According to Goldman Sachs, robust 2010 oil demand growth will deplete these inventories over the next 12-to-18 months and diminishing production rates in key areas around the world will create a supply/demand imbalance.

The top portion of the nearby chart shows the decline in production from the world's top 230 projects. After peaking in 2009, production from these projects is set to fall for the next several years. Excluding OPEC countries (bottom portion of the chart), the decline rates will likely quadruple from 2007 to 2012.

Over that time period, non-OPEC production is expected to fall by 2.5 million barrels per day. Only Brazil, Canada and the former countries of the Soviet Union are expected to see production growth.

One of the largest contributing factors for this is chronic decline rates from some of the world's top mature fields. Mexico's Cantarell field, one of the largest oil fields in the world, produced 30 percent less oil in 2008 than it did in 2007 - a trend that's expected to continue.

Norway, the world's 11th largest oil producer in 2008, saw its oil production peak in 2001 and is down 27 percent since. Another big producer, Venezuela's state-owned oil company PdVSA has seen annual decline rates of more than 25 percent in certain fields according to the Energy Information Administration (EIA).

Adding to the dilemma, many countries without decline-rate issues have been holding out production increases until projects become more cost effective; this is why we recently saw Russia overtake Saudi Arabia as the world's largest oil producer.

The Saudis have been content to sit on the sidelines while awaiting the return of higher prices. The same goes for other OPEC countries; PIRA, an oil-industry consultant, says the cost of oil will have to rise above $80 per barrel in order for the cartel to increase production.

With oil prices currently hovering around that $80 level, OPEC officials have recently hinted that production increases aren't off the table for the cartel's upcoming December meeting.

But even if we see a production increase out of OPEC, decline rates from maturing fields and high barriers of entry to bring new fields online should keep the supply/demand balance tight for years to come.

Regards,

Evan Smith and Brian Hicks
for The Daily Reckoning Australia

• No Spike in Oil Price Following IEA “Third Oil Shock” Announcement
• BHP Billiton: The Oil Company That is Not an Oil Company
• Where Will Future Oil Production Come From and How Can Investors Profit Today?
• Oil Price Chart Shows Slight “Correction” in Near Future
• OPEC Agrees Not to Cut Oil Production Until it Meets in May

"What?" we replied to one of our analysts this morning.

"He's the only Storm Trooper named in the Star Wars movie. I bought a card board cut out of him pointing his laser rifle at you. It was on sale the Science Works exhibit. I've put him behind your desk to remind you that you're under the gun."

True enough. It's not just your editor under the gun, though. What's at stake this week is whether attempts by governments and central banks to prevent more credit writedowns have succeeded. If they have, it could prevent the further transmission of the credit crisis from the financial sector to the real economy. And for investors, it could kick off a Great Releveraging.

Are we changing our tune, then, about what to expect from markets? Not one bit. But the question now is timing. The collapse of 2008 was so severe because of the sudden reduction in leverage in the financial sector. As assets fell in value, the most highly leveraged firms (or lenders who raised money by selling debt) went out of business.

This kicked off a chain reaction in which other market players were forced to sell assets and preserve capital. Banks preserve capital by not lending. This is how the credit crisis "jumped" from the financial sector the medium and small businesses (those not big enough or politically connected enough to qualify for government bailouts). And from businesses the deleveraging crisis went straight to households, who began saving more and cutting back spending.

And now it comes full circle. When households cut back, it eats into corporate profits and bank profits. Households with members who've been fired get behind on bills. Securitised credit card receivables, car loans, and mortgages - a large chunk of bank assets - start to go pear shaped. And banks face more credit writedowns, accelerating the cycle.

This is the cycle the Feds and global monetary authorities set out to short circuit this time last year. Their main objective: increase asset prices to stabilise bank balance sheets and prevent the spread of the credit crisis. How did they do it? TALF, TARP, CAP, the suspension of mark-to-market accounting rules, and the maintenance of low interest rates (in the States especially).

All these clearly did support asset prices, and especially allowed banks to post a quarter two of quarter over quarter earnings growth. This has created the appearance of stability. But what has not improved one bit is the quality of those bank assets purchased with borrowed money. There will be more writedowns to come. But when?

We should entertain the possibility that the Feds can support asset prices for some time. Take Australian housing for example. This week the Federal government announced that it would chuck another $8 billion in taxpayer money to purchase residential mortgage-backed securities (RMBS). Treasurer Wayne Swan says he's doing it to support "the home lending market."

We'd say he's doing it to keep money flowing into the housing sector so builders stay busy, banks stay profitable, and house prices stay high. Remember, this subsidy to non-bank lenders in the RMBS market is there because other investors won't fund these lenders. And why would they when the government is happy to put your money on the line.

The government says the securities are collateralised by high-quality residential real estate. But that's what pretty much anyone who was hawking this kind of debt said in the U.S. for the three years of peak mortgage issuance. This is how real estate - traditionally a local industry where prices vary from place to place - becomes a national market - through the nationalisation of the mortgage bubble. A national mortgage bubble can inflate house prices across the board-making the entire country vulnerable to higher interest rates and/or a credit crisis.

Here you see the public sector adding debt while the private sector scales back. Also, in Australia, there is still widespread public belief that house prices only ever go up. That means the government can support lending because borrowers are still borrowing. This just makes the inevitable house price correction much more devastating. The borrowers with the smallest margin for error are going to be hurt the most.

Here's something else to think about: what happens when the stimulus spending dries up? Treasury Secretary Ken Henry says that the economy could lose another 100,000 jobs and that the withdrawal of stimulus spending will shave 1.5% off Australian GDP in 2010. This is another way of saying the peak effect of the stimulus (in terms of supporting both consumer demand and employment) was in middle two quarters of the year.

So how will Aussie consumers and businesses behave when the stimulus is withdrawn? Did the Rudd government give the economy just enough free money smack to keep its credit high going? Or will the comedown be just around the corner around Christmas? If they're cautious, Australians will put away their wallets and cut up the credit cards and reduce spending growth to match income growth. The retail sector and retail stocks will be hit hard.

There's one other big question for investors heading into the end of the year. We know the government can support some sectors more effectively than others. Big ticket items like housing and cars can be subsidised with tax rebates or, in the case of housing, with a fresh injection of credit to support politically connected non-bank lenders in the RMBS market.

But you have to reckon the economy boosting effects of supporting the housing market are limited. The main beneficiaries are the banks and the builders. Granted, if you're a politician, those are two important constituencies to keep happy. But what about the rest of the economy?

The basic question is how much of it will stand on its own two feet once you remove the stimulus. The stimulus, the FHOG, the government backing of the RMBS market...these are all attempts to revive an economic growth model that's dependent on asset inflation and credit bubbles. That's the model that led to the bubble that led to the bust.

Papering offer the holes blasted in bank balance sheets by the credit crisis seems to have worked in terms of restoring confidence. Call it a successful psychological operation by the government spin doctors and their buddies in the media and banking. The whole purpose of the operation was to appear to recapitalise banks to healthy levels. But really it was to prevent the banks from having to take further credit writedowns, which itself feeds the process of forced asset sales, declining asset prices, and more household deleveraging.

One immediate risk to watch for is Australia's resource export industry. Export volumes are down year. But for the largest export categories, last year's contract prices are still in effect. Looking forward, 2010 could see lower export volumes AND lower prices for bulk commodities like iron ore and coal (especially if Chinese inventory restocking is complete). This would make the current valuations on resource earnings look pretty generous. You'll read more this week on which sectors are going to thrive and fail in this Great Releveraging.

Back to gold and the dollar and the new world currency order. A simple question: what was all the fuss about last week with a new reserve currency anyway? Here is an answer. If OPEC demands payment for oil in something other than U.S. dollars, then people who buy oil (and who doesn't?) have to stockpile the other currencies in which oil is priced and traded. That would be pretty tough on America.

To support its oil appetite, the U.S. would have to buy the currencies in which oil is priced. It couldn't use good old greenbacks. How do you buy foreign currencies?

Well, you can sell your assets (gold, real estate, stocks) and use the money to pay for oil. This is what Australia does. Or you can borrow in a foreign currency (did anyone say future Chinese bond market?) It's also possible you can use earnings on your foreign-owned assets - provided those assets generate enough money to support your oil habit.

These are all options within the free market system. The main point is that all other things being equal, you have to sell something to pay for something. This is why the foundation for economic health is always wealth production, not consumption. Production creates the goods that facilitate the trade that creates the profits to increase purchasing power for the things you don't produce.

But outside the free market system, you could opt for just taking the oil by force. By that we meant that should the U.S. be put in the position of having to pay for oil with new borrowings or asset sales, it might take the geopolitical path of least resistance and resort to a good old fashioned overt resource war. The declining Empire will strike back with its principal remaining asset, its military.

Likely candidates for an oil war? Not Iran. It's too far away. There are too many U.S. troops in Iraq and Afghanistan that would become targets. And the effect of a Middle East war would be too destabilising on oil prices. But Venezuela, on the other hand, is much closer to home.

Granted, comrade Obama is a peace maker. He was a won a price for it. Peace be upon him. And it would not seem like he's not likely to attack his good friend Comrade Chavez.

But if the current president flounders in the fiscal morass he finds himself in, he'll be a one term savior. Some pundits are already calling him "America's Gorbachev." He's the man who will preside over the swift fall from grace of a Superpower.

There will be no second coming (term). And that leaves room for a challenge from a more hawkish member of his own party (Hillary Clinton) or a populist Republican with a handy doctrine of liberty within the hemisphere (let's call it the Palin Doctrine). If Obama is America's Gorbachev, who is America's Putin? That's what Glenn Reynolds at www.instapundit.com is asking.

Naturally all of this is pure speculation. But our main point is that the oil game is not just a currency game. It's a power game. And it's silly to think the U.S. would relinquish its control over the oil market so easily. There will be a fight.

Not that the U.S. could maintain the reserve currency status quo by force. But sooner or later someone at the policy level in America is going to realise that once the reserve currency status is lost, the country loses a huge strategic and competitive advantage. Its standard of living, already in major decline, would face a major body blow.

Just how American policy makers plan on maintaining that advantage is yet to be seen. Of course maybe they don't plan on it at all. The Empire could be so narcissistic and full of false confidence that few people fail to see the inevitable chain of events the country faces. You'll just get more spending and more chest-thumping and more fiddling. Or more war.

Dan Denning
for The Daily Reckoning Australia

• Banks Could Face Larger Asset Writedowns and Losses than IMF has Modelled
• Gold Sales Cost Europe’s Central Banks Billions
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Everyone is Busily Debasing Their Currency
• The Greatness of a Depression is Commensurate to the Government’s Efforts to Prevent It

Earlier in the week we noted that the action in the U.S. bond market was the prime mover for stock and commodity prices. Thursday trading in the States confirmed that. For the first time in five days, U.S. bond prices rose and yields fell. The spread between two-year U.S. government notes and 10-year notes had blown out 276 basis points as investors gagged on the amount of debt being auctioned by the Treasury Department this week (over $100 billion).

But Thursday's auction of $27 billion in seven-year notes seemed to go off without too much trouble. The market swallowed the new debt and did not chuck it back up. It's a little nauseating when you realise that U.S. debt outstanding is $11.2 trillion, or 76% of GDP.

Our guess is that it's going to be 100% of GDP by the halfway point of Obama's term as President. For this week, however, the new wave of Treasuries sent in to battle deflation, recession, and capitalism itself seem to have stemmed the advance of bond yields. Victory! Viva Obama! Viva Bernanke! Viva la deficit! Viva el dollar!

Still, there are other forces that threaten to overrun the Fed's efforts to keep the U.S. mortgage market from further imploding. Eight percent of U.S. homeowners were late on their mortgage payments in the first quarter, according to the Mortgage Bankers Association. The delinquency numbers tend to track unemployment, and unemployment is rising.

What's worse, with prices still falling, more and more mortgages are going under water, where the mortgage exceeds the current market value of the house. After that, foreclosure isn't far behind. And in the States, a record 3.85% of mortgages are in the process of foreclosure. When you add the delinquency and foreclosure figures together, you find that 12% of U.S. mortgage holders are either late on their mortgage payments or already in foreclosure.

That is a nightmare for the Fed. And if 10-year bond yields resume their march higher next week, they will take 30-year mortgage rates with them, killing off for this year (and probably next) any hope from a rally in U.S. house prices. Our guess? Home sales will pick up at these levels but prices will keep falling.

And what does this mean for the rest of the world? U.S. bond prices are in full retreat. The Fed is covering that retreat, turning around long enough to fire more money into the market and slow the advance of the bond vigilantes. But as money flees the sovereign bond market, it will seek refuge in tangible assets and non-debtor economies with more stable currencies and less net debt.

In midst of all this broken recordism, oil prices are climbing higher. OPEC met in Vienna and decided to keep its production levels stable. The group also said it expects world oil demand to rebound later this year, led by Asia. Crude futures are currently trading above $65.00. The energy sector was up on Wall Street and will probably be up for the week here in Australia.

Hey here's some good news for the next one hundred years. "Among advanced economies, Australia is the most integrated with Brazil, Russia, India, China and South Africa, according to a new index from Maplecroft, a U.K.- based global risk analysis firm," reports Bloomberg. Australia is first, followed by Finland, Japan, and the United States.

Jim O'Neill, the chief economist at Goldman Sachs, says "As the economies of the U.S. and Europe struggle to recover, those of the BRICs will prove to be more robust, and will be instrumental in pulling the world out of recession." So it will be prosperity by association if the Maplecroft index is correct.

Whether or not it the BRICS will pull the world out of a recession this year, or next year, or the year after that, we can't say. But the world economic order is definitely changing and the change-what we've called the Money Migration from the West to the East-favours Australia...in the long run. And in the short run? More on that next week!

Dan Denning
for The Daily Reckoning Australia

• Another Big Wave of Foreclosures
• Fed Willing to Print Money to Buy More Bonds to Keep U.S. Interest Low
• Finding Assets that Out Run Inflation as Bond Yields Move Up
• Attack of the Bond Yields
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis

"The global mining industry will undergo mega deals of as much as $US10 billion ($15.38 billion) this year as the economic downturn presents once-in-a-lifetime acquisition opportunities," reports today's Age. It refers to a report by Ernst and Young in which the firms says it expects, "niche deals to increase and a number of smaller $US2 billion ($3.08 billion) to $US10 billion ($15.38 billion) megadeals involving the mid-tiers."

The consolidation makes sense. But it doesn't really help you figure out which resource is bullish or which firm is ripe for the taking. There is also the matter of the US$172 billion in loans outstanding held by resource extraction companies. The need to roll that over makes some firms vulnerable.

The EY report claims that draw downs in global commodity inventories, coupled with $2-3 trillion in global stimulus programs geared toward metals-intensive infrastructure programs is, well, bullish. That's probably true, but not in a way in which you could make accurate guesses about how much more iron ore or coal or zinc demand these plans will generate.

OPEC agreed not to cut oil production again until it meets later in May. That's a bit misleading, though. OPEC said it wouldn't cut production even though global oil inventories are high. But the friendly cartel members admitted they still haven't cut production down to the levels they agreed on with the previous cut.

Thus the nature of the cartel. It's in everyone's interest to cheat just a little bit by over-producing to make more money. Bloomberg reckons OPEC is producing about 800,000 bpd more than its agreed quota. "The crude oil production target for 11 OPEC members bound by quotas is 24.85 million barrels a day, while actual output from those countries averaged 25.715 million barrels a day in February."

For the arm-chair oil analyst, or just the casual observer of global petroleum markets, it's going to be an interesting ten years. OPEC still produces 40% of the world's crude oil each day. And its member nations control the lion's share of the world's proven oil reserves. Check out the table below.

Source: U.S Department of Energy, Energy Information Administration

On paper, you can see that just 17 countries control 1.2 trillion barrels of crude oil reserves. The ten OPEC nations on the list account for 924 billion barrels, or about 72% of total proved reserves. True, the Saudi proved reserve figures haven't changed in years, and are just as unaudited as all the gold in Fort Knox. The Saudi Oil Kings, like America's private bankers, refuse to let the public, or an independent third party, verify that they have what they say they have.

But let's not quibble. After all, Canada's reserve figure is based on the economic production of oil from the Athabasca Tar Sands. With the crash in oil prices, Canadian reserves are not looking so proved. You might say the same for some of the difficult-to-produce reserves in Russia.

Anyway, our point? It will be intriguing to see which falls faster in the coming years...actual production figures...or proved reserve figures. Actual production is falling because some of the world's big fields are in depletion. The proved reserves? Who knows what's going to be economically producible in the coming years? Look for more on the oil story later this week.

"There's no safer investment in the world than in the United States." Barack Obama's press secretary told the world, and especially the Chinese. He was speaking about U.S. Treasury notes and bonds. China owns around $700 billion in U.S. Treasury bonds, which is not only a lot, but more than any other foreign country.

Last week, Chinese Premier Wen Jiabao rattled some cages in Washington. He told a press conference in Beijing that, "We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets. To speak truthfully, I do indeed have some worries."

About 696 billion and counting, we reckon.

Is it possible the Treasury bond bubble has already burst? It is possible! If stocks can't sustain their rally from last week, then the institutional rush into bonds might resume. We wonder if people have quite given equities up for dead. But the chart below suggests that the move into bonds-at least U.S. government bonds-may have already come and gone.

Did the Bond Bubble Already Pop?

Source: ww.bigcharts.com

The chart shows the performance of a Barclay's ETF that tracks U.S. Treasury bonds of 20-years maturity or more. What you see in November is huge spike in prices as the stock market crashed and investors panicked.

What you see since then is a decline to lower lows and now, a period of indecision. "Should I stay or should I go?" It would be normal for institutions to keep cramming into bonds even as bond prices fell and equity prices climbed a wall of worry. But just because bond prices may have topped out does not mean we're giving the all-clear to get back into stocks. More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• OPEC May Cut Oil Production
• How to Buy Crude Oil for US$2 a Barrel
• Higher Oil Prices, the New Normal
• Where Will Future Oil Production Come From and How Can Investors Profit Today?
• Pemex and Mexican Peak Oil Equal Expensive Oil

The bear is out there somewhere, probably sleeping off his latest wealth destroying bender. This makes it safe for talking heads, bankers, and hedge fund managers to poke their heads up on television and talk about glimmers of hope. Stocks in New York are back at 1997 levels.

Back to the Future!

Your editor has been laid low by some sort of virus/food poisoning event from last night. We apologise ahead of time for the lack of vim and vigour in today's letter. Maybe now that the rally has begun, our body is releasing the accumulated tension of the last six months...by repeatedly vomiting.

Notable in yesterday's move is the 11% rise in oil to US$47. Oil is certainly not up on the basis of a huge ecomic rebound in 2009. So what is it? China's been stockpiling oil while prices are cheap. It's straegic reserve is now all full. OPEC is meeting to discuss more production cuts.

Those two facts suggest lower oil prices, not higher prices. But they also suggest that somewhere down the line this year, demand is going to spike for oil at a time when supply/production is in first gear. Is this what the oil price is telling us?

Who knows? Prices are supposed to communicate information. But sometimes they mumble. The Washington Times reports that China has wrapped up $41 billion in oil and energy deals with Russia, Brazil, and Venezuela recently. What's the trade? Simple: cash for tangible goods.

Or, as the times puts it, "A series of high-profile energy deals and mining bids in the past month marked an end to the nervousness that appeared to impinge on Communist Party leaders at the outset of the global financial crisis. Attention has turned from hoarding foreign exchange reserves worth close to $2 trillion to locking up future supplies. Oil has emerged at the top of China's shopping list."

So this is how the dollar standard ends. Not with the floating of the yuan...but with the gradual swapping of dollars for dirt and energy. Seems like a good trade, although once people are on to it, watch out for the dollar. It could head lower...and oil and gold much higher.

It's a tricky strategy, using debt to by assets like stocks and houses. The Federal reserve reports that American household saw their net worth fall by US$11.2 trillion in 2008. They lost 18% of their total net worth-wiping out the last five years of gains.

The houses are still there. And most of the companies are still there (with notable exceptions like the investment banking industry and maybe soon, GM). But the debt people used to lever up so they could get in on the great inflation in assets is still there.

Asset prices always regress to the mean. This cycle has seen a pretty mean regression. The really important question for 2009 is how central banks and governments will handle such large debt-to-GDP ratios when people are losing their jobs, seeing their incomes fall, and watching their asset values circle the bottom of the drain. If the past is any guide, you know they'll inflate.

Did you see the Mother of All Perp Walks with Bernie Madoff? It's amazing no one tried to lynch him.

That will have to be it for the day. We sense some, er, volatility as the market opens. Until Monday...

Dan Denning
for The Daily Reckoning Australia

• Crude Oil Extends its Price Decline
• US Dollar is Getting Trashed
• Corporate Debt is Just One Aspect of the National Debt Problem
• Why the Oil Price Will Correct Itself
• OPEC Agrees Not to Cut Oil Production Until it Meets in May

If, on the other hand, you want to know why oil prices could double this year, or how $52 trillion in total global debt will utterly suffocate central bank attempts to resuscitate bank lending, or Ben Bernanke's secret plan to turn trillions of dollars worth of toxic assets into shareholder equity, read on!

You're still with us? Good. Now, why are oil prices lying?

Prices communicate information. The NYMEX February oil contract fell over 5% today in New York trading to $34.40. This suggests oil is falling in value, at least in the short term. And maybe that's not totally a lie.

After all, the current oil price results from two factors. First, the absence of leverage from the oil futures market leaves prices reflecting immediate supply and demand. With inventories full, the market seems well supplied (so much so that OPEC is cutting production). Second, the reality that oil demand will be flat or slightly fall this year because of the worldwide financial pandemic.

Adequate supply plus stagnant demand equals $35 oil. So why is the December 2010 oil contract trading nearly 80% higher at $61.80? What could possibly happen between now and December 2010 that would cause oil to go up 80%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010). First, the lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with. But the crash in prices has put the kibosh on exploration and production.

Second, as Diggers and Drillers contributor Mike Graham explains in a January article on the subject, the clear trend within the oil market is that historical exporters are exporting less oil. There are several reasons for this, which Mike gets into in his story.

One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world's largest oil exporters face declining production trends thanks to...you guessed it...Peak Oil.

Yes. Peak Oil has not gone away. It's been sent to the corner while the Credit Depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, "swift and violent rise" in oil prices in the second half of 2009.

Currie told a conference in London that, ""Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven't gone away. We still believe the day of reckoning is to come." What problems?

There are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, "This is not 1982-1983 all over again. The supply picture's radically different...the demand picture's radically different. The key difference is that today there are no large-scale next generation projects that are going to save the world. Commodity demand is exponentially higher than it was."

This brings us to the third reason oil prices should rise later this year: the oil trade is back on. Sure, credit may still be a scarce commodity. But if you judge traders by their actions, you can see the market is setting up for a big oil back draft. As evidence, Bloomberg reports that, "Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, two shipbrokers said."

Our friend Dan Amoss back in America calls this the oil arbitrage trade, where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What's less normal is the amount of oil being stockpiled offshore. "Frontline Ltd., the world's biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years," Bloomberg ads.

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What's more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

So what should you do? That's the subject of the January issue of Diggers and Drillers. More on that after we publish it for subscribers first later this week.

Next is a massive topic we are reluctant to introduce today. But we have to. There is no other way around it. It begins with a question: how much air is left in the credit bubble?

Actually, the question comes via Howard Ruff and Steve Hochberg. Let's start with Hochberg.

He's the lead analyst at Elliott Wave International. Bob Prechter's folks have been forecasting for years that the collapse of the credit bubble would lead to a general and massive deflation, including much lower gold prices. In his latest analysis, courtesy of a DR Reader, Hochberg explains:

"The systemic build up of total market credit is so large, currently about $52 trillion, that its implosion will swamp the Fed's attempts to inflate. And as CTC [Conquer the Crash] discusses, the remaining dollars that are not extinguished through bankruptcy, restructuring and write-offs, will increase in value. The thirst for cash will be insatiable relative to all other assets.

"Initially, the Fed's attempt to inflate was akin to using a garden hose to refill Lake Mead after the Hoover Dam collapsed. Over the past five months the chart shows that the Fed has graduated to a fire hose. But creating just over $2 trillion in the face of a contracting pool of $52 trillion in total credit market debt is just not going to get the job done, and the only thing getting hosed right now is us."

" Eventually credit will contract to the point whereby the income generated from economic production will be able to sustain it and at that point, yes, the U.S. dollar should indeed collapse of the weight of all the Fed's machinations and gold should soar. But before the market arrives at that point, deflation must run its course. In our opinion, there is still a long way to go."

But how far? A lot depends on the composition of that $52 trillion in credit. It can't all just vanish can it? But how much of it is securitised by relatively stable assets? And how much of it could potentially melt away under the intense heat of deflation?

This is not an easy question to answer. But it begins with knowing what you're dealing with. Specifically, you have to know who owes how much, and who owns how much. Those are two different questions. Let's deal with the first one. And we promise we'll make this as painless as possible. If you want to review this data yourself, by the way, you can find it here.

Keep in mind this data deals just with the U.S. And keep in mind it is government data. But the general question is this: how much deflation is left in the credit bubble and who stands the most to lose from it?

The Fed breaks up the total credit market debt outstanding into three categories: Domestic Nonfinancial Sectors (households, farms, nonfinancial corporations, state and local governments, and the Federal government), Financial Sectors (commercial banking, REITs, broker dealers, savings institutions, Government sponsored enterprise, Agency and GSE pools, and issuers of asset backed securities), and finally, the rest of the world.

What we find is that $32.9 trillion in credit market debt outstanding, as of the third quarter in 2008, was owed by the domestic non-financial sector. That's 63% of the $52 trillion total. Households are on the hook for most of that, with $13.9 trillion owed (or 26% of all credit market debt outstanding). That would mostly be home mortgages we reckon.

Next within the financial sector are non-financial corporate businesses with $7 trillion, non-farm corporate businesses at $3.7 trillion, state and local governments at $2.2 trillion, and the United States Federal government at $5.5 trillion.

So what does it tell us? Well it tells us that if U.S. house prices continue to fall, there is a lot of room left to deflate in the credit bubble, at least several trillion dollars. It's not hard to see this happening, given the rise in foreclosures, the prospect of even less federal funding for refinancing of mortgages, and the sudden collapse of America's banking model.

But the lack of credit for refinancing and the looming wave of Alt-A recasts this year and next is, in some sense, already old news. What also keeps us up at night is the $16 trillion in credit owed by the financial sectors. How much of that is at risk to further deflation?

You can get an idea by looking at the L2 table on page 59 of the Flow of Funds report. There is $6 trillion in corporate bonds outstanding. Nearly $5 trillion in Agency and GSE-backed securitised mortgage pools are on the books, and another $3.1 trillion in GSE debt itself. This does not include $1 trillion in "other loans and advances" which may or may not include home equity lines of credit.

We're sure you get the picture by now. There is still at least $8 trillion housing related assets owed by the financial sector. That might be kind of tough to pay off, given the falling value of the assets which securitise that debt. So who stands the most to lose if households can't pay their mortgages, corporations default on their bonds, and housing-related assets held by financial corporations continue to fall?

The financial sector combined holds $37 trillion in credit market "assets." It owns $37 trillion in other people's promises to pay. Those promises, all $37 trillion of them, are on the books at face value. What's more, U.S.-chartered commercial banks (Citibank, Bank of America for example) own $8.2 trillion in credit market "assets." Life insurance companies own another $2.9 trillion. Money market mutual funds own $2.1 trillion in credit market assets, while mutual funds own $2.3 trillion.

Do you see what we're getting at? The institutions that have the most to lose from a fall in the value of their credit market "assets" also have large obligations to shareholders and pensioners. Those institutions are counting on those assets to meet their own future liabilities (which do not fluctuate in value). And households are relying on those assets to retire, or in some cases, to live month-to-month on a fixed income.

Someone is going to lose, somehow. Or everyone will.

Households win if the value of the credit they owe (their mortgage) is written down or managed lower by some new law. But investors counting on that asset (often the household itself through a pension or life insurance) don't win if the amount they are owed is arbitrarily reduced.

Either way, Prechter's group is probably right. There is more deflation ahead. A lot of it. And not just in housing.

The corporate bond market would be another place to look. Corporate defaults haven't begun to rise noticeably yet. But faced with a much slower economy and much higher borrowing costs, it's going to be tough for highly indebted firms to roll over their debt, much less take on anything new. Dividends are already being slashed here in Australia.

And where does the deflation of the $52 trillion credit bubble leave us? Well Howard Ruff reckons we get a period of serious deflation, punctuated by a period of hyperinflation. Over at Kitco, he writes that, "First, we will continue to plunge into a major deflation period which will be characterized as a 'recession,' and later in the year as a 'depression.' Deflation and inflation are always monetary phenomena."

"Second, deflation will evolve into a run-away-hyper-inflationary depression because of what government will do to try to prevent deflation, which is synonymous with depression and has overtones of the 1930s."

How will government accomplish that? More on it tomorrow. Meanwhile, and finally, some timely reader mail.

"why do your emails have to be so long winded.... they waffle on toooo [sic] much, one metaphore [sic] after another... can any one really be bothered in there busy lives readin [sic] over all that.... I actually find some of the factual input useful, but there isnt [sic] much of that... a friendly tip, cut your newsletters/emails by 80%, get to the point and lose the metaphores [sic] and long winded useless stories.... the genuine potential investors your trying to pull in wont [sic] be inpressed [sic] with such dragged out point of views...I am a member of a well known share forum, many think the same as I do... the dailyreckoning could do allot [sic] better, it has so much potential, yet your [sic] boring people..."

Zzzz. Huh? What's that? Oh yes, this free daily e-mail about world historic financial events is too long and won't impress interested investors.

First, a tip. Maybe you should spend more time on spelling and grammar. But that is beside the point.

Sure the Daily Reckoning can be long. And we're grateful that you invite us into your living room and office each day to hear what we read. We don't take your time for granted, which is why put time and effort into what we write. And some times it takes time and effort to unwind a complicated subject.

If we had more time, the DR would be shorter. And in fact, we'd like to launch a subscription-based DR later this year. It would be a shorter, more to-the-point version of the DR with action to take. But in the meantime, we don't have the time for a shorter DR! So you'll have to deal with the long one. Or watch television instead. Your choice, if you're still reading that is.

Dan Denning,
for The Daily Reckoning Australia

• What is the Oil Price Telling Us?
• Pemex and Mexican Peak Oil Equal Expensive Oil
• The Coming Oil Back Draft
• No Spike in Oil Price Following IEA “Third Oil Shock” Announcement
• Oil Prices Under $70

You get the feeling that OPEC doesn't want the oil price to go too low. The U.S. Energy Information Administration forecasts an oil price of US$126 next year. OPEC probably doesn't want the oil price to stay that high. The market, meanwhile, is sending oil down to $100. What we need is a goldilocks oil price, not too high, not too low...just right!

The reason OPEC doesn't want the oil price to be too high is that it encourages the rapid development of the alternative energy industry. You don't want your product to be so expensive that your customers begin looking for substitutes.

By alternative, we don't necessarily mean wind, waves, solar, and geothermal (although they are all industries we've analysed with Kris Sayce in the Small Cap letter). You also have to consider unconventional hydrocarbons (coal-to-liquids) as "alternatives" to crude oil. These industries are flourishing in Australia, even if there's no "big" oil company to buy.

Wall Street is extremely depressed today. We always make a point to watch CNBC when we're back in the States just to gauge what the shills would like us to think. They are trying to bottom fish in the financials. But it's a pretty tough sell. Why?

Shares of Lehman Brothers are down 30% on the day. The usual suspects are to blame. The company is seeking new capital. It can't find it. Shareholders are headed for the exits. Where will a strategic buyer come from? The Korea Development Bank looks to have walked away from a deal. Who else?

It's probably not going to be the U.S. Government. It's busy spending US$200 billion bailing out the U.S. mortgage industry. And the auto industry has its hand out too. Ford, GM, and Chrysler are asking the U.S. Congress for US$50 billion in loan guarantees. Anyone else need tens of billions to stay in business? Anyone?

All this comes as the U.S. Congressional Budget Office reports that this year's Federal deficit will be over US$400 billion, up from $167 billion last year. Next year, CBO reckons it will be more like US$438. And these numbers are prior to the spending on Fannie, Freddie, and anything that might come the auto-makers way.

It's not surprising. But let's not forget this is what happens when an economy systematically misallocates capital. It destroys wealth and creates these financial bread lines. The government becomes the capitalist of last resort, providing the funds to keep industry humming (or mortgage lenders lending, as the case may be).

The trouble is, the government is not lending from accumulated savings or its own huge capital stock. It's borrowing. More debt. More deficits. The business of America is now borrowing.

By the way, we caught up with our old college friend and former publisher Addison Wiggin in Maryland last week. Addison is the Executive Producer of I.O.U.S.A. It's the movie version of Addison and Bill Bonner's book, Empire of Debt.

Addison tells me a DVD of I.O.U.S.A. is in the works. He's not sure if the movie will be distributed in Australian theatres. But we'll keep you posted.

The Aussie market? Al Robinson and Kris Sayce are on the case over at Money Morning. For more on that, check them out at http://www.moneymorning.com.au.

Dan Denning
for The Daily Reckoning Australia

• OPEC Agrees Not to Cut Oil Production Until it Meets in May
• Latest Energy Bull Market Won’t Be Confined to Crude Oil
• Hillary ‘Big Govt.’ Clinton Wants America to Sue OPEC
• Increased Oil Production Won’t Solve the Energy Crisis
• Where Will Future Oil Production Come From and How Can Investors Profit Today?

Translation (acknowledging the script for Team America). "We are very unhappy with you. We are going to send you a letter, telling you how very unhappy with you we really are. Really."

The proposal continues, "Filing a complaint at the WTO will send a clear signal to OPEC countries that the U.S. is committed to an open, transparent global oil market. Such a step will give OPEC members an incentive to increase production as well."

The only signal OPEC is paying attention to is the price signal. Despite the bellyaching, the high oil price hasn't led to lower American demand. When that happens, we'd expect oil prices to fall. OPEC has every incentive to produce as much oil as it can at high prices. But as oil producers, OPEC nations have to manage their resource-and not for the benefit of American consumers, but for themselves.

Here's the great part of Hillary's proposal. She's going to change the law so Americans can sue OPEC! Here changes would, "Allow OPEC Production Decisions to Be Challenged Under U.S. Anti-Trust Law - Currently, OPEC countries cannot be challenged under U.S. anti-trust laws, even when they are engaged in coordinated, commercial activity to control the global oil market."

How unfair is that? You can't sue foreign companies for violations of your own national laws? Here you get a glimpse of the supra-nationalist tendencies of Hillary (and most politicians, to be fair). "Hillary supports amending the Foreign Sovereignty Immunities Act so that the Justice Department can bring suits against OPEC countries in U.S. courts for price fixing. Changing the rules would help hold OPEC countries accountable for their decisions."

Absolute first class grade-A garbage. OPEC only controls 40% of world oil production. It is a major force in the supply of oil. But getting OPEC to pump more oil isn't going to solve the problem of Peak Oil. It will only accelerate the rate at which we deplete existing reserves.

And really, is there a more heavy-handed, ham-fisted, lame-brained, anti-Liberal example of big government at its worst? Changing the rules to favour one group over another is the standard tactic of anti-free market do-gooders. The rules usually get changed to favour one group over another, depending on the political flavour of the day.

This reduces all politics to a contest over who gets to make the rules. It concedes that meddlesome rule-making is the appropriate role for government. Wouldn't it be so much simpler if governments stuck to general rules that were fairly applied, without prejudice, to all people?

In any event, it's going to be an entertaining few months in politics. Which American presidential candidate can make the biggest basic economic blunders. It's a three-horse race between Clinton, Obama, and McCain. They will all win... and it's a pretty sure bet the American people will lose.

Dan Denning
The Daily Reckoning Australia 

• Higher Oil Prices, the New Normal
• OPEC Agrees Not to Cut Oil Production Until it Meets in May
• Waiting for the Showdown Between Hillary and Obama
• Australia & China: Already Partners in the Commodity Boom
• Technical Analysts see the Market 80% Psychological and 20% Logical