The Daily Reckoning

The End of Oil Security

The Daily Reckoning

Madrid, Spain

Thursday, May 17, 2007

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*** Stumbling the fog of market trends...knowing the price of everything
and the value of nothing...

*** Stock and art markets near peaks...patsies who are merely 'in the
market'...

*** The dollar's losing battle with the shekel...foreigners will take some
money off your hands...and more!

---------------------

Sotheby's has just had another record sale. A painting by Mark Rothko went
for $72 million.

Somewhere...the gods are laughing.

We observed yesterday that Richard Russell has changed his tune. Now he
warbles an almost up-beat melody; the Dow is entering the third and final
stage of its great bull market, he says. A top is yet to come.

Russell is one of the great old-timers of the guru trade. He has been
interpreting Dow Theory for 40 years.

The theory can be described so simply that it sounds ridiculous:

The stock market runs in big, long trends...it goes up, up and up - until
it reaches the top. Then it goes down, down, down - until it reaches the
bottom.

In theory, that makes it easy to invest. You just have to identify the
primary trend. In practice, you are still stumbling around in the same fog
as everyone else, because you can never know for sure which direction the
trend is really going or when you have hit the extremes.

We have followed Russell for many years. What we find useful about his
analysis is that it emphasizes the long-term trends, which are visible, at
least, in retrospect. And it focuses on values. How do you know when stock
prices have reached a peak? Just look at the values. Major peaks come when
you don't get much value for your money. At major bottoms, you can buy a
share for five to ten times earnings. At major tops, you have to pay much
more - three to five times more. At bottoms, it's not hard to find stocks
paying dividend yields of 5%-8%. At tops, you're lucky to get 2%.

Based on values alone, we judge the U.S. stock market - and the worldwide
art market - to be at peaks, or dangerously close to them.

Russell may be right about the exact position of the major trend...and the
coming Third Phase...but we will stick to the values.

The trouble with investors, if we may steal a line from a dead man, is
that they know the price of everything and the value of nothing. What is
the value of a Rothko painting? We don't have any idea. We just have an
opinion. And in our opinion, whoever spent $72 million for it should seek
treatment...immediately.

But, at least in the world of real investments, there are numbers to help.
We have Return On Investment (ROI) numbers, for instance, to guide us. An
investment that gives us a 10% return is a better investment, we figure,
than one that gives us only 5%. Since you can't really know which way the
market is going, you shouldn't count on capital gains.

Even Russell, with his formulae and his long experience, has often been
wrong, as anyone who stays in the business is proven wrong sooner or
later. It is simply not given to man to know his fate. Look at
earnings...or the yield. If you're lucky enough to get anything more than
that, well...bully for you.

Betting on the direction of the market is a mug's game that violates our
most obstinate prejudice, announced in this space as Bonner's Law:

The quality of information declines by the square of the distance from the
source.

When you buy a company - especially one that is next door to you - you can
study it in detail and make a fair guess about its earnings. But when you
are merely 'in the market,' you are nothing more than a patsy for the
financial industry. You are buying something you don't understand from
someone you shouldn't trust. And if you make any money at all, you don't
deserve to.

Chris Mayer adds in his two cents: "You don't need to invest in
'exciting,' flash-in-the pan companies that the rest of Wall Street is
buzzing about to make a ton of money. You just need stocks that sweat. You
want overlooked stocks that are rich in tangible, physical assets that
support the stock price (covering our downside), and sweat cash - big
time.

"By paying close attention to tangible assets that sweat, you build in a
healthy margin of safety to protect your money from any downturn. Because
tangible assets are physical, useful things that don't disappear when the
market heads south, unlike paper assets, which can lose money faster than
you can say 'wiped out.'"

What hard-working stocks does Chris like right now? Find out here:

Hidden Wealth
http://www1.youreletters.com/t/1248676/12296005/821784/3293/

"A good business is the best asset there is, aside from your personal
talents," Warren Buffett told us, when we sat down with him in Omaha to
interview him for the documentary.

"The best investment is a good business," he continued, "one that does
have durable competitive advantage and that will be around 10 or 20 or 50
or 100 years from now, turning out something people want at a profit."

You are better off following the Oracle of Omaha's advice and studying
your investments carefully...individually...and focusing on value. At
least then when you lose money, it's your own damned fault.

More news:

--------------

Addison Wiggin, reporting from Baltimore...

"'In the long term [his approach] is destabilizing,' Pimco's Bill Gross
said of Alan Greenspan's tendency to lower rates when the going got tough.

"'It promotes speculative activity. That's the corner that Greenspan has
painted the economy into.'

"We wonder what he'll say now that the two are going to be cubicle mates?

"Pimco announced yesterday they've hired Greenspan for his first post-Fed
consulting gig. Gross' track record at the helm of the world's largest
bond fund has been 'meh' of late. For the first quarter, the Pimco Total
Return fund was up just over 1%, ranking near the bottom of the market for
comparable funds. Over the last year a return of 6% put it in the bottom
quarter."

For the rest of this story, and for more market insights, see today's
issue of

The 5 Min. Forecast
http://agorafinancial.com/5MinForecast/5MinForecast_051007.html

--------------

And more thoughts...

*** Historian Paul Johnson once commented that steel magnate Andrew
Carnegie argued, "The business cycle was not an accident or anyone's
fault: It was a fact of life and provision should be made for it...Anybody
could make money in a boom - making it at the bottom of the trough was the
real test of ability."

Johnson went on to describe Carnegie's thoughts: "Once you understood the
principle of unit costs, he argued, you could isolate the problem of
productivity - output per man-hour employed or capital used - and thus
raise productivity at the same time as production. By raising
productivity, you could slash prices."

"And that's exactly what Carnegie did," explains Free Market Investor's
Christopher Hancock "Between 1875-1898, Carnegie's mills reduced the price
of a steel rail from $160 a ton to $17. His ingenuity cut prices by
roughly 90%. He devoured the European steel industry.

"Johnson notes that these enormous savings worked their way into every
aspect of public life: 'No president, by miracles of administration, no
Congress, by enlightened legislation, was capable of bringing comparable
material benefits to all Americans in this way.'

"Carnegie's mills produced the lowest cost steel where it was needed most:
the American industrial machine.

"The same business principles that proved true more than 100 years ago
remain just as sound today. And I believe you'll be hard-pressed to find
another steel producer operating in the heart of the world's newest
industrial boom more conscious of costs and operating efficiency than the
one that I'm recommending to my Free Market Investor subscribers."

To read Christopher's full report, see here:

The World's Greatest Growth Stock
http://www1.youreletters.com/t/1248676/12296005/821625/3271/

*** One thing that makes the whole world of investing difficult to
penetrate is that the rod we use to measure value is as loopy as wet
spaghetti.

If you've been following the strange story of the U.S. dollar, you have
noticed that it's being beaten by some unlikely competitors - namely, the
Brazilian real, the Israeli shekel, the Turkish lira and the Philippine
peso. What gives?

It's hard to know. We measure our wealth in our national currencies. We
adjust for changes in the cost of living. But we don't really know what
the currency itself is worth.

Gold used to provide a fixed scale...something that was sure, and
universal. Gold used to give money real value. Not in terms of
earnings...but in terms of something solid that couldn't be counterfeited,
inflated, or readily debased.

But now, in the name of protecting national sovereignty and national
currencies, governments insist upon being able to pass off as "money"
whatever noodles they've got in stock.

An article in Foreign Affairs explains:

"Capital flows were enormous, even by contemporary standards, during the
last great period of 'globalization,' from the late nineteenth century to
the outbreak of World War I. Currency crises occurred during this period,
but they were generally shallow and short-lived. That is because money was
then - as it has been throughout most of the world and most of human
history - gold, or at least a credible claim on gold. Funds flowed quickly
back to crisis countries because of confidence that the gold link would be
restored. At the time, monetary nationalism was considered a sign of
backwardness, adherence to a universally acknowledged standard of value a
mark of civilization. Those nations that adhered most reliably (such as
Australia, Canada, and the United States) were rewarded with the lowest
international borrowing rates. Those that adhered the least (such as
Argentina, Brazil, and Chile) were punished with the highest. "

Yes, faithful DR reader. That is the way it ought to be.

But as we have been telling you - and any one else who will listen - that
is not the way it is these days. Instead, however absurd the status of the
U.S. dollar may get, there are even more absurd foreigners willing to take
it off our hands...and return it to us in the form of loans.

Which is why we suggest you ignore even Richard Russell this time. Keep
your eye, instead, on our Crash Alert flag - the Bonnie Blue...and Black.

---------------------

The Daily Reckoning PRESENTS: Venezuelan President Hugo Chavez recently
seized control of Orinoco, the country's last privately owned oil field
recently, sending ripples through the world economy. Martin Hutchinson
explains why this even is of major long-term importance...

THE END OF OIL SECURITY
by Martin Hutchinson

By seizing control of the Orinoco tar sands, Venezuelan President Hugo
Chavez delivered a stunning blow to US oil security. If the world economy
worked in the way postulated by the globalizers his action would hardly
have mattered, except to the unfortunate shareholders of the affected oil
companies. However, the world economy doesn't work that way, and Chavez's
seizure is thus of major long-term importance.

Orinoco is important, not because of current production from the region, a
modest 600,000 barrels per day at a cost of $20 per barrel, economic but
well in excess of the cost of Saudi or even Mexican offshore oil, but
because of the size of the tar sands deposit. This has been variously
estimated at between 1.2 trillion and 1.8 trillion barrels of oil, with
higher estimates more recently. At the latter figure Orinoco represents
34% of all known world oil reserves, and 58 years of world oil consumption
at current levels.

Since Orinoco's oil comes in the form of tar sands, extracting petroleum
is expensive, and not all the theoretically available petroleum can be
extracted. However, current estimates that only around one fifth of these
sands can be economically used are probably over-pessimistic; we have only
been extracting oil commercially from the Orinoco tar sands and the
similar Athabasca tar sands in Canada for less than a decade, so
extraction technology can be expected to improve. Over the next couple of
decades, production from Orinoco could be ramped up and extraction
technology improved, so that the sands could take their rightful place
among the world's truly important sources of energy supply.

Thus if Orinoco and Athabasca were freely available to the world market
the extreme "peak oil" theorizers would be wrong; there is enough oil
supply for the world's needs for at least 100 years at current prices.
Only a sharp ramp-up in world oil usage or a disruption in the free trade
patterns of world oil could prevent the United States and other major
world oil users from having enough supply well past 2100. Whether burning
all that oil would disrupt the world's climate is another question (my
estimate is: only modestly, provided appropriate precautions were taken)
but oil supply as such should not be a problem.

Before Chavez's action, a free world oil market seemed a reasonable
assumption. There were certain rigidities, such as the US refusal to deal
with Iran, but Iran is a second tier supplier and there are plenty of
other countries willing to deal with it (as there were with Iraq in the
days of the infamous "oil for food" program.) The main problem has been
the extraordinarily rapid surge in Chinese and to a lesser extent Indian
oil demand, which disrupted established market relationships and was bound
to strain the system as well as raising oil prices.

In a well ordered market, other participants would have met with China and
held open discussions of China's future needs and the potential sources to
satisfy Chinese demand. This would have ensured that China was reassured
about the openness of world oil markets to Chinese participation, and
might well have led China itself to play by the rules in a
value-maximizing way. One way of convincing China that the world market
was truly open to it, for example, would have been to allow the Chinese
National Oil Company to buy Union Oil of California in 2005, a substantial
but strictly second-tier transaction that threatened nobody.

This didn't happen. Instead the Chinese leadership, having been brought up
outside the free market system, naturally don't expect to play by its
rules. Having seen political pressure brought to bear in the US Congress
to prevent them buying an oil source on the free market, China has
determined to deal primarily with the "bad guys" who violate human rights
or are otherwise motivated by hatred of the US and the existing world
order. Since in turn Chinese checkbooks have removed any incentive to good
behavior for human rights violators with natural resource deposits, human
rights abuses have increased, as has anti-Americanism.

However, until now China's actions weren't particularly important. Sudan
is not a major player in the world's oil markets, while Iran is only a
middle tier player and has other potential buyers in Europe. Human rights
may thus suffer because of China's oil purchases, and US foreign policy
has taken a major hit, but the oil market itself has not been
significantly affected. Even China's deal last September to take 500,000
barrels per day from Venezuela, although economically insane because
Venezuela has a much closer market in the US, was for a modest amount of
oil and could not reasonably have been said to be market-disruptive.

The combination of Chavez's visceral anti-Americanism with Chinese
paranoia, when applied to the Orinoco oil sands is uniquely damaging to
the stability of the world's oil market; it is a marriage truly made in
the nether regions as far as the United States is concerned.

If Chavez did not have access to non-US technology, even the simplest of
embargoes would prevent him from exploiting Orinoco beyond its current
state of development. The natural inefficiency of the state-run petroleum
combine Petroleos de Venezuela would cause oil output to decline,
particularly in the technologically complex Orinoco projects, while
attempts to divert sales away from the United States would reduce
Venezuela's oil revenues. Chavez would run out of money fairly rapidly,
and in the next oil price downturn would either be deposed or would return
to the United States, cap in hand like Libya's Muammar Qaddafi. Either
way, disruption to the world oil market and to US energy security would be
minor and short-lived.

With Chinese help, however, Chavez is in a very different position.
Chinese technology is probably not currently state-of-the-art in its
ability to extract oil from sands. However China's ability to
backward-engineer technology and the resources it has available to devote
to the problem would, with the US facilities already in place, quickly
bring a Chinese "technical assistance" crew up to speed. At that point,
there would be no further need for Chavez ever to sell another barrel of
oil to the United States; he could simply ship Venezuela's entire output
to China.

Again, if the world oil market were truly free in the Adam Smith sense,
this would not matter. If China bought its oil from Venezuela, and used
its technological abilities to ramp up Venezuelan output, the United
States could simply divert its purchases to other sellers. However, in a
tight oil market this runs into a problem: in the long term, the major oil
suppliers outside Orinoco, Athabasca and Russia are all in the Middle
East. As it has shown in the gas market and again with its attempted
suspension of deliveries to Estonia, the Russia of Vladimir Putin is a
fairly unreliable supplier. In any case Russian oil production is
beginning to decline, and is unlikely to be increased sharply while the
country is mired in its current corruption.

Thus instead of China being forced to rely on unpleasant and unreliable
Sudanese and Iranians for the additional oil it needs, the US consumer
will now be subject to the tender mercies of the three major Middle
Eastern oil producers, Saudi Arabia, Iraq and Iran. While the US has
troops in Iraq, there probably isn't a problem; Iraq is now believed to
have oil reserves of 200 billion barrels, little more than a tenth of
Orinoco but still enough to be ramped up to supplement other sources. If
and when the US withdraws from Iraq, and that country either collapses
into civil war or aligns itself with US-hostile Iran, the US suddenly has
a frighteningly large number of economic chips placed on the fragile
political stability of Saudi Arabia.

Absent a major world recession, this is a problem that is only going to
get worse. The United States currently imports 58% of its oil needs; that
percentage is forecast to rise to 68% by 2020. Athabasca will supply some
of the excess, but environmental considerations and the difficulty and
cost of extraction mean that Athabasca may not be able to be ramped up as
quickly as the US would wish - the US Energy Department's 2006
International Energy Outlook has Athabasca production at only 2.8 million
barrels/day in 2030, less than 10% of US consumption in that year. China's
consumption, on the other hand, is expected to have quadrupled by 2030,
with the country importing 11 million barrels/day.

If Venezuela were democratic, the United States would not need to worry -
Chavez would be out of office at the latest by 2015 or so, as even the
impoverished Venezuelan masses wouldn't elect him indefinitely. If he
didn't have China to help him, an undemocratic but economically
incompetent Chavez would also undoubtedly fall from power well before
then. However, as Chavez moves towards dictatorship his potential
longevity increases - Fidel Castro, after all, has been in office 48 years
and counting. In 2030 Chavez will still be only 76, five years younger
than Castro is today and with Chinese-derived oil revenues he is very
likely to be still in power. The United States, desperate for oil imports,
may well by that year be begging Vladimir Putin's thuggish successors and
the revolutionary regime that replaced Saudi Arabia's monarchy for oil
market mercy.

The Iraq war was not about oil. It didn't need to be; the world oil market
under the control of the United States, Japan and the EU was more or less
free, so that a hostile Iraqi regime could easily be countered by a
partial oil embargo and purchases elsewhere. The next war in which the
United States is involved may well be about oil, however, and if the
United States seeks to preserve its essential interests by assaulting the
largest source of supply, with the most irredeemably hostile regime, Islam
will have nothing whatever to do with it.

Regards,

Martin Hutchinson
for The Daily Reckoning

Editor's Note: All of these geopolitical factors have made for a very
volatile energy market - but you can take advantage of the rising price of
oil (and the falling dollar) with EverBank's brand-new World Energy CD.
This FDIC-insured deposit account allows you to automatically hedge any
U.S. dollars you put in, simply by spreading them evenly between four
politically stable, energy-centric currencies whose purchasing power
against the greenback is soaring right now.

EverBank has opted to give DR readers first dibs on their World EnergySM
Index CD, before they open it up to the rest of the market - and today is
the last day to get in on this exclusive offer. If you're interested in
finding out more, the only way to get info is to either email them at
worldmarkets@everbank.com or call 800-926-4922. Just be sure to mention
you read about it here in the Daily Reckoning when you write or call.

Martin Hutchinson is the author of "Great Conservatives" (Academica Press,
2005) -- details can be found on the Web site www.greatconservatives.com

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Today's Daily Reckoning - The End of Oil Security