John Mauldin's Outside the Box : Food Prices

A Value Investor Looks At China

John Mauldin — Tue, 12 Aug 2008 14:44:19 GMT

China is all the rage for the next few weeks as the Olympics are going on. Many are calling this China's time to showcase itself to the world. I have a lot of friends and analysts who are big China bulls, believing that the next few years will see continued high growth in China, although less than the above 10% of the past few years.

In Outside the Box, we like to look at some contrarian analysis from time to time. Value Investor Vitaliy Katsenelson gives us some reasons why the outlook for China might not be so bright. This has implications for lots of markets that are driven by Asian demand.

Vitaliy N. Katsenelson, CFA, is a Director of Research at Investment Management Associates in Denver and teaches a graduate investment class at the University of Colorado at Denver. He is also the author of Active Value Investing: Making Money in Range-Bound Markets (Wiley 2007). Enjoy the essay.

John Mauldin, Editor
Outside the Box

A Value Investor Looks At China

By Vitaliy Katsenelson

What do Starbucks and China have in common? A lot! Both got us hooked on consumption: one of fancy, expensive caffeinated liquids; the other on cheap foreign made goods. Both have defied the conventional wisdom - they grew faster and longer than common sense told us was possible. They also share another striking commonality: both are suffering from late stage growth obesity (LSGO).

The Starbucks story

With the beautiful benefit of hindsight we know what happened to Starbucks - it grew too fast, opened too many stores, and sacrificed its own standards to meet unrealistic targets. The company first claimed that it only had a few hundred stores that it needed to close, and then the few hundred spilled into six hundred. Weak consumer spending will likely push Starbucks to re-examine its store count again, doubling or tripling the store closures.

Starbucks percentage of new stores growth in 2007 was only slightly lower than it was in 1999. But in 1999 it had 2,000 stores; in 2007 it was pushing a 10,000 company owned stores mark. Let's put this in perspective: in 1999 Starbucks opened 447 stores - 1.8 stores per working day; in 2007 that number more than tripled to 1,403 stores a year - 5.5 stores per working day. At this level of growth physical limitations come in: there is only so much real estate that fits a company's criteria at a certain point in time. Management started sacrificing on the quality of their decisions, compromises were made that were unthinkable several years before. Stores were opened too close to each other or on the wrong side of the street, expensive leases were signed, they even hired baristas that would have fit in better at McDonalds - you get the idea.

Unfortunately the present and the future will pay for the decisions of the past: stores will need to be closed, long-term leases terminated, charges taken, corporate costs created in hopes of high growth eliminated, and corporate culture of partnership strained by barista layoffs.

Starbucks needs to go on a permanent growth diet (at least in the US), and realize that it has the metabolism of a 37 year old and can digest fewer new stores. By tightening its standards for opening new stores the company will be on the way to recovery, though at slower growth. Starbucks is blessed with financial strength, capable management and unbelievable brand. If management admits to themselves that the heydays of growth are behind, recovery should be fairly painless. Starbucks generates tremendous operating cash flows, which in the past were completely consumed by opening new stores. If the company were to go on the LSGO diet, its capital expenditures would decline and free cash flows balloon - the value unlocked.

But this discussion is not about Starbucks, it is about what is taking place in China.

The Great China story

The benefit of hindsight that provides clarity in analysis of Starbucks today is not there for China, at least not yet. But if you were to open your mind and look past today's cheery newspaper headlines you'd see that China is suffering from a severe case of LSGO.

Ten for ten. Since 1998 its GDP has grown at about a 10% annual real growth rate, and its economy more than tripled in size (in real terms). There were no recessions, just expansion - the Chinese miracle growth? The origins of China's tremendous growth are well known: large population migrating from low (farming) to higher productivity (manufacturing) activity, cheap labor, a capitalism-friendlier communist government, and insatiable demand from the US and the rest of the developed world for cheap goods.

Unlike Starbucks - a private enterprise that has free market principles deeply inbred in its DNA - China is a communist country. Though it is moving towards free market capitalism, it is not there yet. The rule of law is weak, the country infested with corruption, and due to central planning and tight government control of the banking system capital is often allocated based on cronyism (or political relationships) not merit.

Prolonged high growth in this environment results in inefficiencies that are compounded year after year. In other words, though the growth is high, the quality of growth is low, thus asset allocation decisions are likely to be poor. The ten year super-high growth marathon put China at high risk, actually more likely of a certainty, of a severe case of LSGO.

From today's perch we can only guess of the consequences of LSGO, but we'll gain that clarity after the fact - a luxury we don't have. Newspapers that are praising the Chinese growth miracle today will write exposes on what went and is going wrong in China.

I have absolutely no facts to back up what I am about to say, but it is not hard to imagine future stories about poverty stricken farmers that moved to big cities for a better life and found despair; or that inland migration (from farming to factories) only brings a onetime productivity jump as poorly educated farmers-turned-factory-workers add little to productivity improvements afterwards; or how weak and debt ridden the financial system is; or the devastating impact that pollution has on health and productivity; or how the biggest shopping mall in the world, that happens to be in China, is almost completely empty.

Oh wait, the story about the shopping mall is not a figment of my imagination (I am not that good) but has already taken place. In 2005 NY Times ran an article titled China, New Land of Shoppers, Builds Malls on Gigantic Scale, it talked about the biggest shopping mall in the world that happened to be in Dongguan, China. The article said:

"Not long ago, shopping in China consisted mostly of lining up to entreat surly clerks to accept cash in exchange for ugly merchandise that did not fit. But now, Chinese have started to embrace America's modern "shop till you drop" ethos and are in the midst of a buy-at-the-mall frenzy.... by 2010, China is expected to be home to at least 7 of the world's 10 largest malls... Already, four shopping malls in China are larger than the Mall of America. Two, including the South China Mall, are bigger than the West Edmonton Mall in Alberta, which just surrendered its status as the world's largest to an enormous retail center in Beijing." (emphasis added)

Fast forward three years and you find a very different story: the biggest mall in the world - the South China mall, with space for fifteen hundred stores, only has a dozen stores open for business - it is empty. Shoppers never materialized. Billions of dollars have been wasted.

Analyzing the Chinese economy while it is growing at superfast rates is like analyzing a credit card company or a mortgage originator during an economic expansion - all you see is reward - the growth. But the defaults - the risk - are masked by a healthy economy and constantly increasing new business that is profitable at first. The true colors of that growth only appear after the economy slows down and new accounts mature. (In fact, the banks or credit card companies in the U.S. that showed the lowest loan growth during last expansionary cycle have a lot fewer credit problems than those that did - U.S. Bank Co comes to mind here.)

The consequences of LSGO are likely to be very painful for China. As of today we don't know how much of the recent growth came from wasteful, unproductive growth. Only after a slowdown will the true problems surface.

The Speed. What makes things even worse is that China cannot afford a slow down. I discussed this in the past but it is worth repeating. The Chinese economy is like the bus from the movie "Speed". In the movie the bus is wired by a villain (played by Dennis Hopper) with explosives, and will explode if its speed drops below 50 miles per hour. The Chinese economy has 1.3 billion unsuspecting people on board. It could blow if economic growth drops below its historical pace.

A combination of high financial and operation leverage sprinkled with past high growth rates will send this economy into a severe recession if growth rates slow down. Let me explain:

High operational leverage. China has become a de facto manufacturer for the world. With the exception of food products, it is difficult finding a product that was not, at least in part, manufactured in China. Industrial production accounts for 49% of GDP, double the rate of most developed nations (i.e. industrial production for the United States is 20.5 % of GDP, UK 18.2% , and Japan 26.5%).

Chinese miracle growth is largely driven by the manufacturing sector; historically its industrial production grew at a faster rate than GDP. The manufacturing industry is very capital intensive. Building factories requires a large upfront investment. High commodity prices and rapid wage inflation has driven those costs up. Once a factory is built the costs of running it are to a large degree independent of the utilization level - they are fixed - a classical definition of operational leverage. On top of these factors, laying-off workers is a politically sensitive process in China, which creates another layer of fixed costs.

High financial leverage. Debt is the instrument of choice in China. Due to a lack of equity-fund- raising alternatives (their stock market is very young), bank debt and underground finance companies that charge very high interest rates are the predominate sources of capital in China - this generates a great degree of financial leverage. (Though according to my friend Bill Mann, The Motley Fool's advisor of Global Gains newsletter, a frequent visitor to China, state owned enterprises are much more leveraged than private enterprises.)

Total operational leverage. Large piles of debt (financial leverage) combined with high fixed costs (operational leverage) create a very high total operational leverage.

Total operational leverage in China is elevated further as factories are built to accommodate future demand - this is a classical byproduct of LGSO. It is a human tendency to draw straight lines and thus making linear projections from the past into the future. During the fast growth period the angle of the straight lines is tilted upward, causing an over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. (Fear of over investment is overrun by fear of losing customers.)

This type of thinking results in tremendous overcapacity when demand cools. Here is an example: let's say a company saw demand for its widgets rise 10% year after year. It builds a new factory to accommodate future demand, let's say five years. It will likely model a 10% annual increase in demand as well. But what if demand comes in at 6% a year over the next five years? This will translate into overcapacity - not 4% but 20% (4% per year times five years). Suddenly you don't need to build factories or add capacity for awhile.

This greatly leveraged growth is terrific as long as the economy continues to grow at a fast pace: sales rise, costs rise at a slower rate (in large they are fixed) - margins expand - the beauty of leverage. However, leverage is not so sweet and soft when sales decline. Overcapacity is a death sentence in the manufacturing (fixed costs) world. As companies face overcapacity or slowdown in demand, they try to stimulate sales by cutting prices, which in part lead to price wars (similar to what we observed in the U.S. between Sprint, MCI and AT&T in the long distance business during the mid 90s) and to a fatal deflation. Sales decline, costs remain the same - margins collapse.

The weakness in the US and European economies will temper demand for Chinese made goods. China is already showing first signs of slow down - inflation is increasing and rate of real growth is decreasing.

It gets worse: high commodity prices

Chinese demand for stuff (oil, metals, machinery etc...) has a tremendous impact on commodities, driving their prices many fold. High (and rising) commodity prices are negative for developed world economies but they are catastrophic to developing economies - they bring comparatively higher inflation and often stagflation. Here is why:

Inflation is sourced from two broad categories: commodities (stuff) and wages. Emerging markets are twice as cursed when it comes to inflation:

Commodity prices (less shipping costs and government controls - the Chinese government limits price increases on certain commodities, but we know that doesn't work in the long-term) are the same around the world. Thus the U.S. and China will see a similar increase in commodity prices (at least in dollar terms). But the commodity component represents a larger portion of the total product cost in China than in the U.S., as wages in China are a less significant component of a total cost. For instance, bread baked in the U.S. and China will require the same amount of wheat and wheat will cost as much. But baker wages will be significantly larger in the U.S. than in China and will result in a much higher cost of the finished product. Therefore, a spike in wheat prices will have a larger impact on the loaf of bread in China than in the US.
Wage inflation: the US and Europe have little wage inflation, as rising unemployment has diminished the already weak bargaining power of the labor force, keeping wages in check. Economic expansion has put significant upward pressure on wages inflation in China (and India as well).

In combination, these two factors were responsible for inflation in high single digits in China, double the rate of inflation in the U.S.

China is not the cheapest place in the world to manufacture, not anymore. To its benefit, cheaper countries (Singapore, Vietnam etc...) are not big enough to steal a significant amount of capacity and the US in many cases doesn't have the needed infrastructure to bring manufacturing back. Appreciation in the renminbi and high oil prices (which are driving shipping rates up, placing a significant premium on the distance factor) are making Chinese produced goods even less attractive. Something has to give: either the U.S. will consume less or China will keep prices low to stimulate the demand, swallowing the loss, or a combination of both.

It gets even worse...

I constantly catch myself wanting to say "the story only gets worse", but unfortunately it does. The US and Europe can cope with energy and food inflation a lot better than China and other developing nations, as we spend a lot less on food and energy as a percent of our income and have a lot more discretionary income. (Just take a look at magazine section in the book store. There is probably a fishing magazine for the left handed fishermen.)

Though the Chinese consume a lot less gasoline than Americans. They don't have as many cars and don't drive as much, but they do have stomachs - they eat. High energy prices have translated in food inflation that in China runs in the high teens. The average American family spends only 15% of their household budget on food, whereas the Chinese spend 37% . Maybe this is one of the reasons their shopping malls are empty. People that pay high gasoline prices but are full don't riot, but hungry people do. The current situation raises political risk in China and also the chances that government (social) intervention will rise. This also puts in doubt the significant development of a Chinese middle class, at least in the near future.

When I wrote an article for Financial Times in May discussing risks in stuff stocks (commodities, energy and industrials) I called today's environment "a global commodity bubble". I was imprecise, after a conversation with the brilliant Ed Easterling of Crestmont Research (by the way, Ed wrote "Unexpected Returns" - a must read) and reading a wonderful interview with James Montier by Kate Welling, I'd like use James' more precise definition of today's environment: a "global growth expectations" bubble. After all, it is the supply demand (to a large degree) that was responsible for this unprecedented growth in "stuff", shifting the mentality of the market into "this time is different" gear. It is not.

In the past "stuff" stocks were cyclical, their margins played a very predictable foxtrot of bouncing together with the whims of the US economy. Today they are behaving if as Google is their middle name - their sales are climbing in double digits, margins keep expanding and now they are called "growth" stocks. They are not. It is just Chinese late stage growth obesity, which has disproportionately impacted the demand for stuff, creating an expectation that the "growth story" will continue forever. Nothing is forever. Starbucks discovered that and so will China. China is likely to have a bright future, but it doesn't consist of straight to the sky growth trajectories.

Implications. Demand for commodities will decline, while more supply from past investments (there is a significant lag) will be coming to the market - they'll come crushing down to earth. Companies that make stuff will suffer, their margins are at multi-multi-multi-year highs, margins pendulum will swing the other way, to the other extreme. Suddenly they won't appear to be as cheap. (Take a look at my January Barron's article in which I discuss the risk in corporate margins and May Financial Times article which explores China and stuff stocks.)

Intelligence Guidance

John Mauldin — Fri, 27 Jun 2008 03:26:52 GMT

This week I want to share with you one of the more important tools in my arsenal for keeping up with what is going on in the world. As I've told you before, George Friedman and his team at Stratfor are my go-to guys for geopolitical intelligence. Their insights into this facet of the world are simply without peer. Now I want you to see their Intelligence Guidance which they publish each Friday for the upcoming week; last week's edition is below.

The Intelligence Guidance is an internal document that guides their intelligence team for the upcoming week. It's not a forecast of what's going to happen (more on that in a minute) but a list of potential inflection points that bear close scrutiny. On a short term basis, these are the critical items that can move policy in one direction or another. I put this side-by-side with my calendar of Fed meetings, statistics releases, and earnings announcements to get a holistic picture of what's going to be driving markets and plan tactics. I highly encourage you to click here for a Stratfor Membership, at special prices available to my readers, and add Stratfor's Intelligence Guidance to your weekly thinking.

Now about that forecast. Stratfor is just about to issue their third quarter forecast, and you definitely want to incorporate this thinking in your strategic planning. Stratfor's past calls on everything from the Asian currency meltdown to China's internal problems have proven to be eerily prescient. And I should point out that they also provide a scorecard that makes it very clear where their calls have been off, too. The Quarterly Forecast is included free as part of your Stratfor Membership, so click this link for the special deals available to my readers and make sure that you don't miss out on this important look ahead.

John Mauldin, Editor
Outside the Box

Intelligence Guidance Summary:

The following are internal Stratfor documents produced to provide high-level guidance to our analysts. These documents are not forecasts, but rather a series of guidelines for understanding and evaluating events, as well as suggestions on areas for focus.

Analysis

All guidance from last week remains in place (see those below). Supplemental guidance:

1. The situation in Iraq: Let's spend next week focusing on something that is not happening: the war in Iraq. The bombing in a Baghdad market really drove home how few there are. So did indications that Iraq is going to open the oil fields to investment. We need to review the status of the war carefully. Our perception has been that the war is winding down and the general outlines of the resolution are in place. Time to do a net assessment re-evaluating our position.

2. China and oil prices: China has lifted the caps on oil prices, the Saudis are promising to raise output and consumption appears to be dropping. That would indicate that oil prices will fall, but that is not our business. Our business remains figuring out what higher energy prices do to the international system. The China watch remains essential. That is the center of gravity of the problem. They are still trying to ride it out with subsidies. Questions like "What is the status of their cash reserves?" and "What is happening to export profit margins?" become very interesting. They are spending real money to keep these caps on to keep those margins up. We do not know where prices will go but we know where they are. Let's drill into the reserve and margin question.

3. Venezuela and Cuba: Venezuelan President Hugo Chavez tried to create a police state then backed off. Next thing we hear are stories the he is giving sanctuary to Hezbollah, which we assume is psychological pressure from Washington. Then he turns up in Havana for talks with Fidel and Raul Castro. In the meantime the European Union drops whatever sanctions are left on Cuba. Cuba needs Venezuelan help on oil. But it also seems to want to get out of its isolation. It's not all that interesting what Chavez said to the Castros, but it would really be interesting to find out what Raul said to Chavez. Fidel cranked him up. Is Raul following the old line with Chavez, or telling him to calm down?

4. Israeli domestic politics: What is holding Israeli Prime Minister Ehud Olmert up? In any other country the allegations alone would have bought him down, not to mention Ehud Barak, a coalition partner, calling for his resignation. With the Syrian talks clearly proceeding and Hamas agreeing to a truce with Israel, things are at a crucial point. Since this is the Middle East, that's usually when disaster strikes. Olmert's fall would seem to derail everything, but he does not fall. Let's dissect the Israeli situation and see what we can learn.

5. Zimbabwe and South Africa: Zimbabwe is not important in itself. South Africa is, or more precisely, the degree to which South Africa plans to exercise power in Africa. With commodity prices high, Africa becomes important, and as the Chinese increase their presence, the South Africans could use their longstanding close ties to move in as well. It would make geopolitical and business sense to do that. Zimbabwe is the test for South Africa. If either South African President Thabo Mbeki or African National Congress President Jacob Zuma can help pull Zimbabwean President Robert Mugabe out of office, his authority in the continent will be solid. Mbeki and Zuma have the power, but it isn't clear they have the will. If they do not have the will in Zimbabwe, they will not have it to create a sphere of influence elsewhere. The Zimbabwe crisis is in a quiet phase but that won't hold indefinitely. We need to watch South Africa to see if it will act.

Ongoing items:

1. Oil and food markets: Oil and food prices remain at the top of the list. We need to be watching carefully what the Arabian Peninsula is doing with its money and what the Russians are planning to do. In the immediate, we need to be following global crop forecasts. Unseasonable rain in the U.S. Midwest has threatened to bring the corn harvest down by about 10 percent this year. Flooding is hitting China's harvests right now as well, and corn crops in Mexico have been threatened by unseasonably dry weather. As other crops see seasonal disruptions worldwide, we could see increased fluctuations in the prices of these goods. Particularly vulnerable to increases in the price of corn are Japan, South Korea, Mexico and Egypt. Mexico and Egypt are particularly prone to food-related civic unrest, a development that must be monitored carefully. Along those lines, all food crops around the globe must be carefully monitored as prices continue to climb. This is much more immediately significant than oil prices right now. If there are crop failures larger than the U.S. corn crop looming, prices are really going to soar. That is not going to result in a one or two point drop in gross domestic product; it can result in chaos in large parts of the world. We don't know if this is going to happen, but we need to be on top of this whole process hour by hour.

2. China's economy: China is getting hit both ways. As one source put it, bad margins are disappearing. As they disappear, we can expect massive problems. The government has plenty of resources in the short run, and we can expect things to hold together until after the Olympics, but we need to watch carefully to make sure that they do. By then, all of these pressures might recede. But that is dubious. September -- and the rest of 2008 -- should be interesting for China.

3. The European Union: The Irish referendum on the European Union's Lisbon Treaty is in one sense no surprise. The EU is based on unanimity, and there was no way this was going to pass without someone blackballing it. There are two choices here. Either the EU accepts that it is an economic bloc and not a proto-nation, or the EU changes the rules on how constitutions are ratified. Both are hard for the union to do, and as a unit the EU does not do hard things. We need to watch the Germans and French and see what they have up their sleeves. The burden especially falls on France to patch things up because it is taking over the bloc's presidency soon. Never forget that the French solution to violating the Stability Pact by higher than acceptable deficits was to ignore it. There are ways out of this. Let's figure out if there is any consensus among the major players as to what these solutions will be.

4. Turmoil within Iran: Iran is giving off more and more signals of political turmoil. Iranian President Mahmoud Ahmadinejad certainly is not backing off on his public statements, and his opponents -- some pretty powerful -- have said things it is hard to back off from, too. Meanwhile, from what we can tell, the clerical establishment is not looking to oust Ahmadinejad, preferring to see him exit the system next June when he is up for re-election. The clerics fear an intra-conservative rift could cost the conservatives next year's presidential election -- hence the naming of Ahmadinejad's political foil, Ali Larijani, as parliament speaker to contain the president's moves, especially on the foreign policy matters that are preventing Iran from prospering in a time of high energy prices. Meanwhile, the European Union's foreign policy adviser is in Tehran to offer new incentives in the nuclear controversy. In the midst of the rhetoric of defiance, there the Iranians have faintly signaled that they might be ready to reach a compromise of sorts. So let's not take our eyes of this.

5. U.S.-Iranian talks: The controversy over a future U.S. military presence in Iraq, a key part of U.S.-Iraqi strategic talks, continues to escalate. Opposition to any deal that could cut into Baghdad's sovereignty has brought together not just warring Shiite factions but also elements from both major sectarian groups. The Iranians are obviously making this an issue because it not only undercuts their influence in the U.S.-Iraqi dynamic but could create a security threat for them. The Iranians have done more than issue statements; they are threatening to unleash a Shiite uprising -- something that has not happened throughout U.S. forces' involvement in Iraq. Obviously U.S.-Iraqi talks should be watched, but more importantly, we should keep an eye on any signs of renewed U.S.-Iranian contacts because both Washington and Tehran are posturing and do not seek a confrontation.

6. U.S.-Pakistani relations: A U.S. military strike in Pakistan's northwest tribal belt struck a Pakistani military border post and killed 11 soldiers, including an officer. The two sides have agreed to jointly investigate the matter, but Washington's position has been that it struck at hostile forces and the strike was in line with standard operating procedures. This incident clearly shows that Washington's attitude towards Islamabad has entered a new phase where U.S. forces will engage in routine overt military actions -- something Stratfor had forecast for some time. The thing to watch is the reaction from not just the Pakistani street but the state, especially the army.

7. Chavez's difficulties: Chavez reversed himself on three policies: his stance on the Revolutionary Armed Forces of Colombia, a new tax and a new intelligence law that would have required citizens to spy on one another. In the past he has been enormously surefooted. Last week he seemed to be behaving like a man under a great deal of pressure from all sides who had engaged in some pretty careless politics, got burned and retreated. He seems to be weakening. Venezuelan state-owned energy company Petroleos de Venezuela's inability to pay its contractors bodes ill for the company's ability to keep funding Chavez's social programs. Without that support, Chavez is in trouble. We need to keep watching for cracks in Chavez's party as the November local elections approach. Ongoing dissatisfaction with Chavez could give the opposition the fuel it needs to pursue change.

8. Asian economies: Vietnam is having economic problems. Not important in itself, unless like the Thai bhat in 1997, it signals deeper problems. We see issues in Korea and elsewhere. Asia's economies have always appeared to be shakier than others to us. Let's evaluate our position based on these rapid developments.

Your Guided-by-Intelligence-Voices-Analyst,

John Mauldin

What the Export Land Model Means for Energy Prices

John Mauldin — Mon, 19 May 2008 22:10:00 GMT

Goldman Sachs recently forecasted that oil would be at $141 a barrel by the end of the year, and rising to $200 a barrel in the not too distant future. I have seen other forecasts calling for oil to slip significantly under $100 a barrel before starting yet another bull market.

I have written for years that we are not going to run out of oil or energy, just cheap oil. I was just in South Africa, where much of their gas and diesel comes from coal gasification. At one time this was an expensive way to make gas, and South Africans had to pay more for their gas than the rest of the world. Now, it is getting close to "par" to the cost of gas in the US, and is cheaper than gas in Europe.

In this week's Outside the Box, my friend David Galland at Casey Research presents some very troubling thoughts on why oil may rise higher than we think in the next few years. Many of the countries from which the US gets its oil are seeing production fall, not rise. Some of it is political ineptitude, but much of it is from oil production peaking.

Yes, we can move to coal gasification, and the US has centuries of coal for such purposes, but building such plants takes time and capital and political will, the latter of which is in short supply. In the meantime, and until we get a full-blown crisis, oil is going to continue on its path to $200 and higher. But such a rise will not only make gasoline prices higher, it will make a host of new technologies competitive for the first time. The shift in how we make energy is inevitable.

As a quick aside, if we would start a project to build a massive nuclear infrastructure, such as in France, which produces 80% of its energy from nuclear, while at the same time pushing ahead in a Manhattan-type project the development of electric cars (or some hybrid), we could reduce our dependence on foreign oil and lower travel costs by the middle to the end of the next decade. And the environment would be cleaner and safer.

We are headed to such a future. It would be nice if we did it sooner rather than wait for a real crisis. But in the meantime, the price of oil is going to rise and opportunities for investors will rise along with it. My friends at Casey Research publish an excellent newsletter highlighting the opportunities not just in exploration companies but in all manner of energy-related firms. As David writes:

"The good news is that there are no shortage of high-quality energy-related investments available ... in coal, heavy oil, LNG, photovoltaics, natural gas consolidators, "run of river" hydroelectric, uranium and small to mid-cap oil companies with the potential for significant near-term gains in reserves or production."

They have agreed to give my readers a risk-free three-month trial to the Casey Energy Speculator. If you like the research you read below and want more of it, you can click on this link and subscribe.

And now let's see one of the main reasons why the price of oil is going up.

John Mauldin, Editor
Outside the Box

What the Export Land Model Means for Energy Prices

By David Galland,
Managing Director
Casey Research - Casey Energy Speculator

Jeffrey Brown is someone you should know. That's because he can help you understand today's high energy prices and that, as an investor, can make you a lot of money.

I'll introduce to you to Jeff Brown in a moment. But first, as it's relevant to the discussion, I want to touch on an important concept related to investing in challenging times.

You might call it "the Davy Crockett principle" in honor of something that American icon said during the War of 1812: "Be sure you are right and then go ahead."

Simply, it's critical to step away from all the noise and clutter that passes for knowledge on the financial talk shows, and take the time to be very sure you are investing in close concert with a powerful unfolding trend. That accomplished, come what may, you'll come out okay once the dust has settled.

And the earlier you can get on board with a trend, the more money you can make.

In fact, Casey Research chief economist Bud Conrad has shown how, by making just four trades over the last four decades -- into exactly the right sector at the beginning of a strong new trend -- you could have turned $35 into $150,000. Or $350 into $1,500,000 ... or $3,500 into $15 million. And that assumes you don't use leverage. Toss in some options or futures and the returns run exponentially higher. Here's the chart.

While it is unlikely anyone actually made those exact trades, it is a certainty that many investors got in early on one or more of those big moves.

(Interestingly, replacing the last trade -- the move into crude -- with gold produces a final number of $131,496. Proving there is more than one path to the top.)

The key point I'm trying to make is simple: focusing your investments on big trends is a big leg up in your quest for investment success. By then digging in to find the right opportunities, whether they be in commodities or undervalued companies that benefit from those trends, assures you earn returns that are well above average.

More importantly, in the context of the current market environment, the combination of the right investment in the right trend makes your portfolio bullet-proof.

Which brings me to the work being done by Jeffrey Brown, a professional geoscientist with an avid academic and professional interest in something called the Export Land Model.

Turning off the Taps

You don't have to have an awful lot of gray hair to remember the excitement around England's massive North Sea oil fields. While discovered in 1969, it wasn't until well into the 1980s, on the back of surging oil prices, that the fields came into full production. Turning up the taps, the United Kingdom (as well as Norway and Germany, who also have North Sea production) became a significant exporter of oil.

But then, in 1999, something happened: the UK's North Sea production hit peak ... that tipping point after which reservoirs go into decline, setting in motion both reduced production and progressively higher costs related to extracting the remaining oil.

While the experience of North Sea oil production provides yet another useful example of the validity of the Peak Oil theory, what concerns us today is a critical but usually overlooked aspect of the discussion, exports.

At the time the North Sea peaked in 1999, the U.K. was exporting 1 million barrels of oil per day. By August 2004, it had become a net importer. What happened to cause the situation to turn around so quickly?

The Export Land Model

To understand the importance of exports when discussing peak oil, ask yourself the question, "What's more important: the fact that global oil production is falling ... or that the oil-exporting nations are cutting off their exports?"

While the two questions are clearly linked, it is the nuance of the export question that clearly matters the most. Especially if you live in a country such as the US, which currently imports about 70% of its oil.

Which brings us to the Export Land Model (or ELM, as I will refer to it from here). The basic thesis expressed by Jeff Brown and other students of the ELM is that, to fully appreciate the impact of peak oil, you cannot look only at the production declines so presciently anticipated by MK Hubbard in 1956. You also have to look at the rate of local consumption and the effect of that consumption on the ability of a country to export its oil.

The following ELM graph looks at both sides of the equation, and the result as it applies to exports:

As you can see, for illustrative purposes the ELM assumes that, after a country's oil production hits peak it will decline at a rate 5% annually, at the same time that local consumption increases by 2.5%. The dotted red line then shows the impact those two metrics will have on the ability of the country to export its excess production. Using these assumptions, the ELM shows that exports reach zero in 9 years.

Real-world data shows that the metrics used in the ELM are quite conservative. The chart below plots the hypothetical ELM against the actual data from the United Kingdom and Indonesia. While the ELM forecast hypothesizes 9 years between peak to the end of exports, Indonesia's exports ceased 7 years after peak, and the UK's exports stopped just 6 years after peak.

The important take-away here is not that the UK and Indonesia are no longer receiving the oil export income of the good old days -- that is entirely a localized concern.

Rather it is that the global market is now deprived of those exports; between UK and Indonesia alone, the change over just the last decade amounts to a swing in the wrong direction of a total of 2 million barrels per day. And those are just two of a number of important countries which have swung from exporters to importers in recent years.

China, for example, became a net importer in 1993, the result of flattening production against skyrocketing consumption. Over the last decade alone, China's oil consumption has almost doubled, to about 8 million barrels a day, about half of which is now imported.

So, again, while people tend to focus on production, they are overlooking the impact on exports forecasted by the ELM. In the case of China, they went from a net exporter in 1993 to importing 4 million barrels a day today ... with those imports projected to rise another 50% over the next 10 years.

This is what is creating so much international competition for the remaining supplies of oil. And why the trend to higher energy prices is so well entrenched. And if the ELM is right, things are about to get far worse ... far sooner than most people expect.

The #3 Source of Oil to the US Is About to Go Offline

Mexico provides about 14% of the oil the US imports. On any given day that makes it either the #2 or #3 leading source for US oil imports after Canada and Saudi Arabia. Given that the US currently imports close to 70% of its oil needs, the Mexican oil is critical.

But here's the thing. Using straightforward ELM calculations, Jeffrey Brown is confident that Mexico will ship its last barrel of oil to the United States -- or anywhere else, for that matter -- about 6 years from now, in 2014. In a recent interview with Brown, I asked about this forecast.

"Mexico was consuming half of their production at peak in 2004. And if you look at the '05, '06, '07 data, they're basically on track, on average, to approach zero net oil exports no later than 2014," he confirmed.

Of course, the US is completely unprepared to replace this source of oil, especially considering the growing stresses on global oil supplies causing by ballooning demand from emerging markets. That means the international competition for available supplies is only going to get more desperate in the months and years ahead.

What will this mean to oil prices, according to Brown?

"From this point out I think we'll see a geometric progression in prices ... you know, $50, $100, $200, $400, whatever. The only question now is how short the periods will be between prices doubling again."

Coincidentally, while this report was in preparation, on April 30, 2008, PEMEX, Mexico's national oil company, announced it would be unable to fulfill this year's scheduled oil export obligations to the United States ... falling short by about 11%, or 184,000 barrels a day.

(As an aside, I also have to believe that Mexico's coming transition to a net importer and the loss of almost 6% of the country's GDP, now earned from exporting oil, will trigger serious social issues in that country. But that is another story for another day.)

The Even Bigger Picture

In my interview, I also asked Jeffrey to share his thoughts on the situation globally. Here's his response.

"Global production peaked in 2005, and we're now into the third year of decline. And the critical point to keep in mind is, our model and case histories show that the decline rate accelerates, year by year. Using the Lower 48 in the United States as an example, you can see the annual declines going 2%, 3%, 5%, 7%, 10%, 15%, 20, on and on. So it's an accelerating decline rate."

Underscoring Brown's concerns:

On April 15, 2008 the Russians, the world's second largest oil exporter, announced that their oil production appeared to have peaked, with production in the first quarter of this year declining for the first time in a decade. If they have indeed peaked then, based on the ELM, the world could lose Russia's current ~7 million barrels a day in exports within 6 to 9 years.
Echoing the baseline premise of the ELM, Herman Franssen, president of International Energy Associates, projects that Iran, the world's fifth largest exporter, may consume an amount equal to their exports by 2015. A prominent oil analyst, the late Dr. Ali Samsam Bakhtiari, estimated that Iran is either at or near peak.
Most concerning, this April Saudi Arabia's King Abdullah announced they were not going to raise oil production above 12.5 million barrels a day. Commenting on the news, Tom Petrie, vice president of Merrill Lynch, said

"King Abdullah's quote speaks to the fast-emerging reality of what I call 'practical peak oil.' The Saudis and other exporters are placing a new emphasis on elongating the petroleum exploitation and depletion cycle. This stems from a growing awareness of the challenges of conventional resource maturity, as well as rising resource nationalism. This is likely to result in an earlier occurrence of global peak oil output than many consumers yet recognize."

Summing it up, Brown told me that "The reality is that this thing is coming so much faster and so much harder than even most pessimists were expecting."

Rice & Oil: a Useful Comparable

For a useful way to think about energy exports and prices, Jeff Brown points to the current situation with global rice supplies.

As long as there are abundant local supplies, countries are happy, eager in fact, to export excess production in order to generate foreign exchange. But as soon as local consumption exceeds locally available production, then all hell breaks loose, and the next thing you know countries are banning exports, a move that has already been undertaken by Vietnam and a number of other countries.

In that scenario, price is eventually no longer a factor in the availability of the commodity. Vietnam, for example, is not going to let its people starve just because higher global prices would allow it to earn an extra $10 per bag of rice.

And so in the face of the prospect of any serious shortage of an important resource -- energy being maybe the most important - export markets freeze up and the price begins to be set at the margin, literally based on a global competition for the dwindling supplies that manage to leak out around the edges.

"People are crazy not to be focusing on the oil export situation," Dr. Brown told me.

Any White Knights on the Horizon?

Of course, the question of energy alternatives is a big topic and one which needs a far more extensive discussion than space allows for here.

Will viable alternatives be developed to help mitigate a domino collapse of oil exports? Absolutely. Of those alternatives, nuclear, solar, and heavy oil seem to hold the greatest promise.

But the sheer scope of the problem - with the world now consuming the energy equivalent of 1 billion barrels of oil every 5 days - assures that we are probably decades away from a real solution.

In the words of Jeff Brown:

"If you look at the situation in US presidential terms, looking at fossil fuels plus nuclear, the world burned through the equivalent of 10% of all oil ever consumed in Bush's first 4-year term. And, in our model, we're going to burn 10% of all remaining conventional crude in the second 4 years of Bush's term.

"That is the equivalent of around 25 billion barrels a year. So that's 100 billion barrels every four years, and we've burned 1,000 billion barrels. It gets interesting when you consider that current estimates are that we've only got 1,000 billion barrels of conventional crude remaining. I think with natural gas liquids, we've got a little bit more. But of the conventional crude oil, we've got 1,000 billion remaining. Which then begs the question, how fast can we bring on the tar sands and everything else?"

Grasping for straws, I asked Jeff about an article I had read recently about the Bakken oil shale reserves around North Dakota.

"They're talking about somewhere between 200 billion and 500 billion barrels in situ, but the USGS recently came out with a mean estimate of between 2.5 and 4.4 billion barrels recoverable, as an outer limit," he replied, before continuing:

"In 1966 they said, if Lower 48 ultimately recoverable is 150 billion barrels, then the US would peak in 1966. If the recoverable oil from the Lower 48 ultimately came in at 200 billion barrels, then the US peak would come in 1971. The higher-end estimate probably turned out to more accurate, and the U.S. peaked in 1970. But the point is this: a one-third increase of estimated ultimate recoverable - a total increase of 50 billion barrels - postponed the peak by all of 5 years."

Rigging for Persistent High Energy Prices

The trend for sustained higher energy prices appears solidly in motion. If Brown and the ELM are correct, energy prices will double, then double again.

Even if he is wrong and prices don't rise geometrically, the global dogfight to replace declining supplies - decidedly exacerbated by the loss of Mexican and maybe Russian (and ??) exports in the near future - is going to get ugly and expensive.

So, what's the investment angle? Paradoxically, the larger energy companies are probably a bad bet, because they are forced to replace their depleting reserves, which is getting harder and more expensive to do with each passing day.

It is our contention that, because the solutions to the world's energy problems are going to involve a variety of energy sources and technologies, you have to build a portfolio that is equally varied.

That assures you are well positioned to profit from the broader trend, while avoiding the risks of being overly exposed to a single sector. (As an example, solar has had a great run, but most solar plays are now overvalued.)

The good news is that there are no shortage of high-quality energy-related investments available ... in coal, heavy oil, LNG, photovoltaics, natural gas consolidators, "run of river" hydroelectric, uranium, and small to mid-cap oil companies with the potential for significant near-term gains in reserves or production.

In the final analysis, it comes down to two choices: you can either suffer the consequences of persistent higher energy prices, or use the work Jeffrey Brown has done with the Export Land Model as an early warning and get positioned to profit.

The decision is yours, but don't wait long to make it.

David Galland is the Managing Director of Casey Research, publishers of the Casey Energy Speculator, a comprehensive newsletter dedicated to helping individuals and institutions uncover today's most undervalued and compelling energy investments. A no-risk three-month trial subscription is available that allows you to access all current recommendations and to decide for yourself if the service is right for you. Learn more by clicking here now.

Your believing the cure for high prices is high prices analyst,

John Mauldin

Food for Thought

John Mauldin — Wed, 14 May 2008 22:10:00 GMT

What countries are truly the have and have nots of the world? Good friend and business partner Niels Jensen of Absolute Return Partners suggests we look at the old equation in a new way? Food and energy resources may be at least part of the definition in the future. In this week's Outside the Box we continue a them I mentioned a few weeks ago: agricultural needs are going to be a new and important force in the world and when coupled with energy may shift the balance of power in the world in strange a different ways.

When, as Niels points out, Afghanistan poppy farmers are shifting to wheat farming, the world is truly a different place. I think you will find the research he has done to be truly worth a few minutes of your thinking time.

And as a preface, I was reminded a little while ago that a Financial Times headline story last Friday mentioned that China is buying African farmland and building massive amounts of railroads and infrastructure to get grains to the market. I have long been bullish on African farmland. This week's OTB will tell you why.

John Mauldin, Editor
Outside the Box

The Absolute Return Letter

May 2008

"There is nothing so disastrous as a rational investment policy in an irrational world."

John Maynard Keynes

You just know that something is astray when Afghan poppy growers begin to switch from opium to wheat. According to the Independent newspaper here in the UK, that's exactly what is now happening. I have no desire to enter into a pound for pound risk/reward analysis of producing wheat versus opium. However, the consequences of the rapid rise in energy and agricultural commodity prices are far reaching and perhaps not as well understood as they should be. That is the content of this month's letter.

The Silent Tsunami

My story begins with Al Gore. While most of us lulled ourselves into the belief that he was onto something when he tried to convince us that global warming (or climate change, as I prefer to call it) was the most formidable challenge facing this planet, a silent tsunami¹, also known as the global food crisis, began to develop and is now threatening to undermine global political and economic stability, the latter of which has been key to the benign financial markets we have all benefited from in recent years.

According to the World Bank, just over 1 billion people live on one dollar or less per day. People in the poorest countries in the world spend 80% of their income on food. So when you and I have hardly noticed that the bread we pick up from the local bakery has doubled in price over the past year, it is because only 10-15% of our budget is spent on food items². In many emerging economies the number is much higher. Chinese consumers spend 28% of their income on food. In India it is 33%. If you want to know how much it is in your country, go to:

http://www.ers.usda.gov/briefing/cpifoodandexpenditures/data/2006table97.htm.

There are three food staples in the world today which dwarf all other food ingredients in terms of importance. They are (in alphabetical order) corn, rice and wheat. As you can see from chart 1 below, they have all experienced rapid price appreciation since last summer. What is it that has driven this price explosion and what does it mean to financial markets? As with most things in life, there is no simple explanation; a number of factors have conspired to create a situation which is exceptional but also destabilising and hence dangerous.

It Is The Bio-Fuel Policy Stupid!

The explanation given by most commentators is the bio-fuel policy currently being pursued by the Bush administration in Washington. The policy is driven by a desire to unlock the United States from its rising dependence on imported crude oil. The problem, as Bush and his government have been slow to recognise, is the stupidity of the policy in its current form. Let's back that claim up with some hard facts.

In the United States, corn (better known as maize over there) is the primary ingredient in ethanol production although wheat and soybeans are also used. According to a recent UN report, it takes 232 kg of corn to fill an average 50 litre car tank with ethanol - enough corn to feed a child for an entire year. It is estimated that almost 20% of total US corn production will go towards ethanol this year and the number is set to rise to 45% by 2015³.

The problem with corn is that it is low on carbon hydrates, which is where the energy comes from. Instead, American ethanol producers rely heavily on fertilisers with the energy being extracted from the nitrogen in the fertiliser. This is an inefficient and very costly approach - in particular in an environment of rising energy prices because crude oil and/or natural gas are major ingredients in fertiliser production. 33,000 cubic feet of natural gas are required to produce just 1 ton of ammonia!

So what does all this mean? According to estimates from Goldman Sachs, the cost of ethanol from corn is now over $80 per barrel, it is about $145 from wheat and over $230 from soybeans. Other countries recognised this problem a long time ago and use crops with higher carbon hydrate content. In the Philippines they use coconut oil and the Brazilians use sugar cane. Goldman reckons that the cost of one barrel of ethanol based on sugar cane is about $35. So why not import sugar cane from Brazil instead of using corn? One simple answer: Brazilian farmers do not vote at American elections. Idaho farmers do.

Are Investors To Blame?

There is no question that the US bio-fuel policy which, by the way, is now being copied in other parts of the world including the EU, has to take its share of the blame. But it is by no means the only reason for the food crisis. The next culprit on my list is our very own industry - investors of all kinds. In recent years there has been rising demand for commodity-linked investment products from investors all over the world. Pension funds, hedge funds, mutual funds and private investors have all allocated more and more to commodities and, in recent months, demand growth has been explosive, as is evident from chart 2 below. It is estimated that the aggregate value of commodity-linked index funds now exceeds $200 billion, a very significant number in a not very large market.

For those of you following the market for exchange traded funds (ETF), you will have noticed that not a day has passed in recent months without yet another new commodity ETF being launched. Since the issuers of these ETFs do not want to take any risk on their books, all these ETFs are hedged - typically through commodity futures. In other words, every time you buy a commodity ETF, you contribute to the continued rise of commodity prices and hence inflation.

For that very reason, it is possible - but not a given - that much of the recent rise in commodity prices is based more on market technicalities than on fundamentals. If so, this could be the next bubble waiting to burst. We continue to hear stories about institutional fund managers being overloaded with commodity futures but have found limited hard evidence so far.

Water Shortages Are A Problem

Water is next on my list. Australia - one of the world's largest grain producers - suffered badly last year due to severe drought with its wheat harvest being only 50% of the prior year's output. However, water, or rather lack thereof, has played havoc in more ways than one. In China, water depletion is a serious problem and the problem is exacerbated by top soil erosion and poor fertility. China has an estimated annual water shortfall of 40 billion cubic metres. Closing that gap through artificial means (desalination, etc.) would consume the equivalent of 3% of the world's oil output.

Until recently China has been one of the world's major grain exporters. Those days are now over. By 2010 China expects to import the equivalent of 40% of US corn exports. According to estimates from UBS, China's foreign currency reserves, which are the largest in the world, could be slashed in half over the next few years if grain prices were to double again from current levels. As an aside, China has recently decided to abandon its bio-fuel programme. The reasons? A lack of water and cost inefficiencies.

In Saudi Arabia, a country of 28 million people, water depletion is a serious problem. Estimated recoverable water reserves are now less than 10 years and falling rapidly. For that reason, the Saudis have decided to wind down their domestic agricultural industry. Historically, the Saudis have been self sufficient on food. They now say that they will import 100% of their food requirements by 2016.

Have We Been Complacent?

Number 4 on my list is complacency. Al Gore (yes, him again!) seduced us all into focusing on the climate. Many a government agency around the world took its eyes off the ball and allowed food stocks to deplete. US wheat inventories, for example, are now at the lowest level since 1947/48 when the US population was only half the size it is today.

Similar problems have caused panic buying in the rice market in recent weeks where stocks are at the lowest levels since 1976. 3 billion people in Asia and Africa rely on rice as their primary food staple. Governments in India, Thailand, Vietnam, Argentina, Cambodia, China and Egypt have all imposed export controls in order to secure domestic needs. The World Bank is so concerned about the situation that it now predicts food riots in more than 30 countries around the world.

Productivity Levels Are Falling

Number 5 and 6 on my list are closely related. The total amount of arable land in the world is diminishing, primarily as a result of urbanisation. China alone has lost 3 million hectares of rice land to concrete in the past 10 years. In order to compensate for the reduced acreage, higher productivity levels are required. But higher yields require increased use of fertilisers which is not an option available to everyone given the price of oil. In some parts of the world, for example in Africa, there is now evidence of farmers planting less than in prior years as they cannot afford fertilisers. Falling yields are not a new phenomenon, though, as you can see from chart 3.

In one of the largest grain producing areas of the world - the former Soviet Union - the total acreage planted has dropped 12% since the iron curtain came down. The 3 largest producers in the area all suffer not only from reduced acreage but also from low yields compared to western standards. In Kazakhstan, grain yields are 1.1 tonnes per hectare, in Russia they are 1.8 and in the Ukraine 2.4. US grain yields, by comparison, are 6.4 tonnes per hectare⁴. The good news is that there is plenty of land available in places like Russia and Kazakhstan. The bad news? Experience suggests that it will take about 10 years to turn non-farm land into fertile farm land.

The Meat Culture Prevails

The final factor has to do with changing eating habits. This phenomenon has received its fair share of the blame in the media in recent months, but I actually think this is more of a concern for the future than a reason why food prices have exploded in recent months. Eating habits do not change overnight. At the macro level, a changing diet takes years to materialise. Having said that, there is clear evidence that Asia's growing middle classes are switching to meat based diets. If the rest of Asia were to follow Japan's example, the protein intake across Asia will explode over the next couple of decades. The Japanese are consuming almost 10 times as much protein as they did 50 years ago. Why is that a problem? Because it takes over 3 kg of corn to produce 1 kg of pork and over 8 kg of corn to produce just 1 kg of beef!

So What Does It All Mean?

There are very good reasons to believe that high food prices will stay with us for quite some time. Yes, there may be some elements of speculation behind the recent explosion in grain prices, maybe even hints of a bubble, but underlying supply and demand factors are such that we'd better get used to lofty food prices for years to come. That has implications for financial markets left right and centre (finally I get to what this actually means!).

The analysts at Goldman Sachs have calculated the effect rising food prices have had on overall consumer prices (see table 1). The conclusion is inevitable. Whereas in most OECD countries the feedback process between food inflation and non-food inflation is modest, in virtually all emerging economies the feedback is significant. Secondly, non-food inflation is most affected by high food inflation in countries with high inflation rates such as Russia, Indonesia, Argentina and Mexico (see chart 4).

This is an important observation because the investment community is almost universally in favour of emerging markets these days. Rarely have I experienced a period where the bulls have been more plentiful and the bears fewer and farther between. Most investors seem to believe that headline inflation will gradually come back to core inflation levels over the next year or so. Few investors seem to think the unthinkable - that core inflation will gradually rise to headline levels.

Asia May Pay A High Price

Even fewer seem to realise that if oil prices and agricultural prices continue to run amok, the Asian miracle story, upon which so many investors have pinned their hopes for the next few years, may, in fact, turn into a nightmare. The reason is simple enough. Asian countries are large importers of both oil and food staples. Very large!

To give you an idea of the appetite for oil in Asia, take a look at chart 5. As you can see, over 50% of the incremental global demand for oil over the past few years has come from Asia - almost 35% from China alone. In fact, over the last 5 years, China's energy consumption has grown 5% faster than its GDP per year. Yes - per year!

It is now projected that China will overtake the US as the world's largest energy consumer by 2010 despite its GDP being only 1/5 the size of the US GDP. No wonder the Chinese are running around in obscure parts of the world attempting to secure long term crude oil deliveries.

Based on the current crude oil price of $112, and an estimated average price of $64 over the course of 2007, I have calculated the net gains and losses to oil exporters and importers (see table 2). Not surprisingly, the Middle Eastern producers stand to gain the most - $333 billion of incremental revenues - but African producers and Russia also stand to benefit significantly. On the import side, Asia is paying the highest price. The current level of crude oil prices should add about $278 billion to the bill over and above what Asian countries paid for their oil imports last year.

Rising agricultural goods prices, although significant, are not having the same aggregate wealth effect as rising oil prices. In table 3, I have estimated the added cost of rising food prices from importing the three main food staples. Again you will see that rising prices are hitting Asia the hardest. Remember table 3 only looks at the import of raw materials. The effect from rising prices on processed foods is not included.

Neither does table 3 do any justice to the damage done at the micro level. Of the 3 billion people who rely on rice as their primary source of food, over 2 billion live on $2 or less per day. The recent price jump spells disaster for these people and could potentially cause massive economic dislocation throughout Asia. Riots are now a real possibility in many of these countries.

As far as the investment story goes, here is the problem. The prevailing view today is that the western world is yesterday's story and that the best way to ensure continued high returns in your portfolio is to focus on emerging markets - in particular Asia. The argument runs approximately as follows:

The Consensus View

The OECD area (the old world) is plagued by a rapidly ageing population with all the negatives that follow - rising health care costs being the most important. Many OECD countries also have unfunded pension liabilities and large budget deficits, raising serious questions about whether the 21^st century society can afford to maintain the retirement system as we know it today. Some even argue that structures such as the Euro are doomed because of dramatic discrepancies in performance within the Euro zone. Now consider the US dollar. The greenback is probably the most disliked currency in the world today (well, not taking the Zimbabwe dollar into consideration). If you buy these arguments it is no wonder that many investors shy away from the more established markets.

On the other hand, emerging markets - and Asia in particular - beam with opportunities. The population in most emerging market countries is still young, savings rates are high and the optimism is there for everyone to see. In short, it is exceedingly hard to find anyone who wouldn't agree that Asia offers the best growth prospects going forward. So overwhelming is this view that it is virtually impossible to find a single brokerage house, institutional investor, commentator, punter, etc. who doesn't advocate an overweight of Asian shares in equity portfolios.

Do Not Assume One-Way Traffic

While I agree that emerging markets offer better growth prospects than OECD countries, I disagree that it is going to be one-way traffic. As demonstrated above, rising commodity prices will hit Asia much harder than any other region in the world as it is in fact the only region in the world today which is a net importer of both crude oil and food staples.

In table 4 I have listed the largest holders of foreign exchange reserves in the world today. As you can see the list is dominated by Asian countries. All those investors who buy into the Asian growth story pin their argument either directly or indirectly on the size of these reserves. Growth requires investments; however, due to the high savings rates across Asia, and hence the plentiful reserves, the money is there to finance those investments without the countries becoming net debtors. What the argument does not take into consideration is that, at least in some countries, those reserves will be increasingly going towards paying for the rising cost of oil and food imports.

The 'haves' And 'have Nots'

Instead I believe investors will increasingly differentiate between the 'haves' and 'have nots'. And the 'haves' are those countries which control the world's resources. In fact, few countries are net exporters of both oil and foods on a large scale. Come to think about it, it is less than a handful. And no Asian country is on the list. So who is on it? In the old world only one - Canada. In the grey zone (emerging economies but not necessarily young and dynamic populations) perhaps two - Russia and Kazakhstan. And amongst full blooded emerging economies? Noone today, although Brazil has the potential to turn itself into a winner and so does Africa, if it can sort itself out.

All this is not to say that investing in Asia is doomed to fail. There are many good reasons why you want to invest there. However, the invest case is not as straight forward as it appears at first glance, and throwing in a bit of Africa, Brazil and/or Russia may not be a bad idea.

An Afterthought

For over 30 years, the world has had to suffer the consequences of OPEC - an organisation as keen to enrich its members as we in the Western world are hooked on its main produce - crude oil. Has pay-back time finally arrived? Should we be tempted to create OGEC - the Organisation of Grain Exporting Countries - with the objective of ensuring overall resource stability, i.e. food will only be exported to oil producing countries provided they deliver oil to us at a reasonable price?

The largest wheat exporters today are (in order of rank) the US, Canada, Russia, the EU, Argentina, Kazakhstan and Australia. Most of these countries happen to be net importers of oil. Is it unreasonable to apply a 'tit for tat' approach? My heart (as does my bank manager) tells me yes but my gut feel says no. The world has always been a better place when government interference has been kept at a minimum. The problem we face in this particular situation, though, is that not everyone plays by the same rules. If that could be fixed, the world would indeed be a better place.

Footnotes:

[1] A term borrowed with thanks from The Economist newspaper.

[2] Our food statistics come from the US Department of Agriculture and indicate that consumers in countries such as the UK and the US spend less of their income on food than consumers in other countries. This is due to the fact that take-aways and restaurant visits are not included in the USDA numbers. Adjusted for that, almost all OECD countries spend 10-15% of household expenditures on food.

[3] Source: The Daily Telegraph

[4] Source: The Daily Telegraph

Your thinking about agricultural opportunities in Africa analyst,

John Mauldin

Two Essays on the Continuing Financial Crisis

John Mauldin — Mon, 28 Apr 2008 22:00:00 GMT

This week in Outside the Box we look at two brief essays which give us different perspective on the Continuing Crisis. The first is by Mohamed El-Erian, the co-chief executive and co-chief investment officer of Pimco. His book, 'When Markets Collide: Investment Strategies for the Age of Global Economic Change', will be published by McGraw Hill in June, and it will be on my summer reading list. El-Erian argues in the thought-provoking piece from the Financial Times that the crisis is still far from finished, and that those who think we are returning to more placid times may be surprised when volatility suddenly becomes even more pervasive.

The second is by good friend and Maine fishing buddy David Kotok, the chief investment officer of Cumberland Asset Managers (www.cumber.com). He was recently in Africa where he met with the head of the central bank of a small country with headline inflation of 10%. The problem is that "core inflation" is 5% and food inflation is 15%, yet accounts for 50% of the GDP. He asked a group of financial thinkers (including your humble analyst) to ponder what that central banker should do. Do you set high rates and target overall inflation or set lower rates and not worry about food inflation.

Why should we worry about inflation in a small African country? Because the principles are the same, and it makes a real difference where the Fed comes down at the end of the day on this very question.

This week's reading should be very helpful and thought-provoking. I hope you enjoy this read as much as I did.

John Mauldin, Editor
Outside the Box

Why This Crisis is Still Far From Finished

By Mohamed El-Erian

During the past few weeks we have seen a growing number of market participants predict an end to the dislocations that erupted last summer and claimed victims throughout the financial system and beyond. While their predictions are understandable, they are premature. The dynamics driving the disruptions are morphing and may again move ahead of both the market and policy responses.

The optimistic view is based on two distinct elements. First, that the deleveraging process is reaching its natural end as valuations stabilize and institutions come clean about their losses and raise capital; second, that a series of previously unthinkable policy responses have been effective in restoring liquidity to the financial system.

Both views have merit. Financial institutions, particularly in the US, have recognized the scale of the problem and are taking remedial steps. Just witness the recent round of capital raising by Citigroup, Merrill Lynch, JPMorgan and Wachovia. At the same time central banks in Europe and the US have opened up their financing windows, expanding the size of the financing, the range of institutions that can access it and the list of eligible collateral.

Yet, consistent with what we have seen since last summer, the dislocations are entering a new phase. As such, bold reactions on the part of policymakers may, once again, prove to be too little and too late.

Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.

Economic data in the US have taken a notable turn for the worse. Most importantly, the already weakening employment outlook is being further undermined by a widely diffused build-up in inventory and falling profitability. History suggests that the latter two factors lead to significant employment losses.

Pity the US consumers. Their ability to sustain spending is already challenged by the declining availability of credit, a negative wealth effect triggered by declining house values, and a lower standard of living as the result of higher energy and food prices and a depreciating dollar. Job losses will accentuate the pressures on consumers, leading to income declines and a further loss of confidence.

While the financial system has taken steps to enhance balance sheets, they speak essentially to addressing the consequences of excessive leveraging and imprudent financial alchemy. As such, the nasty turn in the real economy may fuel another wave of disruptions that, this time around, would also have an impact on mid-size and smaller banks.

It is thus too early to declare the end of the turmoil that started last summer. Instead, during the next few months we may witness a new phase of dislocations, led this time by the real economy. The blame game will intensify; political pressure will continue to mount; momentum will build for greater and broader regulation of financial activities within the banking system and beyond.

The focus will also be on the reaction of policymakers. Here the outlook is mixed. The good news is that the crisis is now moving to an area where traditional policy tools are more effective. This is in sharp contrast to the situation of the past few months, where central banks were forced to use instruments that were too blunt for the purpose at hand.

But there is also bad news. The sharp slowdown in the US real economy will occur in the context of continued global inflationary pressures. As such, the Federal Reserve's dual objectives - maintaining price stability and solid economic growth - will become increasingly inconsistent and difficult to reconcile. Indeed, if the Fed is again forced to carry the bulk of the burden of the US policy response, it will find itself in the unpleasant and undesirable situation of potentially undermining its inflation-fighting credibility in order to prevent an already bad situation from becoming even worse.

It is still too early for investors and policymakers to unfasten their seatbelts. Instead, they should prepare for renewed volatility.

And our next essay:

Food Price Inflation, Monetary Policy & Financial Markets

By David Kotok

Suddenly food price inflation has become the premier hot topic. The media is now attuned to food issues including emerging market country riots.

In the US, the politicians are gearing up to castigate the speculators and blame everyone but themselves. They conveniently forget that they are the ones who passed the ethanol subsidy and they are the ones who appropriate taxpayer money to pay farmers not to grow crops. And so the political circus begins.

Notice how the three presidential candidates are silent on how the US ethanol subsidy has caused a food price explosion in grains. They avoid the issue of US policy starving many in the world. 1 billion very poor people sustain themselves on $1 or less a day. We have doubled the cost of their food.

Ethanol directly impacted corn which, in turn, also drove up maize. In addition, the substitution of wheat and rice are not easily occurring because of crop issues and concomitant price inflation in those items.

Well Cumberland is in the financial market and money management business. We eat food. We don't grow it and we don't process it. So let's try to inject some serious monetary policy issues into this media hysteria and political cacophony.

In the mature countries, food is a minor portion of the price index. And some of the food costs originate from eating out and some come from food processing. Processed food cost is heavily dependent on the inputs which are non-food items. Labor, machinery, transportation and distribution all come in to play. So in the mature countries we see that the food price inflation may be topical and attention getting but it is not a crisis.

Also, the major mature countries are mostly in food surplus. In the US we are very efficient in running our agriculture enterprise. We actually pay farmers not to till their soil. This is dumb. It occurs only because of our sorrowful Congress who has learned how to bribe the farm belt for votes at the expense of the rest of us.

In the US food has a 14% weight in the consumer price index. Compare that with Canada at 17%, the Euro zone at 16%, England at 11% and Japan at 25%. Only Japan lacks the fullness of food self sufficiency. Sure, food price inflation is important. But it is not the most important issue in these major economies.

The reverse is true for the emerging markets. In some of them the food price component is as much as half the price index. In a few it is above half. Since many of these economies are open to some degree, the importation of food price inflation is hitting them particularly hard. Some are responding with tariff adjustments. Others have actually embargoed food exports. Of course they ultimately make matters worse when they restrict world trade and in the end all suffer because of this protectionism.

What about monetary policy?

Here is where it gets difficult. We will admittedly simplify now and we acknowledge to our critics that we know there are second order effects and are ignoring them to make our point. In our view, monetary policy cannot easily and directly address food price inflation when the source of the inflation is in the raw food commodity. This is also true for energy costs when the source is in the oil or natural gas. The whole concept of "core" inflation vs. total inflation originates in this notion that monetary policy should be directed at the price level changes it can affect.

Let's get to the inflation problem in an emerging economy. Our example is imaginary for simplicity's sake. But it reflects characteristics that are very similar to many countries and regions in the emerging markets of the world.

We developed this simple and theoretical case study and then sent it to a number of economist friends. We suggested that following facts: the economy in question is a small and open emerging market. The food price component is 50% of the price index and is inflating at 15%. The non-food component is inflating at 5%. Thus the overall index is inflating at 10%. In this small and open economy, the main items in the food component are based on maize; therefore, the US ethanol policy which has raised the corn priced has also pressured an increase in the maize price.

Suppose you are the governor of the central bank. You have to set your policy interest rate. Do you base that decision on overall inflation rate of 10% or on the core inflation rate of 5%? Or are you going to confront the food inflation rate of 15%. Let's further assume that your economy is growing at a trend rate of 5% and all other aspects are in trend or neutral position. You have no negative output gap and no above trend pressures. Your only direct problem is what to do about inflation.

My economist friends who answered offered a suggested policy rate as low as 6% and as high as 13.5%. The answers were about equally divided and the respondents sample size is over 20. The distribution of answers was distinctly bi-modal. About half the answers were bunched in the lower range of 6%-8%; the other half were in the double digit area between 11% and 13.5%.

The divided views centered on whether or not to target food, ignore food, or blend policy. No one wanted to set the interest rate above the 15% food price inflation. Nearly all acknowledged that this central bank would have difficulty in communicating whatever it decided. Most respondents worried about changes in inflation expectations because of the complexity of this issue. Most believed the citizens in the country would not understand the monetary policy dynamics that led to the decision.

Some worried that setting the policy interest rate in double digits would impose a very high financing cost on the non-food portion of the economy and cause it to go into recession. They argued that the real (inflation-adjusted) rate of interest for that non-food half of the economy would be 7% or so. That would set the threshold of finance too high.

Others argued that the monetary policy expectation effect would cause the rate of inflation to accelerate if the policy rate was not set in double digits. They were willing to take the recession in the non-food area in order to keep inflation expectations under control. No one mentioned substitution effects. Perhaps that was overlooked. Or it may be because rice and wheat are not easy cultural substitutes and those grains are each experiencing their own price pressures.

In sum, almost two dozen folks with some monetary economics expertise were equally divided on this technical question. It is a question that impacts billions of citizens in this world and many countries, their governments, their currencies and, possibly, their political stability.

We do not know the correct answer. Our view would support the lower interest rate and we would focus on the non-food portion of the economy but we can argue the other side with equal vigor. For us a lot would depend on how the food price inflation spreads into wages and if it could trigger a broader wage/price spiral.

In many respects this question is now being asked of the major and mature economy central banks as well. It appears that the European Central Bank (ECB) favors the higher mode while the US Federal Reserve is positioned in the lower one. For the emerging markets it appears that there is quite a mix of policy and that it is made more complicated by the management of each currency's foreign exchange rate. In sum, our simple case study is actually quite complex when applied in the real world.

David R. Kotok, Chairman and Chief Investment Officer

I trust you enjoyed this week's Outside the Box. And for the record, I thought rates in our hypothetical African country should be at the lower end. Targeting food inflation with high interest rates would hammer the productive, job creating portion of the economy. I have been to 15 countries in Africa and they are in desperate need of jobs. Better to target inflation through control of the money supply and encourage capital formation and foreign direct investment. But it is a tough question.

Your glad I don't have to be a African central banker analyst,

John Mauldin