In today's Daily Reckoning we're going to literally take a big step back and explore the unexamined and dark underbelly of Australia's resource boom: the sustainability (and nature) of Chinese resource demand. Why?

Well, we have a case of nerves, to be honest. Maybe it's too much caution, but the last week has reminded us a lot of June 2008. So it seemed like a good idea to go back and, painful as it is, examine the mistake that everyone made in not seeing the crash in commodity stocks last year. We don't want to make the same mistake twice, even if it means making a new mistake we're not aware of yet.

Make no mistake about it, commodity stocks did crash hard last year. Shares give you leverage on the upside. But when that leverage disappears, they can come crashing back to earth faster than you expect. This is what happened last year. The collapse of resource share prices outpaced the decline in commodity prices. There was arguably no sector of the market (except maybe listed property trusts) that was hit harder.

It could happen again. It's something we aim to avoid. But judging by the euphoric tone of comments in the press, people are forgetting that it DID happen last year. So why are they potentially making the same mistake?

Well, maybe they aren't. Maybe we're assuming the future is going to be some slightly different version of the past. But the big mistake everyone (your editor included) made last year was having binders on about how much the credit bubble had leaked into both commodities futures (driving prices up) and into China's resource demand.

Many people were right to point out the bubble in U.S real estate and in stocks, bonds, and just about every other asset class on the planet. But when it came to resources, most analysts made an exception for the resource sector. The argument was that while everything else was floating on a sea of credit, there was a bedrock of Chinese and Indian demand for commodities which underpinned the Aussie resource market and resource share prices.

Hakuna matata, mate!

That's the same argument being advanced today. And while it is undoubtedly true that resource demand for industrial growth in China and India is growing at mammoth rates, no one is asking if this demand itself is a function of loose monetary policy. If it is - and here's the important point - Aussie resource shares are just as vulnerable now to a big correction as they were in June of last year. That's why we're taking up the subject.

It's a timely subject, too. China's GDP chugged along at 8.9% in the third quarter. The big driver for GDP growth was massive growth in fixed asset investment. It grew by 33.4% in the first nine months of the year, according to China's National Bureau of Statistics.

But the meat of the story is that urban fixed asset investment in primary industry - the kind that consumes huge quantities of Aussie exports - was up a whopping 54.8% in the period. This is China's vaunted stimulus in action. And as you can see from the chart below, China's import volumes are headed off the charts this year, although the effects of the stimulus are petering out (which could be ominous).

The Chinese government unleashed a $600 billion stimulus spending spree on shovel-ready projects last November. That alone would lead to soaring commodity imports. But because China pegs its currency to the U.S. dollar, its monetary policy must match the Fed's. That means China's monetary policy has been every bit as loose and stimulative as Ben Bernanke's in the last year.

For example, UBS reports that new lending in China reached a record US$1.27 trillion in the first nine months of this year. This kicked off rallies in Chinese stocks, real estate prices, and construction. It also alarmed at least some Chinese officials that their dollar peg forces them to import inflation from the U.S., which can be politically destabilising. So now, they are walking themselves back from the ledge.

In yesterday's Financial Times, Qin Xiao, the Chairman of the China Merchants Bank (the country's sixth-largest bank) wrote that the government should not be afraid of a moderate slowdown in the economy. He wrote that, "Monetary policy must not neglect asset-price movements," he writes. "Therefore it is urgent that China shifts from a loose monetary policy stance to a neutral one."

Just how Chinese central planners aim to do this is unknown. Can they be neutral as long as they peg? When you peg your currency to keep your exports cheap - because industrial production and exports drive your growth which keeps employment full and the population from getting restless - it's hard to be neutral when the Fed is anything but. But that subject - when it's in China's interests to allow its currency to appreciate - is a whole other subject for another week.

For today we'd only like to make the point, or raise the possibility, that this decades-long China boom Ken Henry is counting on may be a lot more fragile than he thinks. Is there any reason to believe economic authorities in China are smarter than their buddies in Europe and America? All of them seem to be reading from the same play book. Inflate, stimulate, spend, build...and leave the bill for later.

China's officials have a difficult proposition: industrialise an economy of 1.2 billion people. No one knows how much of that urban fixed asset investment actually contributes the nation's capital stock, or whether it is more excess productive capacity or bad investment designed to keep GDP charging along.

If it's not driven by market forces, odds are there's going to be a huge amount of waste and corruption. And eventually, once the stimulus is removed, Aussie resource producers may find the demand they took for gospel was a function of the credit bubble too. They will have geared up for production increases only to find that the demand has vanished along with the credit that supported it.

But don't tell that to Ken Henry. He sees four long-term "structural implications" because of India and China's demand. In his speech yesterday in Sydney he said that, "I have spoken about the structural implications for the Australian economy of their strong contribution to the global demand for mineral commodities. That demand has supported a considerably higher level of our terms-of-trade."

By the way, Henry says that Australia will run a higher level of terms-of-trade for years. This means the country will get paid more for what it exports and pay less for what it imports. This is a preliminary first-strike on current account deficit hawks. Henry says the current account deficit will rise because of the improving terms-of-trade and that the Australia will import capital because investment will exceed savings.

We don't want to get into it too much in a confined space, but this is an argument worth having. America ran a massive current account deficit. Alan Greenspan blamed excess savings in the developing world for fuelling the surplus in America's capital account. He claimed that foreign investors were happy to pour savings into the U.S. stock and bond markets because it was a better investment.

This surplus in the American capital account kept interest rates low. The housing bubble began to inflate. Household savings rates fell. Spending increased. And at the end of the day, the current account deficit blew out. Americans financed a leveraged boom with foreign money and now have to pay the piper.

Henry says not to worry because Australia will import capital for "investment." That's all well and good if it's real productive investment. But as far as we can tell, Aussie banks are importing foreign capital and pumping it right back into commercial and residential housing, blowing an even bigger property bubble. Meanwhile, Aussie households are encouraged to take on more debt, reduce savings, and believe nothing's amiss here.

Time will tell if Henry's right. After all, by itself, a current account deficit is not evil. But it is pretty odd that a country that prides itself on its exports runs a trade deficit. Importing the capital that gets deployed in your economy isn't a sin either. But if you plow it all into a property bubble, it's a disaster waiting to happen.

But let's not be too troubled about deficits today. Henry says that, "It would be reasonable to consider that, while the Global Financial Crisis has taken some of the heat out of our export prices, we should get used to the idea that we could have structurally higher terms-of-trade for quite some time - possibly for several decades." He says this, among other factors, could lead Australia to a period of "unprecedented prosperity."

And the euphoria? Henry concludes that, "The Australian economy has just demonstrated to the rest of the world that, for some time now, it has quite possibly been the best governed, most flexible, most resilient of all industrialised economies."

Maybe he's right. We wouldn't mind it if he was. But pride goeth before a fall. And there is a real question in our minds about whether the Chinese growth model that's fuelling demand for Aussie resources - driven, as it is, by credit and the stimulus - is sustainable. We'd argue that it's not. But that is long argument which we'll save for next week.

Dan Denning
for The Daily Reckoning Australia

• The Future of the Australian Resource Market, Two Ways the Boom Could End
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Speculators and Chinese Firms Accumulating Australian Resource Companies and Commodities
• The Australian Resource Boom Isn’t Dead Yet
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package

Phew! Thank goodness that whole thing about toxic assets is over. Now we can get back to passively investing in stocks that only ever go up.

There is a serious case of denial coming from institutional investors and the financial media about what's ahead. Sure, it's tempting to think that because things have been so bad they won't get any worse. But what exactly emerged yesterday that changed the situation banks and investors face?

Not much, that we can tell. But that's because this is not a subjective crisis. Whether the situation has really improved does not depend on how you perceive a bank's balance sheet or a company's earnings. It depends on whether that balance sheet is actually healthy and the company can actually grow earnings.

But let's not quibble. The job of the Bear is to lure investors back in so he can smack them back down later. Frankly, the bear was gorging himself a bit anyway and getting a bit lazy.

Stocks were down on average about twenty percent in major Western markets. Consumer confidence levels were low and getting lower. The Bear needs fresh meat. And he can only get that if he can attract more investors back to the market. In you go!

The major economic news released yesterday is at odds with the way the market behaved. We're talking about the news from China that exports dropped 25.7% in February. Imports were down 24.1%.

If China makes and the world takes, China is making less because the world is taking less. And of course, China takes from Australia to make for the rest of the world. If China is making less, it will take fewer Australian resources.

There is a raft of data that need sorting, though. First, fixed asset investment in China actually grew by 25%. Fixed asset investment could be roads, bridges, and buildings-the sort of investment that needs copper, nickel, zinc, coal and iron ore. Or it could be commercial real estate-the kind of shovel-ready government busy work that doesn't lead to any bottoming in commodity prices ore sustained resource demand from China.

Also comes the news from Japan on thermal coal negotiations between Chinese utilities and major coal sellers Rio Tinto and Xstrata. It now looks like thermal coal prices for 2009-2001 are going to come in around US$70-72 per tonne, according to Matthew Stevens in today's Australian.

That's a 44% decline from last year's price of around $125 per tonne. But it's still higher than the spot price of US$60. And it's still 25% higher than the price for 2007-2008. So, as big as the percentage decline is, it's coming off a large base.

That doesn't make coal stocks an instant buy. But here is a clear difference between the extractive resource industries and the financial industries. Prices are responding to changes in demand. Resource producers are not being bailed out or directly subsidised by the government. There is a lot more transparency about what's going on the industry.

What's missing, to use a word analysts love, is visibility. No one can see that far ahead for the economy. This makes reliable price forecasts for commodities difficult to make, which makes earnings estimates hard to make, which makes valuations difficult to make.

Our suggestion? Keep it simple. Focus on companies with cash, little debt, and world class ore bodies (poly metallic for metals miners).

It's a bit nauseating to be told over and over the problem is confidence. We suspect this is a political tactic. Blame the credit bubble and resultant insolvency of the financial system on confidence! Then, give the people a dose of free money, which may numb the pain of the approaching second freight train to hit them.

That freight train is the credit market not responding to increased central bank liquidity in the desired fashion. "Libor's creep shows credit markets at risk of seizure," reports Bloomberg. "The cost of borrowing in dollars is rising as the global recession deepens and central bank efforts to prop up the financial system fail to prevent a growing number of banks from requiring government bailouts."

It is still a bear market in trust within the financial system. Central Banks are more than willing to lend to banks. But banks are hoarding reserves. The only upside of this is that banks haven't relent expanded reserves into the real economy. That would be the engine of inflation.

The downside is that increased bank reserves don't do much to improve the value of the assets on bank balance sheets. To address that, expect G20 finance ministers meeting in London to make a lot of noise about mark-to-market accounting. They want to change the rules so that firms don't have to constantly revalue assets to their current market value.

In any event, the action in the credit markets-Vikram Pandit's ray of sunshine not withstanding-suggest that the financial system is just as vulnerable to trillions more in losses and failures now as it was six months ago. Not a single thing has changed in the last few days to alter that fact.

Nonetheless, the market may rally anyway. The G20's political leaders meet in London in early March. This could be a world-historic event, but not for any positive reasons. We are pretty sure the leaders of the G20 nations are not going to gather together to ratify and sign an agreement that solves all the problems.

On the other hand, all their quarrels and divergent national interests will be on full display for investors and savers the world over. Investors are going to realise this problem is bigger than even big government's ability to contain it. What happens after that should be interesting...

Dan Denning
for The Daily Reckoning Australia

• Rising Coal Prices to Increase Electric Bills in Australia
• Latest Energy Bull Market Won’t Be Confined to Crude Oil
• Australia & China: Already Partners in the Commodity Boom
• Australia’s Next Big Export Industry
• Australia Presents Investors With Great Portfolio of Energy Choices

If China's economy continues to grow at its current rate, it will pass the U.S. as the world's largest economy in 18 years. Of course, it won't grow at its current rate for 18 years - not continuously, anyway. It will grow somewhat slower in spots and sometimes faster. What growth rate comes out in the end is anybody's guess, but the 18-year guess will probably be off.

Then again, the guess also assumes the U.S. stays where it is. And that is also unlikely. The U.S. economy shrank last year and looks to shrink again in 2009. Meanwhile, China is one of the few big economies still growing, though at a slower pace. The result is that China will actually make up ground faster in 2009. As Ting Lu, a Merrill Lynch economist based in Hong Kong, notes: "In 2007, the gap between the growth rates of China and other big countries was huge. Actually, in 2009, the gap between will be even bigger."

As the Great Depression II continues to lay siege to the world's economies, China remains a coiled spring of growth. Even though China is now the world's second- or third-largest economy, it still is a relatively poor country. And its resources are barely tapped.

The vast potential of China is hard to grapple with. Already, China has built the world's largest building (Beijing's airport terminal) and its longest transoceanic bridge. It has the world's fastest train and the biggest dam. As John Pomfret, former bureau chief for The Washington Post in Beijing, observes: "It is a nation of builders, of grand schemes, of gigantism." He calls China's engineers "some of the world's biggest risk-takers. Geeks with guts."

The Qinghai-Tibet railway was another engineering feat. Chinese engineers, already considered the best railway builders in the world, built a railway on the complex and shifting permafrost linking Llasa with Golmud in China's western hinterlands. The railway stretches hundreds of miles across a treacherous plateau.

Author Abrahm Lustgarten in China's Great Train describes the area as one of "intermittently frozen marshes, lakes and soggy permafrost that heave and shift more actively than almost any other geologic environment on Earth." In places, the quicksand is deep enough to swallow a tank. It is also higher than any other railway on Earth - at its peak, more than 16,600 feet above sea level. The cars of the train are pressurized as in an airplane, with oxygen pumped in.

After this stretch of the Qinghai-Tibet railway opened in 2006, the riches of Tibet started to come to light. The Ministry of Land and Resources disclosed huge resource finds - big veins of copper, zinc, lead, iron, gold, silver and other minerals.

"The new reserves make Tibet one of the richest regions in China's territory," Lustgarten writes, "and could shift the country's reliance on imports of copper and iron altogether." Tibet could hold 40 million pounds of copper - one-third of China's total. There is more than a billion tons of high-grade iron ore.

Again, Lustgarten: "Among the discoveries in Tibet was China's first substantial rich-iron supply, a seam called Nyixung, which alone is expected to contain as much as 500 million tons - enough to put an expected 20% of Chinese iron importers out of business."

More than just minerals, there is also an abundance of oil. Sinopec estimates some 65 billion barrels of oil will become accessible in Tibet. "A find, that if proven," Lustgarten writes, "would make the region one of the next great petroleum envies in the world."

What makes these projects economic now is the Qinghai-Tibet railway. Many Canadian and Australian companies already have joint ventures in place to mine the plateau.

The economy boomed in Llasa, too, thanks to the railway. The number of restaurants and bars in Llasa increased over 20% within a year of the railroad's completion. More than a million tourists took the train west to Llasa. Where it was once hard to find a hotel room in Llasa, over 660 hotels sprouted up after the railway. One, the Brahmaputra Grand, is a luxurious hotel with crystal chandeliers the size of Volkswagens and 50-foot tall plastic palm trees. A night here set you back $1,100.

Tibet industry up to that time was mostly in trading yak tails, fur and salt. And now, it looks as if Tibet will play the role of China's great western frontier, much like America west of the Mississippi in the 19th century.

There will be and is an ugly side to all of this that I've not talked about - the suppression of ethnic Tibetans and the weakening of a very old culture. China, though, continues to build and build. As Lustgarten notes: "The western outposts are linked by an expanding transportation infrastructure - roads, power transmission lines, pipelines and railways - built at a rate that makes Dwight Eisenhower look lazy."

But as with the rest of world, the pace has cooled. The fingers of depression wander all over the globe. No one can say how long it will take to work out of this mess.

However, some hopeful signs emerged recently. The China Electricity Council reports that electricity consumption rose nearly 7% in December, year over year. If no one has doctored up those numbers, that would be the first such increase since July. And there is some anecdotal evidence that housing prices in China are on the rise again.

Nonetheless, over the long term, China has lots of room and resources to grow. We got a glimpse of the implications of that growth in the last several years - the huge pull on resources such as oil, for instance. At the moment, economic depression has set in most everywhere. But longer term, it seems foolish to bet against the great dragon in the East.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. I mentioned above that China's electricity usage was up. There is opportunity in that. A slowing economy has not stopped China from investing in energy projects. China's power demand is still growing. And China overall increased spending on power grids by 18% last year...

• Australian Iron Ore Shares on China’s Menu
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Jules Begins His Last Year of School in Boston
• The Century of the Emerging Markets
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike

By the way, by new low, we mean could the indices take out the March 2003 lows? For example, in the week of March 10th, 2003, the All Ords settled at 2,716. It would a nearly 23% fall to there from today's trading level.

This is not an exercise in fear mongering, by the way. For most of this week, we've been focussed on a scenario where an increase in the global money supply causes widespread consumer price inflation and at least some inflation in commodity prices. But we need to take a closer look at another possibility today-a staggering earnings depression in resource stocks.

And be warned, it is not pretty. The only good news is that there are at least two businesses we can think of that will do well in an otherwise abysmal situation. More on them further below.

Here is the problem in brief: we know that financial earnings will suck for the fourth quarter. While Aussie financials may be relatively better off than their U.S. and European counterparts, their ability to increase earnings (especially when they are so reluctant to loan to begin with) is suspect. Either way, with Bernanke talking about another effort to re-capitalise banks, it doesn't appear the supply of credit to the real economy is going to increase any time soon-at least not via traditional bank lending.

Next is the real economy. Last night we learned that industrial production in the Eurozone's 15-member bloc fell by 7.7% year-over-year. Couple this with falling industrial production data from China, Japan and North America and you have nearly irrefutable evidence that the first-half slowdown in the global economy is going to be a lot more severe than any of the official estimates by the likes of the IMF, the World Bank, and the Fed.

None of this is good for Aussie commodity demand. Even though commodity prices are already down by large amounts, we now have the possibility of an ugly earnings shock for Aussie resource producers in the first and second quarters of this year. Whether this is already priced into resource shares is a question we'll deal with in a moment.

But it would be wise to not underestimate the possibility of a massive, earnings-crushing double whammy for resources. First, is rapidly contracting global industrial production. This could lead to an unpleasant (and not priced-in) decline in Australia's export earnings. Financial earnings have already been decimated by the credit crisis. Now that the crisis is storming into the real economy, are resource earnings next?

According to the RBA, "Australia's export earnings make up around 20 per cent of total domestic income on average, and thus have a significant influence on economic activity." Two of the biggest contributors to those earnings over the last few years were coal and iron ore. Both saw huge increases in annual contract prices as pre-Olympic Chinese steel production soared.

But now the reverse is happening. The Chinese are working down stockpiles and inventories. And waiting. But waiting for what? They are not just waiting for a resumption in global growth, at which point they will resume production and demand for Aussie raw materials. No. They are waiting for March and April

March and April are the looming deadlines for the annual contract price negotiations for bulk commodities like coal and iron ore. Right now, spot prices are well under contract prices-a reversal from last year when Indian iron ore traded at a premium in the spot market to Australian contract ore. Indian spot ores traded as low as $65/tonne late last year. That's well below the $90/tonne price negotiated for 2008, and a lot further below the spot price of $200/tonne achieved earlier in 2008.

So what can you expect? Contract prices are going to come down, probably by as much as 40%. The steel producers could ask for an even bigger price cut, but that would ultimately affect the number of viable projects in the Aussie and Brazilian markets (and sow the seeds for a shortage and higher prices in 2010).

Before then, though, you can be sure the decline in contract prices is going to combine with a plunging global economy to punish Australian export earnings. Putting aside the effect this will have on national income (along with job losses to accommodate the lower demand for raw materials), you now have a situation where the earnings recession could lead the Aussie market could take out the 2003 lows.

Just to repeat: the proximate cause of a 22% decline from today's levels on the All Ords would be a brutal double smack down of much lower global industrial production in the real economy (lower resource demand) and a huge reduction in contract prices for Australia's two main export earners (coal and iron ore).

But what would all this mean for resource shares? That is the question. Well, as hard as it is to believe, we reckon it would lead to new lows. Despite their gut-wrenching falls from last year, there could be even worse ahead. Perhaps that is why today's Australian Financial Review leads with the story that "$60bn projects under threat."

The Fin reports that falling resource prices and the lack of access to credit could shelve $60 billion in new Aussie resource projects. And that's on top of the $11 billion in projects that have already been deferred or cancelled altogether. ABARE still reckons there are 85 advanced projects valued t $67 billion that will proceed. But what about the 347 less advanced projects, valued at $220 billion? Who is going to fund those in this climate?

And more important, what would be the best investment strategy in a situation where there is a final, blow-off contraction in the resource patch? Well, as a thought experiment, one way to avoid another massive fall in the ASX and All Ords is to simply liquidate everything now and keep your head low. Such a strategy acknowledges that the bottom of the cycle in commodities has not yet been reached, and that it is not prudent to hang on for grim death. Rallies would be sold.

However, that is not to say that the bottom of this cycle is going to leave you wandering in the equity desert for 20 years. Earlier this week, we published Dr. Marc Faber's analysis that commodities may be the one asset class for whom the current situation most resembles stocks in 1987-the big correction/crash was an interval in the cycle, not the end of it. What would that mean in this case?

It would mean that the real economic consequences of the credit crunch are going to accelerate in the first two quarters of this year, leading to much lower global trade, industrial production, and export earnings for Aussie producers. Already you see this with plunging freight rates. This economic slowdown, along with the seemingly inevitable contract prices for coal and iron in March of this year, mean a steep drop in Aussie resource stocks in the next four months.

And then?

It's important to remember that commodities are heaving perfectly naturally and cyclically at the moment. "We know that this is a perfect economic storm," says Mitch Hooke, the CEO of the Minerals Council of Australian in today's AFR. "There is going to be some wreckage, there is going to be some damage and there will be a drop in supply. But demand will come back and then outstrip supply, and when that happens there will be a rapid recovery in prices and then production."

He's right, of course. This is basic cyclical economics. Its how things worked in the first stage of the resource bull. The increase in prices and the availability of finance led to surge in publicly listed explorers. Mind you with the exception of the base metals, you did not see a huge increase in new commodity supply come from all these new explorers (that's important later).

But now, the cycle has reasserted itself on the downside. Boom gives way to liquidating bust in the commodity sector, where free market economics still functions (unlike in finance). Slower final demand and tighter credit are pushing non-producers and those resource companies without cash or lines of credit right to the wall. There's nowhere left to go for many of them except out of business or into the hands of larger acquirers.

This too, is part of the cycle. When small would-be miners with quality resource projects and ore bodies lack the financing to produce those ore bodies (and can't live off the production of another working mine) they don't survive, at least not without help from a larger, cashed-up producer. This has an obvious effect (and also represents an opportunity for investors). Supply of commodities and minerals falls as the small firms disappear and the big ones mothball capacity. "Pebbles" get scooped up.

But when will the cycle bottom? This year? Not that we're a big believe in equilibrium, but the fall in supply will eventually get more in line with current demand (which itself may fall for awhile). And so you get a consolidation and contraction for a few quarters. Equity prices would react to all this much sooner, of course.

But what is the general, long-term trend for commodity prices? If we accept Marc Faber's analysis last week, the commodity cycle is not dead. It is merely resting. After a 20-year bear market and a eight year bull market, the cycle must now work through effects of a credit contraction and slower global growth.

Some analysts, like those at UCI say that the long term is good, even if the short term could be very gad. "The secular trend remains upward due to tight supply/demand fundamentals. In medium term, focus will be on global slowdown, easing inflationary pressures, dollar recovery, monetary tightening - all bearish for commodities."

Mind you, even in such a bearish argument for commodities, you might find an exception in gold producers, although not the explorers. The junior gold explorers are fast, like everyone else, running out of finance. Our forecast? Gold production is going to fall this year at the same time gold prices rise.

We've focused so much on the demand side for gold as an inflation-hedge that it's easy to forget gold is a mining business. You have to find it and dig it up. It is hard to increase the mine supply of gold.

True, there are large above-ground hoards of gold held by central banks. But in terms of mine supply, you can probably expect lower production this year, meaning those gold producers without debt might make attractive investments, even in the first six months of this year-and especially if the gold price reacts to the increase in global money supply.

Another exception might be LNG. Our man Kris Sayce at the Australian Small Cap Investigator has been all over this story. In fact, his two LNG share tips from the last two months are each up over 100% already. Kris was able to spot the bull within the bear. LNG is rapidly emerging as a substitute for oil as a transportation fuel (see the Pickens Plan by U.S. billionaire T. Boone Pickens).

LNG is also an infant industry in Australia. But it's already attracting the interest of large foreign firms who want in on an energy source coveted by Asian economies like Korea, Japan, and of course, China. So even amidst the general bearishness in oil prices, a punter could find some nice little earners in the Aussie energy patch.

LNG and precious metals are the promising exceptions to the bearish general trend of commodities. It's what our analysts are working on full time at the moment. And there may be others. But we thought it important to at least explore a scenario in which things get much worse for commodities. It's hard to believe that's possible.

However, we simply don't know-and no one does-how markets will react to increasingly large sums of money injected in the global banking system, or what direct Fed purchases of assets might to world's economy. In the long-term, as we've said before, the high saving emerging market nations are going to cease funding U.S. deficits and develop their own economies-focused more on domestic demand export growth.

That scenario-growth of consumption in the emerging world-is commodity intensive and favours Aussie producers. But getting to that that next stage in the global economy is easier said than done. Will it happen this year? Next year? In five years? Nobody knows.

Tomorrow, we'll return to the subjects of banks, the alchemy of turning debt into equity, and what it all means!

Dan Denning
for The Daily Reckoning Australia

• Australia & China: Already Partners in the Commodity Boom
• Dollar’s Demise Has Started a Chain Reaction in Currency and Commodity Markets
• Commodities Tell Us the World Won’t Stop Turning in a Financial Crisis
• Commodity Inflation Causes Consumers to Cut Back on Spending
• The Australian Resource Boom Isn’t Dead Yet

The trade we mentioned yesterday-long commodities and short the U.S. dollar-was described in today's Financial Times as "The Big One." It's the trade everyone made to hedge against inflation and still profit. But is the Big One done?

The liquidation of the short-dollar/long-commodity trade raises a simple question: what's going to lead the market when it turns up next? Typically, the sector that led the last bull market hardly ever leads the next one. There are lots of reasons for this. But the simple one is that conditions for expanding earnings are never as good as they are when things are as good as they've ever been (as they tend to be at the height of a boom.)

Financials have been pounded harder than resources. But as an investor you have to wonder which sector is closer to the bottom, and which can grow earnings more quickly. Which brings us back to BHP Billiton and the composition of its earnings before taxes and interest (EBIT).

The company's profits from operations increased by 22% from US$20.1 billion to $24.2 billion in the last year. But the big driver of that increase was the $6.5 billion contribution to underlying earnings from price increases in commodities (coal, iron ore, oil). By contrast, increased production volumes delivered only $1.8 billion dollars to underlying earnings.

Why does it matter? Well, it means the company's profitability is being driven by sky-high resource prices not increases in production. If resources prices-especially for coal and iron ore fall-then the share would be in a for a serious re-valuation.

Of course, we don't expect a sudden decline in thermal coal and iron ore prices. China's demand for steel should survive the turmoil from the on-going financial meltdown in the U.S. These are two imperial economic ships passing in the night.

However, it's obvious that if BHP Billiton is going to deliver stellar earnings growth next year, it's going to have to buy someone else's production (Rio Tinto) or increase production volumes without incurring cost blowouts. It could always count on resource prices rising faster than costs. But that's the sort of strategy that makes for a nasty earnings surprise.

So is the Big One still the Big One? Is this a blip in the resource trade? Or a sinkhole?

Nothing is too big to fail. Were the dinosaurs too big to fail? Was the Titanic too big to sink? Institutions come and go the same way whole species and civilisations do.

But we reckon BHP Billiton and the Australian resource boom will be a lot longer in the tooth before we have a serious discussion of the end of the boom. However we also reckon the way to invest in it is to find world-class energy and mineral assets whose shares don't already have a steep earnings premium.

Dan Denning
The Daily Reckoning Australia

• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• Australia & China: Already Partners in the Commodity Boom
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Australian Trade Deficit Grows for 75th Consecutive Month

"Analysts rate Westpac (ASX: WBC) a buy," says Andrew Carswell in today's Daily Telegraph. The bank told investors on Friday that it expected profit for the financial year to rise between six and eight percent. Let's call it seven. But wait. It gets better.

Analysts at UBS raised the price target on the stock to $25, which is about thirty-one cents below where it trades today. Bold! Merrill Lynch says Westpac has the lowest risk, highest quality assets in the Aussie banking sector. It rates the shares a buy too. Zig.

But why not zag?

Is it not obvious by now-one year into the credit crisis-that banking is a terrible business when you strip away the fancy suits and big ties? It is subject to massive blowups and failures. When run prudently, of course, this does not happen. Banks are discrete in their loan-making, maintain adequate capital, and pay investors a dividend for their risk.

For banks to deliver faster earnings growth, they have to take more lending risks. This leads, especially at the tail end of a manic credit boom, directly to the situation you most want to avoid, banks that lower lending standards to grow the portfolio. It also leads, inevitably, higher rates of default.

Why on earth would anyone want to own a business that is structurally exposed to black swan events that destroy shareholder capital? Anyone? Beuller?

The 'zag' strategy would be to forget shares altogether until the banking crisis is sorted out globally, in which case you'd be primarily in cash. Or, you could buy shares of companies that are less prone to negative black swans but equally (if not more so) beaten down. Here we have companies like Worley Parsons (ASX:WOR) in mind.

Worley Parsons reported a 53% rise in full year profit today. It's Australia's best engineering firm. It's got business in four different booms: energy, infrastructure, mining, and power. It has clients all over the planet. And as far as beaten down value, it's down 33% year-to-date.

Here's what we'd say for the moment: the beat down in the resource market is going to give you the best chance since 2003 to buy a portfolio of world-class projects at very good values. By the end of the year, a smart investor could end up with a buy-and-hold ten-year portfolio of the best resource and energy firms in the world. It's an opportunity that probably won't come again for quite some time.

Dan Denning
The Daily Reckoning Australia

• Worley Parsons (ASX: WOR) Announces Pilbara Solar Energy Project
• Our Policy on Share Tipping
• Australia Presents Investors With Great Portfolio of Energy Choices
• Financial World Has Every Reason to Encourage Government Stimulus
• Banks or BHP?

The balance of power in the world has shifted to resource producers (because of relative scarcity) and not consumers. You see a mini version of this in China (an iron ore and coal consumer) and its steadfast objection to a Rio Tinto (ASX: RIO) - BHP Billiton (ASX: BHP) merger (Aussie resource producers). The merger, from China's perspective, would create the so-called OPEC of Iron ore. If pricing power shifts to the producers, so does a greater share of the profits. Profit margins on Chinese steel would go down and the cost of steel-essential to China's great industrialisation-would go up.

Second, we see that in the execution of this strategy a resurgent Russia asserting itself against former Soviet territories and controlling all the energy corridors to Europe from Siberia and the Caucasus-you have a potential floor in energy prices. This will scare the heat and daylight out of natural gas consumers in Europe. But it also puts a premium on non-Russian energy projects, which investors might want to consider owning. Hello North West Shelf.

Finally, symbolically (along with the hosting of the Olympics by an authoritarian capitalist State) this indicates the end of benign globalisation and the beginning of a bull market in State on State warfare over resources. It will be a much darker, competitive period of economic history. Not quite a New Dark Ages. But that would be the worst-case scenario.

The good news in all of this? You can do something about it! The resource sector has been pounded so much recently that world-class projects are selling at pretty significant discounts.

Dan Denning
The Daily Reckoning Australia

• Wayne Swan Approves Chinalco Investment in Rio Tinto (ASX: RIO)
• Australian Iron Ore Shares on China’s Menu
• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• The Australian Resource Boom Isn’t Dead Yet

Food – Back in the summer of 2005, I recommended agriculture as a great opportunity. Since then, prices have risen but now we are beginning to see signs that agriculture production may have also peaked (Peak Food). There is mounting evidence that food production peaked in the 1990's in several world regions. For example, South Asia has lost roughly 50% of its arable land due to soil degradation and China has seen a 27% irreversible loss of farmland. The Asian giant continues to lose roughly 2,500 square kilometers of arable land every year due to environmental issues and urbanization!

According to the UN's Food and Agriculture Organization, currently 36 countries face food crisis and millions are at risk of starvation. As food becomes scarce, nations are scrambling to ensure supplies and they are trying their best to protect their populations from rising food resource prices. Traditional food exporters such as Argentina, Russia, China, India, Egypt, Vietnam and Kazakhstan have imposed export limits or introduced heavy export taxes in order to prevent domestic inflation and social unrest. Already, we have seen riots over food in Mexico (Tortilla crisis), China, Indonesia, Haiti and the Philippines. If my assessment is correct, I suspect this is simply an appetizer with the main course to follow in the months ahead.

One of the reasons why food prices are rising is due to the changing diet in China. Today, the average Chinese eats a lot more meat and raising cattle is a lot more water intensive than growing grains (Figure 1). So, as more water is used up by the livestock industry, there is less available for agriculture production.

Figure 1: Goodbye, cheap food!

Source: FAO

Those of you who feel that food output will be increased easily should take note of the fact that agriculture is amongst the world's greatest consumers of water, which is facing its own crisis. A fascinating recent report observes that worldwide, 70% of water is consumed by agriculture. Below I present some of the highlights from this study:

(i) It requires roughly 1,000 litres of water to produce one kilogram of bread. It takes roughly 260 m3 of water to feed one vegetarian person for a year. The more meat in a person's diet, the higher the water usage.

(ii) Arable farmland is shrinking and as a result, per-capita cropland available has dropped from 0.45 to 0.25 hectares in the past 40 years.

(iii) In order to increase crop yields, farmers have been using more fertilizers, pesticides and genetically modified seeds (wonderful).

(iv) Water shortages are becoming a serious problem for increasing food output throughout the world as widespread urbanization is competing for the same water.

(v) Supply of water is declining as the once mighty rivers now carry only a fraction of their former water volume and the groundwater table is steadily falling. Eleven countries accommodating almost half the world's population currently have a negative groundwater balance.

So, you can see how water shortages are not helping our cause and may prevent us from increasing food output in a significant manner. Also, not helping us at all is the crazy "let's burn food to produce fuel" policy being adopted in the West. Figure 2 highlights how rapidly U.S. ethanol production has surged in the past decade and worryingly, it is only going to rise in the years ahead. In my opinion, this policy of burning energy-inefficient corn to produce fuel is a disaster and will cause serious problems in the future.

Figure 2: Washington causing food crisis!

Source: FAO

Whichever way you look at it, resource prices are going to stay high for years to come. And any weather disruptions will only add to the problems by causing price spikes to unbelievable levels. From an investment perspective, I suggest that you consider allocating a portion of your funds to companies involved in agribusiness (seed, fertilizer, specialty chemicals and farm equipment manufacturers). Although, they have risen a lot in the past 2 years, I suspect they will continue to produce stellar returns in the future.

Metals – A few months ago, most analysts and investors prematurely called the end of the copper bull-market. According to these folks, such high resource prices were unsustainable and the copper "bubble" had popped! You may remember that I disagreed with this view and maintained my position regarding a multi-year primary bull-market for all types of commodities. Furthermore, towards the end of last year, I even highlighted copper as a great buying opportunity. Since then, the price of copper has risen significantly.

Furthermore, it seems to me as though copper is currently consolidating prior to launching higher. In case you are confused as to how copper can rise given the nasty housing recession in the United States, you should take into account the fact that China uses up roughly 30% of the world's copper and its economy is expanding at roughly 10% per annum. In other words, physical demand for the metal is robust in Asia and other parts of the developing world.

It is forecast that global copper demand will continue to rise by 4% per annum over the coming decade. This implies that the industry will have to deliver an additional 1.4 billion pounds of copper every year. This is equivalent to four big new mines every year for the next 10 years. Plus, another four new mines will be required every year over the coming decade just to replace depleted mines. I don't know about you, but at least in my eyes, this seems like a gigantic, if not impossible, task.

On the supply side, Chile is the biggest producer of copper and its power situation does not look promising. It is likely that similar to South Africa, Chile will see power shortages this year. Roughly 40% of Chilean power is hydro and 60% is thermal (mainly from natural gas supplied by Argentina). Chilean power demand is rising by roughly 5% per annum and with a reduction in hydro-electricity this year due to less rain, thermal power generation would have to rise by roughly 20% to meet demand. This seems unlikely and a power crisis in Chile seems to be on the cards. Should it occur, Chilean copper output will be affected as the operating mines receive less than adequate power supplies. Since Chile is the key player in copper, this is a very bullish development especially with the metal trading close to its all-time high. If you have not done so already, now is a good time to invest in diversified miners with exposure to copper.

Over in the precious metals department, both gold and silver continue to correct within their ongoing primary bull-markets. Having booked our profits a few weeks ago, currently we have no exposure to this sector in our managed accounts. Should prices correct in the summer, we will re-invest in precious metals mining companies.

Puru Saxena
for The Daily Reckoning Australia

• Robert Friedland: An Interview with Ivanhoe’s Giant
• Best Investment Opportunities Emerge from Water, Agriculture, Gold and Energy
• Water Usage by Big Companies
• Skyrocketing Costs of Sulfuric Acid
• Chinese Foreign Mining Acquisition Equal to All of 2007

Why would a meeting on Australian interest rates begin with a discussion of foreign trading partners? Could it be that foreign demand for Aussie resources threatens higher inflation even more than Aussies hitting the shops with a credit card? Hold that thought.

The Reserve Bank may have some help in cooling demand with high oil prices. Higher energy prices may cool industrial production from Australia's trading partners. If the Asian countries eating up Aussie resources cool down a bit, then the flow of cash coming back to Australia from exports would slow down a bit too. Maybe, just maybe, the pressure on higher wages and business investment would relax.

But who knows? We've said before that the Reserve Bank is helpless to dent the demand for Aussie resources. It's that demand-long-term and enormous-we contend, that fuels inflation in Australia.

All that money flowing back into the economy turns into business, personal, or government spending. You can choke off domestic demand with higher rates. But the most favourable terms of trade in 50 years contribute to back-door inflation that's hard to contain with monetary policy.

Our friend Mike Graham in New Zealand has offered his services as a correspondent. We know Mike from our days in London watching European markets. He sends this report.

"Someone forgot to tell the New Zealand rural property market there's a slump on. While residential prices dropped or treaded water, rural property across the ditch actually reached a new record in May. The national farm median price hit $NZ1.86 million, surpassing April's $NZ1.81m figure. The price of a dairy farm has risen 50% in a year! H. L. Mencken said 'No one hates his job so heartily as a farmer'. Kiwi gumboot-wearers like Kerry Logue would beg to differ.

"Kerry's been getting up at an unspeakable hour to head off to the milking sheds for 35 years. But he's now looking forward to a retirement that would make many lawyers envious. His 113ha farm at Tomarata, north of Auckland, is on the market for $NZ2.8m, a price he'll most likely get. With money in the bank, a hobby 'do-up' villa near Wellsford and a home at Huia, you could say the 62-year-old is creaming it. "Thirty-five years milking is a long enough stint for anyone. My kids thought the old man was crazy still working seven days a week."

"Not as crazy as all that, it would seem. Of course, it's not just good old-fashioned hard-graft that means Kerry's golden years will be just that. He owes a billion people 6,700 miles a beer at his local pub.

"The best way to get rich in 2008 is hardly a secret. You find something that the Chinese want. You produce it. And you sell it to them. In Australia, you buy a mine. In New Zealand, you buy a farm.

"Chinese Premier Wen Jiabao made a confession to New Zealand Prime Minister Helen Clark at recent trade negotiations. His dream is not about a future in which every Chinese will own his own car, receive a world-class education or own his own house. It's a future where every Chinese child will be able to drink two glasses of milk a day.

"An odd aspiration, but Helen is hardly complaining. Thanks to soaring Chinese demand for dairy products New Zealand dairy co-operative Fonterra (NZX: FCGHA) announced in May it would pay farmers a record $NZ7.90 per kilogram for milk solids. ASB chief economist Nick Tuffley estimated the total cash injection would be $NZ9.6 billion this year. That's equivalent to about 6% of GDP, and up from $4 billion on last season.

"Ordinary consumers - already feeling the pinch of expensive oil, falling property prices and tightening credit - are hardly ecstatic. Thanks to China's new taste for strawberry milkshakes, dairy is now off the menu for many Kiwis. Fresh milk now costs 22% more than it did a year ago. Cheese, 60% more. But it seems that the good old New Zealand farmer could be milking it for some time to come.

Dan Denning
The Daily Reckoning Australia

• Inflation is an Artifice Caused by Government
• Australian Dairy Prices Up Due to Grain Prices
• British Lamb Imported From New Zealand
• Australia & China: Already Partners in the Commodity Boom
• Rio Scraps Deal to Sell to Aluminium Corporation of China

The uranium price from last year reminds us a bit of when Jack tossed those magic beans out the kitchen window. Zip. Pretty soon a massive growth had burst out of nowhere.

But the seeds of Uranium Boom 2007 were sown years ago, back in the ‘90's.

For the entire decade of the 1990s, fossil energy was cheap and accessible and abusable. Crude oil crouched below US$30 until the turn of the millenium. The service station down the road was charging you 67 cents a litre for a tank of petrol. The gas that lights your stove and heats your home was a quarter the price it is now.

With everything was so cheap, who could care less about nuclear power?

Certainly not elected officials. They had little choice. What government would incur the wrath of environmentally conscious citizens while heating oil and gas prices are so low? No-one wanted to swap their nice fat oil cow for a handful of silly magic beans. Especially not magic beans that cause radiation poisoning.

So the beans were discarded on the back lawn. Nuclear infrastructure development stagnated. Europe dropped many of its planned projects. US policymakers wouldn't touch the issue. Gas flared, stovetops bubbled, coalfires raged.

Eventually, those beans sprouted, though. Oil has become five times as expensive since the year 2000. Policy-makers and planners have begun to realise that gas is finite. Coal, the other source of base-load electricity, is now copping flak for carbon emissions. In China these days, 60% of big cities have air quality below acceptable limits. Two billion people are going through rapid industrial development in Asia. How can cities keep the lights on without gas or coal?

Countries have changed their tune in recent years, especially developing nations with massive future energy loads to bear. China plans to take its nuclear energy load from 2% of total power to 8% in the next 15 years. To do that it'll have to build two nuclear reactors per year. India wants to double its own nuclear capacity over the same period.

All this nuclear power is going to need uranium fuel. Last year, investors realised this. So the nuclear beanstalk grew. Uranium prices boomed at exponential rates. It spiked at a price of US$140 per pound. Then it crashed.

Despite the crash, you know that sooner or later, uranium demand is going to fire up again. That's what makes the following uranium shares look especially oversold.

First up, Paladin Energy (ASX:PDN) has fallen a long, long way from its high of last year. From a long-term perspective, this chart is really interesting. This uranium company's share price recently rebounded from a low of AU$4.28 on April 14th. This corresponds exactly with a 61.8% Fibonacci retracement. It also matches up with long-term support established back in 2006.

The stock looks as though it may have taken a beating. But technically speaking, that beating may be overdone. Uranium has only fallen a little over 50% in the same period. With this new support, many investors will see this as an opportunity to buy back into uranium shares. It could grant Paladin a new bullish momentum.

Energy Resources of Australia (ASX:ERA) is another uranium miner we like the look of at the moment. Technically, it's also strong, but for different reasons than Paladin.

Since August 17th 2007, the share price has gained 38%. You can see this bullish trend clearly in the brown line on the bottom half of the graph above. The stock is currently trading just above the support line, with a positive outlook on the near-term. Traders have rarely been brave enough to venture below that brown trend line.

We don't think they will now. But also, the MACD indicator on the top half of the graph shows an "upward cross". The full brown line has crossed the dotted black line. This is a bullish signal for momentum traders. It's confirmed by action in moving averages; the 10-day moving average is about to cross above the 20-day moving average.

That adds to the argument for ERA's shares. The stock is simultaneously finding support, and getting two green lights for a turnaround. Now could be the time that these two uranium shares find their bottoms before a long-term bull market.

Gabriel Andre
The Daily Reckoning Australia

• Thorium as a Nuclear Fuel
• Uranium: A Carbon-friendly Substitute for Coal
• Good Month for Aussie Stocks, While U.S. Stocks Fell to Close the Quarter
• How to Trade Gold Shares
• Rising Coal Prices to Increase Electric Bills in Australia