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Financial Sense Newshour

The BIG Picture Transcription

November 22, 2008

Part 1

A Plausible Explanation

JOHN: Well, here we are, the Big Picture after another week here. You know, Jim, last week I was talking about the only way you can get away from all of this stuff is to go buy some beach front property on the Sea of Tranquility on the moon. And I got an email from a gentleman in Boulder Creek, California – Max – he said, “It’s funny, the last four or five months, I’ve been thinking: where can I move to be without having to work for everybody else. There is no Colorado Valley in the world to live with likeminded souls.”

He’s talking here about Atlas Shrugged by Ayn Rand.

“Then I heard you speak of your beach front property on the Sea of Tranquility. I’m game. Is there room for an electrical engineer/contractor?”

And he said at the end, “Who is John Galt?”

So that email made my week. I’ve had it here on the desk and I’ve been giggling about it all week long. So anyway.

You know, one of the things that people are looking at right now, and the markets are doing – I don’t know if you've noticed this – very strange things. And people are trying to figure out what does that mean. One day the markets are down, the next day the markets are up. One day gold is down, and as of Friday here it is up 23 percent. People are saying, But the prices of this still don’t match the prices of that, and we don’t understand why gold is down when the dollar is doing so badly or inflation is up and down. And finally, every so often, Henry Hank Paulson – our Treasury secretary – takes to the airwaves to explain a new adjustment in what it is they’re doing which undoes a previous adjustment that he announced previously. And as soon as he does, Jim, I think it’s good for, what would we say? A 500 dollar tank in the market when he does? Maybe they should just lock him up and put him on medication or something.

JIM: Yeah, we were doing interviews for our Gold Show on Thursday and every time they say Paulson is going to give a speech, there’s this anxiety. And so we were doing an interview, I’m watching my Bloomberg screen and I’ve got my television onto his press conference on mute, and you know, the cable station is putting up the key points, and I’m thinking to myself every time this guy goes on –and he does this almost once a week – and every time he does the guy has no credibility. I mean it’s like he tells you something one week and the following week he says it’s changed. The week after that he’s doing something different. And talk about trying to create instability for the market – that is one way to do it.

And I’m thinking to myself, why is he doing this? And I’m thinking, Okay, who is benefiting from whatever he says? And I’m thinking to myself, one, is the guy just stupid; and I’m thinking, No, you don’t get to be the head of Goldman Sachs by being stupid. 2) Is he talking the book of Goldman Sachs? In other words, is Goldman Sachs short the market? 3) Is he talking the market down and talking bond rates down? And it was amazing, John, because I’m sitting here looking, I have, what, nine computer screens that I’m looking at, and I’ve got one that’s on the Treasury and on the money markets. And do you have any idea where interest rates are today? Just out of curiosity. [3:33]

JOHN: Probably somewhere down in the 1 to 3 basis points. That’s a wet finger. I haven't looked today.

JIM: I’m watching this and what is happening in the bond market is truly historic. And folks, brace yourselves, a one-month Treasury bill pays 3 basis points (100 basis points equal one percent), so you’re getting three one-hundredths of a percent on a 1 month T-bill. A 3-month Treasury bill, as we are speaking today, pays one basis point. Basically, you get no interest on a 3-month Treasury bill. So it pays one one-hundredth. A 6-month Treasury bill pays 44 basis points – that’s less than a ½ percent. If I’m looking at 2-year Treasury notes, they’re at 1%; if I’m looking at the 10-year Treasury bond, they’re at 3.2 percent; if you’re looking at a 30-year Treasury bond, it’s 3.7. Now, we are experiencing the lowest rates that we have seen in nearly 60 years. And remember, last week we talked about monetary policy in a zero interest rate environment; folks, we're here. One basis point on a 3-month Treasury bill is zero interest rates, at a time the Treasury is raising nearly one trillon dollars in the bond market. And I’m thinking to myself, they’ve got to do two things: 1) they’re bailing out everybody – it looks like the automobile companies, they’re going to be bailing out the credit card companies, the airlines are next in line. Who isn’t going to be bailed out? And what they’re getting ready for – and I just want to tell you folks, you heard it here first, is a TARP program that’s going to bailout homeowners. Now, the way they’re going to have to do that is they’re going to have to raise a lot of money in the bond market, and with that they’re going to use it to buy down mortgages for all of these people that are upside down on their mortgage so they’re going to buy the mortgages down, which means that somebody that had a $100,000 mortgage may have a new mortgage based on 50 or 60,000 dollars. 2) they’re going to have to drive down interest rates in order to get this financed, so they’re going to have to bring down interest rates and they’re going to have to bring down long term mortgage rates. Now, long term mortgage rates are tied to 10-year Treasuries, and this is the lowest I’ve seen Treasury rates in my entire career in the financial industry. The actual rate on this Friday is 3.19 percent. And that’s what they’re doing; they’re going to drive the bond market down and remember, with all inflations, as Keynes talked about, the area that you pluck and is the victim of all inflations is money wealth. And that is the bond market. And the bond market 90 percent of the time gets the direction or the future direction wrong. So the bond market is convinced it’s deflation, which is good, they’re buying into this argument and that’s a great concept because they have to be fleeced and that’s what they’re going to do. [7:01]

JOHN: So if we're going to look at what we've heard them say, and Hank Paulson has as much said this, they understand that the root of the trigger that caused this current crisis – not looking at inflation bubbles – is the housing crisis; people are upside down on their mortgages, which you and I predicted about three or four years ago, the defaults are record, so they have to get to the root of this crisis to stop the runaway train.

JIM: They have to stop the runaway train. They have to raise massive amounts of money. In the next 12 to 15 months, the Treasury is going to have to raise more than two trillon dollars and look for the first 100 days in the Obama administration, you may see a half a trillon dollar stimulus program; and here as we mentioned you've got Barron’s that’s supporting it. And then they’re also going to have to deal with the housing issue which is buy down these mortgages, refinance them at a lower interest rate, get the banks involved and bring down interest rates. And I think that’s exactly what they’re doing in this process because remember, they’ve driven money out of commodities, all that money that was in commodities has come out, they’ve driven money out of equities and so people are looking for a safe place to put their money and they’re willing to take zero interest for that. And like I mentioned, if you would have told me that a 3-month Treasury bill would pay 1 basis point, or one one-hundredth of one percent interest or that a 6-month Treasury bill would pay a little under half a percent, or a 1-year Treasury bill would pay 8 tenths of 1 percent, or a 2-year Treasury note would pay 1 percent, and 10-year Treasuries would be down to 3.2 percent, I would have said you were crazy. So it began to make sense that what the government is doing is they’re driving money into the bond market as a safety mechanism at a time the government has to raise horrendous amounts of capital. When you have to raise close to two trillon dollars – it could be more, depending on the trade deficit next year – that’s a horrific amount of money that the government is going to have to raise here and normally when you have to raise, when there is more demand for capital than there is supply, normally the price would go up, meaning interest rates. Instead, it’s just the opposite. And you have to give them credit for the way that they’re finessing this, you know, from their intervention beginning in the middle of July to what they’re doing now, we've got the best guys on the Street. If you would have told me the government would be raising two trillon dollars, get the bond market to cooperate at the lowest interest rates in 60 years, I would have said you’re crazy; but that’s exactly what we're doing right now. On this Friday, I’m looking at the lowest interest rates – folks, what we're seeing occur in the bond market right now is a rush to safety. Everybody is moving into the deflation; almost 95 percent of the market is convinced of deflation. It’s being reflected in short term interest rates and the real key – and we’ll get into this in future shows – is taking advantage of the wrong perceptions being made by the bond market because the bond market investors are those that are going to be fleeced. And certainly I would not be going long term into the bond market right now with these kind of interest rates and this kind of money inflation and you’re going to see more of it next year with stimulus programs. But you know, when I saw this and I saw the Paulson press conferences, I think, you know, this now starts to make sense. And then you put that together with the folks at Barron’s with their letter in last week’s cover issue, they’re addressed to the president and then all of this starts to make sense. [11:01]

JOHN: It does remind you of herding cattle though doesn't it? It has sort of a “moo” quality to it.

JIM: Yeah, and that’s exactly what they’re doing. They’re herding the cattle in a direction and that’s what is happening. People are bailing out of their mutual funds, they’re going into cash, they’re backstopping money market funds, so the money can go into cash. They’re going into bank deposits because banks need deposits because they’ve lost so much money; they’ve done that with an increase in the FDIC to 250,000 and they’re herding people into the money wealth corral at a time when they are inflating massively. First the money printing, step two, the inflation. Right now we’re in the money printing process and remember, there’s always a lag effect. Just as for example, when the Fed began to raise interest rates in the summer of 2004, and stopped raising interest rates in the summer of 2006, the lag effect of that two year rate hike did not really begin to impact the markets until 2007 and this year; likewise, when the Fed began to goose the markets as they really did at the beginning of this year very strongly, and what they’ve done recently since the middle of August. There is always a lag effect and people get the short term fluctuation in asset prices confused for deflation. This is almost a repeat of what they did between 2001 and 2003, but magnified 10-fold on steroids. And that’s what’s going down here, and I think that helps to explain what people are seeing. We are going to get more into the stages of inflation and where we are heading with this and we will do that in the month of December. [12:49]

JOHN: And we're just getting wound up here. You’re listening to the Financial Sense Newshour at www.financialsense.com. Don’t go away. Lots to come.

Come on ol’ Secretary Hank, round ‘em up, put them into money, move them lil doggies out.

Other Voices: Richard Loomis, President & CEO, World Energy Source

JIM: This conversation is taking place on Thursday of this week, joining us on the program from World Energy is Richard Loomis.

You know, Richard, I spent Wednesday night reading the second part of the IEA document and it was all about depletion rates. About the larger fields, the smaller fields, how we're not finding the big fields anymore, what we're finding is in deepwater and these fields are depleting at much faster rates and the natural decline rate of almost 9 percent and the amount of investment – and then we’re having this conversation on Thursday after the market closed and I’m looking at the price of oil and much like the price of precious metals where you can’t get coins; coins, whether it’s silver or platinum or gold are disappearing all over the world and you've got the paper price of gold and silver at levels – I mean you have silver below 9 dollars, and yet try to call a dealer today and try to get silver coins and you can’t. Now let’s apply that to energy. You've got energy costs below 50 dollars and ad nauseum, all you hear about is demand destruction. I don’t know what it’s like where you’re at, but other than maybe people not flying as much as they used to, where is the demand destruction? Isn’t there a disconnect here between the price of oil as it stands today and what’s going on in the actual industry.

RICHARD LOOMIS: Well, in talking to people within the industry and within the financial community that services it, most are scratching their head. I mean there seems to be a disconnect as you described between where the price of oil is, where the demand for the refined products are and just where the trend is leading us. If I were to guess when we were sitting at 120 dollar oil and it was on its way down, several people I talked to would say if you take the speculation out of it and you take the security premium, I could see demand placing this at about 100 dollars, maybe 90 dollars. And then watching everyone scratch their heads as it blows right through that number and it’s now down to 49. It seems that the economic factors that would typically drive this have been taken out of the equation. I think one of the parts of this is there is some instability in the market place. That’s a given. But second, I think what we're seeing now with a 2 dollar gasoline price here in Houston, is we're seeing a lot of demand growth very, very fast. And I think because we can watch these things closely, we’re actually seeing the commodity price being non-responsive. Maybe – and I don’t know this for a fact, but maybe the traders are afraid to push the price back up again for fear of being caught on speculation. [16:19]

JIM: But Richard, what you have – now, I mean there’s some very bad news. I mean every time Hank Paulson gives a press conference the market drops by almost 50 percent right after he talks.

RICHARD: Let me just add to Paulson’s plan, here we have a guy who went to Congress and even got down on his knees begging for a 700 billion dollar bailout to buy what they were calling them, toxic assets? The next week he decides without any Congressional oversight, that he’s not going to buy toxic assets, he’s going to go and buy stock in healthy banks, and then he decides he’s going to broker mergers and acquisitions for those banks he doesn't want to give the billion of dollars to. Then after coming back into Congress, he has the ability say, You know what, I don’t think we should bailout the automotive industry and I’m not willing to come out and help the individual homeowners. So our 700 billion dollar bailout, plus the 150 billion in pork that was added to it, has gone to someone who seems to have no oversight and no accountability as to what he has done with those dollars. I would imagine that causes huge instability in the marketplace because now it’s not supply and demand, nor is it profitability, nor is it the quality of the business that is dictating where those dollars are going, it’s Paulson’s pen. [17:41]

JIM: It’s absolutely amazing to see this guy talk. It’s like every time I seem him go on TV, I go, Oh, no. You almost want to look for a window to jump out of. But as it applies to energy right now you've got Henry Waxman who’s tied to very hardcore environmental extremists; he’s just gotten the chairmanship of the energy committee, so that’s not good news. And where is the Obama administration in this? It’s like: Are we going to be in another situation where basically he gets into office and he still hasn’t got his team put together yet? We're heading into a crisis not only in the economy – the markets themselves – but you know, you take a look at the commodity sector with energy being one of the most important commodities in the world next to food and water in terms of how our economy functions. And you know, Richard, you can’t mine oil in the tar sands at these prices, you can’t produce oil out of the Gulf of Mexico at a profit, especially if you start going to deepwater at these prices.

RICHARD: The deepwater is definitely off limits at these prices. [19:00]

JIM: Yeah, it’s off limits at that point. Since deepwater is fast depleting, why would you produce oil right now at a loss per barrel? You wouldn't.

RICHARD: You've got to wonder, since we know that there is a certain amount of oil that we're using in the United States every day and since we cannot produce more than a third of our oil domestically, and this is taking projects that we would be producing off line. Whether or not the big oil companies ought to go with their hat in hand and go and see Congress and say, Hey, we're going to need a bailout because we can’t maintain a third of our domestic production at these prices. [19:38]

JIM: You almost wonder is this just still deleveraging that’s taking place. You talk to a lot of people in the industry, how are they seeing this? I mean, how do you explain prices? It certainly isn't demand destruction, so is this all just deleveraging; what are you hearing?

RICHARD: Well, I think most are saying, Wait a minute, you can’t reduce demand this much in this short period of demand, so the price is being driven down artificially and I think there is a lot of media hype as to “wait, we’re not going to use oil anymore, we just don’t have the demand for it.” And yet, sitting down here at my window in Houston and I’m seeing a long line of people filling up their cars with gasoline. So the demand is certainly here. Most of the industry has said, “Okay, I give up; I’m cutting my exploration projects. I’m going to hold, tread water. If I can shut projects down, I’m going to but I’m not going to renew my rig contracts. I’m not going to commit to a long term drilling program. I’m going to sit and hold.” And those that have strong cash on the balance sheets and are still maintaining a reasonable cash flow positive are going to ride this thing through. The bigger problem comes when – and I believe it will, when it turns out that we have used up our oil supply, it’s gone to gasoline and we've driven it out and there hasn’t been anything behind it. When we start seeing the demand on the global oil supply and how do we get it back to the United States, maybe they will start to wake up, but we cannot initiate projects fast enough to even get back to where we were. And if you look at natural gas, I mean shutting down a Barnett shale well is not a quick process, so there’s a little momentum that carries us forward, but reopening it is impossible. Those fractures fill up and you’re not going to be able to pull that gas out of the well anymore. So if we begin that process, we will see a resurgence I guess of a natural gas price that will support LNG. That would be good for Chenier, but not too good for the consumer. [21:41]

JIM: You know, it’s amazing, I’ve been doing interviews for my Gold Show and they’re actually having planes right now that are flying silver into India because the demand is so strong. You can’t find it. One of my clients has told me they just ordered silver and they’ve been told that they’re looking at receiving it by Easter of next year. Now, if you look at the energy situation, there’s even talk that what’s going on in the COMEX, what’s going on on the NYMEX with the price of oil that we may lose pricing over commodities because of what’s going on. Dubai is being set up now, they are starting a silver ETF and they’re also setting themselves up to be a trading center for the price of energy. I just wonder in terms of confidence in the United States, Richard, if we absolutely lose control over the pricing of commodities because there is such a disconnect now between what’s going on in the physical market and the paper markets that people are saying – you hear this ad nauseum with the media, they’re overplaying it – “oh, it’s all demand destruction.” Yet at the same time, they’re doing stories about people filling up there motor homes and back to traveling again and people that have taken advantage of SUV sales, which were up over economy cars. So there’s a major disconnect here and you just wonder what the driving force behind it is. [23:09]

RICHARD: Well, we're waiting to see a decoupling of energy pricing to the American dollar. We would definitely lose control. Several authors in my publication have looked at the ramifications of having a euro-based barrel of oil. That would certainly mean that the US economy is no longer driving the global economy. It would be based on other currencies. However, the value of the US dollar has been going up and if you look at that, that would mean that currency traders believe that the US is the first economy that is going to recover. However, the news is pushing it down the other way and I think this is also a decoupling of the price of oil versus the demand for the product versus how much it costs to make it and how much you can charge for it. And in the industry we're used to this. The old-timers are all looking at each other, nodding their heads, you know, boom or bust and saying, here we go again. This will be followed by the cancellation of the exploration projects and then by massive layoffs as this industry typically does; leaving us in no position to go out and recapture the assets when this does turn around. And it also feeds into the negative viewpoint that the public takes on this industry because we cannot smooth out the peaks and the valleys. Having said all that, with oil at 49 dollars it’ll be very interesting to see where it goes tomorrow because two years ago, this 50 dollar oil price would have looked really, really good to most of the producers I’m sure. [24:36]

JIM: Well, it’s absolutely amazing because when you’re looking at this, not only are you seeing the disconnect but you’re seeing the closing down of wells, whether you’re looking at deepwater, whether you’re looking at natural gas in the Barnett Shale; and you know, if people stop and think for a moment, if we were only to go back three or four months ago in July when the price was 147, okay, that price might have been unrealistic but you had some supply bottlenecks, you had speculators come in, but did the world’s economy change dramatically from the middle of July to let’s say the middle of November? Was there such a change economically overnight that would even come close to justifying the prices that we're seeing today?

RICHARD: Well, none that I saw. I guess there’s somebody out there who’s smarter than all of us who’s watching this. But I do know one thing that did happen, the Somali pirates figured out they could go out and take over a tanker, so that took four days of US supply out of the market. I wonder how many more shipments of oil before people start to realize that the supply is being drained before it ever gets here. [25:43]

JIM: That’s amazing too because they are now, I think, Richard, demanding 25 million dollars for release of the hostage. One of the news stations did: Is this is a new business? I mean, these guys are, let me see, right here, “pirates demand 25 million dollar ransom soon for a hijacked Saudi supertanker.” That supertanker has 2 million barrels of oil.

RICHARD: Well, if you think about that, if it’s got that much oil on it, and it’s only going to net 25 million, maybe they will be the price setters. [26:16]

JIM: You know, maybe that’s what we're going to deal with next. It sounds like a good business and some of these guys have mansions, jets and everything.

RICHARD: We’re adding to the oil economy. We’re just not doing it through the rational means. Now here in the United States of course, the media is all about demand destruction. “We’re going into a terrible economy; nobody is going to drive anywhere, nobody is going to buy anything.” And yet, I’ve heard speculation that this year’s retail season will hold its own. It’s starting early and while it won’t be as robust as last year or the year before, it won’t be as dismal as people think. And that being the case, it doesn't give the media much to talk about; plus, the election is over, we don’t have all that political coverage and we don’t have anything all that exciting excepting these Somali pirates going on in the Middle East. I mean things seem relatively calm at the moment, so I guess we're looking for a good story and maybe that’s what Wall Street is reacting to. [27:13]

JIM: Well, I do know that there is a huge option position around 25 to 30 dollar oil, so it looks like the traders are what might be driving this in terms of an option trade that is driving the price because certainly there is something that is occurring here that is more unnatural in terms of where the price is; just as it was probably on the other side of the equation when we got to 147 and especially when we went through 120 and it was like in a period of two weeks we were at 147. You almost have the reverse thing. And Richard this reminds me so much and I don’t know, we’re going to be talking to Matt Simmons here in a couple of weeks, but this reminds me, do you remember the Asian flu crisis and we had the same story: demand destruction. In almost similar terms you had the price of oil from probably a little over 20 dollars a barrel down to 10 dollars a barrel and we had all this supposedly bogus supply of excess oil that was floating around the world that they never found?

RICHARD: Yes. There were two articles at World Energy from Matt Simmons on what he called ‘the missing barrels’ and then the ‘missing barrels again.’ And from his direction and I think most would agree at this point, it was pure fabrication. The IEA and EIA were reporting supplies that simply were not there and demand destruction was not supported. And what it caused was a gutting of the industry – massive layoffs, big consolidations. We got Exxon-Mobil out of that deal and the industry itself took another big, black eye and hunkered down. I think the Economist had on its front cover that we were headed to $6 oil. [28:56]

JIM: Yeah, it was awash in oil is what I remember the cover.

RICHARD: Yeah, so it shows the power of a trend. And are we in one now? I don’t know. I think what we've got here is very odd yoyo. Now, when it springs back, will it spring back as fast as it came down? I think it could, depending on where the demand numbers actually land. [29:17]

JIM: I woke up this morning and I looked at that. Of course, I’m going into – I’m buying long dated calls on futures in the oil markets because there’s some discrepancies that I’m finding in the futures market. But this too will pass because this is – like I said, I was reading the IEA report on depletion and it is probably one of the most alarming things I’ve probably read in probably the last 10 years because here’s an organization – you know, Matt did a serious study of oil fields, I think it was back in 2001, so this is probably the most serious study done since Matt’s work and this is 800 oil fields that account for roughly 75 percent of the world’s energy, and reading that report is absolutely alarming and one almost gets the feeling that you’re on the Titanic. We’re sitting here everybody is celebrating, drinking champagne and dead ahead are these icebergs and nobody says – you know, the ship is unsinkable. [30:21]

RICHARD: Well, and you've also got to think, okay, there is an iceberg out there. Do I go right? Do I go left? Let's wait until we get closer. Now, the thing that we're really interestingly watching is we're watching the fundamentals erode away. I mean we do know where demand is; that 9% reduction in supply, were that our only factor, maybe we could figure in we could find some oil to replace it. But add on top of that political supply destruction where OPEC takes a million barrels a day off the market or where mismanagement down in Venezuela causes rapid reduction. Same thing in Mexico where they are just simply going to cease to export oil. If you add politics on top of geology, now we've really got a problem and it's one not being addressed and I think most of the public sees $2 gasoline price and a barrel of oil coming back down to where they’d like to see it. Problem solved. Nothing could be further from the truth. [31:14]

JIM: I'll tell you just as we did our first video piece, and maybe we ought to talk about that because I think we're heading, contrary to what people are thinking right now and what the media is reporting, the media always looks through the rearview mirror and then they over play something. In fact, you could almost look at the front covers of magazines (and I suspect we'll probably see one either in BusinessWeek or Time), you know, “awash in oil” again or something, which is almost a contrary indicator. But we're going to be addressing some of these issues and why don't we talk about for a moment, Richard, our series because we are, in my opinion, heading into the perfect storm for energy. [31:54]

RICHARD: I think it's really interesting what we're doing. Today in media there are several trends that are hard to deny. When you've got YouTube, Google Video, Yahoo Video, 900 cable channels out there and a plethora of satellite channels, there is a void. At the same time, a lot of what I'm seeing on television are reporters and analysts who really haven't gone out there and done their full research. It's what I would call soundbite video, and our goal, and we're calling the show Reality Check when you and I get together and look at what's happening on these trends and where it's going forward, we're going to provide the viewer with a visual representation of where things are, not too dissimilar from your radio broadcast, but in the video format. It's fast, it will be amusing, it lets us speak to things that are hard to depict in the radio model as we add in the graphics and all of this. I mean it shows a change in the way media operates where we can develop our own television show. In the past, that would have cost hundreds of thousands of dollars. Today we can do it because we care and we can get together and have these discussions, bring our guests on and let the viewers, the people that are coming to my website, coming to your website, see who we are, see what we're doing, take a look at Matt Simmons. In fact on www.worldenergysource.com at worldenergy.TV, I've got two 30 minute interviews with Matt Simmons where he gets into these kinds of details. In our format, we'll be able to go into what happens this week in energy and speak to it and show the charts, be able to see the trends, invite people to join us and perhaps even answer viewers inquiries on what about this topic or that topic in a format that they can sit and watch or listen to quick and dirty, 30 minutes each. [33:51]

JIM: Well, I'm looking forward to doing that because like I said, as we are seeing a big disconnect between what's going on in the physical markets with not only gold and silver, we have the same thing going on now when we look at the physical markets and the paper markets for energy, it's almost like there is almost – there is something here that is not fitting together. There is such a major disconnect and you don't know if this is intentional because I do know there are huge option positions at 25 to $30. If that's what's driving it, in other words, just as players in the industry can play both sides on the long side or the short side, you don't know, but what I see here is something that is so unnatural and such a big disconnect that this has a lot of people in the industry shaking their head again saying this couldn't have come at a worse time.

RICHARD: Think about this, too, Jim. If we are seeing low commodity prices, we're seeing the private companies saying, “Wait a minute, I'm going on hold,” this puts more of the responsibility for our energy supplies on the federal government. And one of the things that we need to look at on our TV show is eminent domain. Will it become a case that the government comes in here and starts saying, You know, I'm going to go ahead and develop this for you, I'm going to own this asset, I'm going to bring this online, I need this supply and drive the private sector out of the business of generating our energy supply. That could make very good shows. [35:20]

JIM: God help us if the government gets into the energy business. It will be run about as efficient as they run Amtrak. Anyway.

Well, listen Richard, as we close, if people would like to find out more about world energy, give out your website please.

RICHARD: Well, the www.worldenergysource.com is our main website, and on there you'll find the World Energy Monthly Review, which is written by myself and my team. We produce all of the articles that CEOs are not allowed to write. And then you find World Energy Magazine, which is our quarterly edition written by the CEOs of the industry. It’s everybody from Tony Hayward over at BP, to Dave O’Reilly at Chevron to David McClanahan at CenterPoint, John Bryson at Edison, all of these individuals preparing their own editorials for the magazine. At www.worldenergy.TV, you'll see our television series and you'll also see World Energy Television which are CEO roundtables, one-on-one interviews with people like Matt Simmons or congressmen or the UK energy minister. We seem to get them all to come on television and speak at length because one of the things about media is we've gone to sound bite, and in this format we can really get in detail on specific topics, not just give it a minute and a half and move on. So it's www.worldenergy.TV. [36:36]

JIM: All right, Richard, thanks for joining us and look forward to our next video production. Thanks once again.

RICHARD: Fair enough.

The Investment Trifecta

JOHN: Well, it seems like we need to have a chat here with listeners because I've noticed, Jim, over the seven years we've been doing this show, we always get new listeners that come in, obviously any radio show does that. And the problem we have, we assume people have been following us along, and we can tell from some of the emails and the Q-lines that that isn't always true. Like look at the whole issue over inflation and deflation. People are saying, “You've got it wrong, it's deflation.” But no, you haven't been listening, we're not talking about price deflation or inflation. We're talking about monetary inflation, so before you yell and scream that somebody got it wrong, you may want to know what they are talking about.

But there is something else as well. A lot of times we will get into political issues. This generally is not a political show, but, and this is the important ‘but’ behind this whole thing, you need to recognize that in any society, there are three legs that hold a society up. Number one is the political and legal leg. Number two is the religious world view leg and no society exists without it, not even secular society. They all have some kind of world view, some kind of a psuedo-religious-philosophical underpinning and the third is the economic. And all of these three things interact with each other. For example, Jim, you will hear religious groups, whether Catholic or Protestant or other denominations arguing about whether or not we should have socialism or capitalism, are they moral or immoral, things along that line. And then that forms a lot of how people vote at the polls and what happens at the polls with the politicians affects what's going to happen in the economic area. Inside of economics, there is another three-legged stool and this is very important. This is one that you talk about all of the time. And the first one is fundamentals. These are the long term issues that drive markets and it involves the soundness of a company, the direction that, say for example, energy is going in the world. Those are long term issues. Technical drives the short term, and that's the second leg of this three-legged stool; and the third of these again –this is where it interlinks to the other two legs of the previous stool is the political – because in reality, long term fundamentals have a political component to them.

So you cannot – I'll say it again, you cannot, cannot, cannot talk about the economy without talking about government because they directly interact with each other. And so certain times, Jim, say for example, look at the whole global warming issue and the Kyoto Treaty. The Kyoto Treaty was largely an economic wealth transfer treaty driven by a supposedly scientific issue and consensus. But it really had its operative in the economic area, not in the political area. So you have to be able to talk about that. What would caps and credits say for example here, do to the economy? These things are all interrelated with each other. Jim, let's sort of do this as a flashback to history so we don't have to deal with current issue into which people have some emotional attachment, but let's go back over the last, well, we'll start 50 years ago. Run us forward from there. [40:03]

JIM: Let's go back to the 60s, John. There were two major political decisions that were made at that time. One, the involvement beginning with the Kennedy administration in a little known area in Asia called Vietnam. That was carried forward in the Johnson administration to a full scale war. At same time, the Johnson administration began the Great Society. And as a result of that, the US began running deficits and there was a point where foreign central banks, we were creating this abundance of dollars as a result of our deficits and foreigners began to turn in their dollars for gold and there was a run on US gold reserves until finally in August of 1971 Nixon severed gold backing of the dollar. From that point forward, the government was able to expand its balance sheet, the Fed was able to print money and we've been on that bandwagon ever since, and we'll get to that later on in this program. But, you know, those were political decisions that were made. The fact that we started the Great Society, the fact that we were fighting a war, the Guns and Butter, began to run deficits and we could no longer back our dollars with gold and once we went off the gold standard, we had inflation, so this was just one example of political decisions that were made by government that impacted the markets, the financial markets of the 70s.

Likewise, in 1979, because we were dealing with double digit interest rates, double digit inflation, Jimmy Carter appoints a man by the name of Paul Volcker to head up the Federal Reserve and he decides he's going to get rid of inflation, he's going to reduce the expansion of money, the monetization of debt and drive interest rates up to a point. Now, that political decision drove interest rates all of the way up to nearly 20%. That had an impact on the market. And then also at that time, there was a philosophy that was coming in called supply side economics and lowering taxes, deregulation and it created this investment boom that created the great bull market of the 80s and the 90s. It was continued into almost this decade. And then at the same time in 1987 Reagan appointed a gentleman by the name of Alan Greenspan to the Fed; and Greenspan believed that he could fight the business cycle and deflationary declines by the expansion of money. So any time we had a crisis, the 87 stock market crash, the S&L crisis, the Gulf War, the recession of 91, the peso crisis in 94 and on and on, it was a philosophy of creating money. So here is an example, John, of political decisions that were made that had an impact on the direction of financial markets. [43:13]

JOHN: So now basically, Jim, after the 20 years of expansion that came in under the Greenspan, the great inflator, Bernanke came in and picked up the reins, but as a result of the asset deflations which really are a blow off from excess liquidity causing all of these bubbles and this malinvestment in the market – almost toxic investment so to speak – the pendulum starts to swing in the opposite direction and then there is a big cry for government to do something. You know, we hear about the failure of the Reagan Revolution and we want to go back to big government now, but in reality, Jim, government never got smaller. In other words, once it started to get big under Lyndon Johnson and move forward, it has simply gotten bigger and bigger and bigger. And as a matter of fact, people talk about free markets not working, and in reality, we have diminishing free markets over the last 40 years. That's what you're seeing. You've got this toxic mix going on right now between the two because whenever government does something, it always involves more regulation, more taxes and more bloated bureaucracies. Nothing ever goes away. There are programs in governments which have outlived their usefulness by years and they are still there. But nevertheless, the public doesn't understand this. They don't understand how the economy works, what monetary policy has done; and ironically, they tend to blame the president. In reality, the president for the most part proposes, Congress disposes; and that's important to understand as well that the president doesn't really have a lot of control over the economy. If things are going well, he or she takes credit for it; if it's going badly, they try to off load the responsibility onto a previous administration or some other cause.

So when people pick government as their path, and believe me, I'm not an anarchist, I'm a believer in government, but I believe much like a lot of the founders did in limited government that enforces freedom. You have to understand what government can do. Unlike the free market, in other words if I'm doing business with you, Jim, you and I come to an agreement, we sign a contract, we do something. A government, unlike private enterprise, can force you to do something by threat of coercion, confiscation or imprisonment. Generally, the free market can't do that. It can also take by force what is yours either by taxation, inflation, regulation or confiscation; and it's always wise to remember that any government that's big enough to give you everything you want, is big enough to take everything you have to do it. And they are more than happy to do that because of the fact that politicians like to insert themselves as –what would we say? – the solution to your problems, you need them. It was like Ron Paul said this week to Ben Bernanke during the hearings and he said basically if we just admit that the system is broken, that means that we're irrelevant. And we don't dare tell people that.

For which Benjamin Bernanke didn't have much to talk about. [46:02]

RON PAUL: In your meetings, and you had a meeting just recently with other central bankers, does this thought come up about a new international world reserve currency, and if so, did the subject of gold ever come up? How do you restore the confidence? Have you recently had conversation with any central banker, and is there a move on to replace the dollar system because the dollar system is essentially declared dead because it's not working, but this indeed was predictable because of these tremendous imbalances that were never allowed to be corrected and they were always patched up. We always came in with spend, inflate, we would run up deficits and since 71, we've been able to correct these problems. Could you tell me what kind of conversations you've had regarding a new reserve currency.

BERNANKE: Yes, Congressman. I don't think the dollar system is dead. I think the dollar remains the premier international currency. We've seen a good bit of appreciation in the dollar recently during the crisis precisely because there has been a lot of interest in the safe haven and the liquidity of dollar markets; and the Federal Reserve has been engaged in swap agreements to make sure there is enough dollar liquidity in other countries because the need for dollar is so strong, so I think the dollar system remains quite strong. [47:23]

JOHN: You know, recently, I was going through the book The Law by Frederick Bastiat, and also Hernan de Soto’s book on free markets and de Soto was really profound in pointing out in countries where the middle class has access to the system, those countries tend to thrive and everybody enjoys prosperity. In countries where government is a hindrance to free markets, largely you wind up with a ruling class at the top and a large underclass who are normally impoverished and then who are forced to operate outside of the legal system because they can't function within it. And to give an example, he enumerated, since he lives in Peru, he went through, they tried to create a business in Peru, a small business which a small entrepreneur would want to start and he listed something like 140 different approvals and permits and steps you had to go through to get this started. As a result, by the way, people start small businesses and say the heck with el gobierno we're going to do it our way. So they are forced to operate outside of the law, and of course this creates an underground economy and a black market and everything related to that. So government has a choice. It can either exist as a protector of private property and free market, or it can become a predator upon it.

Now, if government is perceived as a protector, there is stability because people realize that what's theirs is generally theirs. And government is there to ensure that everybody's contractual rights are enforced, so as a result, one, people feel secure investing in that country because they know they are going to be able to keep most of what they earn; two, they know that legal contracts will be enforced; three, they know government will at least try to maintain a fair playing field which is why we came up with anti laws in this country and see to it that everybody is treated equally and fairly. In other words, you believe in competition, you believe in free market and you don't allow the people in the free market to violate that. However, if government is perceived as a predator, then everyone, while they may not be free to say it, understands that their chief enemy is government itself. They will be reluctant to invest in that economy, they will take evasive action –legal or illegal – when they have to participate in the economy; black markets and tax evasion become common, almost a virtue. The government response to that is to crack down, which then grinds down on the open market even more slowly and causes prices on the black market to go up but encourages the black market, you know, even more, and so it's these two different world views, really now, Jim, that are in competition here in many countries in the West. [49:56]

JIM: What we're pointing out and what we have always said on this program, this three legged stool: the fundamentals which are long term drivers of any bull market or even a bear market; the technical aspects, people following charts which tell you a lot about what's happening short term; and then the political aspect. So we've had people that have been sort of more free market oriented going back to the Reagan revolution and the Reagan revolution is now coming to an end and it began with the Bush administration. How many times have you heard Hank Paulson or the president say we really don't like doing this because we're really free market people, but what we're doing is really not free market. And if you just take a look at the actions, the unprecedented measures that the Federal Reserve has taken since August of last year to, you know, the various programs it has implemented and then also the fact that the government changed the TARP program originally to bail out toxic assets, then it was investing in banks, then it's not. Look how many times, John, that has changed since they originally passed the TARP. And when they passed the TARP program, they had, what, about 48 hour to debate it or 72 hours to debate it and nobody really understood the complexities of it, and then as a result, you had a situation where it changes almost every week. And so you have government getting involved and then you also have the new administration coming in.

If you look at Barack Obama's two books is he talks he would like to undo the Reagan Revolution, and there is even a movement within the financial markets and within Wall Street itself; the front cover of Barron’s last week, an article called Mr. President and here the editors of Barron’s were recommending the new president do seven or eight different things. So anyway, John, here is Barron’s. These were the same guys that were behind the supply side revolution that began in the 80s with the Reagan administration, and they have various packages, these are recommendations that they are making to the new president. 1) Back a bold stimulus package. In other words, go out and spend a lot of money. 2) Support aid for Ford and GM, give them money, so you're talking about socialization of risk. Help homeowners. I'm just going to read this:

The avalanche of foreclosures must be stemmed pure and simple, the central problem for the economy is the housing crisis and the central problem for housing is foreclosures. Most of the solutions proposed so far are half measures. The government should kick in 100 billion to reduce the principal on mortgages that are in serious arrears as of December 1st, drawing on the 700 billion dollar financial bailout program. Participating banks should contribute another 50 billion. The program would reduce a borrower’s mortgage to the level of the home's current value.

In other words, if you have 100,000 dollar mortgage and your house is down to 70,000 in value, write the mortgage down and use it. And then here's what they say that just blows me away:

Homeowners that have managed to keep up with their mortgage payment can feel, well, cheated by this plan. Our advice: Get over it. The state of the economy requires bold actions.

So here you have Barron’s basically saying socialization, socialize the risk here and bail out these homeowners. Now, here's a free market one, delay tax increases until the economy is strong; and here's a little bit of free market, “don't impede free trade, improve financial regulation.” And then another aspect that they are recommending to the new president-elect is change fuel efficiency rules, in other words, increase CAFE goals. So here is Barron’s, supposedly a free market [publication] saying socialize risk, bail out the automobile companies, back a bold stimulus spending program Franklin Roosevelt-style, and then also bail out homeowners whose mortgages are below water. So that is the significant change in mind set. You're talking about a bigger government, socialization of risk; and if you don't think that's going to have an impact on markets longer term, it is going to be inflationary. [54:34]

JOHN: Yeah. Socialization also tends to just simply delay the day of reckoning by defusing the results of it among other people who by the way don't stand to profit, so the people being asked to absorb the risk don't stand to gain anything from it.

JIM: Yeah, and so here is a sea change that's coming to the financial markets and it is going to be driven by government, and if you don't understand that and how are you going to pay for all of these bailouts. Just to give an example, in the fourth quarter, the government is going to have to raise 550 billion dollars; in the first quarter, they are going to have to raise 350 billion. The United States is going to have to finance nearly two trillion, and maybe more when you take a look at our trade deficit. How is that going to be paid for? You can't raise that money strictly in the bond market in savings. You're going to have to monetize it. And when you boil inflation down, it is very simple. You don't create money, you get no inflation; you create money, you get inflation.

And the one thing I think that confuses I think deflationists, is if there is no money, you get no inflation. It is creation of money that creates that inflation. First you create the money, then the inflation comes afterwards. And what happens is any time they do this in these boom and bust cycles, what happens, John, you get the bust, whether it was technology stocks falling or real estate falling. In order to fight that, what happens is they create the money, and the money comes first. You have to create the money and it takes a while before it works its way through the economy and through the financial markets. Just because the Fed has created out of thin air 1.4 trillion dollars since August of 2007, it takes awhile for that inflation to work its way through the system, and it has unpredictable lag periods. The money markets and the bond markets, John, 90% of the time typically get this wrong. What happens is they look at the short term effects which are an asset bubble that is declining. I'm not going to use the word deflating because people use deflation as falling prices, inflation is rising prices which are symptoms, not the true causes of inflation.

Short term the bond market is always looking at deflation, and we had this very same argument when the tech bubble was bursting from the year 2000 to almost 2003 and there were worries about deflation. And you know what? Since we went on a fiat system, we haven't had real deflation anywhere in the world. And what happens is the bond market gets it wrong, assuming that current events are going to be long term events. And you saw this happen in 1933 where you had true deflation from 1929 to 1933. And the reason is we were on a gold standard, so money could deflate against its value of gold, but if you look at charts of what happened after the Roosevelt administration came in, and they did four things. 1) They backstopped the banks with FDIC, we just did this now by raising FDIC limits to 250. That's to keep the money in the banks and keep deposits flowing in which is exactly what’s happened. 2) Roosevelt severed gold from the dollar; 3) as a result of that, the Fed was able to inflate; and 4) there was a major devaluation that came with the US dollar.

Now, we've done three of these so far. We have backstopped the banking system by raising deposit insurance up to 250 and got where the Fed is backing commercial paper, credit card paper, the banks, it's backing up, gosh, there are so many TARP programs. Let's put it this way, they are standing behind General Electric's debt, we are probably going to be standing behind the auto companies’ debt and so we're already doing that step one. Step two, they are not creating enough gold. We've separated gold from the value of currencies. You still need currencies to transact business, but if you look at the accumulation of gold worldwide, gold is separating from money as a store of value. 3) We're create can money out of thin air and that's exemplified by the Fed's balance sheets. Step 4) which is coming, and there is two ways they can do that, they can have foreigners devalue the dollar by simply not buying dollars or unloading their dollars. I mean China is going to have to pay for a 600 billion dollar stimulus program, so they are going to have to use part of the reserves. Or you do it formally. I suspect what they are going to do is an informal devaluation. And the fact that gold is up on the day we're talking by 52 dollars, it's almost up to 800, and the fact that it is up on a day that the dollar index is up, I think that is also significant. But these kind of decisions that governments make, whether it's the treasury or its the central bank, or it's the president with an agenda, this impacts the markets; and we're going to do more on the inflation-deflation debate coming up in the month of December as we carry this argument further into the end of the year.

The point we're trying to make here, John, is there are three aspects to the markets and investing, and if you want to understand the big picture, you'd better understand the fundamentals and you'd better understand government and their role in the economy and the markets. I mean obvious examples, take a look at what the government did in July, intervening in the financial markets, preventing shorting, enforcing a covering of naked shorting on financials which drove the financial index to new record levels. Look for some new other problems. Already I'm reading just following what's going on in Congress right now the 700 billion dollar TARP program, we're going to get TARP II and TARP II is going to get bigger. Maybe it will be one trillion dollars and it will be applied more towards bailing out homeowners with mortgages by reducing their mortgage debt, and we'll talk about what I think is going on in the bond market here, which is going to be significant. So you can't make investment decisions by only looking at one aspect of the markets. [1:01:46]

JOHN: So when a politician says something to you such as we're going to spread the wealth around, you have to ask yourself a series of questions. What's going on here is number one, in essence, what's the economic world view in play. Today we're in the process of trying to figure out which of several competing world views we're going to try to use and by the way, they are nothing new. They have all been tried before. Some have failed. Some have succeeded. Number two: What does that mean? You have to tell people what you mean. Politicians like to bury bad legislation in warm fuzzy worlds. Number three, how are you going to enforce this or implement it? The devil is always in the details. Don't let the warm fuzzy words fool you. What is this new law or regulation going to demand of you? Four, is it voluntary or mandatory? Be very, very, very careful of the word ‘voluntary’ since the government uses a lot of coercion and extortion to force its will upon people and then says they voluntarily complied. Remember, who was it who called our taxes contributions at one point or something like that. I thought, They are not contributions, I don't have any choice in this, you know. You force them out of me. And 5) and here's the biggie, who is going to pay for it; and in the end, it's usually the middle class tax payer and not the rich that suffers the brunt of any program.

Remember, a politician or bureaucrat has three operating rules. Number one, give lip service to your public function. That's the for-public-consumption speeches that are given. Number two, preserve your own interests at all costs even at the cost of your public function and number three, if you're caught doing that, deny accountability. We see that all of the time in governments around the world. It's sort of a -- what would we call it, a mode of life I guess it is, Jim. So there it is. [1:03:33]

JIM: What we're stressing here is there is a sea change politically and economically that's coming to the markets and that is coming to this country, so we're going to shift further away from free markets to government-planned economy and government planned markets. I mean when you have Barron’s talking about bailing out homeowners and for those who have made payments on time, “get over it”, that's a sea change. I never thought I'd be read that in Barron’s, but I did, so that's what you've got to be prepared for when looking at the bigger picture. And we're going to take this up and talk about what this means with inflation going forward and I can tell you folks, it's not deflation, it's inflation, and we're going to get more into detail in the month of December on this. [1:04:18]

JOHN: I would say if we looked at top down government controls throughout history, they've generally been a failure, Jim. They just tend to fail. The collapse of the former Soviet Union was spectacular failures which had been coming for some time. As a retired intelligence colonel once told me who specialized in Russian intelligence, he said we really didn't so much bring down the Soviet Union as it just died of benign neglect ultimately when its demise came because it could not provide everything it had promised to everybody. But for some reason, I don't know why it is in history, we also discovered that people don't learn those history lessons, and so keep trying to repeat them over and over again. We'll see where it goes and we’ll chronicle it as we go right here at Financial Sense. You're listening to the Financial Sense Newshour at www.financialsense.com.

Part 2

Mission Impossible - Part 3

JOHN: Last week, we did Mission Impossible, Part 2; now we're Mission Impossible, Part 3. We said we would carry this all the way through an energy roundtable coming up in the near future because it’s one of the areas where people are talking about, but I don’t think they understand where the picture is going, especially the International Energy Agency report – and that’s we're watching because these trends, just like other trends, you talk about multiple-legged stools, these will collide with each other sometime in the near future here.

JIM: Yeah, last week we were talking about the IEA World Energy Outlook report – probably the thickest one I’ve read – they publish it each year and on even-numbered years they do more extensive study, and as we highlighted last week, what the IEA has done is they have done an extensive study of 800 oil fields, these are the 800 largest oil fields in the world, probably accounting for three-fourths of our energy that we consume each day. And the third part of the report, which we're not going to get into, which is climate change.

But the part b of this report is oil and gas production prospects, and this is where they really get into detail in terms of what’s out there, where we're going to get this energy to drive our economies – not just the OECD or the developed economies, but also the developing economies – and then they also take a look at conventional oil production in terms of what’s happening there and then what decline rates are, what is causing these decline rates, how big they are and the amount of investment that’s going to be needed to arrest the decline rate. That’s because the headline that they made three weeks ago when they first gave their press release is that the natural decline rate is about 9.1 percent. Now, you can bring that decline rate down to roughly about 6 ½ percent, but you’re going to have to invest – and this is mainly just the developing countries, because that’s where almost 99 percent of the demand for energy over the next two decades is primarily going to come from the developing world; the Chinas, the Indias, Asia, Latin America, OPEC itself which is consuming more of what it produces. So that’s where the main investment is going to have to come from.

But it was rather interesting and this is something that I’m going to bring up in the roundtable, they talk about existing oil reserves and they mention the figure that we've got about 1.2 to 1.3 trillion barrels of oil left. But here’s something that they bring up that everybody accepts as gospel which is never questioned, and it always amazes, and they said that actually if you take a look over the last two or three decades, oil reserves have actually gone up and they said the biggest increase in reserves came from revisions made in the 1980s in OPEC countries, rather than from new discoveries. And ever since the 80s, we've only had modest increases since 1990. Well, it’s amazing because within a two or three year time span in the 80s, OPEC reserves went up 300 billion barrels with no new discoveries. And back then, when oil prices were cheaper, OPEC as a cartel was limiting each country’s production based on their reserves. The more reserves that you had, the more you were able to produce; and so we had this 300 billion figure that has never been audited, it has never been backed by, okay, we discovered another Ghawar. That isn’t the case, and so it’s amazing that they have talked about this figure and everybody accepts it as gospel; it’s in the BP Statistical Review (although they do mention that, well, this wasn’t accompanied by any new discoveries); and if you look at the figures that are more worrisome is from 1990 on, there’s been very few reserve additions, and most of the reserve additions that we have globally have come from revaluing existing reserves higher than it has from discoveries. So the fact that nothing has happened and there’s only been modest increases since 1990 just tells me that those reserves that were actually created in the 80s by OPEC, really don’t exist. In other words, it’s barrels out of thin air and there’s nothing to back them.

In fact, we've talked to a lot of authors over the last four years that talk about, for example, Aramco when it was run by a partnership between the Saudi government and the three big international oil companies, they thought at that time (this was back in the 70s) that Saudi reserves were probably closer to 160 billion and since that time they’ve produced like 60 or 70 billion worth of oil, and so this 260 billion figure where the Saudis revalued their reserves by 100 billion, the oil companies that used to work with Aramco said there’s no basis for this; there were no discoveries. And most of the oil companies have gone all over Saudi Arabia, so it’s not like it’s virgin territory and nobody has really explored it. [5:54]

JOHN: So if we examine the situation, we really don’t have a good handle on what the world’s reserves actually are. But factually, we know that on a regular basis, we are using more than we are producing – whether it’s there or not, remains to be seen – but basically that’s what we're doing. So sooner or later we have to get into trouble and when does that look to happen?

JIM: We're seeing bits of it since 2005 when we've seen this rise in oil prices despite this recent pullback. And one of the things that happens is you know, we get these big run-ups and you remember, in 2005 when oil went from the high 40s and it went up to 70 and they said, Okay, that was the hurricanes. Oil prices came down from 70, back down to 50 and they go, Well, we're back to normal. Well, then we went all the way up to 145.

Right now, we’re dealing with $50 oil which is another anomaly and it’s amazing because here’s some really frightening facts. A growing share of additions to reserves over the last three decades has been coming from revisions to the estimates of the reserves rather than new discoveries. The volume of oil, in fact, if we take a look at new oil discoveries has fallen well below the volume of oil produced. And just to give you an example, discoveries dropped from an average of 56 billion barrels a year in the 1960s, to 13 billion barrels a year in the 1990s, and the number of discoveries peaked in the late 60s and have fallen sharply since then. In fact, not only have we seen a fall in both the number of discoveries, but also in the volume of oil discovered. In other words, we're finding new oil fields, but they tend to be much, much smaller and discoveries are rising in areas like Africa, Latin America and Asia; but discoveries or the lack of them we've seen in the two biggest areas, the Middle East and the former Soviet Union. So the drop in discoveries world wide was really – now, the IEA says, Gee, we just weren’t looking for it. And during the bear market in the 80s, who wanted to go out and spend a bunch of money and find a new oil field when oil prices were this low? But the fact of the matter is there has been a downward trend in the volume of oil found, and it isn’t reversing itself. And at the same time, we're not even finding half of what it is we consume each year. So that’s something that I just think it really comes home to bite us at the end of the next decade. I mean we've been making up the difference in conventional oil from gas-to-liquids and biofuels (mainly gas-to-liquids is where we've been getting this.) [8:58]

JOHN: It seems that president-elect Obama understands this. He did last week in an interview and he’s warning people, which is what we're doing here on this show too, that these lower prices people think we've gone back to where we were before. We haven’t. This is a lull in the price increase.

Let’s hear a clip from that interview.

President-elect Obama: This has been our pattern, is we go from shock to trance. You know, oil prices go up, gas prices at the pump go up, everybody goes into a flurry of activity and then the prices go back down and suddenly we act like it’s not important and we start you know, filling up our SUVs again and as a consequence we never make any progress. It’s part of the addiction, right? That has to be broken. Now’s the time to break it.

Okay, but Jim, so we hear from some of the skeptics in this whole thing, well, we've had all these discoveries –in Indonesia, gobs of oil there, and Brazil that these are great new fields and there’s plenty of oil – you always hear the expression, “there’s plenty of oil.” But, for example, the tar sands in Canada have more oil in them than what, Saudi Arabia, for example, than all of the oil available there. How does that stack up against all of this?

JIM: It’s one of the confusions that’s made in the business, and it’s made both by Wall Street and Washington, which is confusing reserves with production. And people assume, Well, gosh, the tar sands have 260 billion barrels of oil, if you can produce 10 percent of that a year, 26 million barrels a day… But you’re not going to do that, John. It’s a mining operation, and some are saying, especially right now where you have for example, oil shale and even heavy oil from the tar sands where the break even costs are in the high, almost nearly 80 to 100 dollars just to break even and make a profit. The cost of extracting that is much heavier and it’s a mining operation which is much different than pumping oil out of the ground, like let’s say within OPEC countries and especially places in the Middle East. And so, you can’t equate 260 billion – when you hear these big numbers, and you say, “Well, gosh, with those kind of numbers we’ll never run out of oil, this is just all a hoax,” [then] you don’t understand how the oil market works because the tar sands are never going to get up to a level – yeah, the reserves may be there and over a 30-year period you may be pumping out maybe 3 million barrels a day out of the tar sands because it’s really synthetic oil, but you know, you’re not going to be producing 10 or 15 million barrels a day. So you hear these big reserve numbers and you think, Oh my gosh, we've got 260 billion in the tar sands and you take Venezuelan tar sand oil, you've got a trillion barrels of reserves, and if you take oil shale you may have another two trillion. And the IEA report makes reference to that. But you can’t make money and you don’t have nearly all the kind of technology you need to extract that oil from the oil shale. It’s going to take 100 dollar oil and it’s going to take a lot more technology and it’s going to be the equivalent of almost some kind of part mining, part oil drilling technology to get that oil shale heated and turn it in to something as synthetic oil that could be sent to a refinery. [12:32]

JOHN: The other factor offsetting this too is that if we look at the top 20 oil fields that are out there, they are accountable for about 20 percent of the world’s production of oil and they’re all in decline. They were discovered a long time ago, and they’re going down. There’s nothing bouncing back on that. So this also affects – this means that whatever you bring online has to replace what’s going down as well.

JIM: And that’s the argument that they never make. All you hear from the pundits is demand destruction. Well, what you don’t see is supply destruction. And the IEA took a look at the top 20 oil fields; many of these oil fields go back to actually 1938 was the Burgan field, which used to be the second largest oil field in the world; that’s in Kuwait. That was discovered in 1938, peak production was hit in 1972 at 2.4 million barrels and today that field is only producing less than 1.2 million barrels.

You take the largest oil field in the world which is Ghawar, discovered in 48, its production peaked in 1980. And so Cantarell, discovered in 1977, it peaked in 2003. And they just go through all these major oil fields, with the exception of maybe Mexico, from Russia to Saudi Arabia to Middle Eastern – mainly OPEC countries, Iran, Kuwait, Abu Dhabi, Azerbaijan, Russia, all these fields discovered decades ago. And here’s the problem: the discoveries that we're making today are much smaller.

And here was another key concept. When they were looking at depletion rates and they are saying the natural decline rates if you add all these 800 fields together, the natural decline rate is 9 percent. The larger oil fields – the Giants like a Ghawar, a Burgan – they tend to deplete at a slower rate; the bigger the oil field, the lower the depletion rate. The smaller the oil field, the faster the depletion rate. And then another characteristic is offshore oil wells deplete at a much faster rate than onshore oil wells. And most of the discoveries that we've been making since the early 90s, all the way up to the present day, have been offshore and they’ve been smaller, so the decline rates in these newer fields are running double digits every single year.

And that is the problem, John, that you know, the drive-by media – these guys never follow their arguments to completion and say to themselves, Now wait a minute, okay, we do have some demand destruction – people aren’t getting on airplanes like they used to because of the cost; maybe they’re not doing as much driving, but I don’t know about you, with the gas prices dropping the way they have, every day this week on the evening news they were talking about happy motorists pulling into the gas station with their motor homes. They had one where they were talking to a guy that had a motor yacht and he was filling his yacht, just thrilled that he could buy diesel fuel where it is now, compared to where it was in July; and homeowners saying the good old times are back. And that’s what Obama was saying in his 60 Minutes interview: We make this mistake; we see a run up in oil, then it comes back down and we say, Phew, glad that nightmare is over. And you know what, this will not last. And what we're not focusing on is there’s a two-sided equation. You've got demand and you've got supply, and even when oil was moving all the way up to 145, from 1998 we saw oil prices go up more than 14 fold, from $10 a barrel all the way up to about 147; and during that whole period of time, John, you would have thought if you were an oil company, you would want to bring as much oil as you possibly could online because you could sell it for extraordinary prices. And during this whole period of time, and especially from 2003 all the way up to the summer of this year, supply was struggling to keep up with demand and that’s because conventional oil has already peaked, and the difference is we're making it up from natural gas liquids which is making up the bulk of that difference between about 73 million barrels of conventional oil and then the 86 million barrels that we consume; and then of course you throw in tar sands, biofuels all made up that. The difference between let’s say 73 million conventional oil and then the 86 million we consume is made up primarily of natural gas liquids, tar sands, heavy oil and biofuels. [17:32]

JOHN: At one time, theoretically we had an oil endowment here in the United States that was bigger than what Saudi Arabia had, and you’ll hear rumblings from time to time about redoing things here, but in reality if we look around the world, whether that’s true or not, what can we find in terms of actual availability of oil?

JIM: If you take a look at where the decline rates are fastest, and the IEA broke this down and they said we have two cases. One, you don’t make any investments, you just deplete your oil fields and then the second scenario is you make additional investments to arrest the decline. In other words, you use technology enhanced oil recovery techniques, horizontal drilling – anything you can do to get more oil out of the ground. The greatest decline rates are in OECD countries in the Pacific Rim. The second highest decline rates are in OECD North America, OECD Europe, Asia, Latin America. The lowest decline rates are in the Middle East and Eastern Europe and Eurasia, and Africa, and that’s where we're basically finding a lot of oil today in terms of the discoveries that we're making. So for those of us in the West, whether we live in Japan, whether we live in the US or we live in Europe, we are seeing the most rapid decline rates because a lot of our oil fields are 1) smaller in size, and 2) they’ve been discovered – I mean we were producing oil in this country in the 19th Century, and during World War II the United States basically funded oil production to our allies. We were the Saudi Arabia of the world at that time. In fact, our oil production was around 10 million barrels a day; that’s how large. And even today, the United States is still the third largest producer of oil, even though our endowment is much, much smaller than other places in the world. So the gist of this is at some point in the future here, 1) we're going to be producing less, and 2) if we want our economies to grow, we're going to have to make it more efficient because despite all the new technology and the new technology economy, America is consuming more energy today than it did five years ago, 10 years ago or 20 years ago. And our fields are declining. A lot of the people that we import from, such as Mexico, their fields are declining. And so where is this oil going to come from, and I think that’s maybe what Obama was making reference to. I think that now that he’s president, he’s going to realize on his watch, he may be facing this energy storm that we're talking about as a result of falling prices, as a result of depletion, as a result of not having access to the credit markets – all of those three adding up at a time if you want to stimulate the economy, get economic growth growing again, you need energy to do so. So as Richard and I have done recently, in a series that we're going to start doing on this, called Reality Check, we will be heading into the perfect energy storm. [20:52]

JOHN: Which of course forms part of the crisis window that we've been talking about, so we're by no means clearing the window. So we’re still in it. We’ll be back in a sec. www.financialsense.com.

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[22:12]

Another Look at Gold Production

JOHN: A hummy hummy day to be talking about gold. People seem to be humming along with it, where are we? 7 ½ percent for gold up – the actual metals, by the way. Seven to eight percent on silver, and mining indexes is close to 28 percent. That’s not shabby, you know.

JIM: Over the years, John, we've been talking about metals production, precious metals and energy are following a parallel track in terms of whether it’s cost structure – costs have been going up – whether it’s finding personnel or even finding large deposits. Just like we're not finding any major gold discoveries, just as we're not finding major oil discoveries. The last major gold discovery, really one of the biggest in a long time, was the Fruta del Norte discovery made by Aurelian. But, you know, we've been talking about in the energy space how costs have been going up at double digits a year, and the same thing is happening in the mining sector. We've got now basically a full analysis of the second quarter production – the third quarter, even though it ended in September, we still don’t have all the information in yet.

But if you take a look at, for example, South Africa, it actually did the best out of any region of the world; cost structures – cash costs – were up 14%, year over year for South African gold production; Australian cash costs were up 34 percent year over year – they went from 293 to 393; Canadian metals production, up 56 percent, from cash costs of 271 to 423. And let me just kind of explain that anomaly. One of the reasons was Canadian mining companies also have base metals in their production, so the offsetting credits that they get from base metals, with base metals falling, there was less byproduct to contribute to cash costs. So that’s what’s behind that. In the US, cash costs went up only 2 percent; and in the UK, UK mining companies’ cash costs were up roughly about 25 percent at 464. But average for the industry is roughly about 440 dollars an ounce, and that’s 24 percent overall higher than it was a year ago. And as we've seen, at one time the price of gold really shot up this year, but year over year right now you’re looking at spot gold is still down – even on this rally this Friday which was a whopper – we’re still down about 4 ½ percent for the year and gold and silver production is down about 35 percent. And as it relates to silver, a lot of silver, 80 percent comes from byproduct, so if you look at copper prices down 47 percent, lead prices down almost 50 percent, nickel prices down 59 percent, tin down 26 and zinc down about 47. And that’s why a lot of the Canadian metals producers have seen a 56 percent increase in their production costs, most of that coming from a drop in byproduct credits that they get from these base metals. And as more and more miners are shutting down because they simply can’t money at these levels, and I’m glad to see them do that because that’s what they should be doing; they shouldn't be producing at a loss just as a lot of the oil companies are shutting down production in the Barnett Shale. They’re shutting down deepwater production and that’s what they should do because precious metals, base metals and energy is a depleting resource and why sell it at a loss just to produce it. And what was interesting - because we're going to interview Peter Marrone from Yamana for the gold show, and Yamana turned out to be the lowest cost producer in the second quarter; their cost of producing gold was a negative 140 dollars an ounce. Right behind them was Agnico-Eagle – they’re producing gold at 113, they get a lot of production byproducts; Minera at 132 dollars an ounce; El Dorado at 229; Gammon Gold at 245.

And looking at some of the big ones, you've seen an increase in Goldcorp, their cost were 308 dollars; Minera Andes at 322, and Buenaventura about 373. And what’s interesting is pretty much the top 10 producers in the second quarter are still Barrick Gold, they’ve produced close to 1.9 million ounces; Newmont is the second largest producer at about 1.3; Anglo Ashanti at about 1.25 million ounces; Gold Fields at 865. So those are the top 5 and then below that you have Goldcorp at 552, so they’re becoming a two million ounce plus producer; they’re probably heading their way towards three million ounces. Kinross, through acquisitions, it produced 400,000; and of course, Yamana, which has now become a million ounce producer, it produced 257 and becoming the lowest cost producer, so Yamana has made it to the top 10 category of top 10 producers in the world. [27:38]

JOHN: When we look at what’s going on especially in the area of shutdowns, that’s happening simply because of the forces that are out there. If the prices are pulling back, then you’re not going to be able to operate profitably; and who can continue operating obviously reflects how well they’re being run on other factors that are in there.

JIM: Yeah, and that’s one of the things that both the mining sector and the energy sector face are rising costs. And it was like I remember a press conference given a while back and it was by the president of one of our major airlines and he said, You know what, we've cut labor costs, we've gotten concessions from our pilots, our stewardesses, we're doing everything we can in terms of route efficiencies in terms of taking off the plane full – a lot of the cancellations that you see today on flights are, hey, if we can’t fill that plane we're not taking off because we lose money. And he was saying, Our largest cost is something we can’t control, which is the cost of fuel. For the mining industry, not only have personnel costs gone up and energy costs have gone up, but currencies have appreciated up until recently a lot of the currencies in the world in the mining areas were going up against the dollar; now that’s reversed itself in the third quarter so that will help a lot of mining production. But it’s really key here when you take a look at your costs going up 24 percent a year, John, producing gold or silver or base metals, the price is set in the market and it’s not like you’re making a widget and you can say, Well, it cost us 350 dollars last year, this year it’s 440 dollars; our costs are up 24 percent, we need to raise prices 25 percent. So we're going to take gold and we’re going to sell our gold at 1000 dollars an ounce.

Now, some companies have actually done that. I can think of a silver company that’s taken 25 percent of its production and they are having a mint produce 100 oz bars and they’re selling their silver for almost 40 and 50 percent premiums over the spot price and they’re taking advantage of this disparity between the paper price and the physical bullion price. But you take a company like Barrick, unless they either hedge their price of gold, when gold prices were over 1000, unless they locked in that price, you just can’t go out and say, Hey, it’s costing us more, we've got to raise the price. So what a lot of companies are doing is they’re scuttling their least profitable mines; or a lot of companies are going into production – newer ones – that are using their high grade to keep their margins up; they’re mining their pits where the ore grades are much richer so they get more ounces per tonne in their milling process. But you don’t want to do that for very long because then what happens is when the price takes off, then you’re going to be mining your low grade.

So it’s amazing how these parallel tracks are running between the mining industry, natural resource industry and what we're seeing in energy. And it’s going to be one of the factors that is going to drive the price of gold going forward because especially things like precious metals like silver where it’s a byproduct of mining. If you can’t mine copper profitably and your byproduct is silver and you start shutting down four copper mines – as one company did – you know what, they’re going to be producing less silver as a result. And that’s what we're going to see more and more, which is why I think you’re going to have to see higher prices not only for energy, but you’re also going to see higher prices for precious metals as well. [31:20]

JOHN: Since you've been talking about the majors here, does a lot of this principle apply to the intermediates as well, or are there different rules?

JIM: No, in fact usually the smaller the operation and depending on the location where your mine is, we're seeing the same thing. If you take a look at Lihir Gold, their price is up 53 percent, their cost structure; Oceana Gold, their cost structure went up 36 percent year over year; Oz Minerals, 43 percent; you take a look at Agnico-Eagle – you don’t have a fair comparison because they used to produce gold at a negative cost (it was like 6, 7 hundred dollars), now their cash costs are about 113; you take a look at El Dorado gold, their costs were actually down 20 percent; Golden Star up 23 percent; IAM Gold up 14 percent; Northgate up 110 percent; Peak Gold up 100 percent. So even the intermediate producers are having the same problem. And of course, even the junior producers even more so. It’s all across the industry, John. It’s like anything else; larger deposits – even the larger deposits and especially for some of the majors, you’re looking at older deposits, especially like Newmont and Barrick where they highgraded their deposits in the 90s, now they’re getting at the lower grade portions of their deposits at a time gold prices fell as they did from July –the same with silver and base metals – their cost structure have gone up and their margins have gone down. And maybe that might have been one of the reasons why you've seen a lack of performance in the precious metals stocks, but going forward you’re going to have to have much higher prices or it’s simply going to be uneconomic to mine. [33:05]

How to Know When We're Close to a Bottom

JOHN: You know, it’s amazing, Jim, how very simple principles that you garner from everyday life come in handy, like, we like to swim in the lake here every summer and there are big high rocks you can jump off of into the water; and there’s a very important thing. When you’re jumping off of high rocks into lakes, learn how to spot the bottom.

JIM: Good idea.

JOHN: And I guess we could apply the same principle to investing. How do you spot a bottom, when you’re looking for it?

JIM: First of all, I would say there are probably five things; 1) look for the media to start talking about something else. You know, it’s the old – I’m trying to think of the magazine cover, I mean every single night it’s “America’s financial crisis, America’s financial crisis” and so at some point the media is going to move on; maybe it will be with the Obama presidency about all the good things that are happening and all of a sudden they move on to another topic instead of talking about Armageddon every single night. So I think probably the first area that you want to look at is watch what the media is doing, watch for magazine covers to change because what do you see on magazine covers, what do you see on financial publications? “How to keep your money safe when interest rates are paying one one-hundredth of a basis point?” I don’t know. But probably the first thing that you’re going to notice the change and you’ll know when something’s happened is when the media begins to change its focus in terms of you’ll no longer have these two hour specials every night on America’s financial crisis. [34:58]

JOHN: So now that you see that shift – although you must admit, I think there is a lag time there, isn’t there, Jim? You know, we've always talked about the media lag in terms of recognizing stuff. But let’s give it that. Where do you proceed from there?

JIM: Well, you know, there are a couple of things that we've seen. Just as low volatility usually could be a warning sign of something is about to change, high volatility is also a warning. And we've hit on the VIX which measures volatility, some of the technicians are saying we've hit a double top; we had a top here on the 20th of this month where the VIX got up to 80.886, something I haven't seen in a long time; and then we had another one of October 27th. So we've now touched that area 80 on the VIX, and it’s now coming down, so whether it will go back up again. So look for a dramatic drop in the VIX and then another one also that measures what’s going on in the credit crisis is something we watch a lot is the TED spread. And the TED spread got to a record level in this crisis when the difference was – just round that off – 4.64 percent over 3-month T-bill rates. And that peaked on the 10th October and everybody remembers that week; that was the week that all the major indexes were down double digits in a single week – probably one of the worst weeks in stock market history. So the VIX peaked out at that time, and that’s when we were having all those problems – Lehman, AIG – all the stuff that was going on during that period of time; and the TARP program, you can remember that. Since then, the VIX has fallen from 4.63 to this Friday at 2.15. so we need to get the VIX back into a normal range somewhere between 1 and 1 ½ and that’ll tell you that the credit crisis is – you know, the money is starting to work, all of this money and liquidity that central banks are working through the system is starting to take hold. Remember, there is a monetary lag from the time the Fed starts printing money and expanding the monetary base to the time it works its way through the credit system. Likewise, when they’re raising interest rates there was a lag effect. And remember, they started raising interest rates in the summer of 2004 and it wasn’t until the summer of 2006 that they stopped and then it was almost a 12-month, 15-month lag time before the crisis really started to unfold, which was August of 2007. And also, take a look at what’s going on with the brokerage stocks and the financial stocks; bank stocks in particular – the BKX Index which was actually up slightly on Friday, but it had a big jump when the government intervened in the market beginning in July when the Index was at just below 50 and got all the way up to just above 80 in August and September, and since then it’s been downhill where on this Friday the Index closed up – it was up 19 ticks at 36.91. So that is another factor that you have to look at.

But I would say the biggest factor that you’re going to want to watch is watch the Japanese yen and the dollar because you know, you've heard about the yen carry trade, well, there’s a dollar carry trade. A lot of debt denominated in around the world is denominated in dollars. And as you get margin calls, as you begin to liquidate your other assets and pay off your dollar loans or come up with dollar margins, there’s a scramble for dollars; and that’s been behind driving this dollar index up to where we are today. It’s not based on economic strength, it’s based on a short-covering, it’s based on a scramble to cover dollar debts; and the same thing for the Japanese yen. If you look at the currencies around the globe, there’s only been two currencies that have been strong throughout this and they’ve been the Japanese yen and the dollar, and these have been the two areas that have had the lowest interest rates in the world. So if you were borrowing on margin, you were borrowing loans – and companies do that, investors do that – the two cheapest places to borrow in the world were Japan and the United States. So probably a turn in the yen and a turn in the dollar are going to be key because the next step in reflating is going to be dollar devaluation, and so I would say probably the most important of those five that we just talked about.

We talked about 1) the media 2) the TED spread, which measures turmoil in the credit markets, 3) the VIX which measures volatility 4) we talked about the Banking Index 5) and then the fifth one is the yen and the dollar and that is probably going to be the key. Probably out of all of those I would say the VIX – well, actually all of them in together; and look for divergences, look for stock market declines with declining volatility; look for a decline in the TED spread and watch for a change in the Dollar Index. And I think those are the kind of things that are going to tell you that reflation is working its way through the system and we’re going to be talking about this reflation-deflation argument after our energy roundtable which we're going to have the first week in December when we’ll have Matt Simmons, Dr. Robert Hirsch and Jeff Rubin from CIBC Markets. But next week, we're going to be doing our Gold Show, which we do every Thanksgiving. But we’ll return to this topic, but at some point, John, you’re going to get that kind of bottoming process and that’s what a lot of people think that we're doing. And some would even argue that this has been one long bear market that began in 2000 and that the recovery period that we had for about a three or four year period was a bear market rally and what we're seeing is the culmination of that bear market rally. Now, not everybody buys that. Some people say that, No, we've got to go back and we've got to have Armageddon, we've got to get down to 500 on the S&P 500; you know, maybe we get another bear market rally that can take us to higher levels with reflation and then we come back and retest the low. Who knows? But these are some key points that I think you can keep an eye on that’ll give you a better indication in terms of where we are in this market cycle. [41:41]

JOHN: You’re listening to the Financial Sense Newshour and we are at www.financialsense.com.