Well just a day after highlighting the size and scope of the Gorgon LNG project in Western Australia, we have news that it really is a big deal. It is so big, in fact, that Martin Ferguson, the Federal Minister for Energy and Resources, said Australia is emerging as an "energy superpower."

Shazzam!

Ferguson was in Beijing last night to sign a deal sending $50 billion worth of Gorgon gas to China over the next twenty years. Exxon Mobil will sell the gas to PetroChina and the Australian government will siphon off as much as $40 billion in tax and royalty revenues over the life of the project.

China gets energy. Exxon gets profit. Australia gets jobs and revenue. Investors get a whole new industry to play with.

Mind you, this comes after the Gorgon consortium agreed to sell $25 billion worth of gas to India over the next 20 years as well. The deals are truly flowing. And there could be more. "As well as Gorgon and Woodside, there is the Sunrise project in the Timor Sea," Ferguson says. He's right. In fact, there are four major LNG zones in Australia.

Back in April we wrote this in a weekly update to Diggers and Drillers subscribers, "The other three major areas of LNG development are the Browse Basin (off the Kimberley Coast), Darwin (for LNG from the Timor Sea), and Gladstone in Queensland (the proposed terminal for export of coal-seam-methane projects in the Bowen and Surat basins). Under the Howard Government, Australia had as ambition the production of 60 million tonnes of LNG per year for export (mtpa). The current capacity of the four regions, according to industry analyst David Wood is more like 90mtpa. That would be more than half of current global production of 175mtpa."

Some of those regions are considered "conventional" LNG zones. Others, like the coal-seam-methane district in Queensland, are "unconventional." There are a few small firms operating there that Kris Sayce has been all over at the Australian Small Cap Investigator. Ferguson is excited about these too. "We also have an emerging industry on the east coast -- coal-seam methane. So we now have the opportunity, in my opinion, over the next 12 to 18 months, of getting investments of up to $100bn in the LNG sector."

With all that investment pouring into LNG production, and all those contracts pouring money into corporate and government coffers, you have to wonder what all the fuss about iron ore is over. In dollar terms anyway, it seems like less of a big deal. Aren't Australia and China getting along swimmingly?

For example, yesterday we learned that Andrew Forrest's Fortescue Metals Group will cut iron ore prices by 35% from last year's price in exchange for $7.2 billion in loans to fund expansion of its operations in the Pilbara. We should note that the price cut was negotiated with the China Iron and Steel Association (CISA) and that the loans will come from Chinese banks.

What gives? It's not likely that Fortescue's agreed price cut of 35% from last year's benchmark price (which is just two percent larger than what BHP and Rio have already agreed to with Japanese and Korean customers) is going to influence the negotiations between Rio Tinto and the CISA. But that seems to be the message behind the deal: you play nice with us and we'll loan money to you.

Fortescue has agreed to sell 20 million tonnes of ore over the next six months at the discounted price. Keep in mind that annual seaborne iron ore trade is closer to 400 million tonnes a year. It is a big deal. But not a huge deal, certainly not the sort of deal that would bring down the spot price of iron ore, which at over $110/tonne, is higher than the target benchmark price being sought by Chinese firms.

In any event, it looks to us like pricing power in the iron ore business is moving toward a new equilibrium. The annual price negotiations in which the ore producers are represented by one party (that can be squeezed by Chinese political machinations) and the steel makers are represented by another party (in this case, the CSIA, which seems to have made a meal of it) will be replaced.

But with what? BHP wants a benchmark index. China, seeking price certainty and the control a large customer expects to have, resists.

Whatever happens, we're beginning to think that energy exports will matter a lot more to Australian bottom lines than iron ore exports. Of course BHP and Rio are large diversified miners and employers. Troubled relations with China for to the two largest miners by market cap on the ASX are not good for investors.

But what is good for investors is the LNG boom. The big risk, as with any commodity, is that increased demand leads to over-supply. But that is not something we're worried about just yet. These projects take years to develop and secure permitting. Just in time LNG doesn't exist.

That means the firms with the biggest head start and the best prospective areas are going to be worth punting on. At least that's the idea anyway.

But while we're at it, let's report that at least one major investment bank is predicting a second commodity boom driven by a shortage of capital spending and resurgent demand. You always wonder if Goldman Sachs is just talking its own book because it's already made its bets in the sector. But for what it's worth, Goldman is predicting another commodity boom.

"We expect a commodity supply shortage in 2010," a company report proclaimed recently. "We have long emphasized that the commodity problem is, at heart, a supply shortage due to decades of suboptimal investment, which has been exacerbated over the past year by the sharp drop in prices and tight credit conditions. As the commodity markets rebound with the broader global economy we expect a redux of 2008 when severe supply constraints forced the rationing of demand through sharply higher prices to keep the markets balanced."

Goldman argues that the, " imbalances have actually worsened owing to the sharp drops in prices and tight credit conditions that have further impeded investment. In this context, it is important to emphasize that the commodity crisis is, at heart, a supply shortage. Although emerging market demand growth has been strong, the structural rise in prices that has been a key feature of commodity markets for the past several years would not have occurred if supply were sufficient. In reality, trend demand growth for many commodities has been slowing due to supply constraints that are restricting overall demand growth despite robust emerging market demand growth."

Goldman's note goes on to recommend a handful of blue-chip firms that will benefit from higher demand growth. Firms like Cairn India, Cameron (US), CNOOC (China), Hess (USA), Peterobras (Brazil), Suncor Energy (Candada), and more. For Aussie investors, there are a smaller number of energy blue chips and a larger number of excellent speculations.

Dan Denning
for The Daily Reckoning Australia

• The Iron Ore Pricing War Between China & Australia
• Buying Oil on Sale as U.S. Dollar Gets Weaker
• Rio Scraps Deal to Sell to Aluminium Corporation of China
• Giant Costco Opens in Melbourne!
• Bailout Deal Will Expand China’s Influence in U.S. Economy

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

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

But is it too much?

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

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

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

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

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

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

Some reader mail?

--Hi,

Peter H.

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

--Dear Dan,

Noah (Brisbane)

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

--Dan,

Rose

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

Dan Denning
for The Daily Reckoning Australia

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

Here in Australia, local shares will probably follow New York's lead and head down. Stocks on Wall Street finished up four days in a row, but couldn't make it five. There was no earth-shattering earnings news. That left plenty of room for grandstanding and other chicanery.

Before we get to the chicanery, what's shaking in the local market? The banks were up. Australia's banks never had the chance to gorge themselves on the stuff that's choking their counterparts in Europe and North America. They were stuck, instead, with large portfolios of residential mortgages. Plus, you can't short sell them anyway. So how low could they go?

The big two miners delivered mixed news. One of Rio Tinto's large investors, Australian Foundation Investors (AFI) says it's worried about the Chinalco deal. Rio's shares fell. BHP shares were up, although that might change today as the company has announced the expansion of mining at Olympic Dam in Australia might be delayed by two years.

All that aside, markets are still in a kind of suspended animation, waiting to see if there is any coherent, intelligent, effective response by the financial players or their regulators to...you know...solve the problems. It could be a long wait.

All hole and no donut. That about sums up the response of the economists and officials trying to un-freeze credit markets and get the economy going. Why on earth is the President of the United States taking time to sort out how much people at AIG get paid? Probably because he wants to distract attention away from how much money he plans to spend, and spend ineffectively.

Look, there's Elvis! Hey king!

That's what distractions are, attempts to change the subject or divert focus.

Distract from what? Huge inflation. Yes. Yes. We know. There is no huge inflation now. In fact, industrial production in the United States fell for the fourth month in a row. It hasn't been this low since 2002. But then, why would output grow when demand is falling and credit remains tight?

Money supply is not falling. Yet the good people who write the Bank of England's Quarterly Bulletin are still warning of a "debt deflation trap." You'll find all the good stuff beginning on page 39. The Bank warns that the cost of debts is rising relative to everything else, making it harder for heavily indebted Britons to pay off debts. Britons are, by the way, heavily indebted.

But are falling prices really so inherently evil? Really...whoever complained about a cheaper cheeseburger? When was the last time you bellyached about the ever-declining price of a pint of beer?

The Bank study resurrects the last period of sustained deflation and connects it with the economic misery of the times, in the 1930s. Then, too, output collapsed. The world's productive capacity far exceeded its demand. And money supply, for a time, briefly shrank as banks (who create most of the money in the fiat system) went out of business.

But all of this talk about the evil of falling prices is just a ruse. Excess capacity exists because the preceding inflationary bubble helped build factories to produce goods sold to people who bought them with credit. The demand was illusory. Unfortunately, the factories were real...it took real labour, real energy, and real raw materials to build them. They remained idle and unproductive unstill something else came along (World War Two) to reignite demand the and the need for war time production.

Falling prices aren't inherently evil. If prices fall low enough, low cost producers of a given good service are driven out of business. Supply tightens. Prices rise.

No...what the BoE and the Fed are doing is evoking the nightmare of the Depression to justify the coming inflation. The fiat money system can't function without just a little inflation. The gradual erosion of purchasing power is what makes it unnoticeable and thus tolerable to private citizens. They don't really notice it 2-3% at a time.

The trouble for the global system now is the tower of debts looming over the public and private sector in many economies. It's all well and good if the general price level falls. But it's no good if, while asset values like stocks and homes fall, debts remain fixed. An increase in the preference for cash makes debts a lot harder to pay off.

Of course, as you know by now, the preferred government answer is to inflate. This is what made the Chinese nervous last week as they reviewed Obama's budget. But the BoE and the Fed have been quite clear about their intentions. They will inflate as much as they need to in order to get nominal asset prices stable.

There are some investors who buy the Fed's bogus line that it can withdraw liquidity and sterilize its money printing before it leads to inflation in the economy. Believing this is a serious mistake that could cost you a lot of money.

The hedge against these inflationary policies (including here in Australia) is to invest in assets priced in dollars which cannot be created by a printing press. That includes oil, precious metals, and other energy commodities. The nominal price of these assets should rise as the money supply rises.

More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

• From the Gold Pan… Inflation, Deflation and Precious Metals
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• Marshalling the Armies of Inflation
• Obama faces huge challenges
• Inflation or Deflation?

This is a multiplayer game, being played at the highest and humblest levels. It's played in Melbourne boardrooms, Beijing backrooms, and even in your living room! Big fish chase big fish. Sharks circle in the water. And the little fish watch it all hoping to catch a wave, and not get eaten.

Australian Treasurer Wayne Swan announced this weekend that Chinalco is more than welcome to 11% of Rio Tinto (ASX:RIO). He made it sound like there were some caveats, provisos, and addendums. But at the end of the day the Treasurer said, "I have decided to raise no objections under Australia's foreign investment policy."

Okay. There are just two conditions that apply, though. Chinaclo has to reapply for Federal permission if it wants more than 15% of Rio and Chinalco said it won't ask for a seat on Rio Tinto's board. Does it even need one?

It depends on what Chinalco (and China Inc.) wants from the whole deal. Does Chinalco simply want to own a big enough stake in Rio Tinto that it can block the merger with BHP Billiton and prevent the formation of an Asia-Pacific iron ore titan? Or does it reckon that in order for the merger to go through with the regulators, Rio will have to carve itself up into various base metal pieces, aluminium being the juiciest?

Besides, there's always the chance that a Rio Tinto - BHP Billiton merger will be thwarted right here at home by the Australian Competition and Consumer Commission (ACCC). On Friday the ACCC raised some doubts about the whole OPEC-of-Iron-Ore vision.

The ACCC said that, "To the extent the proposed acquisition lessens the competition in the global seaborne supply of iron ore, it would be likely to have the effect of increasing global iron ore prices, which would in turn increase prices paid by steelmakers in Australia."

Hmm. Well, isn't that the whole point? BHP Billiton wants to shift pricing power in the resource sector away from the consumers (China) and towards the producers (Aussies). Global ore prices are going up because steel production and consumption are going up. Does the ACCC want to favour Australian steelmakers over ore sellers? And if so, on what grounds?

And another thing. Has the Treasurer really sorted out what's in Australia's best interests? For example, he delayed by 90 days a ruling on Sinosteel's bid to takeover Murchison Metals (ASX:MMX) in the Midwest. While delaying a takeover, the inaction also pummeled Murchison's share price, not exactly a desirable result for Murchison shareholders.

And what was the point of the delay anyway? Was it to hope that Sinosteel would somehow change its strategic objectives by sending it to the corner for 90 days? Or does the Federal government have any idea how to confront the reality that many foreign interest are keen to take ownership of Aussie mineral deposits are willing to pay for it?

Is Australia for sale or not? And if not, who's going to develop all those mineral deposits and turn them into wages, income, capital, and rising standards of living? If not now, when? We're headed out to Geraldton tomorrow to give a speech on the state of play in the Midwest. We're also sticking around for a day to hear from miners who have projects in the region. We'll let you know what we find.

As you can see, we have more questions than answers this morning. But now that China has emerged onto the global stage with a splash, the simple question is "what next?" One way of looking at it is that you're seeing what happens when demography and geology collide.

China's extraordinary growth rates have thus far been driven by a huge advantage in cheap labour. But that growth is resource intensive. If China (and India, and Brazil and other emerging economies) keep increasing per capita incomes, they're going use more energy and resources than ever.

For example, today's Wall Street Journal reports that the average American consumes the equivalent of 7.82 tonnes of oil per year to meet his energy requirements. By comparison, a single Chinese man uses just 1.4 tonnes of oil per year to meet his total energy requirements.

Rising standards of living are resource intensive. One good thing is that more developed economies tend to use energy and resources more efficiently. But is there enough oil in the world for six billion people to live at the same energy intensity as homo Americanus? We doubt it, which will make watching geopolitics and the great contest for energy very interesting over the next ten years.

Dan Denning
The Daily Reckoning Australia

• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Australian Iron Ore Shares on China’s Menu
• Rio Scraps Deal to Sell to Aluminium Corporation of China
• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• The Australian Resource Boom Isn’t Dead Yet

Later today two figures will come out that may or may not confirm the RBA's early declaration of victory over inflation. Home-building approvals will be announced as well as retail sales. If those are muted, the RBA might indulge in a smile or two and some handshakes. Perhaps they can sing the song, if the Bank has one.

The Bank is walking a fine line. It says it expects CPI to remain high now, but believes it will be lower later, which means rates can stay the same. Got that?

But it's clearly worried about the strong terms of trade. "The rise in Australia's terms of trade that is currently occurring...will add substantially to national income and ability to spend, even with the slowing in global growth to below-trend pace that the Bank is assuming. At the same time, rising prices of oil and a range of other commodities are adding to global inflationary risks."

Speaking of the favourable terms of trade, Rio Tinto (ASX: RIO) wrapped up its negotiations with Asian steel producers this week. Here's the score card: Korea's Posco accepted a 97% increase in ore prices, China's Baosteel agreed to an average increase of 85%, and Japanese steel producers settled on a 95% increase.

Tim Gerrard at Austock says higher ore prices will add $900 million to Rio's earnings this year and $500 million to BHP's, according to Matt Chambers in today's Australian. The trouble for BHP is that while Rio settled early and often for a 95% gain, Marius Klopper's outfit wants a bigger gain and a new pricing mechanism. BHP hasn't inked a single deal with steel makers yet.

In fact, BHP's idea to move to continuous pricing for iron ore based on and index got blasted yesterday by the China Iron and Steel Association. Yesterday's Shanghai Daily quoted the association as saying, "The index is improper and unfair...it's not good for long-term stable co-operation between the supply and demand sides, so we firmly oppose it."

Life is not fair. How iron ore is priced isn't really a matter of what's fair. When the market was smaller-fewer sellers and fewer buyers-you could do business over a conference table or a handshake. Not anymore.

The more players in a market, the more liquid. An index would be market-based pricing rather than cartel-based pricing. The Chinese worry that between Vale, BHP, and Rio, just three companies control 70% of seaborne iron ore exports. This is why Andrew Forrest's Fortescue Metals Group (ASX:FMG has been welcome with open arms by Chinese steel mills.

As we've said in the past, China and Australia need each other. It's in each party's interest not to antagonise the other. In today's Australian, Chinese ambassador Zhang Junsai said, "We don't want to see a monopoly in the international iron ore market. That is not in accordance with globalisation."

He also said the Rudd government should encourage "an attitude of welcome" for Chinese companies interested in investing in Australian projects. "We have benefited from your development, you have benefited from our development," he said. "With the development of closer economic relations, it is natural to see today companies from China wanting to invest in Australia."

The answer to the increase in firepower in the Civil War, by the way, was mobility or greater manouvre. Don't get bogged down in the trenches. By combing firepower with mobility (the Blitzkrieg), modern 21st century warfare made information a big part of fighting and winning battles. If you move faster than your enemy can react, by the time he's responding to what you're just done, you're already doing to something else. By attacking his brain-his ability to respond to so many reports-you paralyze him.

Dan Denning
The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Posco’s Production Cuts May Be Bad for Australian Iron Ore
• Australian Iron Ore Shares on China’s Menu
• Australia & China: Already Partners in the Commodity Boom

If not for the iron-ore solid performance of BHP Billiton (ASX: BHP)-up 24.7% on the financial year-it would have been much worse for the ASX 200. Rio Tinto (ASX: RIO) did its part to hold the line for the resource sector as well. Rio was up 38.2% for year, from $98 to $135.50.

But wait, why is BHP's 24.7% gain more weighty than Rio's 38.2%? Is this some weird new math? Some sleight of hand or trickery? No.

The ASX/200 is a market-cap weighted index. A stock is judged not by the colour of its performance but by the content of its market capitalisation. BHP's market cap went from $194 billion to $244 billion in the last twelve months. Rio went from $98 billion to $135 billion.

You reckon Rio's CEO Tom Albanese will not be happy to hear that BHP still means more to Australia-at least the performance of its share market index-than Rio. Yet Rio is not unattractive. The Financial Times reported yesterday that ArcelorMittal (AMS: MT)-the world's largest steel company-may be interested in buying a piece of Rio.

Does that kind of deal make sense? Arcelor is trying to bring its resource supply chain back on to the balance sheet. Buying the world's second-largest iron-ore maker sure would do that. But Rio's biggest customer is China. So does Arcelor just want a piece of Rio's growing earnings? Does it want the ore? Or does it want a piece of Rio's assets in a post-BHP merger carve up?

Who knows? Lakshmi Mittal does probably. But he's not telling.

Yesterday we mentioned we'd look at the markets geopolitically. What we meant by that is that most pundits are assuming the resolution to the credit crisis will come in form of a normal economic cycle or some change in monetary policy, or a currency readjustment. But maybe it will end in bullets.

This current state of affairs is not just a friendly tilt between inflating commodities and deflating financial assets. An allusion is in order. At the First Battle of Manassas on July 21st 1861 the American Civil War got underway. Everyone thought it would be a short, quaint affair. Manassas is not far from Washington D.C.

Today, you take Interstate 66 to Route 50 West, if memory serves (our brother used to live in the area). But back in 1861, day-trippers from DC took carriages out to watch the opening of the war. They brought picnic baskets and clapped. They anticipated a Union rout of the rebel troops led by Confederate General PGT Beauregard.

It was all going the Union's way until a bunch of Virginians under General Thomas Jackson held the line at Henry House Hill. "There stands Jackson like a stone wall," said Brigadier General Barnard Bee Jr. The Southerners rallied and won the battle and the war was much longer and bloodier than anyone expected.

We mention the battle for three reasons. One, it was a nice way to think of BHP and Rio in your portfolio, buttressing it against a larger route. Two, the Civil War was much worse than anyone expected because it was really the first war where industrial production mechanised warfare. You had tremendous firepower concentrated in large masses of men. The result was industrial scale slaughter and a preview of World War I fifty years later.

No one went into the war thinking it would be newer and deadlier. And no one has gone into globalisation believing that there were drawbacks as well as benefits. The obvious drawback now is that a synchronised global asset bubble has become a synchronised global asset bust, with falling asset values leading to reduced consumption, lower corporate earnings, and more falling asset values...all in a downward spiral.

The third reason brings us to Clausewitz, the German military strategist. He wrote many famous things. One of them is that, "war is a continuation of politics by other means." Clausewitz used the German word Politik, which can mean either policy or politics.

One reader writes in that our theory of a seamless migration of wealth and capital from West to East is rubbish. "People never relinquish what they have easily," he writes. "If Asia is to become rich and the West poor, we will see war, actually many wars, first. The history of man is war."

This is the other possibility, then. The economic tensions created by globalisation turn into hot resource wars, via both politics and policy. It's no coincidence that the oil price has gone up since the Iraq war began.

Will Americans under John McCain or Barrack Obama take their new position in the world with good grace? Or are they going to fight it? What is China's ultimate resource policy? Does Australia even have one? Should it? Will markets take a back seat to geopolitics in the coming years?

Let's not be so dire. We could be in the midst of a painful but necessary financial adjustment.

Dan Denning
The Daily Reckoning Australia

• Rumours Swirl Over Chinese Equity Stake in BHP Billiton
• Big Australian Resource Stocks Up 24% in 2008
• Were Chinalco’s Intentions With Rio Always Honourable?
• Dollar is Merely Retreating in Good Order
• BHP Billiton (ASX: BHP) to Report Second Half Results Today

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
The Daily Reckoning Australia

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

BHP Billitons's oil projects showed up in a research report we reviewed yesterday. The report tried to answer the question of where future global oil production would come from. There is a 32 million barrel per day gap between what the world produces today (about 87mbdp) and where the International Energy Agency reckons the world will be in 2030 (117mbpd).

In other words, the world needs another OPEC if oil supply is going to keep up with demand. OPEC currently produces 32mbpd. The IEA says OPEC can double that figure if it invests about US$2.4 trillion in exploration and production. OPEC is not as sure. As you can see, the gab between global production capacity and global consumption is, ahem, pretty tiny right now.

Source: BHP Billiton, IEA

According to BHP's oil man Mike Yeager, BHP's cost of production for a barrel of oil is between $6 and $12 a barrel. For the last three years, production at BHP's various oil fields has hovered around 300k bpd. That makes it the world's 25th largest oil producer, according to the company, which is not bad if your main business is mining.

It's an axiom that the mining business and the oil business don't mix. Energy exploration and production sucks up the capital, while project life is uncertain and cash flows variable. There are lot of known unknowns, and on the exploration side, some unknown unknowns.

But BHP Billiton does know that oil production increased to 378k per day last month, and 415k per day last week. It knows that the fifth LNG train from the North West Shelf is scheduled to begin production this year. It knows that its Neptune field in the Gulf of Mexico, though delayed this week, should begin cranking out 50kbpd in June of this year.

It also knows that by this time next year the Shenzi field in the Gulf of Mexico should begin producing about 100kbpd and that by 2010 the Pyrenees field in Western Australia should produce about 96kbpd. And there are more projects in LNG on the way, too.

That is a lot of good news for an oil company that's not an oil company. By market value alone, BHP Billiton is bigger than BP (NYSE: BP) and not far behind Exxon Mobil (NYSE: XOM) and Royal Dutch Shell (NYSE: RDS.A). If the company is valued as an energy company and not just a miner, then yet another reconsideration of its value may take place. Rio Tinto should be worried about that. All that energy translate into cash for a bid sweetener.

BHP Billitons's cost of production is going to rise. There is huge cost inflation across the entire oil industry as projects move further off-shore and deeper underwater. But this is an example of Australia's exposure to straight-forward bull markets in energy and resources. The businesses aren't easy, but they are not conceptually complicated.

What's so astonishing about Australia's resource economy right now is how it's filtering down from gold and oil to base metals, bulk commodities, and even lead. "The great minerals land grab by China Inc continues with Hunan Nonferrous Metals Corp looking to buy one of Australia's best untapped lead deposits," reports Kevin Andrusiak in today's Australian.

Lead?

"Yesterday Hunan launched a takeover bid for Perth-based Abra Mining, saying it is prepared to spend just $67.3 million to control one of the nation's best untapped lead deposits. Hunan, which has received the backing of the Abra board for the takeover play, has offered 83c for 70 per cent of the remaining Abra scrip it does not already own."

Hunan's offer puts a 44% premium on Abra shares. A 44% premium on lead. If lead gets that kind of premium, what would BHP's oil and energy reserves (1.3boe) and its resource base (3.5boe) command? The resource grab is well and truly on, and it's moving at the speed of lead.

Dan Denning
The Daily Reckoning Australia

• Rumours Swirl Over Chinese Equity Stake in BHP Billiton
• Higher Oil Prices, the New Normal
• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• Where Will Future Oil Production Come From and How Can Investors Profit Today?
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy

What does that mean? Investors are going to have to begin considering the embedded energy costs in tangible goods. Everything in life takes energy, from making your scrambled eggs in the morning to smelting aluminium. Some resources are more energy intensive than others.

Take the Mexican stand off between BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO). BHP feels its exposure to coking coal, oil, and gas gives it an earnings advantage over Rio. Not so!, says Rio. Rio says its exposure to iron ore, copper, and aluminium means it will grow is earnings more and sooner than BHP.

Energy earnings versus metals earnings. It kind of reminds you of the Priority Dispute between Newton and Leibniz over who invented the calculus, doesn't it? Chicken, egg. Egg, chicken. Cluck.

Aluminium is an energy-intensive metal, and therefore more price sensitive in an energy-scarce world. This is to Rio's advantage, the company reckons. "The price for aluminium now has a new base," Rio's chief economist Vivek Tulpule told investors in Melbourne last week.

"Margins for existing aluminium producers who have cheap energy, their own bauxite, and who aren't exposed to the Chinese currency, go up. This is a phenomenon that people have only started to clue on to very recently."

Tulpule also said that, "Though Chinese aluminium supply had traditionally risen in tandem with demand, keeping a lid on prices, soaring energy costs in China and rising bauxite costs had made Chinese producers the most expensive in the world."

In gold, the mantle of lowest-cost producer has always been coveted. In resource, the mantle of lowest-energy-intensity may be the key to figuring out which resources will go up the fastest. Energy-sensitive resources will see producers get hit hard by rising costs. This will cause some to close up shop, reducing production and supply. Prices will rise.

"An energy shortage in Chile may do for copper what cuts in electricity supplies did for platinum in South Africa spark a record-setting rally in prices," according to Heather Walsh at Bloomberg. "Chile may be forced to limit power use for the first time since 1999 because a drought has reduced water levels at hydroelectric reservoirs."

Proximity and possession of energy may even better than access to cheap capital in coming years. Energy is a kind of capital, isn't it? If that's the case, Australia has a huge capital base, with its reserves of coal, natural gas, and uranium.

Thermal coal prices are set to double from US$55 to US$125. That's based on the agreement between Japan's Chubu electric power and Xstrata which should be come the benchmark for 2000-09 contract prices. Spot prices for thermal coal have tripled in the last year. Spot coking coal (steel marking) prices have quadrupled in the last 12 months, and in the last two months they've doubled. Notice a pattern?

"The value of announced cross-border acquisitions by China so far this calendar year is now US$24.5 billion from 56 deals according to Thomson Financial-already almost equaling the record of $US29.8 billion for all of 2007," according to Colleen Ryan in the Financial Review. As usual in the financial world, the easiest way to find where asset prices are headed is to follow the money.

"China's acquisitions of foreign targets reached US$15 billion in the mining sector-the most active sector, largely comprising companies engaged in metals, mining, and chemicals-rising from just US$243 million in the same period last year," Ryan writes. Are you listening BHP?

Dan Denning
The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Why an Energy Crunch Could Lead to Booming Profits in “Solid Electricity”
• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• Base Metals Prices Spiking After China Earthquake
• Australia & China: Already Partners in the Commodity Boom

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

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

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

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

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

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

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

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

Source: International Monetary Fund (IMF)

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

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

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

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

Our point?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
The Daily Reckoning Australia

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