Financial Sense Newshour
The BIG Picture Transcription
February 25, 2006
- Investing in an Inflationary Era
- Emails and Q-Calls
- Other Voices: Honorable Ron Paul (R-Texas), The End of Dollar Hegemony
- Investing in Juniors: The Year of Takeovers
- Other Voices: Roger Conrad, Utility Forecaster
- More Emails
Investing in an Inflationary Era
JOHN: Well, here we go, we have an information packed Big Picture during this hour. We’ll of course take emails all during the hour, and some voice mails from people on our question line. Also, we’ll have Congressman Ron Paul joining us, he gave a very important address on the floor of the House on February 15th of this year, but nobody seemed to notice about the end of the hegemony of the dollar; and Roger Conrad’s going to join us here as well regarding energy consolidation and alternative energy. And then we have the Big Picture things we talk about, Jim. First of all, we’re going to look at investing in an inflationary era. My gosh, they’re all saying, “hey, we have inflation.” Where have I heard that before?
JIM: This program?
JOHN: Oh, shoot, I knew it was somewhere! I never miss this program except when I’m on vacation, Jim.
JIM: Neither do I.
And we’ve got another topic I want to cover, especially given the acquisitions this week of two juniors: we had Yamana buying out Desert Sun; and you had Glamis on Friday buying out Western Silver. So, we’ll also be covering investing in juniors – the year of takeovers.
JOHN: Well, Jim, it seems like the world is beginning to wake up as we pointed out at the beginning of the program here, with finally people are getting it, as espoused by the President, that we are in an inflationary environment. You know, you look at the fact that the CPI rate for January was only up 0.7%, and they tell us that the core rate is only up 0.2%, but if you buy food, energy, healthcare, you don’t pay the core rate, that’s the problem.
JIM: I would love to do that. I’d love to go into a store, just imagine yourself you’re going through the checkout counter, they ring up your grocery bills, and they say $250, and then you give them a card, and then they reduce your bill by the core rate. It just doesn’t work that way.
And one of the reasons we wanted to talk about investing in an inflationary era, John, is inflation destroys a person’s wealth far more effectively than does deflation, because in deflation the purchasing power of the dollar is actually worth more: goods drop in price; the cost of living goes down; and there’s a general level of price decreases as a result of contraction in the money supply. And so, if you have dollars in the bank, and things start going down, your money buys more. In inflation, it’s just the opposite, because with inflation you’re purchasing power is just eaten away.
And I think this is really going to be more important for us baby boomers, John, because unlike our parents’ generation where people tended to work for one company, you might have worked for a company for 25 or 30 years, then you retired, you got the gold watch, and you got a pension. If you look at most boomers, they will probably change employers 4 or 5 times throughout their working career. In fact, they may even change their occupation because of the gutting away of the manufacturing base. One of my best friends was in manufacturing, and after getting laid off 3 or 4 times, as a result of companies that were pulling out of Southern California, now works in the financial industry. [3:26]
JOHN: The other thing that’s really interesting, Ron Paul has quite frequently made the observation, is that inflation is actually like a regressive tax which hurts the poor the worst. They feel the ravages of it worst because it really debases much more of their total living substance than [deflation], even though we go into inflation quite frequently under sort of socialist principles, saying that we’re going to help the poor of society. It’s an interesting twist.
JIM: Well, in regards to the poor, the areas that we exclude from the inflation index like food and energy are a very important part of a poor person’s budget: gasoline; food on the table. All those things represent a larger portion for a lower income person of their budget. And the other thing that a poor person, or a person working just on wages, can’t do, and we’ve often talked about this on the program, you can’t just walk into your bosses office – my friend got a 3 ½ % pay cost of living increase last year, and after taxes that netted out to a only 2% – he can’t walk into his bosses office and say, “hey, I really need 8 to 12% pay increase after taxes to have enough to pay for all the things that are going up in my life.” And so people that are wage earners, people on the lower income scale, and even middle class people are being squeezed by taxes and inflation. So investing in an inflationary environment [requires you] to have discretionary income, either money that you’re putting into a 401K program, in order to take advantage of inflation.
But what I really sense, John, is that given the uncertainty over Social Security – let’s put it this way, there is no Trust Fund, it is unfunded, and the unfunded liabilities are somewhere I’ve heard the figures between 50 and 70 billion, I’ll have to wait and take a look at the government report that comes out, they’re now starting to account for the unfunded liabilities just like a company would, with a regular pension plan in the private sector. So, there’s even a question now of the viability of Social Security. And so what you have to do is you have to rely on yourself – I wouldn’t count on government promises, there’s so much unfunded liabilities – yeah, people may get a social security check, they may go to means testing, but the problem is what is that check going to be worth? You may only pay for your living expenses for the first 4 or 5 days out of the month, and a month is 30 days, what are you going to do for the rest of the month? So, investing in this environment is much different than let’s say investment in a period of disinflation where you have lower levels of inflation, or a period of deflation. [6:12]
JOHN: Alright, stipulating that we are in an inflationary environment, and we are going to do some investing, what are the pitfalls, what do we need to be aware of?
JIM: When you’re making your investments, you want to be in things that are going to appreciate, go up in value, have the ability to either increase earnings, or increase capital, so you’re going to go into more tangible type investments. If you’re in the stock market you’ll want to be looking at companies whose earnings growth is exceptional, because let’s say a company is growing its earnings at, say 5% or 6% a year, but the inflation rate is at 7 – really you’re seeing artificial gains in income. In other words, the company is not increasing its earnings at a rate fast enough to not only make up for the level of inflation, but to keep ahead of it. [7:01]
JOHN: Yeah, but if you really look at reality, Jim, denial still seems to be the rule of the game here. Look where we were with the stock market – let’s take it back 6 years – in 2000, and for the most part we’re still below that point, and investors still seem caught up in that environment, as if that were the real world.
JIM: You know, I think that’s true because we had this 2 decade long, 18 year bull market, basically from 1982 till the year 2000, and the things that worked in the 90s when most people came into the market – basically if you went into an index fund, you were making double digits every single year – I don’t think are going to work in this environment. We’re entering an era, John, where I think there’s greater instability and volatility, we’re seeing anemic economic growth, record unemployment, we’re seeing wars, conflicts, higher levels of prices, rising prices for consumer goods, and so this is a different kind of era.
I’m reading another book called Oil Crisis by Colin J. Campbell. I think it was about 12:30 last night, I was finishing a chapter, and it’s all about this era of instability that is coming as a result of peak oil, where any kind of event occurs– whether it’s weather, infrastructure problems, or terrorist issues – and all of a sudden you have the price of oil spiking. And then he talks about some of the geopolitical risk. And in the last couple of pages I read of the chapter before I put the book down for the evening was a terrorist attack on a Saudi oil facility. Lo and behold, I get up this morning, what do we see? An attempted attack on Saudi Arabia’s oil facility. So, this is the kind of era that we are entering in.
And as oil production peaks, I think you’re going to see a transition to an economy that will get more agrarian in nature. We’re going to move from this high tech information service economy that is dependent on energy for every part of its economic growth: an era of travel, tourism, and finance. And I think you’re going to revert more to an economy that will center on farming because we’ll have to produce food. Goods will be produced locally, that’s going to be important. I mean you’re no longer going to see apples produced in one side of the world being put on a boat or an airplane, and shipped half way across the globe; or let’s say, a head of lettuce that’s picked in Salinas Valley, California being put on a truck or a railroad car and shipped all the way to New York. The 3,000 mile Caesar salad doesn’t work in this kind of economy when you’re starting to see $100 oil, and dare I say, $200 oil. [9:42]
JOHN: Well, Jim, if we look at the history of inflation in this country since the creation of the Federal Reserve if we benchmark it at 1913, we had a period of inflation during World War I in order to fund the war, then another period in World War II, and then finally we had a third period of inflation in the 70s and 80s.
JIM: When you say the '80s, most people think, “well, the '80s and '90s, we didn’t have inflation.” Yes we did. The only difference was that inflation has 2 outlets, it can go into the real economy which is goods and services, which is what we’re seeing now, or it can go into financial assets, creating asset bubbles. And so in the late 80s, especially under the Greenspan Fed, beginning with the stock market crash in October 87, in which he basically flooded the system with money after the crash. And this was very characteristic of the Greenspan Fed, to always pump additional money into the system. It didn’t matter what it was – every time: if we had a recession, if it was the peso crisis, if it was the Asian crisis, Long Term Capital Management, Y2K, Russian Debt default. And you can see this in the money supply growth. In fact I alluded to this in something I wrote on the web this week, in Captain’s Log, where I showed that the money supply was growing at above average rates, faster, almost twice the rate of economic growth. So, that excess money and credit found its way into financial assets, and that’s the pleasant part of inflation because people like seeing their stocks are worth more, or their home is worth more. [11:23]
JOHN: Yeah, basically that’s the run up part of the curve where suddenly there’s a glut of euphoria, and also it carries with it, Jim, the illusion that these times are going to last forever.
JIM: Yes, as you mentioned John, this is kind of the fun part where you see stock prices rise every year, or you see housing prices rise every year, and you think, “gosh, this is really nice, I’m worth more, I don’t have to save, my house is growing at double digit rates” – or if it was the 90s – “my stock portfolio is growing at 20% a year” – that was the great part about inflation. [11:56]
JOHN: But Jim, basically this is the giant glut of euphoria – remember the roaring 20s, right there was the euphoria that you saw from this – and there’s this illusion that it will last forever: “my gosh, those bad times are far behind us.” Everyone forgot we had panics all the way through the 19th Century, various bank panics, and now the good times last forever. But there is a downside to this curve, because there’s a fundamental law of the universe: there’s no such thing as a free lunch. Somebody’s got to pay for it somewhere.
JIM: Well, we’re paying for it as we saw between the year 2000, and 2002, where you saw the NASDAQ lose over 70% of its value. Now, you’re starting to see around the country real estate lose part of its value.
But I think what is going to be different this time, John, and one thing that I discovered in my research after writing The Perfect Financial Storm is this tendency now, as the American economy has become much more levered today than it was let’s say 5 years ago, 10 years ago, or two decades ago, of there being this seeming inability to handle downturns – in other words, to let a recession or a bear market really cleanse the economy, and the financial markets of all its excesses. And the minute that things start to weaken in the economy, or an asset bubble deflates you have the Fed go into overdrive, and they flood the markets with money. And that’s why I think you have seen in this last interest rate cycle we’ve had these flag pole rallies. So, even though the Fed has been raising interest rates since June of 2004, the stock market was up in 2004 – just barely, it came right after the Presidential election – and the same thing you saw, a repeat of that in 2005, where the stock market virtually went nowhere until probably the final six weeks of the year. But on the other hand, it was positive, in contrast to previous rate cycles [where] you saw these downturns. One thing that has been evident throughout the Fed rate raising cycle is they have continued to flood the markets with money as reflected by M3. [14:02]
JOHN: Well, basically, the reason they don’t allow it to correct is because the correction is always painful, and let’s face it, it does not sell at the polls politically. So, what they will try to do, and in every circumstance it would seem, is inflate their way out of the situation which then tends to create asset bubbles, say for example, the one we’ve seen in real estate. And there are some pitfalls, because once again there’s that illusion, talk to realtors today, for example, the illusion that it’s going to keep on going forever, and that things will not reverse, and that there is a day of reckoning.
JIM: Well, I think what you’re going to see right now, is you’re going to see them inflate, which is obvious if you look at the M3 figures which have grown by almost $300 billion in the last quarter. And also next month when they’ll be getting rid of it, and you’ll hear Congressman Ron Paul’s comments about that here. But in this environment of inflation what is really losing purchasing power are investments. Cash – if you take a look at what a bank pays you today, the interest rate that you’re earning on a deposit doesn’t even cover the real inflation rate which is somewhere between 7 and 8%. Ron Paul thinks that inflation rate is actually much higher.
The other thing is you have this emphasis on bonds. When I got in this business in the late 70s, you wouldn’t touch a bond because we were experiencing double digit inflation rates, interest rates were rising. You just knew if you bought a bond you were not only losing purchasing power but we were heading towards higher interest rates which would cause existing bonds at lower coupon levels to lose their value. So bonds will once again become what I call certificates of confiscation, because once you buy a bond, if you have a 5% interest rate, or a 4% interest rate as we have today, if you take a 30-year Treasury bond, at around 4 ½%, and remember you’ve got to pay taxes on that interest, and if you take your after tax return, and let’s say you’re individual here in California, if you take a Treasury bond yield of 4 ½%, assuming you’re an average tax payer paying about 25% tax, plus state tax, that 4 ½% yield is only a little over 3% after taxes, and you have a real inflation rate that’s running at 7 to 8%. So you’re losing ground every single year, you’re not keeping pace with inflation you’re running further behind. [16:34]
JOHN: Does anything in the way of bonds, Jim, work in this type of environment?
JIM: Well, some would argue that TIPS, or Treasury Indexed Securities, would work, because if the inflation rate is 4% at the end of the year the government would credit your principal with 4%. But there’s two problems I have with this, and I think the only way that TIPS would work is if you have a pension plan, because when you invest in TIPS you get a lower up front interest rate than you would a regular Treasury. So if Treasuries are 4, you may get only a 2% yield. Then at the end of the year when the Treasury credits the inflation rate to your principal, even though you don’t receive it, it goes into the value of your bond, and you still have to pay tax on it. So, Treasury indexed securities work better in pension plans where you don’t have to pay the tax. The only problem I have with that is if you take the official CPI numbers, they are grossly understated. So, if you say last year the inflation rate was up 3 ½ %, by the measures I look at, it shows that the inflation rate was running at closer to 7 and 8% – even though your bond is being indexed by inflation it is still understated, so you’re not really getting the full benefit of inflation.
But if you are going to be in the bond market and have a pension that would be about the only type of bond I would be investing in, because you have some kind of protection against rising interest rates, and inflation – but still inadequate when you consider that we understate the real rate of inflation. [18:03]
JOHN: OK, well let’s shelve the bonds then. What about other types of investments that are really good for this type of an environment?
JIM: I also think if you’re investing in the market indexing is not going to work, and if you indexed last year in an S&P fund, or a Dow type index fund you would have been down 0.6%, a little more when you add the expenses of the fund, if you were in [an] S&P fund you only did about 3%. So, I don’t think indexing is going to work in this kind of environment.
The other thing too is I think just broad diversification doesn’t work either. If you were diversified in bonds, and all kinds of stocks last year, well, you might have done a little better, but instead I think you have to focus on the areas that are working, and then concentrate and stay focused. If energy is the top performer, then you need to orient your portfolio more towards energy. If gold is one of the top performers then orient your portfolio towards gold.
We do something that we publish on when my son writes one of the market wrap ups, he does the top 10 performing sectors, and if you take a look at the top 10, like 4 or 5 out of the top 10 are all related to energy. So, if that’s where money is going into, if that’s where the returns are, you need to stay focused, and so I think that is going to be a little bit different. So indexing doesn't work in this kind of environment, I don’t think. And broad based diversification – you know I call it ‘deworsification’ – why go into an area to diversify if it’s losing money? [19:37]
JOHN: OK, well let’s look at the red flag sectors, what sectors would you avoid in this kind of environment?
JIM: I really think that with peak oil, things like consumer products, food, household goods, personal care, consumer discretionary income, retail stores, airlines, travel, and leisure – I think these areas are going to be the hardest hit, because as inflation goes up – as I talk about my friend’s 3 ½ % cost of living increase he got last year, well how’s he going to make up for the fact that he spends more each week in filling his tank of gas or his food bills go up, he has to cut back somewhere, and especially now that you’re seeing the real estate market soften, so there’s less of a possibility of using the home as an ATM machine. Then I think what you’re going to see is discretionary consumer spending, and especially as oil prices start heading higher and as we get to close to $100 oil. So, those items that directly impact the consumer, because at some point this year I do expect a consumer slow down. [20:43]
JOHN: What is going to pick up and excel then in this environment, obviously something’s going to take off.
JIM: Well, we’ve already seen it in energy which is the obvious one. But I think what you’re going to see as we go forward, the big cap oil stocks have done well, but the small cap stocks that are growing their production, and replacing their reserves are going to do even better, because that’s where the real growth in the energy sector’s going to be. So, energy, especially small cap producers,
I also think too the next big thing is going to be alternative energy. Once the world begins to realize that we’re coming close to peak oil, people are going to be shocked, and they’re going to say, “Oh my god, we need to start doing something. What do we have that’s out there that works?” So, I think that alternative energy investments, gold, and silver, I think you’re going to see the oil service sector heat up.
And also here’s one that’ll probably shock a lot of people, I think select real estate. I think, for example, prime farmland is going to become very valuable. I think land located in local communities because I think you’re going to see a broad based exit out of the major metropolitan areas and it’s getting so uninhabitable. We were on the freeway – I took my son shopping last Saturday because he’s starting a new job – and we were coming back on the freeway, and all of a sudden the last 3 or 4 miles before we got to our freeway exit to get to our home I was in a traffic jam, and here it is 4 O’clock Saturday afternoon, and it took me 20 minutes to go three quarters of the distance, and then it took me another 20 minutes, to go the last 4 or 5 freeway exits because I was in a traffic jam. And I think these large metropolitan areas just become unsustainable in peak oil.
I think the welfare state becomes unsustainable under these circumstances, and I think you’re going to see an exodus out of major metropolitan areas, you’re seeing an exodus out of high tax states; you’re seeing wealthy people right now getting ranches in Wyoming, Vale, places that are away from the crowd, and away from very heavily trafficked areas, because I think also that crime will pick up under this kind of a scenario. So, select real estate I think is going to do well, and of course natural resource stocks. [23:04]
JOHN: As housing prices have tripped up with the current bubble, are they going to meet inflation on the way down? In other words, will they ever go back down to where they were, so to speak?
JIM: I think what is coming next is a great inflationary effort. I think the Fed knows that there’s so much debt in the economy today that it just requires even larger amounts of debt; larger amounts of money printing to keep this whole thing up and running. And the amazing thing about when we get to peak oil, John, is monetary policy can only exacerbate conditions because the Fed printing money cannot create a new oil well, it cannot create a new oil discovery, it can just create a whole bunch of paper that’s going to chase fewer barrels of oil, so the barrels of oil are going to get even more expensive.
And I think also that real estate may decline in certain areas depending on what the economic circumstances of a local economy is, so I think you can’t create this blanket type statement, and say, “well, ok, this is what is going to happen in real estate. It’s all going to become local, but I think as a general sense you may see real estate decline but will it turn into a big real estate bust, I think they’re going to inflate their way out of it, and you’re going to see massive inflation. So, maybe it’ll decline somewhat, settle down, and then eventually start reflating again. Maybe in nominal terms it’s going up, but in real terms it isn’t, given the real rate of inflation, but I think you’re going to have to be in tangible type assets because when we get to the final stages of what I think is going to be hyperinflation, people are just going to be grasping on to anything that’s tangible. [24:48]
JOHN: You know, strangely enough, it would seem like people who have incurred large amounts of debt, as we’ve talked about here on the program, as long as their income can keep pace with what’s going on, the inflation would seem to be in their benefit, because they’re paying off their debts – assuming the interest rate is fixed with increasingly worth-less dollars – isn’t that true?
JIM: Sure. I mean if you’ve locked into a 4% or a 5% mortgage, and you have a means of increasing your income, even if you’re getting a 4 or 5% pay increase, or like my friend, 3 ½ %, his mortgage payment is fixed. So even though his income has gone up a little bit, his monthly house payment has stayed the same, and so as long as you’re in a position where you’re able to make your payments each month, yeah, basically your mortgage balance is depreciated away. And that’s the purpose of all hyperinflations really, which is to clear the debt mechanisms in the economy, because essentially you inflate them away. [25:48]
JOHN: hmm, that’s why these mortgage brokers keep calling and saying, “you know we can get you into an adjustable rate mortgage.” And I say, “yeah, cuz I look stupid, right?”
JIM: Yeah, I would not be in an adjustable if you can lock in at this point, because I think when we come out of this rate raising cycle, it’s not going to be like previous cycles, especially as the dollar starts to decline, I think you’re going to see upward pressure on long term interest rates. And you’re going to see a gradual rise in long term rates as the bond market begins to figure it out, that we really do have inflation. Right now, the bond market buys the core rate, and as long as people are buying that, and as long as the Fed can keep the bond market fooled, then we’ve got what we have today. [26:34]
JOHN: Jim, just before we leave this subject right here, we do need to look at alternatives. I’ve been listening to some of the environmental audio sites, and they’re talking about the possibilities, and the drawbacks of alternatives, how realistic is this really going to be? And how long?
JIM: Well, I think quite honestly the next big thing is going to be alternatives. Once the world wakes up, once you wake up one morning and you see CNN talking about peak oil, you see it on the cover of Time Magazine, you’re going to see a panic, and that panic is going to be, “Oh, my God, this is real, what is it that we can do, what is it that we have right now that works, what is it that we have in place that we could start using?”In other words, you’re going to see a dramatic move to alternatives, and once that happens you’re going to see things like, “OK, what do we have that works right now?” Well, we know wind works, we know solar works, we know nuclear works, we know we have coal, liquid natural gas, the oil sands, shale, coal to liquid, gas to liquid gasification, these kind of concepts are going to all of a sudden move to the forefront in energy. And don’t be surprised if eventually you see the majors move into this area very heavily, as many of them are [doing so] such as British Petroleum. You see it in British Petroleum ads.
The other thing I think is going to work very well is the Japanese auto makers, Toyota, and Honda, they seem to be so far ahead of American car manufacturers with hybrids, very fuel efficient cars, because when you start seeing $5, $7, $10 gasoline, as some people are already seeing overseas, you’re going to see people saying: “Oh my goodness, what can I buy or move into that gets me better gas mileage”, because at 5 or $7 a gallon, let’s say you have a Humvee, you may be trading in the Humvee or the Chevy Tahoe at that point to something that gets you a lot better gas mileage. So I think Toyota and Honda is also a good investment. You just take a look at a chart of Toyota or Honda stock, compare that to GM and Ford, and I think those pictures on that chart will tell the whole story. [28:40]
JOHN: Well, Jim, Shaun lives in Chennai, India, and the email says:
Jim, can’t thank you enough for the service you’re providing to people around the world, especially for people living in places outside the US where even in this digital age, information flows are far from efficient.
If you saw how much trouble we had with internet Jim it’s far from efficient here too –
I have a question, rather an observation regarding peak oil. My personal guess is that prices of oil would soar even before we hit peak oil, and that is because demand would outstrip supply even before the onset of the peak oil. So we could easily see triple digit prices even before we reached peak oil. What’s your opinion on this?
JIM: Oh, I think you’re absolutely right, a good example is on Friday, the day we’re doing this show, just a terrorist attack on a Saudi Arabian facility, you had crude oil prices that were up $2.37 today. They went from below 60 to above 60, so any kind of event, in fact in the Hirsch report – which we mentioned last week, which was a report given to the government at the end of their study – they said these are the signs to tell that we’re getting close to peak oil: you’ll see oil price spikes; you’ll see oil prices keep steadily rising; you’ll see increased oil volatility. And you’ll see any kind of event – a political event a weather such as hurricane, labor strikes, infrastructure problems, or fear of terrorism – and all of sudden you’ve got oil prices [spiking]. For example on Friday they were up almost 4%, just on news of a terrorist attack. So, I think you’re absolutely correct.
JOHN: This next email I found rather interesting, I’ve been giggling about it all day, I’ll tell you why in a sec. Richard writes from a very beautiful city, Charleston, South Carolina:
Don Coxe has recently lost many of his weekly conference call listeners due to his continued injection of right wing-nut political views into his economic commentary. You appear to be making the same mistake. To blame the lack of domestic refining simply on tree huggers is nonsense. Suggesting State to State migration is all about taxes is also about nonsense. You know it and so do many of your listeners, save the political BS it only hurts your credibility.
By the way, the reason I’m giggling about this all day is I live in a part of the country where a third of the population now are ex-Californians, who have come to here very specifically for the reasons you’ve cited.
JIM: Richard, you need to get a reality check. You can’t divorce politics from economics, the two are intertwined. I don’t care if you’re looking at the stock market, the energy markets, the commodity markets. In the article that we were talking about was taken from Barron’s, and it was taken from high net worth individuals – they are leaving these high tax States, that’s a reality check my friend. [31:25]
JOHN: What about also you know the issue of refineries comes up here. And this one you’re going to start seeing getting bounced back and forth, as we begin to look around and say we need to do stuff and then the response comes back, “well, we can’t do stuff because we can’t clear all the hurdles.”
JIM: You know, they’ve had a refinery they’ve been trying to start in Arizona, and it’s been going on over 10 years, and it’s all clogged up in environmental lawsuits. People say, “naw, it’s a conspiracy by the oil companies to get higher prices.” I hate to tell you, you couldn’t make money in the refinery business in the 80s and the 90s, and if you’re an oil company, and you have a segment of your business that continually loses money, or has a poor return on capital you get rid of it, which is the reason we went from 300 refineries to the 148 I think we have today. But if you take a look at the last 10 years, and try to increase a refinery, just tell me any city, anywhere that would accept a refinery – there’s - I’m trying to think of the Congresswoman from Olympia, Washington – who was very upset that we were not building refineries but then turned down building a refinery off the Puget Sound. I mean that’s the attitude – it’s BANANAs, or NIMBY. You know the NIMBY people is not in my back yard.
Here in California we’ve become BANANA people, we’re opposed to anything. We don’t want wind farms, we don’t want solar farms, we don’t want drilling for oil; we don’t want refineries. In fact, the State of California was trying to raise money a number of years ago to get enough money to buy off the oil companies to get rid of all the offshore platforms. There’s probably about 30 billion worth of oil reserves off the coast of California which no way with environmentalism that you can touch that. I mean this is a reality. And in the end when we start hitting one crisis after another environmentalism goes away, because at that point people get desperate, and say, “fix or do something, I don’t like this inconvenience,” and brownouts, gas lines, and things like that, you’re going to see this whole political landscape change. That’s reality.
JOHN: Yeah, and right now you’re seeing this temporary marriage between global warming and peak oil, and I think it’s only temporary for a while at least in the political arena. So, speaking of combining politics and economics we’re going to do that right now, and follow with an interview with Congressman Ron Paul.
Other Voices: Hon. Ron Paul (R-TX)
JIM: Well, there are many people that know the United States borrows anywhere from 2 to 3 billion dollars a day to support its trade deficit. Many think that this can go on forever. However, one individual in Congress doesn’t think so. In fact, he thinks the dollar hegemony is coming to an end. Joining me is the Honorable Ron Paul of Texas, he represents the 14th Congressional District, he also serves on the House of Representatives Financial Service Committee, and the International Relations Committee.
Congressman, you recently gave a speech on February 15th which you predicted that the era of dollar of hegemony is about to come to an end. What will bring this about?
HON. RON PAUL (R-TX): You know I think the final event that brings it about isn’t known. I think what determines that it will end is the fact that it’s unstable and it can’t last, and the big question is exactly when and exactly how it will evolve. I think the beginning has already started, you know with some of the changes that are occurring: Interest rates are starting up; and gold prices are moving up; and oil prices are moving up. And so, I think that eventually it will come to a halt, and we will not be able to finance our empire, nor our welfare state here at home merely by creating new money out of thin air. [35:16]
JIM: Why do you think the US has been so successful in keeping the dollar as a reserve currency, especially after 1971, when basically there is nothing backing the dollar where at one time at least we knew that there was gold backing.
RON PAUL: Right. You know, I think it’s rather astounding, it’s almost out of ignorance do they do this, and they’re able to achieve it after they removed all the backing. As I mentioned in my speech, they created another system [which] was even less stable and the 70s were very chaotic, and that nearly came to a close at the end of the 70s – 79 and 80 – when the dollar was very weak and gold was very strong, but then they pulled it off again. And it’s sort of a subjective explanation, which is as long as the foreigners are willing to accept these newly printed dollars the thing keeps going.
But what I’m convinced of, as many others are, is that if they do this they will be defying all of history: that they have been able to change money from something from being of real value, to something that is just created out of thin air. And eventually the people overseas will cease to take our dollar, and they will reject this and realize they’re getting the short end of the stick. [36:33]
JIM: You know, in the latter part of the '70s, when the US was inflating, the dollar was falling like a rock, Jimmy Carter appointed Paul Volcker to head the Fed, and basically Volcker told Carter we better do something to turn this around or the dollar as a world reserve currency is toast. So, Volcker began to raise interest rates until he wrung most inflation out of the system. But today, if you look at the US, we are more indebted today than we’ve ever been before in the country’s history. I don’t think that we could go back to a Volcker Fed and raise interest rates to 21% without something bad happening to the economy.
RON PAUL: No, I’d agree with that. I think that the basic structure of the international monetary system is in much worse shape than it was back then, and that’s why I’m concerned about it. And I think that this has a lot to do with our foreign policy, as well as our oil policy, and agreements that they would take dollars for oil, these are all interconnected. So, if the dollar’s rejected, even partially so, as a reserve currency, it’s going to be very painful for the American people. And in Congress I can come across so many people as soon as they see an imbalance, you know, it’s always China’s fault, or the Arab’s fault, or something else’s, it’s never because we had these huge deficits – if we have this privilege of printing all of this money, and they’re taking the money – so it’s never anybody else’s fault.
They think that they can solve these problems by more protectionism, or demanding that others control their currency values differently, but I think they’re very naïve, and there’s very unfortunately there’s very little interest in monetary policy and understanding of money, and understanding monetary history. I compare this sometimes to the issue of immigration. Everybody in Congress knows about the immigration issues, or port security, they’re up on that, they understand it, but if it comes to money and what fiat money is and what’s happened since 1971, I would say that in that area there’s the least amount of understanding. [38:44]
JIM: You know the irony of all of this, Congressman, is the Fed is perceived by the markets and most Americans as an inflation fighter. I think that’s a misnomer because if you look at since 1913 when we created the Federal Reserve the dollar has lost over 90% of its value. So how can it be perceived as an inflation fighter, is it monetary ignorance?
RON PAUL: Well, I think they do a good job on propagandizing the system, and I recall reading Mises in Human Action, and he says they do it deliberately. They misdirect our attention, they tell people inflation is only rising prices and as long as they can deceive us into believing certain things about prices there’s no inflation and they distract from money – the creation of money. So, they work real hard to fool the people. Just look yesterday they talked about the CPI. CPI you know, overall was going up over 8%. This is, you know, not gigantic but if you looked at real CPI figures it is probably much higher than that, but what the markets do and the governments do, “Aha, it’s no big deal, the core inflation rate is only 0.2% for last month.” So it’s almost like they’re anxious to be lied to, and they don’t even want to know the truth, and they act on those things. They probably figure, even those who know about it in the marketplace, they probably say, “well, I know how everybody else is going to react, and nobody else is going to think there’s inflation out there, so I better pretend there’s no problems out there.” But that’s just temporary. You can fool the markets for a while like we did when we dumped all our gold at $35 an ounce that precipitated the crisis in 1971, but the markets overwhelmed, and finally it broke down. And I saw the 90s as being very similar with the propping up – or the knocking down – of the price of gold, or the dumping of gold, and the loaning of gold, and the forward sales and all this, and they were able to hold the dollar price of gold in check, but eventually the markets overwhelmed. So I think that’s what we’re starting to see now: the markets taking over from the predictions and the plans that the central bankers have had. [41:02]
JIM: You know, if we take a look at the Greenspan Fed which has inflated the money supply beyond anything I’ve ever seen in my investment career, it was interesting that the former Fed Chairman in his first speech after leaving the Fed referred to rising gold prices as a concern over terrorism, but I don’t believe that’s why gold prices are rising; I think the gold market senses inflation.
RON PAUL: Yeah, and I think what he said there sort of goes along with what Mises warned about. Greenspan, he knew and understood and was an Austrian economist at one time. If he wanted to turn honest he would have said you know this is what really has happened: I created all these new dollars, and the dollar has been devalued, and in terms of gold the market is starting to recognize this. No, he wanted to distract from the fact there were too many dollars created, and he personally was responsible in many ways. He says, “oh, yeah, the price of gold went up” you know for some other reason, such as terrorism, so it’s merely a price; it’s not an accurate devaluation measurement of the devaluation that the central bankers have perpetrated. [42:15]
JIM: If we take a look at the money supply as reflected in M3, it’s gone from roughly about 9 ½ trillion to the most recent figure of 10 trillion 280 billion, does it bother you Congressman that beginning next month that the Fed will no longer report M3.
RON PAUL: Yes, it does, and that’s the reason I have legislation in to ask them, as a matter of fact that was the question I asked Bernanke on his first visit to our committee, which got no attention whatsoever. I said, “you know why are you doing that?” And I made the point that the measurement of the money supply is very important to a lot of economists and it’s important to me and it’s important for Congress to have this. And their claim of course was it costs too much money to accumulate this, and I ribbed them a little bit, I said, “you’re worrying about the cost of the Federal Reserve when you can print all the money you want, and you’re going to tell us that you’re going to save money on the collection of this data.” The only thing he would concede if the consensus of Congress demanded that M3 reports he would reconsider, but I think this once again distracting from the evidence: the evidence is measurement of money supply. M3 is not a miracle number, but it’s just an additional number and it just helps us who are studying this and trying to keep tabs on what the Federal Reserve’s doing. [43:36]
JIM: In your speech you refer to in the 70s the United States was very successful in convincing Saudi Arabia in to pricing oil in dollars. Do you think this is one of the important props behind the dollar, because if you look at oil prices which have gone from $20 to close to $60 a barrel, anybody that’s buying oil on the world today is paying almost 200% more, which means they have to have more dollars to pay for that oil.
RON PAUL: I think it’s very important. I don’t think that’s the only issue at stake but I think it is important, and some think that might be one of the main reasons why we had to go in – one of the unspoken reasons – why we had to go in and get Saddam Hussein because he wanted to price oil in euros. And now next month the Iranians have threatened they’ll price oil in euros. And of course, Chavez in Venezuela has threatened to do the same thing, and they’re our great enemies now, our CIA tried at least help in that the coup – in the attempted coup – against Chavez, and now we have really tough language directed towards the Iranians. So, I think I think it is very important, and if everybody in the world needs more dollars to spend to buy the oil I think this gives the dollar a tremendous boost. And that’s why I think maybe we’re nearing the end, because as time goes on we’re going to have more and more enemies in the world, and more money in the hands of Moslem Arab nations who’ll be willing to do whatever they can to undermine our system. [45:17]
JIM: Empires need to be financed, they need a source of revenues, either taxes or tribute from nations that are part of the empire. The United States in a sense has an empire but its empire is supported by dollars. What could happen Congressman if for example the US gets involved in a military adventure that the rest of the world doesn’t approve of, couldn’t they put a stop to this by dumping dollars, or refusing to finance us?
RON PAUL: Yes, and, that’s I think a likelihood but the only thing that keeps it from doing it right now is the fact they hold so many dollars they’ll be hurt too, but eventually it may be in their interest to do it anyway. So, they could bring it to a halt, and the way things are evolving worldwide and how much hatred is being expressed between the two it doesn’t look very good.
JIM: You know, Congressman, you were known for your advocacy of liberty, of returning the United States to a constitutional republic. Why is it there aren’t others in Congress that think like you? You’re a rare breed when you look at the way most people in Congress talk or act or vote.
RON PAUL: Well, it is a lonely place there, there’s no doubt about it but not many people in Congress have been exposed to Austrian economics, or monetary history, and they don’t have any interest. They conveniently find the Fed is very helpful to them. This allows the Congressmen to vote for whatever they want, and they don’t have to be responsible. They don’t necessarily have to raise taxes, they can have some taxes, they can borrow some, and then the Fed comes to their rescue. And this is why I think money is so important – the gold standard’s so important – even if you didn’t look at all the economic benefits. If we look at the political benefits I see that as important if not more important, because it holds big government in check. But as long as governments can spend and finance their system through inflation, and the creation of money, they’re always going to do it. So, if you don’t have sound money, I think you will always have big governments which means you’re going to have a welfare state at home, and a warfare state or an empire abroad. And that’s exactly what we have today, and we can’t afford it, and it will come to an end. [47:35]
JIM: How are we going to pay for all this, Congressman. I’ve seen that the government has what? Over 50 trillion of unfunded liabilities for Social Security, and Medicare; you’ve got nearly 75 million baby boomers that are going to be entering the retirement picture in the next 10 years; we’re running 400 billion plus budget deficits, even larger if you take the off budget items; we’re running 800 billion trade deficits. I mean, do we get to the point where we just print so much paper money that we end up looking like Argentina, or Germany?
RON PAUL: Yeah, I’m afraid that’s the case. We won’t be able to pay for it. The debt sort of takes care of itself; the debt is growing and it’s huge, but if you depreciate the money in real terms, you know, the debt comes down. If you depreciate your money 10% a year, or 5% a year, your actual real debt goes down at that rate. Now we have all these obligations and we’re adding them on all the time, whether it’s Medicare, or now prescription drugs, and private pension funds. I think the government’s always going to send people their checks, and take care of them, but what will happen is the cost of living index increases will never keep up, and the standard of living of people will have to go down. And that’s what’s hard for people to understand. And because I think we’re a lot less productive; we don’t have a manufacturing base, we haven’t created a manufacturing job in 5 years. And yet people don’t feel poor, people still are doing quite well, but they might feel good because they borrowed against their house equity which was an artificial increase in that it was an inflated value due to what Greenspan has been doing. So, I think that the enjoyment of the wealth that have today is sort of a fictitious wealth, and that will change. And I think that the people who are really, really going to suffer are the people who are just barely making it on their own, and they don’t like welfare, or they’re retired and they’re on a fixed income; I think their standard of living is going to go down sharply here in the next 5 to 10 years. [49:41]
JIM: Congressman, just out of curiosity, do you know any place in the country where I can shop and get core rates for the things that I can buy?
RON PAUL: Get what kind of rate?
JIM: I’m just being facetious here, every time we see the inflation…
RON PAUL: Oh, you mean like the core inflation rate. Yeah, yeah that’s it, if you don’t eat and you don’t drive your car, you don’t have much inflation rate. But somebody did this a few years ago: there was a private measurement of inflation, and it was much more accurate, but what if you took medical care costs, and education costs and food and energy, and a few things like that – or the cost of government – I mean we might be living with an inflation rate of 15 or 20%.
And I think poor people have a higher inflation rate. Republicans and Conservatives always preach only the rich pay taxes, the poor never do, but the poor pay the inflation tax, they end up paying more for their gasoline, and it hurts them a lot more – sort of a regressive tax. And the very wealthy you know, they have enough money and they compensate for some of this cost of living increase, but in many ways the inflation tax – the pain of the inflation tax – is dumped on many low, middle income people. [51:00]
JIM: Well, Congressman, I know you’re a busy man, I want to thank you for joining us on the Financial Sense Newshour, keep up the good fight, Congressman, we need more like you, and if you want to hear the Congressman’s speech you can go to house.gov/paul, and you can pick up his speech. Congressman, all the best to you Sir, and thanks for joining us on the program.
RON PAUL: Thanks for having me.
Emails and Q-Calls
JOHN: Jim, we have an email here from Laurent in Milan, Italy:
Hi Jim, thanks for your broadcast. I have a series of questions related to Venezuela. Chavez claims to have oil reserves more important than Saudi Arabia’s, of course we can’t trust him, where could I find objective data on this subject?
JIM: Well, you would have to take a look at overall oil production out of Venezuela and it’s already peaked. I think what Chavez is talking about is his sort of tar sands type heavy oil which needs a tremendous amount of investment and capital to really get that kind of production up. But since Chavez has come in he decimated the state oil industry when he fired 18,000 oil workers, and replaced it with his cronies, so production in Venezuela has really gone in to disrepair, and gosh I’m trying to think the last year when production was that high, you’d have to go back to the early 90s I think.
So, there’s a study that comes out each year, it’s a statistical study by British Petroleum, you can look on their website, on their annual report, and it’s the BP Statistical Review, and that’ll give you oil production by year, by country and I think you can see Venezuela on that. So, it’s a great source by the way, but there’s some footnotes you need to be aware of: sometimes BP has accepted for example at face value some of the reserves that these companies report, and if you look at these reserves there’s something that will strike you as odd – in other words these countries keep producing oil each year but their reserves never go down which is implausible. But one source to check this out would be the BP Statistical Review and that’s on the BP website. [53:07]
My name is Ken from Seattle, Washington. My question is how do you think the value of the Swiss franc against other currencies will fare in the coming years? And why did the Swiss central bank sell half of their gold a few years ago? I would think from a Swiss perspective the stronger the currency the better. And in light of this what do you think of the Swiss annuities for the conservative part of one’s portfolio.
Well, that’s one of the reasons the Swiss central government sold gold – remember gold was in a bear market so a lot of the central bankers said, “hey, let’s get rid of our gold, and we can take that money and invest it in interest bearing securities, and earn money.” That’s one thing. In terms of the currency itself, Switzerland today is viewed more as a safe haven, not so much for gold backing of its currency, but the stability of the country itself. And In terms of a dollar depreciation, yeah, the Swiss franc will do well against the dollar, as the euro and other currencies. In terms of Swiss annuities I’ll tell you the best dollar depreciation hedge that you can get is gold and silver itself. I think that’s even much better than foreign currencies.
JOHN: Just want to remind everybody coming up shortly we’ll have an interview with Roger Conrad, part of our Other Voices series here on the Big Picture, and we’ll be talking about alternative energy because we got an email from Bill in Westchester, Pennsylvania, who says:
Jim, you spend 98% of your time and energy discussing whether and to what extent we have an energy problem, your energy roundtable this week was a perfect example. You’re simply plowing the same ground over and over. I didn’t learn one new thing. I’ve heard it from you and others before, it is time for us to turn virtually all of our attention to possible solutions.
I would probably point out on this that a large portion of people still haven’t turned their attention to the fact that there is a problem yet.
JIM: Yes, we still have to get through the problem stage, and recognizing it as a problem. We’ll probably do a show on alternative energy. Right now, we’re quietly accumulating alternative investments and you’ve heard me refer to them off and on the program. So, perhaps in the future we’ll do an alternative energy show, but you’ve got to recognize the problem and 99% of the people still don’t believe there’s a problem. [55:20]
JOHN: And you can’t fix a problem by the way unless you have clearly identified the problem.
Investing in Juniors: The Year of Takeovers
JOHN:Investing in Juniors. That’s our next topic here today on the Big Picture. It’s going to be a year of takeovers. What have we seen so far?
JIM: Just take a look at last year, we saw Goldcorp go after Virginia Gold, El Dorado Gold after Afghan Mining, Oxiana after Minotaur Resources, High River with Jilbey Gold, Crew Gold took off Guinor; IAM Gold – Gallery Gold; and then just this week we saw Yamana take out Desert Sun; and then on Friday we saw Glamis take out Western Silver.
So, the gold market’s heating up, but I think the gold market is like the oil market: the big gold companies are becoming in many ways finance companies. They’re not finding these large elephant sized deposits that are going to help them replace the reserves that they lose each year as a result of production. So they’re beginning to recognize that and it’s cheaper today to go out and acquire an existing deposit than it is to go out, and stake new ground, drill holes. It takes 5 to 7 years, why not go out and buy somebody that’s done all that hard work? They’ve got their permits in place, and that’s what I think you’re going to see; and I think you’re going to see the takeover of juniors start to accelerate. This is a good example just this week alone. [56:43]
JOHN: You made an interesting comment about big gold companies becoming finance companies, very much in the same situation as oil: they’re not finding enough gold to replace what they’re producing. We’ve actually heard comments this week from various circuits about peak gold. I keep hearing that.
JIM: Well, it’s just like oil, we’ve spent a lot of money in exploration over the last 2 or 3 years, but tell me the major gold discoveries that have been found; I haven’t heard of any. You’re not finding the equivalent of North Seas, or Alaskan slopes in the gold business. Yes, there’s you know, million oz deposits, maybe 2 million, but even those are getting scarcer. We’re going to address this issue in an upcoming gold roundtable that’s going to be a little different than some of the things that we’ve done in the past, but right now I think the reason acquisitions are going to start accelerating is a lot of these companies are coming to the conclusion, “hey, we’re not finding the elephants any more; and given the fact we downsized our exploration department and a lot of people were let go during the 90s, during the bear market.”
And let’s face it, the gold industry like the energy industry has a shortage of personnel. I’m involved in a couple of companies right now where we need to get 2 more drills on a property, and the soonest that we can get a drill is next month; so we need 4, we’re getting our third drill next month, I’m involved in another company that we’re trying to get a second drill. And it’s not just getting the drill, you’ve got to get qualified personnel. The geologist that I use to investigate juniors I invest in was telling me that they were flying people in from the States to the Canadian oil sands because there’s this shortage of personnel. So, I think this whole industry has gone through such a bear market: you don’t have the equipment, but secondly I don’t think you have the targets that you can go out and discover. In other words, the world has been geologically mapped, and there aren’t a lot of people sitting around, “there’s a whole big area of the earth we’ve never looked at, and we think there’s a big gold area there.” I just don’t see that. And, I think also, not just fewer targets to drill, fewer elephant sized projects, but also shortage of equipment and personnel. [58:55]
JOHN: Well, if we’re going to talk about acquisitions, what can we expect to see now?
JIM: I think the target that you’re starting to see with companies is you want to look at companies that are in late stage development that are probably, oh, have the ability to accumulate maybe 2 to 3 million ounces of gold, because now with higher energy costs, higher personnel costs, also governments wanting a greater share of the pie, you really need more than a million ounces to really become economical, unless you’re in a very low cost area where you could mine the gold, open pittable, and mine it for a very inexpensive price. 2 to 3 million oz deposits seems to be the thing that companies are looking for. You want to also look for juniors that are located in mining friendly countries, especially with the Hugo Chavez’s around.
I think you want to look at companies that maintain good community relations with the local community – that’s very important. There’s been several very notable gold finds recently that were turned down because of environmentalism, because there wasn’t a good relationship with the local community, and the local government put a stop to it. And then you also want to look at areas where they have access to energy, so that if you do discover gold it’s a major discovery, it’s going to be easy to put in roads, infrastructure, and get energy to a project because mining is a very energy intensive business. [1:00:22]
JOHN: You know Jim you mention something that was really significant a little earlier, and that was it is cheaper to go and buy existing reserves than it is to go out and hunt for them for yourself.
JIM: Well, I think that’s why you’re starting to see this. That’s why Glamis bought Western Silver; Yamana bought Desert Sun, before that they bought another gold company in December. But right now this seniors and international producers are selling for premiums over net asset value – those premiums are roughly about 20% today. And you compare that to junior producers that are selling at almost 20% discounts, well, then you compare that to junior development companies – these aren’t producers – they’re selling at 25 to 35% discounts.
This gets back to the point, John, that I made earlier, it’s cheaper to go out and buy somebody, and especially if you can buy many of these juniors are selling at these steep discounts to their net asset value, which is I think why now that many of the majors and the intermediates who have seen their stock price and their market cap rise in value are now starting to use that rising market cap as a currency to go out and take something that is selling at a steep discount.
It’s one of the reasons even towards the end of last year we were come to this conclusion, and one of the reasons why I think this year almost 75 to 80% of our portfolio is going to be in these late stage development plays, because I think that’s where the real value is in this gold market. Yeah, you’re going to make money if you buy the seniors and the intermediate companies, but I think the real value is going to be these juniors. Maybe you start with a company that has a million ounces, that can add another million, or maybe another 2 million ounces, these are going to be the companies and especially if they can mine that gold in an open pit situation which is less costly to mine where you get the ore grade to the mill, or if it’s large enough, you can use the low grade and get it on the leach pad so you can use modern techniques of mining, and mine that gold at a very low cost, and that is becoming more important now especially as the cost of energy starts to go up.
So, I think if I was playing this market this year I would be looking at juniors because I think that is where the plays are going to be. I mean my geologist is out now on 2 different projects that we’re looking at that we think could be attractive takeover candidates because they’re not only building their ounces up, but also they’re in very mining friendly jurisdictions, and they’ve been pumped and dumped by the investment bankers, and people have ignored them, and represent great bargains. And I think that’s why you’re seeing companies like Yamana jump into the fray, they’re trying to become a major, and don’t be surprised if you see some of the seniors make some plays this year as well. [1:03:12]
JOHN: Well, if I were a company looking to acquire something there’s obviously costs involved in this and what is it these companies doing acquisitions are looking at.
JIM: There’s a metric that we use and that is used in the industry, it’s called TCA – total cost of acquisition – and really what you’re looking at as a mining company if you’re going to make an acquisition is you want to know what are the recoverable amount of ounces of gold that are contained in the deposit. So, what TCA looks at is the market cap of the company, plus their net debt plus the CAPEX, in other words if you buy a junior what is it going to cost you to put a mill in, and the total operating cost. And the closer that you can get the combination of those below the cost of spot gold – in other words, if let’s say gold today is selling at 560 an oz, well, if you can buy a junior and buy it at 40% below the spot price of gold, meaning all your costs of acquisition per oz, because that’s what a company’s going to look at. They know they’re going to have to buy the company, so that’s going to take x amount of dollars, they’ll take on that company’s debt if there is any; you’re going to have to put in a mine, and then you know when you put that mine in what are your operating costs. What is it going to cost per oz to get it out of the ground? You add all those up, capital expenditures per oz, acquisition costs per oz, operating costs per oz, and what you’re trying to do is buy ounces below the spot price of gold.
And several of these companies, for example Desert Sun was selling at a 69% cost in comparison to gold. In other words it was selling at roughly 31% below the cost of gold. So all those costs added up you might have took a look at that and said, “look, I can buy this company, put in a mine and still get it below the cost of the current price of spot gold.” The same thing happened with Goldcorp buying Virginia Gold. They bought that at a price of 68% to the spot price of gold.
So this I believe John is going to be the year of the juniors because the mining companies are waking up just like the oil companies are. There aren’t any major elephants out there, or deposits that are going to say, “aha, these are the kind of deposits that are going to replace our reserves for the next 5 to 10 years.” In other words there aren’t any Ghawars out there on the gold side. In fact, Ralph Bullis did a study on the world’s gold mines and gold deposits about 2 or 3 years ago, and that was his discovery: there were only so many 5 million oz deposits; there were so many 10 million; very few 3 or 4 million oz deposits.
And so I think the companies are waking up to this, and by the way the people that do have the deposits aren’t really the mining companies, the new discoveries are being made by the juniors, and they’re the ones that are sitting with the great deposits right now, and I think for a while, I think you saw the majors and the intermediates just sitting around, “I don’t know if this gold market is real, will the price stay up, and gosh, we’re used to having the juniors eat scraps off our table, we’d give them some money and we’d steal these companies.” That is beginning to change, and I think once one company starts making an acquisition move you’re going to see others that follow, and you’re going to see my Pacman thesis play out. So, that’s one of the reasons why we’ve got like, gosh, 10 or 15 candidates that we’re looking at right now for our gold account, because we think that’s the play this year. Now, I could be wrong I mean gold could crash, something like that could happen, and then we could have a tough time of it like we did in 2004 in juniors and roughly 2005. But I don’t think the odds of that happening this year, I just don’t see that happening. [1:06:55]
JOHN: Mark is in Tampa, Florida, Jim and he says:
Here’s what I can’t figure out, when CNBC starts round the clock coverage of peak oil sometime in the future, will that make oil stocks go up, because their product will be so much more expensive, or will peak oil make stocks go down because the long term prospect of oil companies is limited.
JIM: I think you’re going to see peak oil cause stock prices to go up. Let me give you a couple examples that illustrate this. We can go and take a look at Exxon’s stock. Exxon-Mobil, which is the largest oil company in the world, if we take a look at Exxon’s average daily production over the last couple of years: in 2000, Exxon was producing 4,277,000 barrels a day; the following year it dropped to 4,255,000 barrels a day; the following year it dropped to 4,238,000 barrels a day; then it dropped to 4.2 million barrels a day. So, in fact Exxon, when they reported their 4th quarter profits said that their average daily production declined in the 4th quarter, however Exxon’s revenues have gone through the roof as the price of the commodity that it sells has also gone up. So when you see oil prices go from 20 to 60 to 70, Exxon had net sales of 187 billion in 2001; and in 2005, Exxon’s sales were almost 371 billion, reflecting this big jump in the cost of oil.
So, I think you’re going to see oil stocks go up, but I think the oil stocks that are going to go up even more so will be the junior oil and gas stocks, that’s the area that you want to be focused on. That’s where we’re shifting our attention to, companies that can increase their production, replace their reserves, and can operate in a way that the big oil companies can’t. I mean the big oil companies need elephant sized fields to make things economical whereas smaller companies are more nimble. You take a company that’s producing a hundred thousand barrels a day, and they go to 200 or 300 thousand barrels a day, that becomes a significant cash flow to the company.[1:09:06]
Other Voices: Roger Conrad
JIM: Well, after a robust year for the utilities markets last year, one trend that’s beginning to emerge is mergers itself. You’re finding more utilities get together, they’re becoming bigger; there’s more consolidation in the industry; and another topic you’re starting to hear is alternative energy. To talk about these two topics, joining me is Roger Conrad, he’s editor of the Utility Investor.
Roger, we seem to go through these waves in the utility industry, but one clear trend that we’re starting to see is more mergers.
ROGER CONRAD: Yes, absolutely. And this is a continuation of what’s happened in the last several years. I think one thing that makes this very interesting is the fact that we have had about 3 years of rather robust rally in most utility stocks, so valuations are not cheap any more as they were – particularly as they were – three years ago, right after that historic bear market drop in so many and crackup after Enron. There are a lot of deals being announced, in fact, the dollar volume continues to get bigger. I think we’ve talked about in the past the fact that the Public Utility Holding Company Act which was a Depression Era piece of legislation that required a lot of big holding companies to be busted up was removed by legislation this last Summer, and in fact the final phase out of the law occurred earlier this year, so there’s definitely a lot of potential for activity. And [there’s] a lot of reason for companies that announce a deal to expect regulatory approval. And in fact we’re seeing that kind of activity start to take place with mergers between big companies like in different States such as Constellation Energy and FPL Group, Duke Energy and Cinergy, and others, as well as mergers between companies that are more adjoining or more proximate regionally, such as the emerging bidding war for a company called Keyspan Energy in New York. [1:11:09]
JIM: Do you think one of the reasons behind this is that we’ve seen basically low interest rates, which make it easy to finance a deal but also appreciating stock prices? I mean, the utility index has gone from a low of roughly 167 back in October of 02, to today’s closing price of 410. That’s a big movement.
ROGER: Yes, in fact the movement that was made between the end of 2002, and the middle of last year was the most dramatic rally in the utilities since World War II, so we have backed off somewhat from the highs there. I think on a positive note earnings have started to catch up a little bit to the share price gains that we saw. The fundamentals for the utility industry remain very, very strong with very positive regulation, the continued reduction of debt, as well as operating risk, and then also tightening market conditions.
If you look at the power markets around the country, the big slump that we sank into earlier this decade – a big power glut has been somewhat sopped up by continuing demand, by consolidation of ownership, more rationalization of older, very costly plants being shut down, but the end result has been the power market has tightened up, and one of the clearest pieces of evidence of that was I think the 55% increase in power prices in the recent New Jersey auction. So, there’s a lot of evidence out there that conditions are tightening up, and that’s very positive for the industry. I think that makes would be buyers perhaps, even with the prices higher, a little bit more willing to put down some serious money, and make some acquisitions. And in fact one of the suitors for Keyspan Energy is a British company called National Grid which already owns a large collection of distribution and transmission utilities in New York and New England, and taking over Keyspan would give them a lot of properties in New England, and also on Long Island. And Keyspan of course the original core of that company was Brooklyn Union Gas, so it gives them a nice stake in New York, and New York City as well. [1:13:14]
JIM: Roger, another trend that we’re starting to see and maybe this is a reflection by utilities as they look for sources of power: alternative energy. You have utilities like FPL Group where I think about 25% or close to that figure they’re looking at wind power. Is this another trend we’re likely to see in the future?
ROGER: I think so. I think of course one of the major drivers has been high natural gas prices, not so much the $15 per million btu price that we saw in the wake of hurricanes Katrina and Rita in the Gulf last Fall, but prices that are certainly well above the assumptions made in the mid-90s of $2, $3 gas – so, we may settle here for natural gas in the $7 range. But there are now 2 peak seasons for natural gas, there’s one in the Winter of course, and the other’s in the Summer because most of the power plants that were built back in the 90s, and the early part of this decade were built to run on natural gas. So, there’s a tremendous call on natural gas now, and since that’s the fuel that’s basically competing with everything else right now, it makes things like wind power very, very interesting. And actually in Texas, for a short time this Winter, wind power was the cheapest alternative given to customers in that market, so that’s something that seems almost impossible to believe if you remember some of the wind power plants built back during the 70s, that were very inefficient.
So, wind power has become competitive – the utilities have seen that, and they’re looking at in terms of it being an economic alternative to gas, but also they’re able to comply with environmental regulations that have been enacted in state after state that basically mandate that utilities use a certain amount of renewable energy. And if you look at the other alternatives in renewables such as solar, biomass and so forth, they’re very interesting technologically and they make good reading, but wind power’s really the only thing that’s practical at this point that they can use. So, we’re seeing tremendous demand by the utilities throughout the country contracting companies like FPL which is the big Florida utility but it also has a very large unregulated power producing unit. They’re winning contracts in various parts of the country to build and operate wind power, and then sell that back to utilities – under very nice contracts.
So, again partly because the utility has to conform to new regulations, and partly because it’s an economic thing for that utility to do: to diversify away from some of the other more volatile price sources of energy such as natural gas. So, it’s a big business. FPL is a big player, AES corporation is another one there, some people might remember them as a big international producer that really flamed out in the early part of this decade, but it’s back under much more rational management, and now it’s a major player in wind as well. So, that’s a couple of ways to play it, in addition to and to the fact that so many utilities are starting to use more wind power. [1:16:31]
JIM: You know, Roger, it seems to me if I was a utility, and I was building natural gas power plants I’d be a little bit worried with natural gas production in decline, not only in Canada and the US, but even more importantly another way of getting natural gas to this country is LNG, and just about everywhere – whether you’re on the West coast or East coast – if you mention you want to build an LNG terminal, immediately you have all kinds of suits that are going to block you from doing so. So, it seems to me I’d hate to be dependent and build a natural gas power plant when the price of natural gas is not only getting more expensive but it may be you can’t get it.
ROGER: Yes, I think that’s a really good point. I mean of course a lot of the plants are running on gas now were built with the assumption of $2 gas prices, and abundant supply, and of course there was an assumption made they would be able to go out find more and more supplies. And that unfortunately there’s been a rude awakening to that kind of idea, but the whole industry basically did operate on that model. I mean, in California you might remember the huge stranded costs per ceilings over, how much less these nuclear plants and so forth would be worth when you opened up the market and they had to start competing with natural gas. Well, it seems like a very bad joke right now, but I mean that was definitely the mindset back then, and when States deregulated like California, then they had to give utilities compensation for the predicted loss of value in the power plants that would again be open up to competition. And the stranded costs there were widespread projections that competing with natural gas power plants was going to potentially send many utilities into bankruptcy. And you know, it’s amazing how when there is a change like that and everybody is set on certain projections like that, how things can work out to be a 180 degrees differently.
But there’s a lot of companies out there that have a lot of natural gas power plants and they’ve learned the hard way that they’re not economic. Calpine corporation was the predominant developer of natural gas power plants and they kept right on building them right up until recently, continued a very aggressive style, and I guess management made the decision that gas prices would come down, and finally what happened the Fall, with the hurricanes shutting off a lot of the gas production and spiking up gas prices, finally that just kicked them in to Chapter 11, and it’s very much up in the air whether they’re going to come out as an operating concern, or whether the creditors will parcel out the assets and so forth. But it’s pretty clear that the natural gas production model has not worked out anything close to what its proponents had thought, and that you don’t want to be stuck holding a bunch of gas plants. It’s ok to have some but you want to have as nuclear plants and other alternative energies as well. [1:19:25]
JIM: Roger, if you were to play the utility market right now where would you be going because I mean the index is selling at 18 times earnings. The dividend yield, while still attractive in relative terms to other indexes, and let’s say, other sectors of the market, but at 3.4% dividend yield certainly isn’t what it used to be. Where would you be going right now if you were making new investments?
ROGER: Well, I think there are a few areas. Obviously I think you don’t want to be sinking money into a utility stock yielding barely 3% without a lot of growth to it. I think that you may not have much risk but there again you’re not going to make much either. I think one area you can go to, the big utilities – I call them dominant companies that are building dominance throughout their regions or throughout the country or in a particular niche – I don’t think they’re being fully valued to account for growth fully generated, and that would include companies like Duke Energy, or Dominion Resources, or even FPL at this point – I think they’ll be valued a lot higher down the road, and they’ve been running in place for about the last year or so – the earnings are catching up to the valuations. Another place to look would be the companies that really got smashed during the early part of this decade, and are still fighting their way out of it, and you know, this is a very reliable formula for recovery going forward.
Some of the folks in your area might remember a company called Pacific Enterprises that wound up merging with San Diego G&E to form Sempra, and that company invested in everything except for the utility business, and it wound up sinking them. And in fact they had to cut a lot of things loose, take some pretty huge write-offs, made a lot of shareholders very unhappy, but if you look today and particularly at parts of Sempra, it’s a very, very healthy company.
So, what these companies have to do is basically just cut their operating risks, cut the things off that are bleeding, and start cutting debt, and we’re past the point where companies have to cut off unfavorable operations, and repair relationships with regulators. Now, the recovering companies, the ones that really got hit, that are coming back, are in the stage of just paying down debt, so I think as they get stronger and stronger, and as they move towards paying a dividend they’re going to get profit[able], and one in that group would be Sierra Pacific Resources, and that’s the utility that serves Las Vegas and fast growing parts of Nevada, and they’ve really pulled themselves together. I think over the course of the next 12 to 18 months they’ll probably begin paying a dividend again, and pulling their credit rating back up towards investment grade. I think as they’re able to do that the share price will continue to rise. So that’s kind of a long term bet but it’s also a very sure one.
Also another one not quite as far along in recovery would be Aquila, and that’s the former UtiliCorp, and that again got involved with a lot of unregulated businesses that blew up in their face, and now they’ve cut those out, and now they’re in the stage of paying off debt and rationalizing things. And that one actually’s still trading under $4 a share, and I think if you’re looking for a potential 4 or 5 to 1 – 4 or 5 bagger, going forward 2, 3 years down the road – that would be a good place to go. So, that’s a couple of areas.
A little bit off that track would be the telecomm sector, and I think that’s still a very cheap people still looking for the doomsday scenario, you can buy the class of that sector – Verizon for example – and I think fairly cheaply. So, those are the places that we’re looking right now. [1:22:56]
JIM: Why don’t you tell people about your website and your newsletter.
ROGER: The newsletter’s called Utility Forecaster and we’re happy to provide sample issues to anyone who’d like one. We have our 800 phone number, we’re open 9-5 Eastern time so 3 hours ahead (800) 832-2330, or if anybody you know wants to contact your offices and we’ll be glad to honor any requests.
The website is utilityforecaster.com, that’s the website for the newsletter. I also do a weekly newsletter, comes out every Friday, and that’s actually free to anyone who’d like to take a look at it, to get an idea of the kind of thinking I have and also what you might expect from the other products, and that’s utilityandincome.com, and you can just go to that site at www. utilityandincome.com and you can sign up for that for free. So, anyway, there’s plenty of ways to get a hold of us. [1:24:03] Note: Financial Sense re-publishes this e-newsletter.
JIM: Alright, well Roger, thanks for joining us, on other voices this week. All the best sir, and I hope to talk to you again.
ROGER: Thank you very much for having me.
JIM: Speaking of peak oil, California’s talking about a plan to increase its freeways so you know talk about "stuck on stupid."
Campaign Commercial: When this car was new, so were California freeways, now our freeways have more cars in them than anyone ever imagined. Californians are stuck in traffic for half a million hours every day. Senate President Don Perata has a national responsible plan to invest in highways and freeways, this plan will reduce traffic congestion and make our highways safer. To find out more, check out perataplan.org. Say yes to the Perata plan, and yes to California’s future.
JOHN: There it is Jim, I can think of one of the most effective rapid transit plans in California was Bart – Bay Area Rapid Transit – but other than that everybody’s stuck in their cars, and this State Senator seems determined that we’re going to be more efficient in how we’re stuck in cars.
JIM: You know, at a time the world is approaching peak oil when we should be thinking of mass transit, being able to move more people to and from work more effectively, where mass transit would help alleviate not only the congestion but also the problems that we’re going to be facing with peak oil, we’re talking about a new bond program to go out and borrow a bunch of money to expand the freeway system. Talk about maybe a decade or two too late.
JOHN: Roland writes from Germany where he listens:
The only reason that there are renewable energies in Germany is that these energies get huge subsidies. The price for 1kwh is: conventional power plant – coal or gas – 2.4 euro cents; wind energy 11.4; solar energy 57.4. Do you think this makes economic sense? And the reason for high gasoline prices in Germany is that 80% of the price at the pump are taxes. Is, therefore, gasoline and oil expensive?
JIM: Well, once you get to peak oil you’ve got to recognize oil’s going to be harder and harder to get, and if you’re going to run your economy, as the price of oil starts to go to $100 a barrel, and eventually $200 barrel then alternatives will start coming on stream. And the more efficient we get at producing alternatives or making alternatives then the cost per kilowatt-hour will start to come down. But we’re going to have no choice, unless we’re going to have to go back to the dark ages, and I don’t think nobody wants to do that. I mean a lot of us kind of like the lifestyles that have been brought about with fossil fuels and the industrial age. So alternatives to me are going to become the next big thing, and the higher the price of oil the more affordable, and the more economic will become alternatives.
JOHN: Dennis writes from Hudson, Ohio:
A number of people advocate investments in oil companies as a good way to play peak oil. As large oil producers deplete their reserves and find no new equivalent replacement reserves how will the reduction of reserves impact the share price versus the expected increase in earnings due to an increase in the per barrel price of oil? In other words, if a company is burning through its inventory without replacement shouldn’t that be factored into its price share, even though the inventory it’s selling may be bringing in record profits?
JIM: Well, I think it’s going to be reflected in the performance of the stock. I mean if you took a look at some of the faster growing smaller cap oil companies that are finding new oil, replacing their reserves, they’re appreciating a lot more than the big oil companies. I believe the big oil companies in effect are becoming royalty trusts – they’ll be using more their cash flow to increase dividends, but you’re still going to make more money. But you’re absolutely right, if you’re talking about relative stock performance then you’re going to want to look at companies that can not only increase production but also replace their reserves and that is indeed getting harder for the majors. [1:28:10]
JOHN: Well, Jim, they’re threatening to throw us out of the studio now we’ve obviously chewed up our welcome, so, what do we do next week on the show?
JIM: Well, next week we’ll return to the topic oil: Sonia Shah will be my guest. She’s written a book called Crude: The Story of Oil, a rather interesting book, an interesting journalist, very well thought of, and following Sonia Shah, Stephen Leeb will be on our program March 11th The Coming Economic Collapse; Floyd Upperman, Commitments of Traders; John Howe, The End of Fossil Energy; Gwynne Dyer, Future: Tense: The Coming World Order. So, all of that coming up in the next 30 days. Well, you’re right John we have run out of time and as always we’d like to thank you for joining us here on Financial Sense Newshour, on behalf of John Loeffler and myself we’d like to wish you a pleasant weekend.