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Financial Sense Newshour

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September 6, 2008

Part 1

London Gold Pool - Revisited

JOHN: Yes. Here we are back from vacation, bright tailed and bushy eyed. Or is it bushy tailed and bright eyed?

JIM: Say that fast.

JOHN: I can't do it. I can't do it. So we have learned one serious lesson: We should never go on vacation here on the program. Either that or we have got to change when we go on vacation because it always goes to heck in a hand basket. A lot of things start to happen. Of course that’s when you want to be in the middle of it.

But anyway, we have a pile of things we are going to cover here today on the program. Some due to news events, some due to ruminations we have been ruminating on while on the vacation time. And we are going to get into a phenomenon in the markets that in reality we have not seen since the 1960s and what I'm referring to here is what is happening to the paper price of gold and silver; at the same time, what is happening to the physical market for bullion. And this is an interesting phenomenon because, like we said here, we haven't seen this in about 40 years, but let's take this back to 1960.

JIM: Well, what you had in 1960 is you had a very famous economist, a Yale economist called Robert Triffin and he exposed at that time, John, a fundamental problem in the Bretton Woods international monetary system. If the US stopped running a balance of payments deficit, the international community would lose its largest source of additions to reserves and this resulting shortage of liquidity would draw the world economy into a contractionary spiral leading to instability. Because remember, the US currency was the globe's currency, it was backed by gold.

And eventually what happened is as a result of Triffin’s recommendations, it was an international agreement that was reached with the IMF and they set up something called SDRs or special drawing rights. They were intended to supplement the US dollar and provide a mechanism for expanding international liquidity without requiring additional US payment deficits or additional dollar balances. Now, the problem is, as Europe, as Japan recovered from World War Two, nations’ dollar holdings began to grow to such a level that was far in excess of its ability to convert these dollars into gold at $35 an ounce. And so by the beginning of the 60s, the free market price of gold started to test the dollar peg of $35 an ounce. So in 1961, with demand rising and US gold reserves falling, President Kennedy's Treasury [Under-]Secretary at that time, a guy by the name of Robert Roosa, proposed that the US and Europe form a gold pool and pool their gold resources together to prevent the market price creeping up above $35 an ounce. And on his suggestion, in 1961, the central banks –mainly at that time were G7 countries, it was US, Britain, France, Germany, Switzerland, Italy, Belgium, Netherlands and Luxembourg – formed what we call the London Gold Pool. And its whole purpose was: Any time demand would come into the market to drive the price of gold above $35, they would intervene, dump gold into the market and hopefully keep the dollar peg of gold at $35 an ounce. [3:51]

JOHN: But didn't this create a problem in that other countries, led by France, then began to exchange their dollars for gold, so this seemed to expose the weaknesses of the system.

JIM: Yes, because at that time, the United States was running twin deficits and also there were a lot of excess dollars and there were a lot of people saying wait a minute, this is unfair. So during this period of time, as a result of the Vietnam war, which began during the Kennedy administration, then we got the Johnson administration, the Great Society programs and the US began to run not only budget deficits but trade deficits and the Fed during that period of time began to ramp up the money supply. So as a result, the dollars that began to accumulate in central banks became huge. And Charles de Gaulle at that time thought this was an unfair advantage that the United States had as holding a reserve currency. And he held a press conference in, I think it was the first part of 1965, and he was calling for a return to the classic gold standard rather than the dollar gold standard. And he was complaining that the US at that time given what we were doing, we were fighting a war in southeast Asia and also we had started these Great Society programs of Lyndon Johnson. He claimed that the US was incapable of balancing its budget. So he was calling for a return to the classic gold standard. I mean he lost that argument because we never did go back to it.

But what he began to do, he said, okay, if we're not going to go on a classic gold standard, then you know what, here are my dollars. Give me gold. And what he did is he demanded that in the future that French dollar claims would be settled in gold, and his actions at that time hastened the end of the dollar and the international monetary system which was linked to gold. But de Gaulle started a run on the bank of US gold reserves, and the reason Nixon severed the gold link with the dollar back in August of 1971 is if he did not do that, the US would have lost all of its dollar reserves or gold reserves and we wouldn’t have had any gold left. So the problem that de Gaulle highlighted between the classic gold standard and the gold exchange standard and the unfair advantage that the US was afforded, in essence, the US was able to settle its debt in its own currency which it could print without limit; so we were able to export our inflation to the rest of the world, which we continue to do right up to this day. [6:34]

JOHN: So let's fast forward to today. We've come forward 40 years approximately. We operate under a fiat system, the dollars are used in trade. As a matter of fact, worldwide, when we talk about things like oil and other issues and as a result of this mechanism, we continue to export that inflation. So what has changed? It seems like it's business as usual.

JIM: What has changed, John, is we're in the middle of a global credit crisis with the United States as the epicenter of this storm. You've heard comments made this week, for example, by Bill Gross. There is a tsunami of dollars floating around the globe, and as a result of the US's twin deficits, both budget deficit and trade deficit, the Fed is running out of bullets and paper money is losing its value. Directly in front of us, the US is facing another major wave of losses that's going to hit the financial system. I mean we've seen that FDIC is going to have to be recapitalized. They have a little over 50 billion in the fund and just the IndyMac bankruptcy alone is going to absorb almost 20 billion of that. You've got also depending on who you read, I've seen a major wave of bank failures. They are estimating that between 200 and 700 banks are going to go under. And not just banks but a few big banks and investment banks are going to go under and the government is going to have to nationalize Fannie and Freddie. [8:00]

JOHN: Well, given the crisis window that we're running into, you would think that there’s recognition of this, gold and silver would be going up; but instead, the price of paper bullion is plummeting while the physical market is experiencing difficulties in delivering supplies. So it seems that there is a big disconnect right know between the paper market for gold and silver versus the physical market. So what causes that? [8:30]

JIM: I think what you're seeing here, John, is probably the 21st century version of the London Gold Pool. Instead of using bullion, they are doing it in the futures market with paper contracts.

JOHN: Yeah. Explain how that works.

JIM: Well, if we take a look at this, and I'm going summarize this as we get to the end, but if you take a look at July, you had three US banks that held 86,400 contracts –short positions – in the COMEX gold market. John, that is a 10 fold increase in a short position in less than a month. Earlier, one of these investment banks had also a large short position on the TOCOM. I think it was close to 50,000 contracts. These short positions held by the banks accounted for over 21% of the open interest versus a 1.8% short position a month earlier. In fact, if you get to the silver market, three investment banks had short positions that accounted for over 25% of open interest contracts on the COMEX. This short position increased from 4.8% short to 25.4% position of all contracts in less than a month. In terms of ounces, it becomes even bigger. It equated to almost 170 million ounces equivalent or roughly, John, 20% of the annual output of silver from mines in a single year. The gold short position equaled nearly 10% of the world annual mine production, so what took place in-between July and August was probably the largest short position that was put in the market in gold and silver ever recorded by US banks. And what they were trying to do is control the price of gold, keep it from rising as it did when Bear Stearns crisis hit because what was hitting in February was the insolvency not only the banking system, but also the insolvency of Fannie and Freddie; and in order to keep that down in the next credit wave crisis, which is unfolding, John – but what is happening, it's beginning to back fire. [10:49]

JOHN: Okay. By back firing, do you mean that the physical off take is at record levels and the lower they take the price of gold and silver the more buying it will seem to generate? Obviously, people are smart enough, they see the price going down, they are going to jump back in.

JIM: We're going to get into this with an interview that Eric King did with the head of trading, a high government official in Dubai or the Dubai gold market, but even on this Friday where you have the price of gold up, they have taken silver down by 64 cents. And this just came across, and I want too check on this, but the largest silver refiner in the US, Johnson Matthey has suffered delays of four weeks, six weeks and recently eight plus weeks. Now they are stopping taking orders. The latest news is that the refiner plans to wind down their silver operation all together due to difficulties of getting silver. So you're right. That's exactly what is happening from Seattle to Denver, all over the United States, gold and silver buying is approaching record levels.

A story today just right out of Reuters, this is from Reuters on Friday, Indian gold demand rose on Friday as buyers and sellers kept themselves busy ahead of the peak festive season due a fall in prices, dealers said. In fact, falling prices and rising demand has led to a supply crunch in the markets, said a dealer with a large private bank.

So it's not only getting difficult to get silver Eagles and one ounce rounds and small silver bars. And it's not, John, in the US. In other words, if it was just occurring in one – let's say with the two or three refiners, you could say, well, look, they've mismanaged their inventories, they got caught short, but it's not just in the United States. It's a global phenomenon. It's happening in Dubai, it's happening in Mumbai, it's happening in Johannesburg. One wealthy buyer alone cleaned out a gold refiner of Krugerrands by buying 5000 ounces. I've been told that if you want the next batch of silver eagles, your waiting date is going to be January and February of next year. In fact, just go on and type silver Eagles on eBay and you'll see prices for silver Eagles as much as $25. One refiner I talked to cannot get silver blanks in order to make silver rounds or small bars. What he's having to do is buy 1000 ounce bars and this individual was telling me normally when he used to get them in three days, it was three weeks and four weeks. Now, if the story on Johnson Matthey is true, you may not be able to get it at all. So you're seeing delays in deliveries.

And what is happening here is investors are dumping their dollars and exchanging them for gold and silver. In essence, what is happening is the paper gold pool market has triggered a run on the bank, very much like de Gaulle did in the late 60s when he triggered a run on US gold reserves. So I guess you can say, John, we've all become Frenchmen now. Just as de Gaulle triggered a run on US gold reserves, the paper gold pool has triggered a run on the world's gold reserves; and that is probably the best explanation I can give you to help explain the divergence between what we're seeing occur in the paper markets and what is going on in the physical markets. [14:27]

JOHN: Well, don't you think also that more and more people are disregarding the happy talk they are hearing come down and there’s a general recognition, especially when people understand the value of gold and silver that the fertilizer is really about to hit the air conditioner in the credit markets? The financial system is hanging over the edge. They can see that. And so while there is this public lip service paid to the fact of, “well, we are getting it under control, blah, blah, blah, blah” on a daily basis, there is an undercurrent now of people saying this thing is going to blow and we'd better be ready for it.

JIM: You're absolutely right because we're going to get into one of the other stories, the Next Rogue Wave. The next step is monetization, but in the larger scheme of things, there is something else that's going on here, and that is the decomposition of money itself. If you take a look at money or, you know, the dollar bills, euros, the loonies, whatever you want to call this paper money, money has two roles to play in society. It is a medium of exchange. It allows you to use paper dollars if you want to buy something at the store. That's what it's used for. If you're a manufacturer, you need to order goods, you transact in paper money. And so you need money to transact commerce.

But as a store of value, which is the other component of money, fiat currencies are all failing. They are losing their value against real money such as gold and silver. And I don't think as many people in the gold community are saying that we're going to go back to a classic gold standard. There is just too much physical deficits coming that are going to be creating problems, so there are too many future liabilities in developed countries. As far as the US is concerned we're heading towards a path of hyper inflation. It's rather interesting, but David Walker who is the former comptroller of the currency and the head of the US government accounting office – he now works for Pete Peterson's foundation – gave a speech last year and he wrote a report on the federal government's fiscal policy. He said it remains unsustainable. In a five-year period between 2000 and 2005, unfunded liabilities grew by nearly 20 trillion dollars, and today that figure is expected to be 63 trillion; and by 2017, the Brookings Institute estimates are that figure will grow to 98 trillion dollars.

And what happened is Walker said, we'd better get a handle on this now. The Bush administration tried to do this in its first term. It was rejected in his second term, so we basically did nothing.

And what Walker did is he took the unfunded liabilities, of the US government and he said we're going to need to do two things to bring this into balance. And he had what was called a baseline case and what he called an alternative case, in other words, things actually get worse than what he anticipated. And he said in order to do this, we would need to increase income taxes by 44% and decrease government spending – and not counting interest expenses on our debt – by over 20%. Then he said the alternative case is if we continue these unfunded liabilities, if they continue to grow, if our budget deficits continue to grow, he said the alternative scenario is you would have to increase taxes by 88% and decrease government spending by over 40%. So if you take a look at this election campaign, John, just imagine if John McCain or Barack Obama came with a platform and said that “if elected to office, I am going to raise taxes 88% and cut government spending by 40%,” what do you think the American public would be saying? [18:50]

JOHN: Well, there would be a big negative reaction to the whole thing, but I don't think any politician is going to go there and say that.

JIM: Absolutely not. And the problem is if they were to do that, imagine the financial repercussions or the social distress that would follow in an attempt to implement such draconian policies. So the result here is if we don't gain control over this, which is unsustainable, then we're on the path to some kind of episode of hyperinflation with similar consequences to the hyperinflation that we saw in the Weimar Republic in the 1920s. And so that's the route that we're going because nowhere across the political spectrum –with the exception of Ron Paul – have you heard this from either party or either candidate that this is what we're going to have to do. That is not how you get elected, John. [19:52]

JOHN: No. And it was funny listening to one of the speeches by one of the main candidates. I was in Colorado during the Democratic convention, but we were sitting and my father-in-law turns to me and says there is not a prayer's chance in heck that he's going to be able to pay for all of this. So even my father-in-law who lived through the depression of the 1930s understands that we have now outrun our ability to sustain all of this. But like you say, no politician is going to tell you exactly what the handwriting is on the wall about. They are not going to do that. And it looks like the only way out of this is to inflate our way off this mess because no politician of either party is going to take whatever actions are needed to correct the fiscal imbalances. So there is some lip service paid to it.

You know, in all of the speeches either by Senator McCain or Senator Obama, I think I've only heard Social Security mentioned once, and I think it was Senator Obama saying they were going to secure Social Security, or something like that to make sure it was going to be there.

JIM: How?

JOHN: See, that never gets into play. But that's the point. Neither of them is talking about this, and the issues being discussed at both of these conventions, the Democratic and the Republican, neither of them covers where we're held the into the storm. Which means that whichever party is in power when the fertilizer hits the air conditioner will be the first party out because people don't understand why and they'll just start, it will create some rather violent political upheavals.

So basically, as we look at this situation, Jim, that's where we stand, politicians aren't going to deal with it. Let's go back to gold and silver. We're on this track, the track isn't going to change, what happens next? [21:27]

JIM: If you look at what's going on in the markets right now, investors are afraid; they are confused. One day the market goes up, and if you want to go long, the next day the market goes down. If the market goes down and you want to go short, then all of a sudden the next day the market goes up. And when you have wide scale intervention –and I'll get to this in just a moment – what everybody is looking for is a trend and you don't have one because the markets are in disequilibrium. You have forces of deflation. You hear a lot of talk about that. And you have forces of inflation. There is a lot – I mean just a ton of disinformation and a major disconnect between the paper and the physical markets that we're seeing in bullion, and actually even what we're actually seeing in the oil market. And also, the financial markets and the economy, there is a major disconnect. On this Friday that you're talking about, the jobless rate hit 6.1%. They thought it was going to be 5.7. So it was larger than expected, so there is a disconnect that’s going on. And also you have a lot of deleveraging and forced selling and we're going to get to this as we summarize.

But what investors have them before them, John, I think is a clear choice. You have the inflation argument –and we're going to get into why we think that is the outcome – and then you have the deflationary you argument. And if you believe its deflation, then you go to cash, you go to bonds and that's what you're seeing somewhat. The 10 year yield – let me just call it up here on my screen here on this Friday –you've got the 10 year yield here at roughly 3.63. And that's down from a peak that it hit in the middle of June where it was over 4 ¼%. And so there is a lot of shift over into that direction.

If you believe in the inflation you hold onto your inflation hedges, which hopefully you own free and clear without leverage, and I believe that this move was orchestrated and that's what I want to get into next. It was unnatural and it will not last. That is what the bullion market is telling us: Just like the failure of the London gold pool failure in the 60s, this too will fail. And it's obvious here when you see these shortages. So if you believe in the inflation story you get your physical while you can and while it's affordable and you need to become, like de Gaulle, a Frenchman. [24:02]

JOHN: If we go back to July, Jim, I remember you were forecasting oil at 125 and then you later revised that to 145 dollars a barrel, which we hit, I think, within two weeks of that. The CRB Index was at record levels, oil at 140. So here we are in the middle of this crisis, but what's going on in terms of numbers doesn't seem to reflect the crisis, so you tend to believe this is an intervention.

JIM: John, it was probably the largest and massive intervention that we’ve ever seen in probably the financial markets. You would have to go back probably to the 1930s to find something equivalent to what has been done in the last two months.

But you have to understand the back drop.

As we headed into the mid-summer months in July, we had several things. We had oil prices that had hit a peak of 147. You had the CRB Index which was just hitting record after record after record. You hit a peak of roughly, let me see, on 473, which was hit on the second day of July, and just like we had that credit crisis with Bear Stearns in March where you had the gold market exploding and just as you had oil prices setting a new record, the CRB hitting a new record, you had gold prices that were at 960, and then all of a sudden, the next credit crisis hits with Fannie and Freddie. If you looked at the bank indexes, they were all breaking down to new record levels. You had the dollar that was plummeting and at a pivotal point roughly around 70. And you had all of these calls about inflation, inflation, the Fed had to raise interest rates, they had to defend the dollar; and then you had just about every anchor, “this is a bubble, this is a bubble, this is a bubble.” And so at that point, you had commodity prices at a record level, you had the financial system breaking down, you had the dollar ready to plunge to new record lows, you had the inflationary indexes –whether you're looking at the consumer price index, the producer price index – hitting new record levels; and we were getting ready to head into another financial crisis and you had calls for the Fed to go out and hit or basically start raising interest rates to defend the dollar because you had a lot of central banks’ selling of mortgage assets because all of a sudden we were finding that “oh my goodness, this isn't the AAA paper that I thought I had.” So you had all of this stuff hitting at once.

Now, the other thing that you also have is any time you get a move in a market, whether it's commodities, whether it's oil, whether it's the stock market, if you look at the dominant trade from the beginning of the year, it was to be long commodities and short the financials because every single quarter you were getting record write-offs. And also by the way, at the same time that you had rising commodity prices, turbulence in the financial markets, you also had rising interest rates. From a low in March during the Bear Stearns crisis when the government intervened, you had the 10 year treasury note go from a low of about 3.3% all of the way to a yield of over 4 ¼%, and so we had a crisis brew. But what was happening here, as this trend, it was the only trend that was working because the markets were down double digits and any time you have a trend, John, you always get the hot money that starts to move in. And what happened is the hot money started to move in the commodity markets and these are what we call speculators, and they were on margin, and so at that time, Bernanke was saying we saw lower inflation rates ahead. That's when they hit. That's when you saw a ten-fold increase in the short position in gold, a five-fold increase in the short position in silver and it continues. And what happened is they hit the markets and what happened is they drove and forced a deleveraging of these speculators; and at the same time, this trade –long the commodities and short the financials – at the same time they also had the cooperation of other government agencies. In other words, okay, if you generate a short squeeze, what made the short squeeze even worse is the SEC comes out and says they put a stop-gap measure on short selling. And so as people were short the financials, as they tried to get stock, you didn't have short sellers coming in and saying this is all hokey, this is unreal, this is false. You had short sellers prevented for a 30-day period and then they extended it, so you had this massive reversal. And so with these price mechanisms that they were able to engineer is all of a sudden, John, in a six week period of time, you had a reversal of the thinking, now you had people talking about deflation, and they kept citing falling commodity prices and you reversed the paradigm thinking on Wall Street to one of, instead of rising inflation, falling inflation; instead of a credit crisis and financial crisis in the banking system to one of going long the financial system; and they engineered this change or paradigm shift which we're going to get into here in just a second.

But here is the problem. If you look at, there is a couple of measures or key indexes that we look at, and one is, John, if you take the yield of the 10 year treasury note and you plot that against headline inflation, it's obvious with the 10 year treasury note at 3.63, headline inflation at 5 ½%, that is indeed an inflationary warning and even worse than this, and we'll get to this in another segment, is if you take the producer price index which is pipeline inflation ahead, back out the federal funds rate, John, we're at a level that we have not seen since 1974, so there are massive bets right now that are being made by the bond market, that's being made by traders, that's being made by the Fed that we're headed for lower inflation rates and the last time that you had massive bets in this one direction was in 1974, John, just before the rate of inflation, the rate of monetization was about ready to take off. And that's exactly where I think we are.

And I think what they were trying to do here, John, is buy themselves down because any time you get a massive selloff like this, and you have to remember, that those that were in the commodities sector represents a small minority of investors. You can see this whether you look at the 13-Fs of major mutual fund or major fund managers, it's a small minority. But when you do this kind of massive technical damage, which is what they were trying to achieve and that's why they kept intervening. This is almost like what Robert Rubin did against dollar shorts in the 90s. As the dollar was beginning to appreciate against other currencies, they intervened all of the way up, and so they drove massive losses in this sector; and what happens when you have those kind of losses, John, everybody gets gun shy. They are afraid to buy. And we just got an IMF report that just shows that this massive intervention was coordinated with central bankers around the globe where they are intervening in their own currency markets to drive their currencies lower against the dollar. But like the London Gold Pool, John, these things don't last. [32:30]

JOHN: You really have to down to a question at some point here when we get to this level is why the pundits on some of the financial channels don't seem to see this. I ask myself this every single day: why don't they see this if we can see this coming. You obviously have strong pushes in this direction. What do you see that other people aren't?

JIM: You know, the thing that I look at is I look at and listen into conference calls, whether I'm listening to a conference call from BHP Billiton which produces a lot of raw materials, or I'm listening in to a conference call from Freeport McMoRan, Freeport Copper, if I'm listening to a conference call of Rio Tinto or I'm listening to conference calls in the oil sector. I mean, John, it's funny, and we did an interview, we're going to cover the oil and why I think oil is going to be at 145 dollars by the end of the year or at least by this next winter. But if you take a look at the Baker Hughes rig count, John, it's the highest it's ever been. It's at record levels and yet we're not able to increase output significantly. So if everybody is buying into oil is going to $75 and gasoline is going to below $3, I'll tell you one thing, the oil rig pump doesn't support that, nor does the investment plans that are being made by oil companies and oil service companies. And the same thing has held true. I would put confidence in what the CEO of BHP Billiton or Freeport or Rio Tinto or Rio de Valle is saying than I would on some Wall Street pundit.

I mean, John, you remember this, gosh, this was prior to the 2006 elections. It was the summer of 2006 and the first week in August, Goldman Sachs rejiggers its commodity index and it reduces the weight of natural gas and oil forcing net selling in the commodities market and as a result, you had a hedge fund blowup, Amaranth. This week we saw a hedge fund blow up, Ospraie. And then the oil price went down and then as we got into the winter months, it started to work its way back up towards 70 and once again in December, Goldman Sachs rejiggers the commodity index and reduces the weight of oil and natural gas. And you remember, John, in the month of January of 2007, we had a two week warm spell in New York. You had people going around with golf shirts on and everybody was saying global warming, oil was going back down to $40 a barrel. Well, that lasted all of about two weeks and they were shoveling 12 feet of snow in Buffalo and oil went from $50s and ended up the year at the end of the 2007 over $90; and I think that's what's going to happen again.

But you go through these periods and you have this paradigm shift and you've got everybody running in one direction and nobody is stopping to say “wait a minute, the facts.” I mean if you take the current thinking, I suppose one or two more hurricanes going in the Gulf of Mexico, what's going to happen then? Is oil going to go to 75 because fewer rigs got destroyed than was anticipated. I mean it’s just absolutely insane, but what triggered all of this was intervention, John. They had to intervene in this market because we were on the verge of collapse, a collapse in the dollar, a collapse in the financial sector, the Fed being forced to raise interest rates, now you have Fed governors talking about lowering interest rates, so this was all artificial; and that's one of the reasons why when you intervene in the market, you get these divergences which is the disappearance of physical. [36:22]

JOHN: The crisis was only delayed. In other words, it will be revisited again. We're still saying that.

JIM: Yeah. I mean this Friday, I just saw on my screen several financial issues. I mean you've got debt of Washington Mutual; they are 8 ¼ bonds that mature in the year 2010. You want to guess what their yield to maturity is?

JOHN: It’s probably something off the chart.

JIM: Over 40%. I mean, what the heck is that telling you? I mean it is just the most bifurcated market. It's only on Wall Street, which I call the street of dreams would you ever see these kind of anomalies and then see people that buy into this balderdash. There is such a major disconnect here it is unreal. But anyway, I think the long and short of it, just like the London Gold Pool caused a run on the gold reserves of the US, this modern day version of the London Gold Pool that was executed by three investment banks, and it was not just their short positions here. I was following their short positions on the TOCOM and I'm not going to mention the name, but one large prominent investment bank here had a massive short position even on the TOCOM. And so it's amazing, but it failed, John, because as of this Friday, they are having shortages in Mumbai. We've got perhaps Johnson Matthey which may shut down production of silver, so, you know, it's disappearing off the shelf and the only thing I can say is get it while you still can. [37:58]

JOHN: And you're listening to the Financial Sense Newshour at www.financialsense.com. And coming up next, we'll have Eric King here on the program who will be anchoring a program with Ian MacDonald from Dubai looking at the status of the world precious metals situation, what is fact, what is rumor. There is more smoke than light in most places right now. We'll try to separate the two. We'll be back.

Eric King with special guest: Ian MacDonald, Executive Director - Gold & Precious Metals Dubai Multi Commodities Centre

ERIC KING: Welcome back to the Financial Sense Newshour. This is Eric King doing this segment of the show. There is a debate raging about whether or not there are physical shortages in the gold market. Whenever it come to an issue like this, there are a lot of people with half-informed opinions that are really creating a lot of static and noise, and they are doing a great disservice in trying to get to the bottom of the issue when the best thing they can do is to be quiet. One person who does have his hand on the pulse of this issue is Ian MacDonald who joins us from Dubai, otherwise known as the “City of Gold.”

Ian, before we get started, I just wanted to thank the government of Dubai and its press department for their generosity in allowing a senior government official to be interviewed on Financial Sense Newshour. I think the global audience will appreciate the input you have today, particularly on the subject of the physical gold market.

Ian, Dubai is known as the City of Gold and you're one of the largest physical trading hubs of gold in the world. Can you give listeners a little bit of background as to what it is you do in Dubai at the DMCC or Dubai Multi Commodity Center.

IAN MacDONALD: Oh, certainly. First of all, let me start by saying the government of Dubai is probably unlike any other government in the world. It's a very entrepreneurial government, and one of the reasons I think the government here is entrepreneurial and very keen to promote businesses is really based on the fact that the oil here in the – certainly in Dubai is scheduled to probably run out in 2015, so the government is very keen to promote other businesses and diversify away from the oil. In fact, the oil components of the GDP for Dubai right now is a very smooth path for GDP.

But to go back and answer your question, Eric, basically the DMCC was founded by a royal decree in 2001 to look after the commodity space here in Dubai. We've got a number of divisions. I head up the gold division, but I've got colleagues heading up energy, diamonds, general commodities, soft commodities, steel and so on. And the list goes on and on and on and actually keeps growing by each year. But my job is to focus on the precious metals –and as you said, we are one of the largest trading hubs in the world – looking after the gold and the other precious metals. And the purpose of our function here is to really promote gold, the whole gold industry from A to Z. Essentially we have been looking after the physical market making sure the infrastructure is in there, the regulatory structure is in there, which is very, very important; and last but not least, good governance because you know, unless you have good governances, markets will not grow. You've got to have international confidence. [41:51]

ERIC: I agree with you. We're having a problem certainly with that on the US side right now. We won't get into that though. As a senior government official, one of the aspects of your position at the DMCC is to promote growth, and one of your most recent initiatives has been to launch the DGR or Dubai Gold Receipts. This is an award-winning platform for dealers to finance physical gold inventories. Can you comment on that?

IAN: Oh, absolutely. This was actually launched a couple of years ago prior to my arrival at the DMCC. The rationale and the concept behind that was we were actually concerned several years ago, the government, that there could be a credit crunch, so it was a very forward thinking idea and we wanted to make sure there was plenty of finance available in the markets to finance gold inventories, silver inventories and products and so on. So what we actually did, we developed an electronic financing platform. It's 24/7, it's real time, where essentially traders can import the gold into Dubai, put the gold stock into an approved warehouse and for financing, and then once it's delivered, a receipt is issued via the electronic platform and the banks on the system can look at the receipt and make a proposal to the trader or the potential borrower for financing terms. And it's all done electronically, it's very fast and unlike traditional trades of finance where you need an army of lawyers in the room and this – with the DGR (Dubai Gold Receipts) you do not need that. In fact, it gives the lender full title and full security, so the international banks and the local banks here do have full security to the underlying product they finance, and it can go on indefinitely the term of the financing. But it's fully secured and fully backed by the government of Dubai, the DMCC. [43:58]

ERIC: You also have the DSAM or Dubai Shariah Asset Management, which is a fund to invest in the commodity arena. Can you talk about that because if you listen to people like Bill Gross who manages the largest bond fund in the world, or say a BHP Billiton or even a CalPERS, there is going to be increasing demand for this type of instrument going forward for investors globally, and you are filling this need with this type of fund, are you not?

IAN: Oh, absolutely. Basically, we're due to launch DSAM, which stands for Dubai Shariah Asset Management Company. We're going to be launching the fund this month, later in the month, but what we saw – although we had done a lot of initiatives for the physical markets here and we will continue to insure that the physical markets continues to grow here, we needed to bring the financial market – the banks and the institutions – closer to the physical markets. So one of our first initiatives was to create DSAM which is a joint venture between the DMCC and Shariah Capital in the USA which is a USA company and listed on the AIM in London. (And for your listeners, that's the Alternative Investment Market.)

But what we're going to be doing is essentially launching a fund of funds focusing purely on the commodity space here in Dubai and we're going to have a gold fund, we're going to have an energy fund and a natural resource fund, a metals fund, from say base metals and we're just going to launch a number of funds. And in fact, we have appointed some fund managers. I can mention Tocqueville Asset Management and Lucas and Zweig will be amongst the initial fund managers – they are all US based – to come out with the various funds. The DMCC will be seeding the funds with 50 million US dollars per fund initially. But the fund is going to be open for anybody in the UAE or any other part of the world to invest in these funds.

The other thing we've been very keen to do is to make sure that all of or new initiatives for the financial side are Shariah compliant. This is a very, very important issue here in the Middle East and generally to roll out Shariah compliant products. And for your listeners that is really to make sure that any investment product here in the Middle East are conformed to Islamic law. [46:46]

ERIC: You will be launching five funds this month and you started to get into that, but it was interesting to me because you're going to launch a gold ETF on the DIFX later this year, and even though you're such a physical gold hub of the world, I think there is going to be significant demand for that product. What are your thoughts on that?

IAN: Well, we do too, and again on the gold ETF, it is modeled on the same model as the one launched on the New York stock exchange and the symbol GLD. And we have the same joint venture partner for that, which is the World Gold Council in London, and the difference being largely our gold ETF will be Shariah compliant again, which is as I pointed out extremely important for this region; and the only difference being the depositories will be in London and Dubai and the rationale for that is to insure that we've always got plenty of liquidity in the gold markets for the gold ETF. We're planning to launch that later this year and we'll track the price of gold, of course. [47:59]

ERIC: Let me ask you, Ian, because you've been at this for 30 years, and when you described the demand for gold to me in an earlier conversation, you described it as quote mind blowing. You said, again I'll quote you: “To be candid, I've never seen such a disparity between the paper market and physical market in my entire career. We are actually seeing shortages of physical gold in the market due to the surging demand in this region.” Can you elaborate on that a bit?

IAN: Well, yes, certainly. And by the way, it's not only myself. It's other veterans of the gold market are saying similar or making similar comments about the strong demand. You know, demand here in the UAE has been going up and up and up. I don't have the figures in front of me, but last year we were about 560 metric tonnes coming through Dubai and physically shipped from all over the world. But this year, it's clearly going to be higher. The first half of the year we were up 40 plus percent in terms of value on the gold. Obviously, a lot of that was due to the higher prices, but nevertheless, it's still a higher tonnage. But what we're actually seeing now, Eric, is quite a swell in demand, and it's a bit of a mystery what’s behind it. We've gone through a year of what I call dollar hysteria with the US dollar collapsing and – but I maintain to so many people and I was publicly quoted saying look, it's not just about the US dollar that's fundamentally weak. There are many, many other currencies. And what I've noticed is now the dollar is recovering, but the euro, the pound, many, many other currencies around the world are under a lot of downward pressure now. To everybody’s surprise, they didn't rush out of the dollar and put their money into euro or sterling we’re finding it’s going into gold. You know, I think there is definitely signs of currency disdain, and what is unusual, it's not just limited to Dubai. It's generally throughout the region, and many, many other countries going up to Pakistan, India and so on. India, obviously, still remains the number one importer. [50:28]

ERIC: You know, the feeling that I get when I've been talking to you or even now, Ian, is that basically you have many people globally that no longer want to save their money in paper but rather want to save their money in gold. Is that accurate? Are we basically talking about a global sort of flight from paper into physical gold? Is that really what we're talking about?

IAN: There is no doubt about that. You know, I remember in the 60s and 70s, tangible assets, hard assets were in favor and probably by the 80s, paper was king. Clearly paper is no longer king. You know, there’s been a lack of confidence in paper in fact. It doesn't matter if it's a currency or paper investments. There are great concerns about what's going on. And commodities are obviously –even with the correction that we've seen – commodities remain very, very hot because very few countries in the world are addressing the problem with currencies. And certainly not to sort of upset anybody in the USA, but in the USA the energy crisis is not really being dealt with. They are talking about taxes, but nobody is talking about drilling or increasing production which the world needs as the world economies continue to grow. We're not only seeing shortages in gold – gold production is not increasing at all. [51:59]

ERIC: Ian, the difference between what you do over there, and say, the futures market or the paper market is that you won't sell the gold unless it is on the shelves there. Do I have that right?

IAN: Absolutely. And this is one of the reasons we have such a discrepancy between – or disparity between the paper market and the physical markets. The paper markets are very, very efficient. Let's not beat around the bush on that one. The futures exchanges are critical components of any financial market. They do bring liquidity to a market and you must have liquidity in any capital markets to make them viable and credible, but you've got to remember, when you get paper selling in New York or London, it will take weeks, and weeks and in fact, now it's taken months to get that physical gold – really convert that piece of paper into physical gold and get it into the markets like Dubai and other regions in the world. We're even getting stories now that the refineries are backed up at least until September and even October – the whole of September and October now. And again, we have not seen in the industry any expansion of the refinery capacity anywhere in the world. In fact, we've seen a decrease. Many, many gold refiners, for one reason or another, have been pushed out of the market. [53:24]

ERIC: You know that's interesting because I know Johnson Matthey just shut down a unit in Australia, and people think of this big bull market and that there would be an increase but as you said there has been a decrease. But there has been a decrease in mining. There has been a decrease of refining and so all of this contributes to the gold bull. But I don't want to sound naive here. But for the listeners, where does your gold come from because you'll eventually process it and send it out to customers. Isn't it from places like England or the United States?

IAN: Oh, the gold is coming from all over the world, from the United States, Europe and unfortunately in some ways, some of the bigger suppliers have been central banks to the market. But even the central banks are having second thoughts about a gold sales policy. The biggest supplier in the world is no doubt the European Central Bank who under the Washington Accord can sell up to 550 metric tonnes a year, which makes them the largest single supplier of gold in the world – far larger than any other mine out there. But now what we're starting to see is even the central banks are having second thoughts about their gold reserve policy, which is clearly one that has not worked for them. Most of the countries started selling when gold was down to 250 dollars an ounce, including my mother country, unfortunately. These are very unfortunate sales, you know, they’re selling the lows and not the highs. [54:55]

ERIC: Along those lines, I know they've been hounding Germany to sell gold, the second largest holder of physical gold in the world, and they won't sell any. Good for them. But doesn't it stand to reason, then, Ian – and I don't want to get political here, but doesn't it stand to reason that the Western countries for quite some time in reality, as you were just saying, have been emptying out their vaults of gold, which is the only true money, and as someone with your heritage from the Western hemisphere, don't you think that that’s foolish? It's foolish for them to do that. I mean, you don't want to insult your primary suppliers, but don't you think that's a foolish policy on their part?

IAN: I think it's something that has to be reconsidered and readdressed and unfortunately, so many central banks have forgotten why they have the gold in the vaults in the first place. And the reason being, historically, governments have never been able to curtail their spending habits and deficits – maintain an orderly budget and the gold was always there as a war chest just in case of out of control spending by a respective government. And unfortunately, history is repeating itself again and this time the war chests are very low. Even though we're off the gold standard, the fact that the gold is there like in the United States does bring a lot of confidence behind the currency. I call it more of an unofficial gold standard. And Eric, I would not be surprised to see a number of central banks over the next one to two years rethink their policy on holding gold reserves. I do believe we're going to see very, very shortly probably even central banks adding gold to their reserves. [56:41]

ERIC: What you just said to me tells me you're hearing something, and they should reconsider, but you must be hearing something for you to make that statement.

IAN: Yes. It's just on market knowledge. You know when something is wrong or something is up with the market and you know, quite something – we’ve got something big happening here in the physical gold market and the gold markets in general. I also do feel that I have spoken to a lot of countries and where we're seeing the gold demand surging again, and the Russian invasion of Georgia and the threats towards – the Russian threats towards Poland have really rattled a lot of countries and I think that part of the buying is attributable to the Russian invasion. There is no doubt about it. But the big one is the currency disdain where people are getting a little tired of their currencies constantly losing their value. There is not enough attention being put on this issue. [57:43]

ERIC: I agree with you, Ian, and I think net when you look at these countries as you said and you look at inflation and then the bonds and the return, you're get net negatives it feels like, I think, to people globally. So obviously, I think the disdain is just a reality of the toxicity in the system right now and the constant paper money printing which should really kick into high gear with the US being in trouble now.

But you did a paper for the mining industry back in 2000, 2001 timeframe and you talked about the reduction of participation by banks in Switzerland, the UK, etc, in the physical gold market. And the reason that that resonates with me is that when I purchased over three tonnes of physical silver and took delivery, shortly afterwards, I think it was Morgan Stanley in 2003, but they were sort of the last of the bullion banks to even have a division that dealt in physical silver. They shut it down and as a contrarian, I thought, well, that's perfect now. There is officially no participation in the silver market. And if you map that on a historical chart, the rise in silver started almost directly after that shut down. Talk about that paper you wrote and what your message was then and where are we today.

IAN: Well, it was actually a very simple paper, Eric. I had my concerns about what was happening to the structure of the market, and you know, I noticed more and more banks in particular just do not understand the physical gold market, and having been in the banking industry for over 30 years, normally, if you mention gold and anything about physicals to sort of a banker, they run out of the door. They don't want to hear, and that's a fact and a reality. But I just one day started writing down in New York alone there used to be over 40 banks, institutions, dealers dealing in physical gold and now we're down to a handful of names only in just the West. And I'm not including – I didn’t even add in there the banks in the Middle East and other regions of the world. This was just western institutions. A lot of names disappeared through mergers. We used to have three major Swiss banks and now we've only got one. Fortunately, they’re one of the names that are still active in the physical market, but, you know, when I see comments by a lot of analysts, I can see they don't really understand the physical market and what's going on because, yes, the focus tends to be on open interest and COMEX and NYMEX and so on, which is a good number to look at and I’m not undermining that, by what nobody is really looking at is what's happening in the physical. And the reason we can't track that or have difficulty in tracking it is because it's handled outside of the banking institutions. And I would clarify, there are probably a handful of banks still left in the physical markets, but you can count them on one hand. [1:00:53]

ERIC: When you like at the price of gold here, Ian, and maybe you don't want to speculate on this, but where is the price of gold headed in your opinion.

IAN: As the government of Dubai, we don't like to put out price forecasts, but production is falling worldwide. Central bank sales are folding and demand is growing, so a kindergartener kid could tell you where the price is going. The trend is still up even though we've had a good healthy correction. You know, we did see resistance was more, I would say, a psychological resistance when gold hit 1,000 earlier this year and went through a thousand dollars an ounce, and I think that run up was largely due to the Bear Stearns collapse. It was just panic buying that we – when the rumors were floating around market. But having said that, there is no doubt the trend is up on gold just based on the fundamentals. The only thing that could hold it back is if we had a massive worldwide recession. I don't see that right now. There is no economic numbers out of the USA for example. In fact, there is even talk of growth this year within the USA, which is encouraging. Certainly, nobody wants to see an economic collapse or even a depression. [1:02:16]

ERIC: Ian, as we wrap up here, before we go, I do want to touch base with you on the oil market. You know, you mentioned very briefly your European colleagues being very nervous about this Russian invasion of Georgia and this can usher in all types of consequences. When you look right now, you know, that the Saudi Arabia has increased oil production, but there is a price to pay for that, right, because we're talking about really early depletion or an acceleration of the depletion of their reserves; correct?

IAN: Oh, that's it. You know, you're just going to run out sooner. That's the bottom line. And although countries like Saudi Arabia have plenty of oil reserves there is a limit of how much they can pump out. Fortunately, they've been able to pump out another million barrels a day, to help the current crisis. But I think there is also a great expectation that when the prices go high, oil producers can turn up the spigot and just turn the taps on faster. In any natural resource extraction business, it doesn't happen that way. It's very, very difficult. You actually need a huge amount of capital and billions and billions to be invested in order to do that. And you can't slow it down and crank it up as easy as a lot of politicians would expect. You know, here, and going back to what I said earlier the UAE is clearly gearing up to when the oil runs out, and this is why we have been diversifying the economy very much so. And fortunately, the rulers have created a very modern vibrant economy here. [1:03:56]

ERIC: Well, Ian, in closing here, let me just say this as New York loses – or continues to lose – it’s position as a money center because of the corruption, I suppose I could say that New York's loss is going to be Dubai's gain because I know you want to become a global money center over there. And let me also thank again the government of Dubai and its press department for allowing you to come on the show. And Ian, also thank you for your time on this show. I think this interview should settle once and for all the debate on whether or not there are shortages of gold in the physical market. So, thank you, Ian.

IAN: Eric, thank you very much.

Part 2

Street of Dreams and the Inflation Depositories

JOHN: Well, earlier this spring, Jim, my wife and I decided to throw our kayak into the river and we discovered that the current in the river was too strong and we were just being pushed along down this little old logging channel. We didn't even have to paddle and I started singing it's a small world after all because it felt like -- it felt like being on the ride at Disneyland. And sometimes I think finances go like that in that same direction where you just feel like you're being carried along the street of dreams and you're not sure whether you're in touch with reality.

I know we take time off every August, we talk about that. These tend to be working vacations because you and I pile up a big bunch of reading material and start plowing through it and we don't have to worry about doing shows and other business affairs during the week. So what did you come away with here? Were there any new insights? And given the events that happened over the last month, and let's face it, we had the conflict between Russia and Georgia. There was a major selloff in resource stocks, pending nationalization of Freddie and Fannie, and finally we had one hurricane which everyone braced and hoped wouldn't be too bad and it turned out not to be, but they were afraid it might be. But nevertheless by the way, we shut down quite a few oil platforms and those aren't going to come back online very quickly, so we were down about 10% in our production capacity. It sounds like a crisis, not a vacation. At least it's the time you want to be on the air. But did you actually get any sailing in and did you actually get any reading in?

JIM: I actually got to do both. I mean it was fun because I just ordered a new spinnaker, so it was kind of nice. As anybody knows that’s a sailor, when you sail down wind a lot of times you don't go as fast with your regular sails and that's the ideal sail a spinnaker that's the big puffy balloon sale that you see in front of sail boats. It was kind of fun. It was kind of surreal, John. It just goes to show you where technology has led us. You know, I'm out in the bay sailing, but I had my blackberry with me so I could check market stories, market quotes and also communicate with the office. You know, that's what is amazing about the world that we live in today. Here you're out in the middle of the bay or offshore Pt. Loma and you're sitting there and getting market quotes and able to keep up with stuff. So you know I don't know what we did before we had cell phones and the internet. It's sort of like when you're addicted to the markets like I am, wherever you go, you take that stuff away with you. However, I did get a chance to do a lot of reading and a time to formulate a lot of my thoughts, John, in terms of where we were going.

And John, I'm probably convinced now more than ever that we're moving rapidly into that crisis window that you and I have been talking here so often on this program. And I'm also convinced of my hyperinflation thesis. In fact, you're already starting to see it. I'm convinced of this hyperinflation thesis. You've got Bill Gross warning of a financial tsunami coming unless the Fed and the Treasury start acting. But you know, when I read things, I always do this. I mark them up and I categorize them. I put “radio show category,” and I'll sort of pile these things according to categories that I want to talk about or try to pile them together and reach some kind of consensus in terms of what I'm seeing. So I file these away, and when I came home this Monday, I had literally a tub. We have this tub that we use for mail that we get from the post office that, you know, if you have large packages or a lot of mail. And it was a tub full of things that I had read during the month – articles, stuff that I print out. And when I got home Monday, I literally took this mail carrier full of reports, papers, articles, magazines that I had read and I'm going to be sharing a lot of this over the next couple of weeks. But one of the things I did is I sat down in my study and I sort of put all of these articles together into piles. And I was sorting of saying, here is a thought, here is a trend or a concept.

And what I came up with is we're going to call this The Street of Dreams and it was this current paradigm shift that we had talked about that was orchestrated in the last segment. In the month of July, we went from July and August up until that first six months of the year or first half of the year we were talking about inflation, financial crisis and then all of a sudden, there was a paradigm shift; and only on Wall Street, which I call a street of dreams –or, you know, you probably call it an amusement park – could you see these kind of fantasies. And there are currently four of them and we're going to address each one of them: 1) The economy’s on the mend, and I think that got a little shattered this Friday with the jump in the unemployment rate; 2) the credit crisis is over; 3) inflation has peaked and 4) the commodity bubble has burst and is over. [5:22]

JOHN: Well, that sounds intriguing. Let's dive right into it. Why don't we pick apart each of these. I know we both share the view that if the true inflation number were used to subtract against nominal GDP, it would show that we entered a recession in the fourth quarter of last year.

JIM: Yeah. The first assumption is that the economy’s on the mend. You heard this with not only Fed testimony in July that they thought that the second half of the year would be stronger. You're seeing it with some of the analysts’ estimates in terms of corporate earnings. But probably the first assumption was based on the jump in GDP that we saw of 3.3% in the second quarter. Now, as many people would admit, a lot of this increase came from the stimulus checks and also what I call some statistical gimmickry with the inflation rates. The inflation rates actually dropped dramatically –the GDP deflator – in the second quarter. So I don't think anybody listening to this program believes that inflation fell dramatically in the second quarter. However, I want to discuss a gauge that a friend of mine, Brian Pretti, recently used in an article that he wrote and that is the Chicago Fed’s National Activity Index. And this index has called every recession over the last four decades. Whenever this index, John, dips into below negative territory and especially below a negative 0.7 percent, it indicates a high probability of recession. Now, this index is made up of 85 indicators of national economic activity and it encompasses as you would expect, the major categories of an economy. There are four broad categories including industrial production, personal income, employment and personal consumption. Now this index, by the way, dovetails with the National Bureau of Economic Research. That's the entity that calls or pronounces officially whether the US economy is in a recession or not. That index fell below negative one and is currently below a negative 0.7 percent, so it is flashing in bright red a recession ahead of us.

And when you look at its key components, I don't care if you're looking at personal income, if you're looking at payroll employment –just look at the unemployment jump that we saw this Friday – industrial production, non-defense capital good, new orders, retail sales, everything confirms that we are in a recession; although the experts haven't officially called it a recession. Maybe that comes after the election is over. So John, I believe Wall Street's view on this second half recovery and the Fed's view that we're going to see stronger growth in the second half of the year is going to be proven to be false. [08:17]

JOHN: Well, let's face it, the economy certainly doesn't feel robust. You know, everywhere you go and you talk with people, they tend to seem to share that view, as a matter of fact, despite pronouncements one way or the other. What do we call it? – a cognitive dissonance we keep referring to here on the program where by the pronouncements of politicians or financial people doesn't seem to match what people feel on the street. Let's move on to point number two, the credit crisis will soon be over. What do you think?

JIM: The only thing I'm going to say that's a whopper.

JOHN: With cheese or with just plain.

JIM: That's double cheese whopper with that one. I mean if you have a professional Bloomberg, it's called WDCI. And what this does is it measures the losses that have been written off globally and the amount of capital that has been raised. As of last week, we've got worldwide losses of 507 billion, 361 billion of capital raising. And then what it does is this table that I'm looking at, it takes the largest firms around the globe, it takes the amount of losses that they've written, the amount of capital that they've raised, you know, Citigroup has written off the largest amount of losses over 55 billion. They've had to raise 49 billion in the capital markets; behind Citigroup, you have Merrill Lynch with about 52 billion in capital losses, 30 billion in capital raises; UBS with about 44 billion in losses, 28 billion; HSBC, 27 billion, 5 billion in capital; and it goes down to Wachovia, Bank of America, Washington Mutual and –let me see – Morgan Stanley, JP Morgan, the Royal Bank of Scotland, etc.

So what we've seen is 500 billion in write downs and financial institutions have raised roughly about 361 billion to offset those losses. But as we gain more transparency in the financial markets –especially a lot of this off balance sheet debt – it looks now that like total losses are going to average and I've seen depending on who you're reading between 1.6 trillion and 2 trillion, so we still have a long ways to go. In fact, losses should keep climbing all of the way up to the end of the year and into next year. So what we're looking at, John, is a second wave of the credit crisis is directly in front of us. So what we should actually begin to see is a picture forming of rising losses through the end of the year, contrary to what a lot of people are saying about most of this is behind us.

In addition to that, you've got financial institutions that are going to have to roll over about 900 billion dollars of expiring short-term debt that is going to have to roll over and be refinanced. Many of these financial institutions simply will not be able to service that debt. They are not going to be able to raise the capital or refinance their debt and survive because the cost of funds for some of these institutions is becoming intolerably high. As I said, I saw a couple of trades go across my screen of Washington Mutual's 8.25% debt maturing in 2010; and if you take a look at the price of that, it's pricing a yield to maturity of over 40%. You know, financial institutions – as one expert said, the total financial system is dangerously close to the edge. You've got FDIC which only has a little over 50 billion, of which they will probably use 20 billion of that just in IndyMac alone. FDIC is going to have to be recapitalized and there isn't enough money in the fund to cover the coming bank failures.

I also believe that you're going to see some kind of catalyst going forward here that's going to trigger government nationalization of Fannie Mae and Freddie Mac. I mean both of these entities need to raise over 50 billion dollars every month simply to meet existing debt obligations as they come due over the next six months; and I've read estimates depending on who you're looking at from both the FDIC and more independent credit analyst that estimate between 200 and 700 financial institutions are going to fail. And that means several large investment banks are going to go under, several large banking institutions are going to fail and many, many more –both investment banks and banking institutions – are going to be merged. Now in 1991, you had in the S&L crisis we actually had 1500 financial institutions fail, so 700 failures may be a very realistic number. I mean just looking at some of the news stories that we had on Friday here, you have mortgage foreclosures in the US grew at the fastest pace in the second quarter as interest rates increased and home values fell prompting more Americans to walk away from their homes that they simply couldn't refinance. This is the highest foreclosure rate that we have seen in nearly 29 years. We got the unemployment report on Friday jumping to 6.1. That means as more people lose their jobs the probability of failure or foreclosure increases even more.

And another issue that we don't have time to get into today is credit default swaps. So as default rates double over the next year, this is going to be another bomb shell that's going to rock the credit markets and that's probably a topic, John, for another show. [14:23]

JOHN: So the credit crisis, basically those credit issues are not over. Just as an aside, what should people do by the way if they think their bank is in trouble. Can they figure out if their bank is going to be in trouble, and if they do, can they do anything about it?

JIM: Well, the first thing, if you're listening to the show, if you're reading the headlines is for goodness sake, keep your deposits under 100,000; and better yet, if you're in with a weak bank, find a stronger bank. And if you want to sleep at night, if you just you want to keep some money that's a cushion, you want it there for emergencies, then, you know, put it in T-bills. You know, if you need that for cash emergencies because the only downfall to that is money is losing its value. But you know what, if you want to be able to sleep at night, that's what I would recommend that you do. [15:11]

JOHN: Okay. So I believe there are a number of agencies that will for you rate your bank like an a b c d and tell you how risky they think your bank is. And by the way, Jim, that may not be too important like you say, if you're using the money as a medium of exchange and you only keep a limited amount in the bank, then that's pretty much where you're at. It's the overstock, so to speak, if you have excess cash in the bank that really becomes a liability given the FDIC ability to cover it all.

JIM: There is another site. The link is too long to repeat on the air, but if you just Google “institutional risk analytics.” That's Institutional Risk Analytics (www.institutionalriskanalytics.com). This is a site run by Chris Whalen, there is -- I think Chris charges $50 and you can get a brief analysis of your bank and an update on what they are seeing in that bank for the next four quarters. So I think the charge is 50 bucks, but it's Institutional Risk Analytics and you can get an update on your bank in terms of how safe it is, and so I'd recommend that you do that because we've got a major financial crisis directly in front of us as we get towards the end of the year and move into this crisis window. I have this analogy and there are two analogies, but I think of the little Dutch boy, you know how he's trying to plug the holes in the dyke?

JOHN: Yeah.

JIM: And I think that's what you're seeing right now. You're just trying to plug all of the holes in the dyke and just get us through the November election before the fertilizer hits the fan, and I think that's what's going on right now.

JOHN: Do you think we'll make it to January 20th, or is it going to fall apart before then?

JIM: I think after November, you know, there are just too many holes out there and there is going to be too much – I mean, you know, you take a look at two numbers or two news stories that just on this Friday, the unemployment rate rises to a five year high at 6.1. What does that tell you? People are losing their jobs. The second story is mortgage foreclosures in the US rise at the fastest pace in almost three decades. [17:20]

JOHN: So it's the storm brewing.

JIM: And another one. HSBC predicting the financial markets’ power shift moves from New York to Asia. Paul Volcker says the financial system is broken. I mean I'm just looking at all of these and it's almost like I'm looking at what's going on in the markets and I'm looking on what these stories are. And it's like I said, John, there is a disconnect between the physical market and bullion and paper markets and there's another disconnect between the financial markets and what's actually going on in the economy. [17:55]

JOHN: Listeners to the program here are sort of ahead of the game anyway, Jim, because of the fact we're saying this is what's coming, so now this will not catch you by surprise. There are things you can do. 1) Keep the amounts in your bank if you have amounts this large under 100,000 because that's what's insured by the FDIC. 2) You can evaluate the status of your bank either through Weiss Research or through Institutional Risk Analytics. 3) if you really have excess amounts of cash that you don't want to keep in the bank, you can move them into treasury T-bills which will at least keep them liquid and preserve them from what might happen to your bank. So there are some things that you can do, and lifestyle-wise you can also begin making some adjustments as you see these things happening because you know ahead of time what is headed our way. [18:42]

Let's look at point number three here, Jim, and that's the assumption that inflation is coming down and will no longer be a problem. It's very much the same thing as its euphoria over oil right know. “Oil is coming down, it's broken, we're not going back. We've come back to reasonable levels.” [19:00]

JIM: If you look at this, John, and you look at going forward, we know that inflation began to accelerate around this time last year, so if you look at what we may see in the third, the end of the third quarter, the fourth quarter, we know the year-over-year change going forward should bring headline inflation down because it's going to be shown or measured against higher numbers that we saw last fall. So for a short period of time and also because we've seen the recent drop in oil prices, that's going to help some of these numbers. However, you know, there is a lot of built up inflationary pressure in the pipeline and it's being held in several inflationary depositories. So, as we go forward, you're going to see more fiscal stimulus and you're going to see, you know, if you listen to the speeches of either Barack Obama or John McCain, you're talking about massive fiscal stimulus that's going to come from either what we're going to do in the energy sector or what we're going to do in the infrastructure sector. And you also have large calls from prominent people like Paul McCulley talking about the paradox of thrift. If people start to save and they try to cut back on spending, then as a Keynesian, you say, okay, now what you've got to do is bring forth major fiscal spending, and with this fiscal spending and Treasury help to finance this fiscal spending. And that is inflationary.

So as we go forward, you're going to see more fiscal stimulus and eventually because of credit losses, which are going to be so horrendous, you'll eventually see the Fed step in and they are going to go to monetizing debt. And this was something that was brought in the February testimony with Bernanke by that one congressman, John, and I wonder if we can go to that clip briefly because this congressman hit this issue dead on. [21:04]

SENATOR: It appears to me that if one of these highly interconnected investment banks were to fail in the near future that the Fed's balance sheet then has limited or no room left on it. Coupled with there being no legislative frame work in place going into this, would the Fed in essence have to monetize the situation to bail them out? Would the fail have to deal with new Treasury paper to bail out the bond holders which is what really occurred with the Bear Stearns situation if another situation came? So my questions to you are three. Can you assure us –and I think I know the answer to this question – but can you assure us that you will not conduct any similar Bear Stearns transaction if another investment bank or GSE gets in trouble without the prior explicit authorization from Congress via some sort of enabling legislation? Two, if you decide that there is no alternative than to conduct another bail out or support, however you want to call it, to one of these troubled organizations, will you be willing to monetize the debt to finance such a transaction due to the current limitations on your balance sheet? And thirdly, on your claim that your actions with the Bear Stearns transactions are granted to you under Section 13 of the Federal Reserve act, are there any limitations within that section or elsewhere as to your abilities subject going forward to deal with these situations?

BERNANKE: Well, I’ll try to address those range of questions. Over the weekend when we were working on the Bear Stearns issue, I was in touch with Congressional leaders, kept them informed and I – the sense I got was that you know, there was not an objection to pursuing it. I also of course worked very closely with the Treasury and SEC and other authorities to develop a consensus for the actions we took. And as I've argued before, I think they were necessary. So I, you know, I don't want to make any commitments. I don't think a situation like this is at all likely, but unless I hear from Congress that I should not be responding to a crisis situation, I think that it’s a long standing role of the central bank to use its lender of last resort facilities to address –

SENATOR: So the first answer is ‘yes.’ So the second question is then would you potentially monetize the situation if the balance sheet –

BERNANKE: There is no monetization. This is a sterilized operation. There is no affect on the money supply. In addition, I would add that our lending not only took this Bear Stearn's issue, but more generally to the banks and so on is not only collateralized with good haircuts, it's also recourse to the banks themselves. We have not lost a penny on any of this lending. And it is just lending. We are not purchasing any of it. It goes back to the bank when the term of the loan is over. [23:42]

JOHN: But the financial pundits keep talking about deflation or lowering inflation ahead when here they are talking about monetization.

JIM: You know, when the Fed starts exchanging its debt for toxic waste, it's just another form of monetization because if that toxic debt was left on the bank's balance sheet, the losses would be so horrendous that their capital would be wiped out and they would be considered insolvent.

But you know, it's funny because I've got a graph that I have in front of me and it's the 10 year treasury yield that goes back to the 1970s, and as I mentioned in an earlier segment, in 1974 there were a lot of bet that's were being made in terms of the direction of inflation. You know, if you take a look at 1974, there was another period of time where you had major bets that were being made in the fact that inflation was coming down, Nixon had wage and price controls. And if you look at that brief period, you had the 10 year treasury note hit a roughly about 8 ½%, 8.6% in 1975, and then from 1975 all of the way to roughly the end of 1976, you had the yield drop from 8.6 down to 6.8.

But what happened, John, from that point, we start seeing rising oil prices, we start seeing the inflation rates start to rise. By the end of the year, by 1976 where we got down to roughly 6.8, we saw the yield on the 10 year note go from 6.8 all of the way up to 10%, 10.4 in 1979. In fact, if we just go forward two more years, then we saw that rate go from a high point towards the end of 1979 when we hit over 10.6, we had a spike upwards in 1980 as a result of the 79 recession to 13%; from 13% the yield drops down to 9 ½% in 1980. And then it jumps right back up again to almost 15 ¾% in September of 1981.

So the point I'm making right here is there is a big bet that is being made right now of a particular outcome, and it is not just Wall Street, but it's also a bet that is being made by the Fed. And this is very close to the same bet that you saw made in the early 70s. If you look at a sharp rise in the PPI rate and if you back out the federal funds rate, we're almost at the same point as we were in 1974. So basically, you've got the bond market, you've got the Fed and you've got Wall Street are making a bet on this particular outcome and we know, John, looking back historically what that outcome was. The markets and the money wealth which is debt instruments made an incorrect assumption and was out of touch with the underlying inflationary pressures that were building up in the economy and you fast forward here over 30 years later that same bet is being made, and those same assumptions are being made today.

For example, you have the assumption that well, if the economy weakens, there is going to be less demand for goods. But you don't talk about the supply. Look what's happening about a lot of the supplies of, you know, the Johnson Matthey story that we've talked about, and then we also have this concept that economic growth is bad for some reason, that if the economy grows too fast, that creates inflation. So you have this diversion of thinking away from the thought process of its not money and credit that create inflation. It's, you know, when businesses raise prices, when labor demands more money or some kind of odd event of weather as you're seeing, you know, with hurricanes that may drive the price of a commodity up. So we've been told ever since this economy began to slow down, which it did in the second quarter of 2007, that inflation would be heading lower. That hasn't happened. In fact, just the reverse has happened. Inflation rates, as skewed as they are, have been heading actually upward. And I don't need to tell you if your listening to this program, you experience this on a day-to-day basis when you pay your bills, when you fill your car at the gas station or you make a trip on the weekends to the grocery store. So I think we’re going to see rising rates in the months and quarters ahead as all of these depositories of inflation start to come out and enter into the real economy. Who knows, maybe they'll have some statistical miracle that they can work, but I do believe you're going to see rising inflation rates. [29:13]

JOHN: All right, let's get to the final assumption that the commodity bubble has burst and the bull market in commodities is over, so let's get back to business and get back into those financials.

JIM: You know, first of all, you have to assume that this was a bubble. And I think to assume that this [is a] bubble is absurd. In a bubble, whether it's the tech bubble of the 90s, if it's the real estate and mortgage bubble of this decade, whenever you have a bubble, you have rising prices occurring at the time you have rising supplies in inventory. Whether it's more homes coming to the market or being built by builders or its technology stocks and technology inventories, whether it's broadband computers, or it's more supply that's brought to the market. And eventually, this rising wave of supply overwhelms demand and eventually prices collapse. If this is a commodity bubble, then show me or point to me where the huge stock piles of oil, copper, wheat and grains and many of the essential materials that we consume every day on a day-to-day basis, you don't have grain silos that are topped off. Instead you have inventory levels of grains that we have not seen since we began keeping track of this going back to the early 60s. Energy inventories are at some of the lowest levels that we've seen in five years, so I don't believe this has been a bubble, nor do I believe this is over. We've got a long, long way to go here. [30:50]

JOHN: Well, I come back to the experts that tell us that all of this is over. I even heard one of the financial anchors say this week he's looking forward to 2 dollar gas and 50 to 75 dollar oil, so they really believe that this thing is on its way down and the storm is over. At least that's what they are telling us.

JIM: You know, there is nothing new here, John. Since you and I have been doing this program since, what, the winter of 2001 right after the events of 9/11, all along the way when oil was at $18 a barrel all of the way to its recent high of about 147, we listened to people on the Street and they've missed this entire run up in oil, they've missed this entire run up in commodities; and so the one thing that I think is more important is I look for inventories, I look for an inventory build and I can say oh my goodness, the inventories are starting to build, and you know, that would be a sign to me. The other thing I look at is what the CEOs that run these commodity companies are telling us, whether it's a conference call with the head of BHP Billiton that says, yes, they are seeing certain weaknesses. But in their broad commodity sectors that are consumed and used to build infrastructure or run the economy, they are seeing a strong demand. I mean they just put through 75 and 85% price increases. That isn't a situation where you have an abundant supply that you can force through that kind of demand in a product. You also have, you know, companies saying that they can't find large copper deposits or they don't have enough personnel. You’ve got the rig count for oil companies at the highest level that we have seen in decades and yet we have a failure of new supply to come on-line, and we're going to get into this in another program in terms of China, but I can tell you this: China is changing its emphasis from an export driven economy to one of an internal driven economy. And if you look at all of the internal measures, retail sales, domestic consumption are starting to increase and it's like the old problem that you owe the bank $5000, it's your problem. If you owe the bank one hundred million dollars, it's the bank's problem.

And I think China realizes that relying on the US or selling to the US with its weak credit conditions, its weak domestic and financial conditions is going to be a problem. And you've heard a lot of stories about, you know, Chinese growth. Well, you know, Chinese growth has dropped from 11% to 10.6%. And who knows? Within the next 12 months, you know, maybe Chinese economic growth gets into the mid-9s to 10% growth. But John, you're talking about the third largest economy in one of the most populous nations in the world expanding its economy at a 10% growth rate; that hardly tells me that we're going through a slow down – and we're going to cover that in the later show because there is just too much stuff that we have to get through today. So I just don't buy these arguments in terms of this was a commodity bubble. If it is, where are the surplus inventories and why are company CEOs that run these companies able to put through 85% price increases and telling us that's not what they're seeing in the businesses. That's not what people are telling us here, and that's a very important thing I think that you have to keep in mind when you look at this. [34:38]

JOHN: Well, if we look at whole world of bad news here that we've covered over the last 40 minutes here on the program, basically the myth of the economy is on the mend, look at the jump in unemployment rates, foreclosures are out there, even the guy on the street seems to understand that this is not really on the mend. So that one checks off as being a myth. The credit crisis – well, given the current banking situation, nah, that's not going to happen. We're going to see reverberations from this whole thing over the next year. That is going to continue haunting us well on down into what you were talking about bond defaults, swaps and other reverberations. Headline inflation, negative interest rates – it seems like inflation has not peaked, and given the track that the Fed is on, as a matter of fact, it’s going to have to monetize a lot of the malfunction in the financial system, and that means more inflation on the horizon. And finally, commodities – there never really was a bubble, it was simply a turn around into a bull market in commodities. They keep trying to call it a bubble. So that's not over with yet. There will be a time when it's over, but it's not right now. And you're listening to the Financial Sense Newshour at www.financialsense.com.

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[Economic chat with President of Global Century]

We're entering the fourth year of a down stock market. Is it time to sell?

Have we hit bottom yet?

What can you tell small investors who are really starting to worry?

Just this. Relax. The market goes up, the market goes down, but over the long haul, the market goes up. Yes.

Is there any chance that stocks might rebound this year?

I'm really the wrong guy to ask. I got completely out of stocks in late 99, and I haven't followed the market since.

You got out of the market three years ago?

Yes. You see, around that time, we at Global Century became convinced that stocks were heading for a crash and that bonds were a safer bet, and we were right. My own bond portfolio is up nearly 30%.

But if you're moving out of stocks and into bonds three years ago, why were your brokers telling people like me to do the exact opposite?

Well, obviously, if you think as we did that stocks are heading down and you want to unload them before a crash, you have to convince somebody out there to buy them. That's just common sense. Yes.

Back in the summer of 2001, I wanted to move money into some defense related and home security stocks, but your brokers talked me out of it. Is that because you and your friends were buying those stocks and wanted to keep the price down?

Exactly. We felt with the 9/11 terror attacks coming up later in the summer, that sector in the market would probably triple in value, and once again, we were right.

You knew in advance about 9/11?

Basically. Yes.

So earlier when you said you didn't own any stocks, that was a lie; right?

Correct. That was a lie. Yes.

Hi. Like a lot of us here, I followed your brokers’ advice and over the last few years, I've lost 80% of my life's savings.

That does not surprise me at all.

I would just like to say that although I think you're an evil person, even though I came here intending to kill you, I've been really impressed with your honesty. Your kind of straight talk is rare in today's business world.

Thank you. At Global Century, we like to be completely up front with our clients. That's why in our prospectus, we clearly say that our investment advice is often self-interested or deceitful and may work to our client's disadvantage. We think you deserve to know that.

For straight answers to your investment questions, stop by our offices for a free consultation.

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I've read it. It's not in there.

You're right. It's not in there. I just assumed you hadn't read it.

I appreciate your honesty.

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Global Century Investments, hard questions, straight answers.

[38:35]

JOHN: How do they do it? If you watch CNBC or you talk to a lot of pundits and refer to other things, you always wonder how do they get it wrong so often, so consistently on such a regular basis? You go back to 2003 – no. Let's go back a little bit earlier, 2001, there was all of that talk, Jim, you remember about deflation and instead we had inflation and the inflation gave us a real estate bubble and began to cause the rise in the commodity prices. But they were always seeming to be talking in the opposite direction. I don't know if they work hard at being wrong or if it just comes naturally to them, but we need to look at the issue of inflation because when they talk about inflation by the way, it's usually in the area of rising prices rather than the root cause and that's what Ron Paul is always thumping on is the root cause is monetary policy.

JIM: From Milton Friedman to the Austrian economists, it's always been a widespread belief –even to the classical economists – that inflation has and always will be a monetary phenomenon and an increase in the money supply causes inflation to decrease. But there are other factors that always come into effect that determine the side effects, in other words the rising prices that you would see. And they all work together and one of them is money velocity, the turnover the money. In other words, you could have an increase in the money supply, but a drop in money velocity and you would not see any increase in inflation because people would be holding on to cash, they wouldn't be turning it over as much; and then the other thing is what we call the supply of real values in the economy.

And at any point in time, all three of these variables are operating and working with prices in either direction. But only one of the three, money supply, is subject to the control of the government. And to prevent inflation and achieve price stability, you have to control this event. And so if you look at today a graph of MZM –money of zero maturity – it's on the up swing. If you look at money supply growth rates around the world, whether you're looking at Brazil which is growing at 32%, over 30% in Russia, India 20%, Australia 18%, China 16%; you know, if you take a look at the supply in our major industrial countries around the globe, for example in the OECD countries, M3 has grown at 8%. The areas where it's not growing that much is in Switzerland and Japan. So unless you understand that, then it's very difficult to understand inflation.

And the one thing that happens, and you saw this in Germany when Germany made the decision to not back the Reichsmark with gold to finance World War I, even though they began to expand the supply of money, money velocity actually decreased. The absorption of money was absorbed by what we call money wealth which was the bond market. It was absorbed by increased savings, and so there are a number of things that can operate and velocity is one of them and money velocity can remain sluggish in the beginning of inflation. So the money supply could be increasing but if velocity is coming down, and because, John what happens sometimes when a central bank begins to expand the supply of money to combat even a slowing economy or a financial crisis, you have these depositories that can absorb this money. And also, you might have, for example, if you're an individual and you're saying gosh, I'm going to lose my job, the economy is slowing down, we need to build our savings and if you build those savings, it may be the velocity of money isn't turning over as much. The velocity of money in the foreign markets with the dollar is increasing, where the velocity of money here in the United States is actually not going up. It's been slow. So you can offset a growing money supply with a lower velocity of money rate. And it's only when people catch on that there is real inflation out there that the money velocity starts to increase because then people begin to say, well, you know what, I don't want to increase or hold onto my money. I want to spend it as fast as I can because right know what is happening is I'm seeing prices go up, so I'll spend it today rather than save it because tomorrow the cost of goods will be even more expensive. And so that's the problem that you have right here.

And the third element is what we call aggregate values. In other words, when a central bank creates money, it can't always control where that money goes too. It can go to the real economy, into the cost of goods and services as we're seeing today, or it can go into the financial economy. It can go into debt instruments. It can go into financial deposits at the bank. It can go into what we call money wealth, which are debt instruments and it can absorb that. So the financial markets play a significant role, and the capital markets play a significant role as a depository of future inflation. In fact, it is one of the principal repositories of inflationary potential. Monetary inflation invariably makes itself felt first in the capital markets. And you saw this in the 90s when in November of 1994 the Fed began to expand the supply of money in the economy. What happened is you began to see that money go into the financial markets and we got a tremendous boom in the financial markets from 1995 to the beginning of the year 2000. So the financial markets have always been a main depository for this kind of money, and the one thing that is very clear is that when money is created, individuals have two things that can happen. A man can put his money into things. Those are goods. Or a second choice would be putting your money into paper things – stocks, bonds, mortgages, savings accounts, insurance policies, commercial paper, money market funds. And this second category of values is entirely outside the national product –in other words, GDP – and it corresponds to national wealth. But what it is, it's a depository for this inflation that is created.

And that is one of the problems that you have in this kind of society because when people invest money or put it into the capital markets, this forces the price of these values in the capital markets to increase, whether it's the value of a bond, interest rates coming down as you're seeing now or it's the value of the stock going up or it's in real estate prices going up. And that's one of the things that we have to keep in mind here is that this money wealth -- [46:11]

JOHN: Before you go on, let's tell people what money wealth is, and you may want to review what velocity of money is too, by the way.

JIM: Velocity of money is how quickly the dollars that we have in the economy are turned over. Because it's actually the supply of money and its turnover, that's what creates our economy. It's how fast these dollars are turned over. The slower the velocity, the less the impact that you have on money creation. The higher the velocity, and this usually comes in in the latter stages of inflation when people wake up and they say I don't want to hold onto my dollars. I want to spend them. It’s kind of like what you saw happen between 1922 and 1923 when the money wealth of Germany said, “I'm out of debt instruments, I'm into something real, I'm going to spend the money today because whatever I have today, the goods that I'm buying with what I have today will be more expensive tomorrow.” So that's money velocity.

But money wealth works differently. Money wealth is debt instruments and debt includes all forms of money: contracts such as bonds, mortgages, debentures, notes, loans, deposits at banks, life insurance, pension obligations. And in contrast to what we call real values, things like ownership of stock where you own a business, a tangible asset, debt does not represent a direct ownership of real assets, but it does represent a subdivision of the interest in those assets. In other words, the banks claim on your home, your home is a real value. The bank's mortgage or its claim on that house is what you call money wealth. And the thing that happens is when you have debt that is created by government, you always have – and I'm going to get into this in a second, you have to have an absorption for that. And at every inflation, you always see a tremendous expansion of paper wealth in relation to real wealth – in other words, paper wealth versus real wealth represented in like businesses, stocks and things of that nature. Government debt grows excessively and private debt grows even more excessively; and certainly we've seen both of those events take place in this decade. And this colossal expansion of paper wealth is probably the single most powerful single influence for absorbing, moderating and containing those inflationary forces.

On the other hand, the existence of an over expansion of paper wealth supplies the principal compulsion which the government uses to inflate anew and erode the real value of paper wealth, and if you are looking for any kind of inflationary storm to take place – as I believe that’s what we're seeing now – you always have to keep an eye on the paper wealth because at every turn, it is this paper wealth (these pools or these tanks and reservoirs which have accumulated inflation over the decades) where this inflation has been stored without causing a real inflationary storm in the economy. And that's one of the reasons why you can see lagging money velocity and price appreciation in the capital markets and it creates these spurious values in product and property that lend their aid, the most mammoth reservoir for inflation. The size of – just think of a large ocean and it's unnatural is the artificial growth of money wealth and this is the factor which you must constantly monitor because in the 70s, I’m going to go back to some of the things that we referred to earlier where you have several graphs and I think I'm actually going to write an article on this. I've been thinking about coming back to the writing mode because there is so much disinformation out there because if you take a look at, for example, a graph of the 10 year yield of treasuries and you compare that to the CPI where you have negative real interest rates, if you take a look at the Producer Price Index less the federal funds rate, we've got two major indicators right now that are telling us ahead of us is a massive inflationary pipeline. And on top of that, the third indicator that also tells us this is this massive pool of what I call money wealth or all of this money that is laying in the debt markets right now; and it is only when its money wealth wakes up to the fact that it has been fooled and that's why you see so often the Fed concentrate on inflationary expectations because what they are watching there is when inflationary expectations start to increase, you generally see – with a lag effect – an increase in velocity; and it's the combination of that increase in velocity combined with an increase in the money supply and also this depository of money wealth that has been the shock absorber that we have seen in the markets to absorb all of this inflation. When that starts to come unglued, that's when you're ready to enter the next stage of inflation. And that was why they had to do what they did in July because of what they knew they needed to do going forward which is why they have worked feverishly to try to artificially turn this commodity market down and change the paradigm talk not only in Washington but on Wall Street. [52:12]

JOHN: Well, let's talk about some of this money that you were talking about because if we look right now, inflation is above – at least headline inflation – is above 5%, I think the real world is a lot higher than that. Federal funds rate is 2%, but as far as bonds, the bond yield, it's not going to make enough given inflation after your post tax or whatever payment on that to make it worth investing in it.

JIM: Well, the one problem that you have, you know, with government deficits, which we know are getting larger and we know from the campaign platforms of both candidates that these deficits with spending are going to get even bigger. Now, government deficits and government debt are not inflationary if they stand alone. But, John, they never do because the creation of government debt is always accompanied by an increase of the money supply. And that increase of government debt is always competing against private borrowers for a static supply of capital. So a large government debt issue would drive interest rates upward and interest rates higher and that's anathema to government, so a large amount of government debt, a large deficit simply could not be marketed without a large increase in the money supply. So therefore, when you see government deficits increase, a concomitant increase with these deficits also is an increase in the money supply because deficit expenditures by themselves could accelerate the velocity of money because the government spends its money more rapidly than let's say cautious private spenders right now. In other words, the government is spending its money as fast as it can get it where right now with the public, people are frightened, they are seeing high rates, they are seeing a rise in unemployment, and so when people see that, they react cautionary and they say “oh my goodness, I'd better start increasing my savings, I can lose my job.” So this combination of an increase in the quantity of money and the velocity of money can be stabilized if it's absorbed by this money wealth.

The only limitation to this inflation absorption affect of government debt, like any kind of money wealth, is the credibility of that debt, and that is very, very important. It is one reason why they had to do what they did in the month of July because as long as the government can sell its debt, it can use that debt to restrain the inflationary effects of its high velocity spending and it's money creation. But at some point, and we saw a bit of that with the rise in interest rates leading up until this intervention in the markets that we saw in the month of July and August, you had rising interest rates, you had the credibility, we read stories in the press, the Chinese have been dumping their mortgage-backed bonds of Fannie and Freddie, other central banks have done that. So this money wealth that the government used as an absorber of its inflation, only if people and institutions trust in this money wealth, but if that trust is lost through inflation, the restraining capacity of government debt is lost. At some point, and I don't know. It was 1977, 78, when the money wealth in this country finally said, you know what, I don't buy this story about inflation anymore, I want a higher rate of return, I'm going to take my money out of debt instruments, I'm going to put it into something that's real, or real values because money is losing its value. That is the reason that you are seeing what is taking place today because existing money, which has been absorbed or employed in the debt markets leaves these debt markets for other markets. And when it does, you have a gigantic depository of inflation that now starts working its way into real values and the government debt begins to depreciate. It forces interest rates up and it begins a compounding process and then you also see accompanying that also an increase in velocity. That's why over and over and over again when you hear the Fed officials talk or you hear Bernanke on Capitol Hill, they keep talking about inflationary expectations. And so we have right now these huge depositories in the bond markets, and right now some of that credibility of the bond market is beginning to be questioned, whether it's Fannie Mae, Freddie Mac – and right ahead of us, John, on top of that, you have a tsunami heading our way in the debt markets, which is an instrument we're going to tackle in another topic here in the Big Picture. [57:32]

JOHN: So if we look at these depositories of money wealth, whatever the mechanisms might be, they've basically been absorbing this inflation over the last couple of decades, which then causes the Fed and or the Treasury to work together to try to contain these markets.

JIM: They have to do that because if they don't, then what happens is this thing begins to unravel. It eventually does, John, but right now, they are trying as much as they can. Once again, it's like that Dutch boy that's got his finger in the dyke. You plug one hole and another one begins to burst and eventually the dam breaks and right now they are trying to contain this as much as they can. And who knows. Maybe that's one reason why Paulson is leaving his post – he's not going to even serve out his term – immediately after the election.

Part 3

The Next Rogue Wave

JOHN: Welcome back to the third hour of the Big Picture here on the Financial Sense Newshour. We are not doing the Q-lines this week because we have so much material to cover.

Jim, you know those nonlinearities –is how I guess a friend of mine would call them – that occur, or the things that really throw the loops into the markets. Sometimes markets in financial situations are poised for a fall, but then something has to push them over the edge like an avalanch, you know, the snow builds up and the snow pack gets just right. But it takes some little extra piece of energy in there to trigger the avalanche before it rolls. That is what a rogue event is. If we had to look at another rogue event heading towards us and it could come from a geopolitical source as well as an economic one, but it would affect the markets and finances worldwide. Where would we be looking for that?

JIM:John, I think the next rogue wave Nassim Taleb calls then black swans, but I would say the next rogue wave is definitely going to take place in the credit markets. In the first stage of this credit market that unraveled beginning last August, in this what you saw is a lot of companies start coming clean and they began to write off this mortgage debt. And as a result of that, it was almost like before they even announced the losses, they tapped the financial markets to raise capital whether they were going to sovereign wealth funds or if you were going to private individuals. I mean if you look at to date you have roughly about 514 billion dollars of capital losses and you've had about roughly about 364 billion in capital raises.

Now, if you take a look at where most of this money was raised from, it's remarkable. Roughly 60% of the money that was raised to recapitalize these financial institutions came from public investors, large institutions; 20% came from governments and sovereign wealth funds; and then about, I would say, another 20% came from private investment institutions. So during this first phase is quickly as these losses were written off before they even did that in order not to spook the markets, they had contacted or gone in and done some capital raising. But if you take a look at –whether it's Fannie Mae, Freddie Mac – some of their preferred debt, preferred stock which is trading for 50 cents on the dollar, you've got Washington Mutual debt due in three years, trading for a yield of 40%. And so if you take a look at this first phase, they were able to raise enough capital to basically satisfy their capital requirements and also they were selling off assets in the financial markets in order to absorb and keep their capital ratios because they have to keep this constant ratio between equity and the amount of, let's say, assets that they have on their balance sheet.

Now we're getting into this second wave that's going to hit and if banks are keeping their leverage ratios 10 to one, if hedge funds are keeping their leverage of 20 to one, sometimes 30 to one, you've got another round of losses that are going to be written off going forward. In fact, many knowledgeable financial experts are saying that right now the estimated total losses for the sector, it's estimated that commercial banks have roughly about 700 billion of losses that will be ultimately written off. Investment banks have about 110 billion. Insurance companies have about 300 billion. You've got pension funds, money market and then kind of an odd category of financial institutions: Individuals. And that's around 840 billion. So the estimate is somewhere in the neighborhood of roughly two trillion dollars of losses. Now, as I mentioned, so far as of last week, we've got roughly worldwide, financial institutions have raised or written off roughly around 514 billion dollars and they've raised 364 billion in capital. And we can split that up in the Americas, it's roughly about a quarter of a trillion dollars, 184 billion in capital raising. Europe has written off roughly about 230 billion dollars of losses, 155 of capital raising; and Asia probably the best, they've written off about 24 billion. They've raised 22. And then of course the top financial firms underneath this are Citigroup with the greatest amount of losses, Merrill Lynch, UBS, HSBC, Wachovia, Bank of America, Washington Mutual and Morgan Stanley JP Morgan.

And the problem is, John, we're heading in to the third and forth quarter. The headlines that we're talking about, for example, today, where you had that jump in the unemployment rate to 6.1%, you had the largest jump in mortgage foreclosures and those mortgage foreclosures are accelerating; and as more people lose their jobs, that means more people are going to be unable to meet their mortgage obligations, that means more delinquencies, more defaults. You've had several of these financial institutions play with their accounting where they've extended the loan loss period for recognition from 120 days to 180 days, and so what you have before us is a picture of rising losses, and when you have, for example, Washington Mutual that has some of its debt trading at a yield of over 40%, John, how are these institutions going to be able to tap the capital markets and say “we need to raise new capital?” You can't afford to be paying double digit interest rates to shore up your capital and then making loans at single digit interest rates. You know, that just doesn't work.

And that's why I think going forward here and especially it's going to be interesting as we get to the end of the fourth quarter where you have almost 900 billion dollars of short term debt that is going to be rolled over, who is going to be able to roll that debt over and at what price? So that's when you hear talk about how dangerously close the financial system is to a precipice right now. We have not been this close, John, since 1933 when Roosevelt declared a bank holiday. In fact, it's amazing because you have, for example, the Federal Reserve system. There was a paper called Central Banks and Crisis Management that was written by Joseph Haubrich and James Thomson and Emre Ergungor. It's called Central Banks and Crisis Management. And what they are talking about, as these things unfold, whether we're look at the peso crisis in 94, the Asian crisis in 97, the Russian debt default and Long Term Capital Management crisis in 98, and of course the credit crisis that we're going through now, so what you have the Fed talking about is creating a permanent management corporation; they call it the resolution management corporation, RMC. Very similar to the RTC that was created in the S&L crisis where a lot of these failures – whether it's bank failures, whether it's investment bank failures – financial institution failures where you can roll this debt in and then quickly begin to liquidate it; much in the same way that we did with all of the investment properties, commercial properties, hotels, resorts, mortgages that we did in the S&L crisis in 1991. So look for that.

The Fed is already Telegraphing what some of its next moves are going to be and certainly that we've seen in this crisis where the Fed now has loaned out roughly 60% of its balance sheet where it is taking its high quality Treasury debt and loaning that to banks to sustain credit and also to keep the banks from being declared insolvent. Because a lot of this toxic debt the Fed has taken on its balance sheet, IF that debt was left on the balance sheet of the financial institution, they would have mark to market losses and those losses would overwhelm and wipe out the banks equity and so the branches would be declared insolvent. So basically, it's kind of like off balance sheet debt. What the Fed has done is off loaded this toxic waste onto its own balance sheet, and the problem that we're going to have, and it's going to begin here with Fannie and Freddie is I don't know what the triggering event, maybe they are going to wait for something to happen after the election, but there is going to be some event, and I don't know what that's going to be that's going to be a catalyst for nationalization. And it will be when short term bond investors decide, you know what, we're no longer going to buy this stuff. We're not going to allow the agencies to roll over the debt. As I made a reference to earlier, both agencies have roughly close to 60 billion dollars of debt that rolls over each month that they have to refinance these existing debt obligations as they come due over the next six months. And so debt financing is no longer a sure thing because who is going to refinance it?

And the other problem that you have here too, you've got Freddie Mac has a market cap value of roughly about 3.3 billion. You've got Fannie Mae has an equity value of roughly 7.6 billion dollars. This is what market cap of 3.3 so let’s say we have 10 billion, and these are the two institutions that underwrite and guarantee 5.2 trillion dollars of US mortgages.

And the other problem that you have is if you do get and if you take a look at these agency bonds who owns them, Fannie and Freddie? You have US chartered banks own 12% of the GSE's debt representing almost 11% of their assets. You have mutual funds that own 12% of the GSEs, representing 8 percent of their assets and then of course you have households, individual investors which own about 11%. Then you have state and local governments that own this. You have state and local government pension plans, private pension plans, broker dealers. The shareholders are probably going to get wiped out. The other thing you have to worry about is a lot of this preferred debt is also held by banks. So if you go into some bail out, how do you engineer a bail out which is basically a government takeover of these two institutions without wiping out the shareholders and the preferred shareholders and even maybe asking some of the bond holders to take some of the pain? So that's the kind of crisis that we have facing us going forward and you already have the tell-tale signs, John, of, they are talking about a permanent Resolution Trust Corporation so they can off load these assets and liquidate; and the problem is with all of this debt that is going to have to be rolled over by financial institutions, this 900 billion dollar figure here in the next six months, where is the money going to come from and who are the investors that are going to supply the capital. What cost will this capital be? If you have Washington Mutual debt yielding 40%, I mean that is a red flag in itself that there is trouble coming to that institution. At what rate will they been able to raise capital, and so you're going to probably see mergers going forward and you're going to see a lot of institutions go forward.

And one of the things that just -- this is probably the greatest nightmare scenario that I can think of, John, in this crisis window is we begin to monetize and inflate our way out of here because there is just no way out besides monetization. That's what that congressman was referring to. But you’ve got to set the stage for that and you’ve got to have the market clamoring for some kind of rescue. But as most of the experts say that the housing market will probably not bottom through somewhere in the year 2011, 2010, the credit crisis as it presently stands –there’s two trillion of losses – will probably not bottom out sometime until maybe the third or fourth quarter of next year. As we're trying to work our way and get this crisis out, then we've got the peak oil crisis that begins to hit the market and John, as we know, central banks do not create real value. They cannot create oil in the ground. Then that hits and then we get, John, the perfect financial storm. So these are some of the decisions that policymakers are facing and it's no wonder they had to engineer this sell off in the commodity markets in July and August at a time Fannie and Freddie were on the verge of insolvency, banking institutions and indexes and prevent short selling. I mean now you understand the gravity of what is directly in front of us.

And the amazing thing about this is if I can draw an analogy is we're on the financial Titanic and from the deck you can see all around giant icebergs in front of us. And the crowd is wondering what's going to be on the menu for dinner and what orchestra will be playing for this evening's entertainment: If you're on the financial Titanic, the best thing you can do is keep your eye on the life boats and we all know from the Titanic there weren't enough life boats for all of the passengers. And John, I think that's explains or helps to explain why you are seeing a worldwide rush to buy gold and silver because people know those are the life boats and those life boats are in limited supply. [15:10]

JOHN: And Jim before we leave this segment right now just as we're talking right here on Friday, breaking news story on the Wall Street Journal news wire. This will get your guns up there.

JIM: Yeah. This is from the Wall Street Journal. It says breaking news, Treasury is close to finalizing a plan to backstop Fannie Mae and Freddie Mac. Full article coming soon. Possibly as soon as this weekend. So once again, some form of intervention, nationalization and who knows, but that will be the story and they'll announce it maybe on this weekend. [15:43]

JOHN: We'll have to keep a watch on it and see where it goes, but this is exactly in line of what we're talking about here, isn't it? We talk about it and somebody: cue the Fed.

JIM: This is so surreal sometimes when you see this. We're sitting here doing the show and then flash right across the screen, so that story coming this weekend.

JOHN: You're listening to the Financial Sense Newshour, www.financialsense.com.

$145 Oil

JOHN: Well, during the station break, Jim, I just happened to punch up a story from Der Spiegel online, it's Friday September 5th, “Cost shock. Gas and energy companies are going to be raising prices drastically.” For the Germans it will be a very expensive winter is what this article is saying in Der Spiegel. Of course if we go back, how far back are we going to drag on this? Last year I remember you were predicting oil would hit 50 and then after it went through the 50 mark you predicted 125 and then altered that to 145 which made it in two weeks, and now we're at 105 and everybody is saying the bubble dollars and commodities is broken, the crisis is over. You don't think that, do you? I know you better than that. You don't think that.

JIM: You know, John, it was amazing and probably the most amazing thing for me was to come back from vacation and turn on the television and see Gustav hit the Gulf of Mexico and then take a look in overseas trading and see the price of energy down six dollars. I'm thinking, what the heck is going on here? And The Oil Drum had a great article that showed kind of like a doppler radar picture of the gulf of Mexico showing the path of Gustav and the number of oil platforms that were directly in front of it, those that were on the fringe and then those that were to the side would be okay. So you had this shut down where the Gulf accounts for 25% of our energy needs – both oil and natural gas, and you had this shut down. Then on top of that as you're going to see here with an interview with Curtis Burton who actually owns an oil company, has rigs in the Gulf of Mexico, about what is going on and any time you shut down a rig or you remove the supplies, you evacuate the platform, John, this isn't something like you walk in a room and you flip on a switch and the oil and natural gas begins to flow again. The estimates that were made is that it would take us probably 60 days to the end of October before we could get up to roughly about 65% capacity and then they would take us up to the end of November before we would get up to 95 percent capacity and now of course the latest estimates that there is a possibility that hurricane Ike, what was it, John? [18:37]

JOHN: As we're doing the program, Ike has sustained winds of around 120 which keeps it in the Category 3 hurricane right now.

JIM: And if it does round Florida and head into the Gulf where the waters are much warmer, it could pick up steam because heat helps create energy in a hurricane. The greater the heat or the warmth of the ocean, the greater the strength of the hurricane. We saw that with Gustav. As it entered into the gulf, it picked up wind speeds and became a higher category storm. So they are still doing damage assessment.

It was amazing. When I saw this hit on Monday and I saw the price of oil down, I began to talk to people that I know in the energy industry. I made phone calls. And it was amazing when I turned on the financial and they were trying to explain the selloff in oil because its damage was less than expected. How did the suits on Wall Street make that assessment? I mean did they have guys out there that went out there and they examined the rigs; and I even heard one financial anchor saying they were looking forward to 2 dollar gasoline. Yes, we've seen a pull back in the price of gasoline.

But you know it was amazing, there were two reports and we did this, I think, our last show in August where you had you the Interagency Task Force on Energy issue a comprehensive report, it was about 80 pages; and then also I had ordered and I got the IEA's mid term report on energy, and one of the most significant things that we're not really talking about here is the IEA – and they are doing what Matt Simmons did back in 2001 – and they are saying, you know, we keep making these demand estimates and we just assume that the supply will be there to meet demand; and we know that conventional oil production peaked in around May of 2005. And so we weren't seeing these new supply factors come into the market to keep up with the demand, so they are going back and they are looking at the world's 250 largest oil fields and that report is going to come out in November and when it does, we're going to have a full roundtable of experts to discuss it. But as a result of looking at that and looking at the decline rates (and especially with the second largest oil field in Cantarell where the decline rate of production has literally fallen off a cliff, it's almost down 50% in roughly about four or five year period) and what they said is the depletion rate of the world's existing oil wells we’re raising that from a 4% rate to over 5% and that translates that we need to find on a daily basis 3.5 million barrels of new oil every single day just to keep even. Then they took a look at demand destruction forces in the OECD countries which are developing countries and then they took a look at what's going on in places like Latin America, OPEC where the price of energy is subsidized; and in Asia, especially China, where the cost of energy is subsidized and there is going to be further subsidies that China is going to use its surplus to help its own people with subsidizing energy. And so when energy is subsidized and you're paying below market costs, you tend to consume more of it. They said that the demand for energy in non-OECD countries was 3.7%, so the net effect between the developed world and the developing world was an increase in energy consumption of roughly about 1% a year. In order to handle that, we were going to need to find one and a half million barrels of new oil.

So if you put the two together, you have 5 million barrels of new oil that we have to find and bring on stream every single day to keep us even and expand economic growth, John. And if you want to translate that what that means, that means finding a new Saudi Arabia every two years and I can tell you emphatically that is not going to happen. And it is just absolutely amazing when the government comes in and they interfere with the marketplace like they are doing now. I was reading a report that some of the demand for fuel efficient car was starting to falter off because people are buying into the story, hey, the price at the pump has come down 60, 70 cents and people are talking about oil going to $75 a barrel, you know, maybe I'm not going to buy that fuel efficient car or I'm not going to buy a Prius and pay a premium. You've seen a little bump recently in SUV and truck sales because a lot of car companies are making incentives whether they are giving employee discounts or whatever it is; but they are starting to move some of these bigger gas consuming vehicles which is exactly the opposite of what you want to see done. When you have the problem and the situation that we're in right now, you want people to conserve. You don't want people to say, “Phew, I'm glad that thing is over.” You know, John, it's kind of like remember when we were with $50 oil in January of 2007 and they were talking about 40 dollar oil, lo and behold, 11 months later, we were at oil prices over $90 a barrel.

So I'm going to make a prediction here, and John, you hold me accountable. By this winter, I don't know if that's going to be December, January or February, but by winter, we will be back up to 145 dollar oil again, so that's my new price forecast. 145 by winter. [24:30]

JOHN: It's interesting that we don't see the price at the pumps come down. Why is that people are asking? They say the price of oil has come down, but we're not seeing it at the gas stations.

JIM: We've got refinery bottlenecks, refineries operating. You just had 15% of the refineries in the gulf area just taken off line with hurricane Gustav. You would think that 40% of our refineries concentrated in the gulf of Mexico subject to the ravages of hurricanes, it might make some sense after 30 years to build some refineries located outside of some adverse weather pattern. I don't care if it's a small peak refinery, just as they build peak power plants. But I mean, that is the crisis that we are in right now and that is the crisis I fear.

What we're going to do here is we're not going to cover a lot about energy, but what I wanted to do, I wanted to share an interview with you with somebody that's in the oil business, somebody that operates oil platforms in the Gulf of Mexico and that's what we're going to do next. We're going to have a further discussion of oil in the weeks ahead as I'm preparing a major segment on that in future shows. [25:47]

JOHN: And in line with what we were just talking about here, we're going into our second Other Voices of today. We'll be talking to Curtis Burton who is CEO of Buccaneer Energy, and they operate in the Gulf of Mexico. So the Financial Sense Newshour will be back in just a moment right after this.

Other Voices with Curtis Burton, CEO, Buccaneer Resources

JIM: Well, we've certainly seen a lot of events in the month of August. Here we are in the height of hurricane season. We had hurricane Gustav hit the Gulf of Mexico taking out quite a few platforms. We have production of energy in this key producing area of the United States down, and yet we've got oil prices down as if there was no damage as a result of the events that transpired from this hurricane. Of course we have other hurricanes on the horizon and when I looked at this, I said you know what, I've been talking to people in the oil industry and that's what we're going to do here. Joining me is Curtis Burton, he's Chairman and founder of Buccaneer Resources which operates from the Gulf of Mexico with rigs.

I'd like to get, Curtis, your opinion on the things that we've seen transpire here with this latest hurricane and get your perspective. Talk about offshore platforms: What happens when a hurricane comes in, how you have to disassemble things, get it on a boat, get all of the gear, plug the hole, get out of town and what the process is of putting that back together because I was absolutely blown away that after this thing hit that we had oil prices plummet.

CURTIS BURTON: Well, some of the punters, as they say, have been reporting that everyone is talking about how we dodged the bullet. And it's striking, one of the deals I picked up it was very striking to see that the market made up its mind about the extent of the damage before anyone knew what it was. And it's typical. You've got -- you've got some strange things going on that are nonsensical, but it's pretty par for the course, I guess. [28:08]

JIM: What you're seeing is basically, I don't know if you saw the headline news from the head of Baker Hughes who said that although Gustav appears not to have been as destructive to offshore rigs as Katrina as far as getting back to work, this is just as bad.

CURTIS: You actually have a couple of different things going on. The scenario you were talking about is one where you do evacuate and if you have an offshore mobile drilling rig like for instance we use on Pompano which are known as jack up rigs, those guys tend to move the rigs out of harm's way to the degree they can; and like you said, they shut everything down and if they are drilling something, they stop drilling. They come out of the hole, they move the rig to a place they think is going to be safe and send the crew to the house. And so just mere towing back into place and reinitiating all of that – we're sitting here waiting on a rig that was supposed to be – I mean it got caught up in all of this and he was supposed to be on one of our wells on Pompano this week and it will be probably now the 15th of the month before he's there because he's got to collect his crew, get back on site, finish what he was doing and then he’s got a 55 hour tow to where we are. So, you know, it isn't, you know – contrary to the way Wall Street has it – it isn't “oh, well, there is no impact.”

For instance, intervention vessels and what are called lift boats which are light duty vessels, those rates have doubled since the storm because everybody needs one and nobody can get one. You had 96% of the gas production in the Gulf shut in and you had 100% of the oil production shut in. When you do that, mother nature isn't helpful because you don't just go back out there and turn the thing on and everything returns to the way it was. What you're doing is a start up on a well, so you have to start it up slowly and it takes – it can take a week, 10 days for that well to get back to pre-storm production level and guess what, sometimes they don't always go back because you've had, you know, things that have gone on with the well bores, you've had water collect over a perforation, any one of a number of things can take a well that was producing 10 million cubic feet a day before the storm and it starts out at maybe six or seven million cubic feet a day after the storm, so that you bring it on slowly and don't hurt the well. And it may have been a 10 before and it may only get back to 9.2 or something like that. So isn't a zero sum deal. For instance, 96% of the gulf production was shut in on gas. Our wells at Pompano happen to be part of the lucky 4% stay online because we were out of the path of what was going on. So unlike some of the other storms, you kept some level of production of gas going, but the real thing that people are missing because they don't care about economics to the oil and gas industry, the fact that lift boat prices doubled, crew boat prices doubled over the short haul. They don't care about that.

Unfortunately, what they also don't see is the bigger picture of hurricanes or the kinds of things that the Wall Street pundits get all excited about because it forces a move in the price of oil and gas. But that's what I call speculative movement where what they really are missing is the longer term picture is just horrible. I mean I just finished a white paper where if you look at worldwide crude oil production and consumption from last year, demand exceeded new production by 0.9 percent worldwide. On gas, demand growth exceeded production growth by 0.7 percent world wide and when you narrowed that down to the market that everybody is speculating on, ie the US one, production grew at 4.3% on natural gas in the US. That sounds pretty good because it's a pretty big number in our business, but consumption in the US grew at 6.5%, so you had a net negative of 2.2%. You know, when you're riding on the knife edge and just having enough, that's a big deal.

And so I've always argued there are two things that drive oil and gas prices. One is short term speculative behavior like is caused by hurricanes, but the real driver is long term supply and demand. It's one of those deals where if supply exceeds demand on a long-term basis, price goes down; if demand exceeds supply on a long-term basis, price goes way up. And what you've been getting over the lost couple of years, if you think about those numbers that I cited to you in what happened in 2007 where in both oil and gas demand growth exceeded supply growth, that makes no sense. And the reason it makes no sense is you're into the third year of the highest pricing for commodities that this industry has ever seen. Now, if you’re GM and you're getting the highest price for your cars that you've ever seen in history, what is GM going to be doing? They are going to be making every car they can to sell every car they can and the same is true in any other industry, so you can pretty well bet that the industry has been producing every ounce of oil and gas they can for the last three years. And they've been doing everything they can to get more into the pipeline because the prices are where they are. And if you think about that, if the industry has been doing everything it can and you're still falling short of growth, you have a very very big problem. And focusing on temporary upsets from hurricanes and then pushing the price down, it's stupid is a good word. [34:25]

JIM: Curtis, take us through the process and I want to go to, let's say, a deep offshore oil rig. You're out there working and the company at headquarters in Houston or somewhere is following the weather map and you're getting reports. At what point do you say, “all right, let's pull up everything, let's get out of here”? Take us through the process. Do you do it when you have definite confirmation it has entered into the Gulf because, you know, sometimes hurricanes look like they are heading one direction, they can turn, take us through that process. How does it happen? Does someone make a call back in Houston and then if that call is made, take us through the process of decommissioning a rig, and then, if you would, take us what needs to be done when you need to bring it back online.

CURTIS: Well, obviously, it varies with every operator on what the scheme is, but generally speaking what they are doing is they are watching the weather forecast and they are typically watching sort of all different tracks, and as it becomes clearer and clearer where – as it enters the Gulf, as you say, typically if it's a slow moving storm they are not doing to do too much until it's obvious that there is going to be a threat to production and then it takes about a day or a day and a half, even longer depending on what it is that you’re doing. Present to the deep water rig situation, if you're at 6,000 feet of water, you have crew evacuation that you're typically going to do because those are going to be floating vessels. You are typically going to be bored up and those guys are also typically set up – sometimes the vessels are not not going to be bored typically, they tend to be a DP deal, but you're going to have shut down operations on your drilling side that you're going to commence well in advance of when you think that storm might get there and that could take a couple of days. We have a deep water application simply because the time it takes to get stuff in and out of there. Typically, also, if the storm gets closer, you're going to be shutting down operations and then you’re going to be evacuating crew in most instances there may be someone, a skeletal care-taker crew there, but many instances in shallow water for instance, you've automated the process where all of the personnel essentially are going to be brought to the beach. For instance, in the case of this rig I was talking about a minute ago, we're operating at Pompano in the fields that we typically work in 150 feet down to 50 feet of water. More often than not as we said, those rigs are going to be totally evacuated after they've been moved to some place that they think they are relatively safe and out of harms way. Even in a shallow water operation by the time you dismantle, storm blows through, and then you recollect your crew, get back out there, move back on to the location, you're looking at anywhere from a week to 10 days and the impact is evidenced by the numbers that I gave you, and that's in a good scenario. If you've had little apparent damage like it appears we've had here, the Hercules rig that we're using, the 152, was on another project. They were slated to be to us sometime this week and now they are looking at probably the 15th. So they've got to get back out there and get hooked up and so we've effectively lost in my production activities 10 days of time from this hurricane event.

And what's then mild about this is grossly over-hyped, which is part of the problem we're getting into. The global warming guys are so absolutely determined that we're going to have a bad hurricane season that, you know, this was a Category 5 hurricane according to the press releases, right up until it turned into a two and then whimpered out on the beach, the one three or four weeks back was going to be a massive hurricane and when it finally made landfall it was a tropical storm. So that is part of the disinformation that's out that there that really costs us a lot because you've got these days, you can't ignore warnings, even if you don't really believe them, you have got to react to them, so what happens is the industry starts shutting down even when some of the data tells them that maybe that's not all together necessary and you have lost time. There is nothing you can do to get that time or that production back. I mean it's just gone. [39:10]

JIM: Curtis, you know, I've seen some various estimates in terms of the damage and it looks like, what, 40% of production was down or close to it and if you take a look at that being 25 percent of our supply, I've seen some reports that it's going to take, what, 60 days before you're back up to about 65% of capacity and maybe 90 days before you’re up to 95 percent capacity. Does that seem reasonable to you, or do you think that's too pessimistic or is that optimistic?

CURTIS: Well, actually, the first number you cited UMS has already put out some numbers in the official MMS – not me talking – 100 percent of the oil production on the Gulf of Mexico was shut in, 96% of the gas production was shut in – well, technically 95.4. But I've seen on some of the other services 96%, not that it makes a big difference.

And like I said, you do have some facilities like ours, the Pompano field, where we were part of that 4% that didn't get shut in, but what I alluded to earlier is the case and it's what you're talking about there. You don't just go back out there and turn these facilities on and they come back life to where they were. You have to gradually start production back up and if you have another hurricane, what I'll call false alarm for the level of shut down we've gone through, come into the area, you start this process all over again of shutting this production in and what that does is that makes that restart – every time you shut these wells in and bring them back on, you hurt them. Anybody in the business that's been around this very long, what they don't like to do is exercise these wells anymore than they absolutely have to because, like I said, you can have a well that was making 10 million cubic feet a day and even after you gradually bring it back on, you can maybe wind up only getting 9 million cubic feet a day out of it. So yes, the kinds of things you're alluding to about time lags that it takes, there will be an impact. Again, the statement that I quoted earlier Daniel Yergin, Cambridge Energy Institute, said it's very striking to see the market made up its mind about the extent of the damage before anyone knew. So that's kind of where we are, and that's even ignoring what you're talking about which is a real world consequence of what's going on. [41:45]

JIM: You know what's amazing about all of this too, Curtis, is everybody is talking about demand destruction and you talked about actually you're seeing signs of some increase in demand and we know from the IEA report, a midterm report that just came out in the month of August, and also the Interagency Task Force on Energy which looked into commodity speculation in energy. The IEA raised its depletion rate from 4% to 5.2 and they said that we need to find 3 ½ million barrels a day of new oil just to stay even and then they took a look at demand growth in OPEC countries, Latin America, China and India, and that was going to be around 3.7%, so they said net net around the world oil consumption is growing at 1% a year, so we need to find another one-and-a-half million barrels a day to sustain economic growth, so five million barrels a day. Curtis, that's the equivalent of a Saudi Arabia every two years. Where are we finding that kind of oil?

JOHN: That's really what I was pointing to is that you're not. And here's the other thing: You're not going to. Like I said, the numbers that I was pointing to on supply and demand, what they tell me, I’ve based my whole career over the years on looking at statistical data and seeing where you're going to be five years down the road. The reality is, like I said, you're coming out of three years of the most robust commodity prices the energy industry has ever seen and like any other industry if you have large demand for your product and you get good, strong prices, you're going to be out there producing as much as you possibly can. So you can conclude from what I'm saying that the industry is producing at it's maximum capability right now. You hear people talking about peak oil and all of this other stuff. I'm not talking about peak oil. I'm just saying common sense tells you if you can get even 107 dollars a barrel which is where it was yesterday, that's higher than it's been for 90% of my life, and so the energy industry is out there trying to capitalize on this as much as they can. If they’ve got that incentive and they are still falling short to the extent of the numbers you quoted or to the worldwide numbers I wrote, which in oil, you're down about a percent in difference between what demand growth is and what supply is – you're at negative 1% – well, that just tells you, you have a huge problem because you can't keep up and that’s even you referred to China and India and Brazil.

Because Buccaneer Energy is an Australian-traded company, I have over the last years spent a lot of time in Australia and in Hong Kong and looking at what going on in the Asian market and people don't understand the reality of what's going on. China and India are going to dominate the energy picture over the next few years as far as growth in consumption, and you don't have to look any further than that. I was at a conference in Sydney for Buccaneer about a month ago and they had a Chinese expert and he said, “listen, let me tell you what's really going on and it's not getting through to people in New York.” The Chinese have been subsidizing the price of energy coming into China. The Chinese government is subsidizing the price of energy coming into China to the tune of 30 to 40 billion dollars a year to keep the price low. And he said, a lot of people in New York think –these Wall Street guys – think that “oh, if demand falls off in the US, demand falls off in China and things fall apart.” This guy was an expert in that region and he said, let me tell you something. If the total demand of products in the US from China went away, totally went away, he said it impacts their economy by about 5%. He said what the Chinese are doing right now is they are gearing up to improve the quality of life for 1.3 billion people and that is staggering. I don't know any other way to put it. You're talking about people that are consuming a small fraction on a per capita basis of what we do and those guys are getting cars, they are getting better houses. So what’s happening is, you bet, what you said is absolutely right. We’re about to have a huge amount of demand out of China, out of India, out of Brazil because you've got effectively Third World economies in terms of the way the people are living that are coming into a mode where at least in China in my opinion they don't have any choice but to keep the masses happy with increasing standard of living.

And what this guy said –not me – what he said was, so, because of all of that, you're not going to stay in the Chinese peeling off and giving up on subsidizing energy prices. They are going to do it because they have to and they are going to do it because their economy demands it and their economy isn't –in contrast to what a lot of people in New York think – their economy is not dependent on the US. So what that really says on a worldwide global basis is you're about to get into a sure enough race for energy worldwide. And to the degree that the politicians and the people who are running America don't get that, you're going to go back to four, five, eventually, six dollar gasoline prices because you are in competition for a commodity that is going to get increasingly scarce.

And so what I have been saying for a number of years is what has kind of gotten into vogue lately is that look, okay, I just want to laugh when I hear politicians say, “well, there is no point drilling because it will be 10 years down the road before any of that hits market.” Well, that's a lie. Okay? Yeah, it's 10 years down the road before deep water reserves hit the product line, but you take companies like Buccaneer where we are out redeveloping old oil fields and the US is full of old oil fields, we are redeveloping old oil fields, we went in in January, drilled a well and had it on production in March. That is not 10 years and there are plenty with the right incentives in the industry can go out and do those things. Yes, there are segments, deep water being one of them, some of the other areas that areas have been drilling in, there is going to be a lag. But the bottom line is how stupid is it if you've got a resource that you can help keep the cost down for the American public and you've banned the industry from going in there and using it.

You need to be, in my view, you need to be doing two things. You need to get rid of all of this foolish political posturing and let the industry loose to do what it can to help hold costs down for the American public; and at the same time, I believe that as a country, we need to have a goal to develop an alternative energy source so that we are the ones that have the fuel for the next century. You know, people lose sight of the fact that we have been using oil and gas as a primary fuel for only about 100 years and if you could solve your transportation issues with an alternative fuel source, you would go a long way towards addressing oil and gas issues and that's really the way to bring the prices down. Because there is the half truth that some of the politicians are telling is – you're right, you can't drill up enough oil to solve the problem, but you also can't come up with an alternative in less than about 10 years. So if you're smart to be doing both those things with a real focus, not casually, not letting hurricane price impacts drive what you're doing but making it a national priority to say, you know what, we're going to get all of the domestic production we can to help keep prices low for Americans; and at the same time, we're going to develop alternative energy source or transportation so that America can be the person that has that solution to offer to the world.

And if you had that solution look at what being the guy that has the solution for the world has done for Saudi Arabia, you know, they are watering the desert out there. So there is a huge economic incentive to be the guy that develops that solution and that's what our politicians are talking about. Not posturing: “Well, there is no point in doing that because it will take 10 years to get done.” You know what? I was running a technology program in 1991 and we were very well acquainted with those numbers and it took 10 years back then and it still takes 10 years, but we have the technology to do it better and faster in many ways. I mean there are a lot of things that we couldn't even access 10 years ago because we brought along better technology. It's unfortunate that it's been allowed to descend in a political football when so many Americans have been hurt by the energy process and it really isn't the oil and gas companies doing that. They don't set the prices. Wall Street sets the prices and the politicians make it worse by ignoring the realities of the supply and demand situation. [52:13]

JIM: Curtis, given the price of energy today, somewhere around 105, 106, I can't help but think that with the amount of oil and natural gas that has been taken off line, which means we'll get further behind in building up our gas reserves for going into the winter months and then of course the demand for heating oil that, you know, I think that we could very well see again, by the time we get to this winter somewhere between December and February, we could see oil prices right back up at 145 to 150 level. What are your thoughts on that?

CURTIS: It's inevitable, Jim, again it is the short sighted view of the world that you look at hurricane impact and you say “that's significant.” It really isn't. I mean it's this long term supply and demand thing and that’s -- nothing has happened there except as you have correctly pointed out, the hurricane just make it's worse. Now, just because you only have oil leaking out into the gulf and you don't have everything in the gulf shut down a week after the event doesn't mean that it hasn't had significant impact and that's what a lot of the guys – sure, they’re sort of saying it in veiled ways, but there are a number of guys I have seen quoted the past few days, they keep saying, “well, yeah, it's not as bad as it could have,” but still and all, there's an impact. And when you're this far behind the eight ball as we are, you mentioned a number about we had to have five million barrels a day of replacement production, I think that was your number somewhere around five just to kind of keep even.

JIM: Yes.

CURTIS: That's an interesting number because you can go in and look at crude oil production in the US. We currently in the US produce about five million barrel a day, which is about 6% of the world's production. So what you're saying is you have to replace us. You have to replace everything we're doing just to keep up. It shows you the difficulty of achieving that. And again, it underlines, at least with me as an American and as someone who – I was kind of semi-retired and came back in the industry because I really wanted to help the country by going out and doing what I knew I could do with the right group of people, redeveloping old oil fields. And so when I look at the stuff that's going on, you say, well, we can do as an industry – as an oil and gas guy I can do everything I can do to help. But to really solve the problem, you also have to have a parallel track running of coming up with an alternative way to fuel transportation. I mean that really is the issue because transportation I may be off on my hard percentage number, but transportation is the overwhelming driver. I think it’s something like – [55:08]

JIM: I think it's somewhere around 70%.

CURTIS: I was going to say 65 to 70 percent, somewhere in there. But it's like if you talk about balancing the federal budget, people that are into that, say, well, until you deal with entitlements you'll never balance the federal budget. But of course the entitlements are all government give-away programs, ie we're entitled to this, so the same sort of rule applies here, you can't fix the energy problem unless you deal with transportation. It's the 800 pound gorilla in the equation. The nice thing about that is one of the things I've always reveled in in being an American is if you look at our history, this country is at its best when it's challenged and coming up with solutions to technical problems really is something that in my opinion we do better than just about anybody else in the world.

And if we stilled all of this negative infighting you have got going on between Democrats and Republicans and all the other people, we got on board with a program to let’s put all of the oil and gas in a pipeline that we can and as a country, let's focus on coming up with technical solutions to our transportation problem, we could do that. Look at what we did with the Apollo program. From 1960 to 1969, you went from not having a space program to going to the moon. Don't tell me that developing a way to deal with the energy crisis is harder than that. The problem is the politicians that ought to be focused on helping the average American avoid high gas prices are too interested in being on the 6 O’Clock News ranting about how Exxon is taking advantage of everybody. You know, Exxon's profits last quarter, you had Dick Durbin and several other people get up and talk about how awful it was that Exxon made all of that money. Well, what they didn't mention was Exxon in that same quarter paid ten billion dollars into the US treasury. I didn't see them offering to give any of that money back to the US public. I didn't see, you know, just like what I do in Buccaneer. For every dollar I make, the government regulatory people get 25 cents of it before I get anything because they are my 25% partner in most of the leases I've got. That's tax money coming into the coffers that they don't want you to know about. You know, they are making a huge windfall with what's going on in the industry. [57:45]

JIM: Well, listen, Curtis, unfortunately we've got to cut this short but I appreciate you coming on on short notice because when I was going through some of the reports that I was reading in terms of assessment of damage and then you turn on the television and you see the financial anchors talking about two dollar gasoline at the pump and 75 dollar oil, I'm thinking, you know, what planet are these guys on and what knowledge do they have that the people in the industry don't have? So I appreciate you clarifying that. If people would like too follow your company, you want too give out your website and your ticker symbol please.

CURTIS: Buccaneer Energy. We’re traded on the Australian stock exchange. The symbol is BCC. Our primary deal is we are redeveloping old oil fields here in the US that have been abandoned by larger companies and so it's a very bright looking future from where we sit. [58:40]

JIM: All right, Curtis, listen, I wish you all of the best. Keep up the hard work. The country needs people like you going out and producing energy for us because that's what make this is whole society of ours run. Thank you so much.

CURTIS: Thanks, Jim, I appreciate the opportunity. Goodbye.

JOHN: This week we had to delay using the Q-lines on the program because we had so much material to use, so we will keep those in our archive here and forward them to next week. And Jim, speaking of next week, now that we're back in the saddle, what are we doing on the program.

JIM: Next week, John, joining me on the program will be Rob MacDonald he represents a law firm that could be bringing the first class action lawsuit against irregularities in the investment markets, especially relating to financing of juniors and a lot of the manipulation of the market. He'll be my guest on naked short selling. Also coming up on September 30th, we'll have a special round table with up and coming silver producers, Lorne Waldman of Silvercorp will be joining me, Keith Neumeyer, he's CEO of First Majestic Silver, Mark Bailey of Minefinders and Robert Quartermain of Silver Standard. So we'll be talking to two existing silver producers, Silvercorp and also First Majestic and two up and coming producers, Minefinders being both a gold and silver producer and then Silver Standard being silver producers. So an interesting perspective. This will be following the Denver Gold Show which starts next week.

Also joining me on September 27th, Doug Noland of credit bubble bulletin fame and we’ll talk about where this thing is going forward, are we facing a financial tsunami as Bill Gross is suggesting. And October 4th Frank Holmes has written a new book called The Gold Watcher, he manages US Gold. He'll be joining us. We have a lot of other great things coming up, including some out takes that we will have from this year's ASPO Conference on the oil markets, so a lot of great things in the days ahead.

Good to be back. Gosh, it was a vacation but it wasn't a vacation and I think we have made the resolution that next year we're changing our vacation time. What do you think?

JOHN: I think it would be a wise idea. I don't know. Either that or the year we do change the vacation time according to Murphy’s Law everything will be peaceful and calm.

JIM: All right. On behalf of John Loeffler and myself, we'd like to thank you for joining us here on the Financial Sense Newshour. Until you and I talk again, we hope you have a pleasant weekend.