market is not a retirement machine. The name of the game is to generate gains. And we are at least open to the idea that it may be possible to make better gains as a medium-term trader of ASX 200 stocks than simply buying and holding for grim death.

On the other hand, there are some very exciting disruptive energy technologies that have a huge upside if you can stomach the risk. Woodside Petroleum Don Voelte took a swipe at those technologies in a recent article published locally. And for good reason. He's got a bit to worry about. More on disruptive energy technologies tomorrow...

Dan Denning
for The Daily Reckoning Australia

• American Family’s Share of Government Debt Now Over Half a Million Dollars
• The Very Large Bubble of Government Debt
• Uranium: A Carbon-friendly Substitute for Coal
• In a Bear Market Most Stocks Go Down, So What Do You Do?
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis

By the way, what has happened to Stern Hu? He's disappeared from the front pages of Aussie papers. As far as we know, he's still being held in jail without charge. Do you reckon the writ of habeas corpus exists in the Chinese legal system?

Speaking of jails and steel, BHP says Chinese iron ore imports are recovering and spot iron ore prices are up 38% year-to-date because of the resurgence in Chinese demand. China's Ministry of Transport says iron ore imports to major Chinese ports were up 35% in July from a year earlier. That's a lot of steel.

But is it too much?

Is it possible China's steel industry - which is hovering up so much Aussie iron ore - has excess productive capacity? Would demand for iron ore be lower if the Chinese steel industry were more efficient? And what effect would that have on the Aussie ore industry?

We'll answer some of those questions in a moment. But first this from the 21st Century Business Herald, "Mr Xu Lejiang Baosteel chairman also confessed the existing of both structural and periodical overcapacity in China's steel sector. The former refers to the heavy polluting and energy-intensive capacity like construction steel, and must be weeded out. He said that while the latter points to those redundantly advanced capacities that cannot find sufficient demand like ship plate."

"China's steel output has taken up 48% of the world's total in the H1 of this year, further exacerbates the oversupply picture and hurts the healthy industrial development. And Mr Roland Verstappen vice president of ArcelorMittal also said steel overcapacity is quite clear in China and which will press down steel prices, sweep smaller mills out of the market and causes unemployment."

Full employment is a political objective in China, and probably dictates a fair bit of economic policy making. But if Roland Verstappen and Xu Lejiang are correct and China has too much steel capacity, we reckon it's something Aussie ore juniors (and their investors) should keep in mind. Of course for there to be a contraction in Chinese steel production, there'd have to be a policy shift...or the entire Chinese economy would have to contract/implode for a period after the popping of its own credit bubble.

But let us leave aside the bubble fall out in China for another day. Let's get back to Australia. BHP and Rio are larger suppliers to major steel makers. They'd be fine even if Chinese demand fell for a while. But the smaller ore outfits who have made supply deals with smaller mills...they might have a rougher time of it.

By the way, we don't have time to get into it in detail today, but yesterday we said to keep your eye out for tangible assets at good valuations. By that, we were referring to companies with net current assets at or in excess of their market capitalisation. It's more complicated than that. But we'll have to expand on it next week.

Some reader mail?

--Hi,

Peter H.

Good questions. Answers can be sent to dr@dailyreckoning.com.au

--Dear Dan,

Noah (Brisbane)

This morning it was the orange pill. And it was called Ibuprofen. The best way to deal with the garbage in the newspapers is not to read them. But the best defence against misinformation is your own education and knowledge. Keep building your ark.

--Dan,

Rose

The honourable men of Rome were more than vilified after they killed Julius Caeser. They were killed. More from Shakespeare next week!

Dan Denning
for The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Australian Iron Ore Shares on China’s Menu
• RBA Leaves Rates Unchanged, Rio Wraps Up Negotiations
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• The Iron Ore Pricing War Between China & Australia

"China also bought 590,000 tonnes of aluminium, 159,000 tonnes of zinc, 30 tonnes of indium and 5,000 tonnes of titanium, said Yu, who works in the National Development and Reform Commission's industry department." Now that metals prices have rebounded, though, will the stockpiling continue, even at high prices? Or was it a case of bargain shopping at everyday low prices?

There are several components of demand. There's real economic demand (you need the stuff to make other stuff). There is investment demand (you're buying it in order to make a profit from what you think the price trend is. There is also pure speculation, and it's possible that some middle-men were flat-out speculating by buying alongside China's State Reserve Bureau (sort of like the banks and brokers in the U.S. buying Treasuries ahead of the Fed late last year to improve Q4 earnings).

But if you're trying to figure out the ultimate direction of certain base metals prices (or commodity prices in general) you have to also consider the currency in which they're priced. Or, as my colleague Dan Amoss writes, "You also want to consider what Ben Bernanke and Tim Geithner will do to debase the dollar in the coming years. If you're a foreign creditor facing with this constant portfolio decision, which has higher marginal utility? Is it 1.) US$2.32 or, 2.) one pound of copper?"

Dan is referring to a pretty handy economic concept. Marginal utility is the economist's attempt to quantify how much satisfaction or benefit you get out of each additional good or service you buy. You have probably heard the term "diminishing marginal utility" more often.

An easy way to understand this is that while one cheeseburger may satisfy your appetite (and your craving for animal fat), four cheeseburgers gobbled down in a row are neither useful nor terribly good for you. They might even be bad (although as an American, we are reluctant to concede this point).

In Dan's scenario, U.S. dollar holders will ask themselves if each additional dollar owned is more useful. Given the fact that the U.S. monetary authorities are making so many dollars, it's pretty clear that each additional dollar added to supply makes each existing dollar less useful. It is not very satisfying to see a methodical reduction in the purchasing power of your savings.

If Dan is right, then stockpiling real assets (even during a relatively weak economy) makes more sense that stockpiling U.S. liabilities. Or, as Dan says, "The Chinese will probably go with #2, especially because copper (and oil, and iron ore) can be stored and used in infrastructure projects to keep the population somewhat placated with infrastructure jobs," says Dan.

He adds that you should look for the Chinese to stockpile resources on the dips in commodity prices, while selling/divesting of U.S. Treasuries into the rallies that come with 'safe-haven' buying. That sounds right to us. But the only catch to the plan is if Treasuries fail to rally on safe haven buying.

On that score, the Treasury market seemed to survive last week's big auction without a huge spike in yields. If the economic news remains neither bullish nor exceptionally bearish, then we reckon Treasuries could rally (prices up, yields down), providing a discrete exit opportunity for certain large investors.

Incidentally, we still haven't seen much in the Australian press about the long-term consequences of government deficits. That's probably because most people are accepting the government's case that Australia's borrowing (and its deficits) will be temporary. We're not as sure. And besides, there are some serious questions about how structural deficits affect a country's currency, its credit markets, and its interest rates.

Those are just some of the questions we hope to take up at our upcoming debt symposium/summit, which will precede the first Australian screening of I.O.U.S.A. We've even picked a date, booked a venue, and secured a cracking panel of experts to train their eye on Australia's very own addiction to debt. Stay tuned for your official invitation!

Meanwhile, did you see that China has astonishingly and rather conveniently discovered some 3 billion metric tonnes of hematite and magnetite iron ore? It's apparently true, and probably comes in pretty handy during the current stagnated annual price contract discussions with Aussie iron ore producers BHP Billiton and Rio Tinto.

As you know, China is the world's largest steel maker and thus the largest importer of iron ore. Chinese geologists claim they have found Asia's largest iron ore deposit ever in Benxi city, which is in the northwest province of Liaoning. The good news is that the deposit is said to be about 2.5 miles long and 1.8 miles wide and could, officials say, have a mine life of 50 years-if a mine is built.

The bad news is that the resource (not a reserve because it's not know if it can be produced economically) is buried around a mile underground. That's a long way down, or a long way to lift iron up, if you prefer, and if you're strong (which China is).

Contrast that with the Pilbara, where the stuff seems to lying around waiting to be found in the hundreds of millions of tonnes by any Tom, Dick, or Kerry. That's right. Iron Ore Holdings, owned by Kerry Stokes, told the ASX yesterday it was increasing by 50% its estimate of its mineral resource at Iron Valley in Western Australia.

This deposit is only 97 metres below ground. It's surrounded by big projects by BHP, Rio, and Fortescue. And the company says it reckons its sitting on a 132 million tonne resource-which is up from the 88 million tonnes it believed it had just three months ago.

Proving up a resource into a reserve-and seeing your share price benefit because of it-is the name of the game for the iron ore juniors. Despite the big Chinese find, we reckon the Iron Valley story is where the Big Picture meets the Little Juniors (or where the rubber meets the road, if you prefer).

At the right prices, stockpiling commodities makes sense to people who will need them later anyway and already have too many U.S. dollars. And if prices aren't right...if..in fact...commodity prices decline (either because of slow economic growth or a halt in stockpiling) then commodity stocks probably fall a bit too...which makes those very stocks-especially the smaller ones that need capital and JV partners-the next logical candidates for acquisition or accumulation.

Dan Denning
for The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• India Beats China to Walk Away With 200 Tonnes of IMF Gold
• Have the Chinese Stopped Industrial Stockpiling of Raw Materials?
• China Performs a Kind of Financial Alchemy
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike

So profitable in fact, that it could soon be Australia's single largest export industry.

That's why, since last November I have been recommending two companies to subscribers of Australian Small Cap Investigator that I am certain will profit from a new wave of investment in this industry.

The industry is liquefied natural gas (LNG).

It's hard to imagine that in a country as rich with resources as Australia, liquefied natural gas production is still a relatively new industry. Overseas, the production of LNG has been going on for years. Here in Australia you can count on one hand the number of LNG terminals that we have.

There are just the two. One is based in Karratha to service the North West Shelf off Western Australia. The other is a ConocoPhillips facility in Darwin.

But the investment I've tipped to ASI readers isn't in either of those areas. That's because all the new investment in LNG is happening in Queensland. And it is thanks to the investment that explorers have been making in coal seam gas (CSG). There are at least four new LNG terminals proposed for construction at the Queensland port town of Gladstone.

The first new entrant to produce is likely to be one of the eventual winners in this new industry. The company I like the most is scheduled to be the first to get its LNG terminal ready for business. In addition, its LNG plant will be operational at least three years in advance of the competition. That's a significant head start, or first-mover advantage if you will.

So, why is now the time to be getting into LNG? And why am I recommending it in ASI and not our resources newsletter Diggers & Drillers.

On-shore and unconventional LNG product (coal-seam-gas) is virtually an untapped market in Australia. The opportunity for large-volume, high-dollar exports is enormous. It falls clearly into the category of a high growth play, even though it's what you might call a traditional "extractive" industry.

Australian companies haven't entirely sorted out the economics of the LNG market, on both the cost and revenue side. But it's the revenue side that makes it so appealing for small cap punters. According to industry sources, if the LNG industry develops successfully in Australia it could generate $20 billion in total exports by 2017.

Let me put that in perspective. By the time the production of this product peaks in Australia it could quite easily be our most lucrative money-winning industry in the coming years. Right now, coal and iron ore between them churn out nearly $30 billion a year in exports. Those exports are the profit lifeblood of household Australian names like BHP, Rio Tinto, Fortescue, and Macarthur Coal.

You're talking an industry that could be bigger than the ones that built BHP and Rio. That's why I believe the single most exciting industry for smaller companies is energy.

But don't just take my word for it. Robin West, chairman of consultancy firm PFC Energy, told the Financial Times last year that "Australia's gas reserves are potentially the biggest OECD gas reserves left in the world and are not subject to the same political constraints as non-OECD reserves."

And because of the expected growth in demand for gas, along with the maturing of many overseas gas fields, international companies are eager to get a slice of the action here in Australia. Not wanting to miss out, domestic companies are also keen to exploit it.

You only have to look at some of the recent corporate transactions in this area. You'll remember the USD$5 billion investment by US energy giant ConocoPhillips in a CSG joint venture with Origin Energy. And UK based BG Group's $5.6 billion takeover offer for Queensland Gas.

That is why Australia has the potential to become a major and important global supplier of LNG, and that's why I have recommended ASI subscribers invest in two of the best small cap LNG companies Australia has to offer.

Kris Sayce

for The Daily Reckoning Australia

Editor's Note: Kris Sayce is the editor of the Australia Small Cap Investigator. For more on his research into LNG stocks, go here.

• LNG – The Energy Play for 2009
• Uranium: A Carbon-friendly Substitute for Coal
• Gorgon LNG Deal with China a Really Big Deal
• Queensland Govt Chooses Coal Seam Methane Over Resource Boom
• Australia Presents Investors With Great Portfolio of Energy Choices

So, this morning, we write to you in a puddle of our own regret. We lacked foresight, and water-proof pants. We’ll try to exhibit a bit more of it as we map out where the money is today (foresight, not water-proof pants).

Foresight, of course, is a quality everybody wants and nobody has. Who couldn’t do with a little more of it? It’s one of those constants that you always need to constantly invest well…foresight, hard work, patience, a bit of luck here, some good timing there.

Meanwhile, the only news that matters in Australia today seems to be takeover-related…

Western Juniors Could Create 4th Biggest Iron Player in Australia

Here’s some foresight. Investors who jumped on the iron ore train are getting their dividends. Yesterday Murchison Metals (ASX:MMX) gave iron cousin Midwest (ASX:MIS) an all-share merger offer worth . The market loved it. Midwest leapt 12.3%. Murchison flew 8.3%.

Everybody won, except Sinosteel. The Chinese giant was closing the net around its prey, Midwest. The nerve of another prey to go and outdo it.

Together, the two iron diggers would have a market cap of AU$3.2 billion. That’s bigger than Portman (ASX:PMM), Mount Gibson (ASX:MGX) or the other second-tier contenders. It’d leapfrog the companies up to fourth place in the industry, behind Fortescue (ASX:FMG).

The structure of the deal, though, tells you a little more about the whole matter.

Sinosteel already has 19.9% of Midwest. That’s the maximum you can own without bidding.

In a direct response to the stake, Murchison has proposed a reverse-takeover. It has offered itself up as a sacrifice to the deity of iron ore. Under Australian corporations law, a reverse-takeover means the deal only needs 50% acceptance from Midwest shareholders to go through. Otherwise, a standard takeover would’ve meant a minimum of 75%.

Ergo…the two do not want to be bought. Not by China. Not at any price near what Sinosteel is offering. The Australian iron sector is combatting external consolidation with internal consolidation. Both mean share prices are going up. Here the five top juniors’ performance this year. They’ve made gains of between 21% and 65%.

Midwest’s management has recommended that shareholders accept the deal. You’ll find out in the next three months what they think of it.

You’ll also find out exactly how desperate China is to get its paws on our iron. The ball’s in your court, Sinosteel. The company will most likely withdraw, and reassess. Perhaps it’s content to pay huge spot and contract prices for iron in Asia. Or perhaps it’d like to own the next best producer after Fortescue.

St George Accepts Westpac Bid…Almost

A much bigger takeover is slowly plodding towards the finishing line. St George (ASX:SGB) signed a scheme of agreement with Westpac yesterday. It had prudence enough, though, to add some fine print to the contract. We’ll do a deal you, Westpac. As long as your shares stop dropping

So far, Westpac’s bid is 10% smaller than when it came into the world. The stock is at a year-low. If the fall that began last week in the All Ordinaries accelerates, Westpac’s shares may continue to erode. Maybe the finishing line is a little further away than we thought.

Two takeovers are evolving parallel to each other. There’s the iron story in the hard-asset market, and the banking story in the financial sector. Both are mergers, involving shares only. No cash. Analysts tell us that the prices are good. Yet the parties involved have reacted entirely differently.

Midwest said “Yes” and left it that. St George said “Maybe. Just don’t let your share price fall.”

Sadly, Westpac doesn’t have a lot of control over that. And those two reactions might reflect the underlying businesses, we reckon. Iron ore miners are willing to jump on the front foot. They’re merging to create more scale in a growing industry. Banks are on the back foot. They’re merging as a defense against falling earnings margins.

Westpac’s interest margin has fallen from 2.6% in 2003 to 2.25% last year. It won’t have improved since the last report, filed in November. Bankers aren’t making as much as they used to. That’s the bottom line. There are better companies to invest in.

Al Robinson
The Daily Reckoning Australia

• Saudi Arabia Pours Oil Investment into Australia
• Riding the Bear & Deep Drilling in Australia
• The Iron Ore Pricing War Between China & Australia
• Australian Iron Ore Shares on China’s Menu
• Wayne Swan Approves Chinalco Investment in Rio Tinto (ASX: RIO)

The Australian reports this morning that, "Chinese interests have approached a major Australian superannuation and investment fund to be their partner in a multi-billion-dollar swoop on 9 per cent of BHP Billiton." This proposed deal involves three parties, the Chinese Party, an Australian fund, and a global private equity firm.

That's pretty clever. Under that deal, reports the Oz, China gets a 4.5% stake in BHP Billton. That's would be worth about $12.15 billion, using yesterday's closing price. The Oz also reports that under the terms of the proposal, the Chinese could buy back the fund's stake in BHP Billton in five years at an agreed upon price.

That sounds like a call option to own another 2.25% in BHP Billton in the next five years. Given the earnings BHP Billton may generate from its iron ore and oil divisions, that could be a handy little capital gain. What do you think the intrinsic value of an option like that would be? The Aussie fund better stipulate a high price for that future agreement.

But remember, this is just one front in the ongoing strategic resource game playing out. The second front is Rio Tinto. In March, Chinalco's Xiao Yaqing said he would like to eventually increase his stake in Rio Tinto from the 9% he picked up in the late January over-night raid with Alcoa (NYSE: AA) (which has made a nice little move in New York, by the way).

Since then, China's interest in Rio Tinto has taken a back seat to China's interest in Fortescue and BHP Billton. But could the Rio pursuit revive? Aluminium prices are likely to rise with the shut-down of some of aluminium smelters in China (more on that below.) What will commodity will generate the most earnings growth in the next five year: iron ore, aluminium, or oil?

The third front is Fortescue. Yesterday was a milestone for Andrew Forrest's mob in the Pilbara. They went from being an iron ore explorer to an iron ore exporter. Take away an "l", add a "t" and you have a whole new ballgame. Fortescue loaded 180,000 tonnes of iron ore from its Cloudbreak mine on to a Cape-sized Baosteel ore hauler. It's on its way to China.

What are Fortescue shares really worth? Charlie Aitken at Southern Cross Equities reckons they are worth more than today's price. The company aims to produce 100 million tonnes per year by 2010. If the company averages $50/tonne, that's $5 billion pretax. After 30% corporate taxes, you're still looking at $3.5 billion in earnings for shareholders.

Andrew Forrest says he'd welcome Chinese investors on the Fortescue share register. But spots on the register are already at a premium. Over 70% of Fortescue's issued capital is owned by just five major shareholders (including Forrest himself). If China Inc. wants in, someone else is going to have to sell out.

Fortescue's top 5 shareholders own 70% of issued capital

Joel Steinberg's holding company Leucadia (NYSE: LUK) which some people call a mini-Berkshire Hathaway, owns just under 10% of Fortescue. Aussie institutional investors shunned Twiggy Forrest when he went looking for extra capital to cover cost blow-outs in 2006. Steinberg ponied up over $400 million, $300 million for the 10% equity stake and another $100 million in unsecured notes paying a 4% royalty on Fortescue's production.

At the time, Fortescue wasn't producing anything, and no one was sure it ever would. And because Leucadia's offer valued Fortescue at $15.20 a share (a 35% premium to the share price at the time), it looked like Steinberg had overpaid. But maybe not.

A 4% royalty on production of 100 million tonnes per year at $50/tonne is about $100 million a year. And over ten years, that's about $1 billion in royalties (not a tough sum to calculate)-and remember that's on just the $100m in unsecured notes. With that kind of return, Steinberg could sell some of the equity to, say, China, and still come out well ahead on the deal.

If Steinberg doesn't sell to Baosteel, will Harbinger Capital Management? That's the firm run by Phillip Falcone in New York, and rumoured this week to be shopping its 16% stake in Fortescue to potential buyers. Harbinger's stake is held in trust by its Australian representatives.

All we know is that Aussie institutions are on the outside looking in when it comes to the Fortescue registry. Existing shareholders might make the Chinese pay a pretty penny. But the Chinese might be happy to do so.

The final front in the iron ore wars is the negotiation for this year's contract price. It's going nowhere. In fact, the China Iron and Steel Association ordered all its steel mills and traders to boycott Rio Tinto's sales of ore in the sport market, according to today's Financial Review. Yikes.

Earlier this year Rio Tinto threatened to sell more ore into the spot market-while still fulfilling all its contractual obligations and the pre-agreed price. With spot prices nearly double the contract price, Rio Tinto was both taking advantage of the higher spot price, and indirectly pressuring China to agree to the 85% rise in contract prices that both BHP Billton and Rio Tinto are asking for.

China's move to ban the purchase of Rio Tinto ore in the spot market is the negotiating counter punch.

Will the ore wars spread beyond these four fronts? They already have, of course. While these big battles are entertaining, real ground is being gained at the junior level as Chinese companies get on to the registers of many smaller iron ore companies.

Dan Denning
The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• The Fourth Biggest Iron Player in Australia
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Gorgon LNG Deal with China a Really Big Deal
• Rio Scraps Deal to Sell to Aluminium Corporation of China

That's the percentage increase in the annual iron ore contract price Aussie producers charge major Chinese steel makers. It includes the much sought after "freight premium" which recognizes that it's cheaper to ship ore from Australia to China than from Brazil to China.

So what does it mean? Well, Chinese producer were hoping to NOT have pricing power in the ore industry lie with suppliers. But that hope seems to have faltered. Time for plan B. Plan B is to take equity stakes in a large number of smaller Aussie iron ore, and don't discount the possibility of China Inc. taking a large stake in BHP a la Chinalco in Rio Tinto).

Plan B also includes raising steel prices. Granted, as you can see from the chart below, courtesy of Macquarie Research, steel prices are already up 65% this year alone. But as you can also see, Chinese steel prices trade at about a US$400 discount to U.S. and world export steel prices. Whether this is how the Chinese subsidise domestic steel consumption or not, we can't really say.

But we can say that Chinese producers will increase exports this year and raise prices. Prices for domestic steel in China might differ from export prices. Who knows? But either way, you can be sure the Chinese steel producers aren't simply going to absorb the huge increases in coking coal and iron ore. Chinese steel is going to get more expensive, whomever the buyer is.

Normally, you'd expect to see higher commodity prices curtail demand. But for both steel and oil (see below) you haven't seen any evidence yet that higher prices are slowing down demand. In fact, as this second chart from Macquarie shows, Chinese steel production is slated to grow by 10% this year. It even looks like the double bottom in steel production growth rates is in. Is it the beginning of a new steel boom?

One company that hopes steel prices keep going up is Aquila Resources (ASX: AQA). The company told investors yesterday that it could produce about 25 million tonnes of iron ore per year from its ore bodies in the Pilbara... for the tidy sum of $4.1 billion.

Welcome to the iron ore boom, Aquila (a company which also has coal and manganese assets). The company's announcement was a little like a new doctor in a small town hanging out his shingle right across from the old doctor. The company isn't producing anything yet. But like the other ore hopefuls in the Pilbara, it believes that with a little capital and a little deep water port facility at Cape Preston, its pre-feasibility study indicates it would have a nice little business.

What is the difference between a shingle and a "for sale" sign?

Meanwhile, the original third wheel in the Pilbara, Fortescue Metals (ASX:FMG), begins loading its ore for shipment to China this week. It's been a long time coming. But FMG's business has opened the door in the Pilbara and the Mid West for a long roster of other, smaller ore producers. The good old days of just BHP and Rio are long gone.

Dan Denning
The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• The Iron Ore Pricing War Between China & Australia
• The Market Price for the Resources China Wants is Rising
• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy

Exports fell by 4%, or about $18.2 billion in the month. The big laggards were metal ores, minerals, and coal. Metal ores and mineral exports fell by 18% in the month, or $624 million. Coal exports fell by 16%, or $281 million. Coal and metal ores weren't exactly being lazy. You can blame the weather (flooding) and continued bottlenecks in export infrastructure.

There is a simple explanation for Australia's trade deficit: the country really doesn't make much. How else can you explain something that's been a regular feature of the economic landscape for the past 75 months? From our quick scan of the figures at the ABS, the last time the country ran a monthly trade surplus was in October of 2001.

Since then, of course, exports have ramped up with the resource boom. But as the Aussie dollar has strengthened and the U.S. dollar weakened, export profits have been tempered by the fact that Aussie exports face rising costs in local currency terms but get paid in weaker U.S. dollar prices.

The upside is that commodity prices have been rising. Some of this is dollar weakness. Some of it is too little supply. And much of it is growing demand. This all makes for rising prices.

And while we're on the subject of rising prices, let's hear it for iron ore, thermal coal, and coking coal!

The standoff with China over the iron ore contract is partially responsible for the $800 million fall off in trade revenue. But that revenue is about to soar again with a series of agreements on the price for steel making ingredients. How can the steel producers still make a profit with iron ore and coking coal prices rising so much? Hold that thought.

The Financial Review reported yesterday that BHP is close to sealing the deal with South Korean steel maker Posco for a coking coal price of US$300 in 2008-2009. That is up from US$97 last year. That's a nice little gain. Coking coal in the spot market is already going for around US$350, according to the Fin. Australia exports 68% of the world's seaborne coking coal.

Iron ore, you say? We covered it earlier this week. But we reckon the contract price will rise by at least 75% before June 30th. And even thermal coal for power plants is expected to at least double from its current contract price of US$56 per tonne.

Combined, the rise in coal prices should boost export income from by $35 billion to $56 billion. That will be handy to have. Still, don't expect a huge improvement in the trade deficit. If you look closely at the breakdown in the import figures, there's a lot Australians import from abroad.

The main three categories (according to the ABS) are consumption goods, capital goods, and intermediate goods. This includes things like textiles, electronics, toys, books, leisure items (in the consumption goods category) and things like civil aircraft parts, telecommunications equipment and industrial machinery (capital goods), as well as well as fuels, lubricants, papers, plastics and spare parts (intermediate goods).

If you don't make it here you have to buy it from somewhere, or have it not at all. Australia does produce some things. But for a rich Western economy, its production-and lets remember this a country of 20 million people-is largely concentrated in raw materials and agricultural goods, not finished manufactured products.

The strong dollar eases the pain of imports a bit, especially since many of the imports are cheap and come from Asia. But it's generally true that profit margins are greater in finished goods than raw materials. Australia's had its bacon saved in this respect because resource prices have been rising by so much and so quickly.

Makes you wonder what will happen in a generation or two (perhaps less), when the resource profit growth is gone and the country's productive capacity hasn't been diversified. Expect to see a lot of service jobs at low wages.

We were a bit gloomy yesterday about Australia's prospects for decreasing it reliance in imported refined fuels. A larger question might be whether the country can increase its net oil production. Consumption is growing faster than production. Like every major country in the world, Australia would like to find more domestic oil.

The good thing about finding oil is that geologists can tell you what kind of geologic formations bear oil. The bad thing about finding oil is that its getting more expensive, mostly because companies are having to look further and further off shore, just to find reserves to replace current production (not to ad to reserves.) The government is getting busy.

"The Australian government invited bids for 35 oil and gas exploration permits in five petroleum basins off the northwest and southwest coasts as it seeks to address a rising deficit in crude-oil supply," reports Angela Macdonald-Smith in Bloomberg. "Australian spending on exploration jumped 57 percent last year to a record $2.66 billion even as the number of wells drilled fell, as equipment and labor shortages drove up costs. Explorers need to boost work in frontier areas to avoid a A$28 billion petroleum trade deficit within a decade."

The permits on offer are for exploration in the Browse, Bonaparte, and Canarvon and Perth Basins. As you can see from the picture below, courtesy of the Department of Energy, Resources, and Tourism, all this years offshore exploration permits are in the West. Proceeding clockwise, the basins are Perth, Carnarvon, Roebuck, Browse, and Bonaparte.

Source: Department of Resources, Energy, and Tourism

There are a ton of off-shore petroleum development projects in WA from last year. We're also keeping our eye on off-shore natural gas in the Otway and Cooper Basins in South Australia.

Dan Denning
The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Terms of Trade Driving Runaway Australian Inflation
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• The Australian Resource Boom Isn’t Dead Yet

The path to Australia’s first big bauxite fortune will look a lot like the same path Andrew Forrest trod in iron ore. Forrest—who according to Forbes magazine is Australia’s richest man—realised he didn’t need to compete with BHP and Rio Tinto. Just becoming Australia’s third biggest producer of iron ore would be enough to make him a very rich man.

He was right. Incredibly, Forrest’s company Fortescue Metals (ASX:FMG) has yet to ship any actual ore to China. But the inherent sense of the business proposition—and rising iron ore prices—have propelled the stock to amazing heights anyway.

Incidentally, while Warren Buffett took the crown as the World’s richest man this year (net worth of US$72 billion), India had four men in the top ten. Russia had 87 billionaires on the Forbes list. Russia’s richest man, Oleg Deripaska, is the world’s ninth-richest. He made his money in Russian aluminium, not in Russian oil.

Australia’s Aluminum Chain

The advantage of looking for bauxite where it’s already been found is that you know it’s already there. According to the Australian Aluminium Council:

Australia is the world's largest producer of bauxite, producing 64 million tonnes (mt) (36%) of world bauxite production in 2006.
Australia is the largest producer and exporter of alumina, producing 18.4 mt (28%) of world alumina production in 2006.
Australia is the fifth largest aluminium producer, with 1.93 mt (5.8%) of world aluminium production in 2006.
In 2006, the bauxite/alumina/aluminium operations employed over 13,500 direct employees and around 5,000 contractors (including 1,500 construction workers).

The heart of Australia’s aluminium business is in the Darling Ranges. In fact, they produce 17% of world’s alumina. Alcoa’s Huntley mine is the world’s largest. The other four bauxite mines are the Boddington in Western Australia, the Gove in the Northern Territory, the Willowdale in Western Australia, and the Weipa in Queensland.

Once the bauxite is refined, it usually ends up going to one of Australia’s seven alumina refineries. Those are:

• Alcan Gove (Northern Territory)
• Comalco Alumina Refinery (CAR) (Queensland)
• Kwinana (Western Australia)
• Pinjarra (Western Australia)
• Queensland Alumina Ltd (QAL) (Queensland)
• Wagerup (Western Australia)
• Worsley (Western Australia)

Alumina can then be sent off via direct shipping to a smelter in another country (where energy is cheaper, say the Middle East), or it can be turned into aluminium right here in Australia. Most alumina (85%) is smelted into aluminium, although some is used as an industrial abrasive agent.

There are five aluminum smelters in Australia. As we said earlier, it’s an incredible energy-intensive business. In the past, aluminium smelters alone have account for as much as 12% of Australia’s entire demand for electricity. This is why aluminium is the one metal often referred to as “solid electricity”.

Australia’s “Solid Electricity” (Aluminium) Smelters

• Bell Bay (Tasmania)
• Boyne Island (Queensland)
• Kurri Kurri (NSW)
• Point Henry (Victoria)
• Portland (Victoria)
• Tomago (NSW)

As it is energy intensive, the smelting business in Australia probably won’t see much expansion. Australia has plenty of potential energy (coal, uranium, natural gas). But none of it is clean, green, or cheap. And because of the high energy cost, the profit margins in smelting are smaller than the margins in alumina refining.

The Gindalbie Model and Chinese Demand

The fact that China is running into rising energy costs means it will have to curtail aluminium production. But that will not curtail its demand for aluminium. Indeed, that is the main argument for rising aluminium prices this year; that production growth will slow while demand does not.

Rising aluminium prices should be good for Aussie bauxite producers, especially those who follow the same business plan of Gindalbie Metals (ASX:GBG). Gindalbie’s plan was simple: buy up a bunch of old tenements on which everyone knew there was a resource, then go shop them around to clients in Asia.

This same strategy applied to bauxite doesn’t compete with BHP or Rio. But that is the beauty of what economists call economies of scale. A firm need not compete with Rio to become successful. It simply has to prove up its resource base to reserves and then find foreign customers eager to take that alumina from the convenient ports nearby.

The nearness of Darling Range bauxite tenements to port facilities in Rockhingham, Freemantle, and Bunbury is a big plus. Prospective bauxite firms, like the iron ore juniors, plan to negotiate off-take agreements directly with customers in Asia. The bauxite is mined in Australia and shipped as ore to Asia.

Judging by joint infrastructure products between Aussie-based Murchison and Japanese-based Mitsubishi in the iron ore business, and investment agreements between Yilgarn Infrastructure and five Chinese partners (approved in January by the Foreign Investment Review Board), neither the Western Australian or Federal government’s have trouble with Aussie firms having foreign partners.

In fact, without the joint venture partners, it’s not likely these bauxite and iron ore tenements (which are not large enough for the big boys to produce) will ever be produced at all. But such is the marginal demand for commodities coming from China today (and for the next 10 years we reckon) these smaller companies stand a real chance to take a resource everyone knows is there and turn it into a profit-making venture for shareholders.

Regards,

Dan Denning
for The Daily Reckoning

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