Agora Financial’s Rude Awakening

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Laguna Beach, California

• Financials vs. Commodities – the multi-trillion dollar question,
• Just how “crazy” is $200 oil?
• Some Rude homework for you and the kiddies and plenty more…

Eric Fry, reporting from Pasadena, California…

At yesterday’s Value Investing Congress in Pasadena, California, several presenter’s urged the attendees to buy “beaten down” financials like Legg Mason (NYSE: LM) and American Express (NYSE: AXP). “That’s where the value lies,” they said. Several of the other presenters advocated buying certain stocks in the red-hot energy sector.

The guys who liked financials weren’t very keen on oil stocks. And the guys who liked oil stocks weren’t very keen on financials. In fact, a few of the presenters prepared detailed charts to illustrate why the credit crisis might be far from over and why they were continuing to sell short various financial stocks.

Both groups of investors saw themselves as genuine value investors. But their opposing perceptions of “value” could not have been more extreme. “That’s what makes markets,” as the old Wall Street saying goes.

Here at the Rude Awakening, we normally profess agnosticism. But in this particular instance, we refuse to conceal our faith. We trust resource stocks. We distrust financials. The inflationary monetary policies of the U.S. Federal Reserve inspire us to cling fast to our faith in the commodity sector, while continuing to revile the financials as if they were evil incarnate.

Nevertheless, we don’t possess a crystal ball. We could be dead wrong. Commodities might be a big, fat “sell,” while financials might be a screaming “buy.” But we just don’t believe either of those perceptions.

It’s a matter of picking one’s poison. We prefer the poison that pulls essential commodities up from the earth’s core and sells them to a commodity-constrained world, rather than the poison that loads balance sheets with toxic waste and then marks the toxic waste to fantasy prices for the purposes of padding bonuses for insiders.

Last Thursday and Friday, we examined (once again) the bear case against the financial sector. [Too Small to Succeed and The “Goldman Sachs Phenomenon”].

Today, we’ll take a peak at the long-term bull case for crude oil and other natural resource investments.

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What Comes After A Trillion?
By Eric J. Fry

The supply of newly-minted dollars bills has doubled since George W. Bush took his first oath of office. The world’s known supply of crude oil has decreased by about 13% over the same timeframe. These two data points are part of a new macroeconomic equation that equals soaring oil prices.

Before the human race began sinking oil wells into the ground 150 years ago, the planet’s total geological inheritance of crude oil totaled about 2 trillion barrels. But mankind has already burned up about one trillion of those barrels. So we’ve only got one trillion left. By contrast, during those same 150 years, America’s total government liabilities exploded from $75 million to $54.6 trillion.

As the planet’s supply of oil slips below one trillion barrels, and America’s pile of liabilities soars above 54 trillion dollars, crazy things might start to happen – crazy things like $200 oil.

“Net of all accounting gimmicks, the actual federal budget deficit is running at an unsustainable, system-dooming pace,” warns John Williams, founder of Shadow Government Statistics. “The consolidated statements show that the actual annual federal deficit for the fiscal year ended September 30, 2006 was $4.6 trillion, up from $3.5 trillion in 2005. Total federal obligations at year-end were $54.6 trillion, up from $50.0 trillion in 2005.”

[Editor’s Note: The 2006 GAAP statement can be found on the Treasury's Web site, under Financial Management Services at: http://www.fms.treas.gov/fr/index.html]

America’s fiscal condition, says Williams, “has deteriorated beyond any hope of a solution within the existing system. Raise taxes? Even a 100% personal income tax would leave a deficit…Such circumstances in the past – though no nation on earth has ever come close to experiencing the level of fiscal and financial fraud now being perpetrated on the American people – typically have been ‘cured’ by revving up the printing presses and creating excessive quantities of money. The end result is a monetary collapse in a hyperinflation, with the currency becoming worthless.”

Williams’ dire forecast might be way too pessimistic. $54 trillion certainly seems like a lot of money to owe, even for the world’s “richest” nation. But maybe this monstrous IOU is manageable. After all, we Americans still retain the “exorbitant privilege” of repaying our debts with the money we make for ourselves. The approximate cost of making each dollar bills is 4 cents. Every CEO in America would envy those profit margins.

However, as long as we American’s may continue to operate the big machines in big rooms that splash special ink onto special paper, we might be able to forestall a day of reckoning. But we probably will not be able to forestall an era of soaring commodity prices.

That’s because most of the things that dollar bills buy do not simply fall off of a printing press. Delivering a gallon of gasoline to the local service station, for example, requires billions of years of geological preparation, and then billions of dollars worth of exploration and development effort, and then billions of dollars worth of refining and transportation infrastructure. Furthermore, 80 million barrels of oil passes through the world’s engines and power plants every day…and those barrels are never coming back again.

But crude oil is not the only natural resource that is depleting and/or in short supply. And the U.S. dollar is not the only currency on fertility drugs. So a forward-looking investor could expect to see the prices of most major commodities rise in terms of most major currencies. But this simple conclusion is easy to miss when most of the relevant data points contain nine to twelve zeros.

Most of us have some vague idea that one trillion is the number that lies somewhere between one billion and one bazillion. But beyond that, we have no clue. And because we have no clue, we have a hard time making a connection between the one trillion barrels of oil that lie buried somewhere inside the earth’s crust and the 54 trillion dollars of liabilities that lie buried somewhere inside the U.S. government’s balance sheet.

So how much is one trillion anyway? The creative folks at govbudget.com provide some
perspective:

• 1 trillion seconds = 31,546 years.
• 1 trillion dollar bills placed end to end would reach 96.9 million miles, far enough to reach the Sun.
• The average new car costs $28,400. $1 trillion would buy more than 35 million cars.
• The entire Federal budget is $2.8 trillion. A stack of that many dollar bills would circle the Earth more than 7 times.
• Gross Federal debt is more than $8.7 trillion, which would make a stack of dollar bills that would reach from the Earth to the Moon and back with some to spare.
• $8.7 trillion in one-dollar bills would cover an area larger than each U.S. state except for Alaska and Texas.”

The nearby chart paints a picture of the largely unfettered global growth in U.S. money supply since the early 1970s, plotted against industrial production – a proxy for “goods” in their many varieties.

The chart below includes a marker indicating President Nixon’s canceling of the link between the U.S. dollar and gold in 1971. Once this anchor was removed, all that remained was a pure fiat monetary system, or what James Grant calls the ‘faith-based’ system.

As the shackles of gold convertibility slipped from the wrists of the U.S. Treasury, America embarked on a grand experiment. It would borrow vastly more money than it would receive in tax revenue, while also promising to pay even larger sums in the future as Social Security and Medicare “entitlements.” By spending – and promising to spend – vast sums, the government would pile up multi-trillion-dollar liabilities.

But this grand experiment included an ingenious wrinkle: The government would satisfy all its liabilities with a currency that it would print for itself. Incredibly, this grand experiment has performed marvelously so far. Americans pile up “deficits without tears,” as Jacques Ruff, advisor to former French president Charles De Gaulle famously griped. “They give without taking, lend without borrowing and buy without paying.”

But the tears might begin welling up at any moment.

America’s grand monetary experiment is beginning to return some undesirable results – like a slumping U.S. dollar and a troubling uptick in inflation. These related trends manifest themselves in the form of $900 gold and $120 crude oil.

In other words, the skyrocketing oil price is as much a monetary phenomenon as a geophysical one. Paper currencies and debts proliferate rapidly. Natural resources do not. That’s why the prices of natural resources like crude oil MUST increase over time. And that’s why you should listen to that little voice inside your head when it tells you: “$200 crude oil may be crazy, but not nearly as crazy as a $54 trillion IOU.”

[Joel’s Note: A bet on one, many will tell you is more or less a bet against the other; financials or commodities; trillions in debt; or the last trillion barrels; expanding fields of dollars, or shrinking wells of oil.

Here at the Rude Awakening, we always advocate due diligence before investing. Therefore, we suggest those who prefer to bet on the dollar take a brief moment to appreciate exactly how much dollar-denominated liability the government printing them holds.

Rude homework for debt-betters: Count to 54.6 trillion, the total amount in U.S Government liabilities in dollars. Given the average American life expectancy of about 77 years and assuming you count at one dollar per second with no time for eating, sleeping or golfing, this should take you (and your progeny) a tad over 22 thousand lifetimes…give or take a few grandchildren. (Usually we’d suggest double-checking your figures, but we’ll make an exception in this rare case.)

Rude homework for commodity-backers: Count to 120 – approximate price a barrel of oil trades at while you read this. Then click here to calculate your profits.

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Rude Endnote: We hit the market today with the Dow off 206.48 points and the S&P 25.69 points under. The dollar buys about 0.6517 euros or 0.5110 British pounds. Gold is sticking around $873 an ounce and light sweet crude for June delivery, closed yesterday at a record $123.53.

Until tomorrow…

Cheers,

Joel Bowman