A Floor Under the Price of Oil (and Gas)

This article demonstrates what we have always discussed regarding the floor on the price of oil. As compared to the early 80s when relatively high prices encouraged exploration around the world for easy to develop oil glutting the market, new discoveries are in hard to reach places, like 10,000 to 20,000 feet under the ocean. Even though the discoveries in deep water the past few years add to the known world oil supply, they will not get developed at lower (current) prices. This means we are stuck with the lower cost reserves that are dwindling around the world.

The Alberta oil fields are relatively inexpensive to develop and produce. They are generally profitable at $30-40 / barrel, depending on the formation and the oil quality (the amount of stimulation required to get it out of the ground). The really cheap oil that is profitable at $10 / barrel is just about gone in North America (light sweet crude near the surface, like West Texas crude, or "Jed Clampett" crude as I call it). So, when you hear people talk about oil going back to under $20 / barrel, they really don't know what they are talking about.

Some of the more adventerous or less proven drillers are not a good idea right now. But PWE, PVX and PGH have very good operations that don't have many questions.

Also, see www.mcdep.com for his educated opinions on the status of the oil market.

I have attached an article from Barrons Online titled "The Downturn's Impact on One Oil Driller, Callon Petroleum gets a downgrade after it blames economy for decision to terminate project."

"The Downturn\'s Impact on One Oil Driller";

CALLON PETROLEUM (Ticker: CPE) announced that it has decided to indefinitely suspend development of the Entrada field, located in the deepwater Gulf of Mexico. Management cited the recent collapse in oil and gas prices and higher-than-expected development costs as the reasons for terminating the project.

To date, Callon has successfully drilled two exploration wells at this field. The third well recently reached a total depth of 21,100 feet but needs to be sidetracked.

In March 2007, after owning 20% of Entrada, Callon acquired the remaining 80% interest from BP PLC (BP) for $150 million. Subsequently, in the first quarter of 2008, Callon sold 50% of the field to Japan's ITOCHU Corp. for $155 million, with Callon remaining the operator. At the time of the divestiture, Callon estimated Entrada's development costs to be approximately $300 million.

At year-end 2007, Entrada had an estimated 192 billions of cubic feet equivalent (Bcfe) of proved reserves (a total of 339.6 Bcfe of proved plus probable reserves). After adjusting for the divestiture, Callon's pro forma year-end proved reserves were 168 Bcfe. Therefore, approximately 57% (96 Bcfe) of the company's total proved reserves are now uneconomic in the current commodity price environment.

The field was expected to begin initial production in the first half of 2009. With the project now halted, we are lowering our earnings estimates, and our proved net asset value also decreases accordingly. Entrada was expected to double the company's production rate, and without this new source of cash flow, Callon will likely be forced to make major cuts in its capital budget for 2009.

After two years of planning, the suspension of the development of this large asset is a very negative event for the company. Ultimately, Callon may have the opportunity to divest its remaining interest to a company that has the balance sheet to see the project through to its conclusion, but in the near term, Entrada's economic value has diminished considerably. Based on the potential for a large reserve write-down, the minimal visibility on production growth, and the uncertainty about the company's post-Entrada operating strategy, we are downgrading Callon Petroleum shares from Market Perform to Underperform.

Paul McCullough Proclaims the Fed on the Right Track

Check out this morning's CNBC appearance by Paul McCullough. He is one of PIMCO's three leaders, that includes Bill Gross and Mohamed El-Erian (who left PIMCO to be Harvard Trust Fund's manager of $38B, but came back to PIMCO and is highly respected). The three of these guys don't get it wrong too often.

http://www.cnbc.com/id/15840232?video=938759900

So, if we are in for a period of stabilization due to the pouring on of liquidity into our financial system, and then due for some significant inflation to pay for all that stimulation needed to save the financial system and home values, we should be positioned accordingly with our portfolios. And because this has been our thesis for the past year or more, we are.

But I never thought we would go through this severe a deflationary recession to get to the expansionary inflation; only talked about it as a remote possibility since I thought the Fed / Treasury knew enough history to avoid it. Bernanke undoubtedly does. But don't underestimate the ability of the Congress to get in the way of solving our national problems. They have no trouble getting us in (way too loose regulation on lending / banking and way too socialist in home lending policy), but want to find someone else to blame when the stuff hits the fan (I am thinking of a certain Sen. Barney (Fife) Frank).

Thinking about how to lever up at these depressed stock price levels leads me to two of the Proshares ETFs: DIG and UYM. Both use leverage to get 150% of the Dow Sector index. Here is a sampling of their holdings and performance (naturally, miserable the past few months):

UYM

http://profunds.com/ProFundsProfiles/FundID_402/Basic_Materials/Profile.fs

DIG

http://profunds.com/ProFundsProfiles/FundID_413/Oil_and_Gas/Profile.fs

Off the Charts Bad

The past week has brought the stock market, actually all investing markets, to the worst place they have been, by many measures, in recorded history. This is actually encouraging. If it is this bad, how much worse can it get? And we are all still standing, so we should congratulate ourselves for that not-so-minor accomplishment.

How bad has it been? From today's Barrons, here are some quotes from Michael Santoli:

"The virtually unwitnessed level of damage in a short period almost defies hyperbole. After Thursday's drop to an 11-year low on the S&P 500, the index was farther below its all-time high than at any time since 1949. The year 2008, had it ended then, would rank as the worst since 1872 at least. The S&P hadn't been as far below its 200-day average since 1932. Nearly 40% of S&P 500 stocks were below $4 billion in market capitalization, the minimum new stocks must meet to be added to the index. More than 40% of the stocks in the Russell 3000 were trading below $10."

"Investment-grade corporate bonds have outperformed stocks since 1980. The S&P 500's indicated dividend yield rose above the 10-year Treasury yield for the first time since around the time the Giants and Colts faced off in their classic 1958 championship game."

Yesterday, I blogged the opinions of super-Bear Marc Faber who is finally calling for an end to the crash. Other long-time bears, even perma-bears like Jim Rogers, David Tice and Peter Schiff, are calling for more of the same. Technician Louise Yamada is calling for a low around 400 to 600 on the S&P500, which is another 50% drop from where we are today. All of these are forecasts are possible, but are they likely? It seems that even if market cycles are never the same, at least they rhyme. The two major historical references are the twin 1930s declines and the twin late 60s and early 70s declines. The path from here is likely to be similar to the aftermath of both periods.

And from another article, an interview with Robert Fetch, are similar sentiments:

"...the market is clearly discounting a fairly severe recession. There's a good chance that before this is done, the S&P will make a new low. When the S&P went below 804 last week, the percentage decline off the highs marked the greatest bear market in history since the Great Depression." "You have the capacity right now, as a value manager, to find good, solid low-valued stocks of good companies without having to pay a premium for them for the first time, really, since the early 1980s".

What marked both the 1932 and the 1974 market bottoms and resulting economic declines, was a government led effort to restimulate the economy which eventually led to a dynamic market environment. The two periods had different political settings. 1932 marked a three year period under President Hoover where the government did nothing while the markets and economy declined. Hoover and the Congress were following "Laissez Faire" (hands off) economic policies under the theory that market economies would heal themselves without government assistance. It proved to be a painfully incorrect theory.

It wasn't until FDR took office in early 1933 (March back in that time), that the New Deal was born and the government poured money into the economy with the goal of re-employing people to alleviate the very high 25% unemployment of the period. In hindsight, economists, led by Milton Friedman, have shown that had the initial response to the 1929 market crash and resultant asset deflation been more aggressively reflationary (aka stimulation through low interest rates and work programs), the worst of the Great Depression might have been avoided. In any case, investing in the market in early 1933 would have proved very beneficial, even given the 1937 correction, severe in its own right.

The 1968 and 1974 twin crashes were a little different, politically. 1968 was brought on by the uncertainty around civil upheaval caused primarily by the Vietnam war and two major political assinations (Martin Luther King, Jr. and Robert Kennedy) coinciding with a blowoff top of the 60s tech bubble. Thereafter were several years of economic gyrations and failed government policy as indicated by the collapse of the gold standard and the 1972 wage-price freeze to contain inflation. Then in 1973 came the OPEC oil crisis and gasoline rationing accompanied by a 400% spike in oil and gas prices. The proverbial straw came with the Nixon Watergate scandal and his subsequent impeachment.

But unlike 1932-33, the market collapse in 1973-74 did not coincide with a Presidential election. Instead, we had Gerald Ford serving essentially two years of a lame duck Presidency, during which nothing significant could be accomplished in Congress or the Administration to repair the economy. Under Jimmy Carter, there were efforts to stimulate the economy which worked to some degree. But the stimulation in the vicinity of high oil prices, caused massive inflation by 1978. Then came round two of OPEC's assault on the Western world's economies. High oil and gas prices in 1978-79 caused another significant recession and 20% market decline which was eventually resolved by Paul Volcker's attack on inflation and then the Great Bull Market of 1982-2000.

It is clear to me that we can rely on one of these two precedents to forecast the next 5-10 years in the markets. As pointed out before, even if history does not repeat, it rhymes. Here is a chart comparing the three periods in question that makes that point:

If we are at the end of 1932, just prior to the inauguration of a new Democratic President with a mandate to fix the economy and get people back to work, we can look at a market run 0f over 400% between February 1933 and February 1937. If instead, we are at May 1938, we can look at a 50% run over the next 16 months. After the market peaked in October 1939, the fear over WW2 stopped the market ascent and it went sideways until February 1945, near the end of the war.

If, as I think we are, at the market bottom of September 1974, on the heals of Nixon's impeachment in August, we can have at least a 70% run over the next two years as we did until the uncertainty over the 1976 election stopped the run up that summer. But because the market crash has coincided with the Presidential election, we may have a much more robust recovery in the market and economy than in 1974-76. Barak Obama has already promised to rebuild the national infrastructure to put people to work. This will be his New New Deal. The resulting spending will pump a lot of money into the economy, will lower unemployment and eventually improve the consumer spending outlook.

If the last scenario is correct, what will benefit? Infrastructure, materials and energy companies. The improving consumer will also benefit the developing export-driven economies in Asia and restart the Chinese economy (further increasing demand for infrastructure materials and services). Some names that look interesting, all down 60-80% from their peaks, are engineering companies: JEC, FLR and URS; Materials stocks: CX, BHP, FCX, NUE; Energy stocks: PWE, MRO, PVX, SU; and Asia stocks: FXI, IFN and TDF.

I already own most of the above, and have held them through this decline for better or worse (mostly worse as of late). But the case for infrastructure is better than ever. Now the above stocks are dirt cheap by every fundamental metric. Even if the timing of the recovery of the market is off by 6 months or a year and there is more decline to come in the immediate future, held over a 5 to 10 year time frame, the above will reward.

Good investing!

"Dr. Doom" Marc Faber calls for a Huge Market Rally

There is a certain Marc Faber, who is an anti-American Swiss national, living in Hong Kong, who has long called for the demise of the American stock market and the US dollar. He is interviewed in Barrons's regularly, and is a member of that journal's elite "Investor Roundtable".

Last night (Friday morning Europe time), he gave an interview where he is calling for a huge rebound in the stock market, and a collapse of the US Treasury bond market and US dollar, in response to the current market decline and the monetary expansion to prop up the economy. This is the scenario that I am positioned for, with big holdings in Canadian energy (non-US denominated) and material stocks and funds.

He did end his interview with an ominous warning that if the monetary expansion / reflation does not work, then we will experience a tremendous depression, worse than the 1930s. But this is how he got his title: "Dr. Doom"

Here are some of his quotes. You can see his interview on the right hand bar of this webpage.

"The sheer amount of money governments are pumping into the financial system will eventually lead to a very strong rally in beaten-down assets (aka energy), investor Marc Faber said on CNBC Friday.

But Faber also warned that if the markets remain depressed as liquidity increases the result could be a depression worse than in 1929. (don't know how this could happen...they seem mutually exclusive...either you have an asset deflation-based depression, or inflation. If it turns to hyper-inflation and worthless currency, ala Germany in the 20s or Argentina in the 70s, it would destabilize the economy, but would not be called "a depression").

By and large asset markets are "terribly oversold" now, while investors are going overboard into the U.S. dollar and U.S. Treasurys, Faber, editor of the Gloom, Boom & Doom Report, told "Squawk Box Europe."

"What you could see in the next three months is a very strong rebound in asset markets, in equities, followed by a selloff in bonds and eventually a selloff in the dollar," he said.
Governments and central banks around the world are providing liquidity and that will eventually have an impact, Faber said.

And once the buying starts the rally is likely to be "stronger than people expect" given that financial institutions are sitting on so much cash, he added.

'Colossal Deflation'

"I think the intervention by the government in the past and at the present time has created more volatility, not less, and so right now we have deflation, we have colossal deflation in asset prices," he said, noting that equities alone have lost $30 trillion globally.

But "I assure you if you throw enough money at the system, eventually you can reflate, especially in the United States," Faber added.

Statistically a rebound should happen, but if it doesn't "the air is out" and the world faces an economy "worse than the depression of '29 to '32," he said.

Is there a Rainbow somewhere?

All:

This has been a very tough few weeks. As bad as the market was at the beginning of the year through the middle of March, this is much worse. Now the economy has joined housing in the dumpster. And with a vaccuum in government between the Presidents, the timing could not be worse (I wonder if it is any coincidence that previous major market bottoms in 1932 and 1974 were during Presidential transitions, as well).

I still plan to review some of my small cap favorites and their Q3 reports. There is a lot of good news there that makes me more optimistic after reading the reports. I will try to get to it over the Thanksgiving Holiday, if not sooner. But for a quick overview: the Canroys and the high dividend closed end funds that have just been hammered by hedge fund redemptions and the changing currency situation, continue to have decent earnings and cash flows. None of my high dividend funds has had to cut its dividend yet. That time may come, but there is so much fear built into the prices now, that I am convinced they will weather the storm nicely.

As the high dividend funds / Canroys dip in price, but continue to yield high monthly income, I just reinvest it into the stocks to average down my cost. This way, when the eventual / inevitable rebound comes, my performance versus cost basis will be that much more fantastic. I will have a lower cost but also a lot more shares. And, if worse comes to worse, and they rebound no time soon because the economy goes nowhere, I may have those dividends to help pay my monthly expenses in the event of unemployment! Hope that last one doesn't come true, but we can never know the future....

I continue to think this economic and market situation is most like the mid 1970s. Then as now, we had an unpopular President (Nixon) forced out of office after an unpopular war (Vietnam), which put the country in a generally bad mood. Then as now, we had a massive oil shock that crunched the economy after many years of above average times, making the change in mood that much more dramatic. Then as now, there was a fundamental shift in the manufacturing / auto sector and the creation of new country markets that put pressure on global materials supplies (Japan, Germany, S. Korea, etc). It took us 8 years, till 1982 to recover from the 73/74 crisis. The best investment place to be during that period was in materials and energy stocks, which can withstand and even thrive during a period of weak economic performance, deficit spending and global inflation.

I am copying yesterday's edition of the Prudent Speculator that I receive. First, John Buckingham who runs the newsletter and fund is a common sense kind of guy who keeps his cool. Second, he references quotations from Steve Leuthold, who is a local (Mpls) market forecaster with a very good long term track record. So that is worth reading on its own. Good investing!!


The Prudent Speculator - Wednesday Evening Hotline: November 19, 2008

*** Executive Summary 11/19/08 ***
Near-Term Woes - Retesting the Lows
Long-Term Opportunities - What Does History Say?
Sales - Closed Out ASYT, PLAB & THC
Partial Sale - Sold 50% of ASEI at $71.20 for Certain Accounts
Hotline Special - Buy DAR up to $5.46

Another horrendous day in the equity markets, with the 'modest' 5% decline in the Dow Jones Industrial Average masking the damage done to the overall market as evidenced by a 7.9% plunge in the Russell 2000 small-cap index and the 7.4% drubbing suffered by the S&P MidCap 400. The advance/decline line was ugly as well with preliminary readings showing only 192 winners on the New York Stock Exchange compared to 3,001 losers. The numbers were not quite as bad on the Nasdaq, but a 326/2,524 ratio was dismal as well.

While the catalysts for the giant selloff included renewed concerns about the viability of Citigroup (C - $6.40) and the U.S. auto industry as well as the Commerce Department's report that housing starts fell 4.5% on a sequential basis to a seasonally adjusted 791,000 annual level that is now 38% below the reading a year ago, the Federal Reserve received a lot of the blame as the minutes of the Federal Open Market Committee (FOMC) meeting on October 28-29 were released this morning.

It shouldn't have been a big surprise that the FOMC "generally expected the economy to contract moderately in the second half of 2008 and the first half of 2009, and agreed that the downside risks to growth have increased." This is consistent with the view of many economists, though the participants did lower their collective forecast for growth in 2009 to between negative 0.2% and positive 1.1%. Of course, we would argue that the massive decline seen in equities over the past year might suggest a far worse economic environment than what the FOMC is projecting. Clearly, unemployment will continue to rise into the new year, and the FOMC now predicts that the jobless rate will average 7.1% to 7.5% in 2009, but, again, we believe that the stock markets have priced in a substantial higher number.

Despite our continued optimism for the long-term, we realize that with fear running rampant these days and it unlikely that economic or corporate news will be uplifting in the near term, we have to brace ourselves for more volatility and the likelihood for additional weakness in the short run. Having said that, the technical indicators we look at are about as oversold as they have ever been, suggesting that we are overdue for a significant bounce. For example, the S&P 500 is now 35.5% below its 200-day moving average while the Russell 2000 is 39.0% below its 200-day moving average. Those figures stood at 34.1% and 35.4%, respectively, when stocks began a six-day rally on October 27 which took the S&P 500 up more than 18% from 849 to 1006. During that same time-span, the Russell 2000 rebounded from 448 to 546, or more than 21%. In addition, the Volatility Index (VIX) hit 74 today, not far from the record close of 80 seen on October 27.

We always operate with a long-term, three-to-five year investment time horizon and we continue to think that this period of time will be looked back upon in subsequent years as one of the best buying opportunities in stock market history. As 71-year-old money manager Steve Leuthold said in his latest investor letter, dated October 28:

"If the current U.S. recession (which got underway about a year ago) is about 20 months in duration (our estimate), it would be the longest recession since WWII (average being 11 months). As a leading economic indicator, the stock market would begin to rebound in November 2008, per our historical economic time clock.

"Today's stock market, per our valuation benchmarks (P/E ratios, Price to Sales ratio, Price to Cash Flow ratio, et. al.), is quite undervalued, in the low 15% of our 60 year valuation history. From current valuation levels, the stock market has returned an average of 40% over the subsequent two years and 66% over the subsequent three years, historically.

Obviously, there can never be any guarantee that history will repeat, and we realize that many folks think that this time is different, but we've survived 1987, 1990, 1998 and 2002 by continuing to adhere to the Al Frank strategy of buying and holding broadly diversified portfolio of undervalued stocks. And the market as a whole has persevered through numerous crises with equities seeing long-term returns on the order of 10% to 12%, dating back to the 1920s.

Of course, despite our long-term optimism, we do realize that the companies we own must make it through the near term in order to participate in the eventual recovery. Though we know from experience that the biggest losers going into a bear market are often the biggest winners coming out, we have become more critical of some of the names we hold, opting to sell these stocks a bit quicker than we might have in a more 'normal' market and economic environment. With so many other undervalued stocks available for purchase, we prefer to slowly redeploy these proceeds into other bargains that might offer a little better reward/risk profile.

For example, yesterday we decided to part ways with Asyst Technologies (ASYT - $0.24) and Photronics (PLAB - $0.47), two struggling semiconductor capital equipment companies. With the odds of bankruptcy having risen dramatically, we sold ASYT at $0.23 and PLAB for $0.54. Both companies are presently spilling red ink and with conditions in the tech sector having deteriorated in recent weeks, we are worried that high debt levels may be very problematic.

With the prognosis for hospital owner Tenet Healthcare (THC - $1.46) looking increasingly dire, we decided to finally lay our position to rest this week. In its most recently reported quarter, the company reported that it ailments were becoming more malignant. Bad debt from patients is hovering at 8% of sales, and services are steadily becoming less profitable as a higher percentage of them are to Medicare, Medicade or uninsured patients. Because Tenet depends on more commercially insured patients (admissions of which fell more than 3%), layoffs and the economic downturn have pressured occupancy down to one of the lowest in the industry. With negative tangible book value and debt of $10 per share, we decided to let our THC shares go yesterday at $1.72.

Given the low share prices for the three sales, the value of the holdings at this stage of the game were not enough to move the proverbial needle in terms of performance going forward. Such was not the case for our final sale as Mark Mowrey explains…

In an environment such as this, it's vastly more difficult to justify holding sizable positions in winning stocks with rich valuations, especially when one considers the multitude of inexpensive alternatives into which one can funnel the gains. 'Course it's also tough to move money out of a stock that's been bucking the general trend downward. A smart value investor will put prudence above cupidity, nonetheless, as we did with our holdings of American Science & Engineering (ASEI - $68.04), half of our stake in which we sold yesterday for no less than $71.20 per share for those portfolios where the position was more than 1.3 times the 'normal' size. For Mowrey Portfolio Compiler and Buckingham Portfolio we received $71.25 for the shares sold, while Al received a penny more for TPS Portfolio.

The generally lumpy revenue series took a turn up for American Science in the latest quarter, as the traveler, parcel and cargo inspection systems seller gained further traction in sales of its z-backscatter systems, which produce photo-realistic images of items baddies are carrying or shipping but should not be. Service revenues were higher, too, on account of a higher total number of systems in operation. Margins were on the rise as well.

Meantime, the sales pipeline has continued to grow - backlog is at a record high - as the company targets new markets for products like the z-backscatter vans, intended for use in force protection, counter-drug and anti-terrorism applications. And with intentions here and abroad to further border protection efforts, the long-term outlook is pretty grand.

And, yet, given current market valuation metrics, this stock seems already to have priced in a good portion of that eventual growth, trading at 36 times trailing earnings and more than three times revenue. A price-to-book value measure of 3.6 times is similarly rich, most comparisons considered.

Tempting as it was to hold fast to the shares and hope for greater gains on the whole position, we found it better to sell a chunk of our holdings in ASEI to reduce some of the risk that the rosy picture will fade. The remaining shares we'll hold for a revised-higher target FG price of $78 as the balance sheet is pristine with over $10 per share in cash, net of debt, and fiscal 2009 (ends 3/09) earnings are expected to jump to more than $3.00 per share from the current trailing-12-month tally of $1.87.

Eric Hare pens this evening's Hotline Special on Darling International (DAR - $3.60)…
Darling currently operates in two segments and has been at it since its founding in 1882. Its first segment is the rendering services business, where Darling collects and processes animal by-products, converting them into useable oils and proteins that are needed in the agricultural leather and oleo-chemical industries. Darling collects these by-products from grocery stores, butcher shops and meat/poultry processors. The finished products that Darling delivers via animal parts are pretty impressive. Using meat and bone they can make anything from pet food to fertilizer, using grease they can deliver animal feed and bio-fuels and using tallow Darling can assist in the making of numerous consumer goods.

The second segment, restaurant services, involves the collection of used cooking oils from restaurants and recycling them into high-energy animal feed ingredients and industrial oils. The need for this service is high, as it allows for restaurants to be more productive as it helps streamline the kitchen cleaning process.

A large portion of the by-products from rendering are high growth markets. Demand for new bio-fuels continues to grow and with the new administration starting in January, we’d expect it to at least stay the same. Furthermore, Darling does wonders for the environment. The recycling of fat and protein through the rendering process significantly lowers the amount of green house gas that would have been emitted.

Darling operates all over the world, with the United States providing the majority of its revenue. As a global provider with a proven aptitude in acquiring and synergizing other companies, Darling has an ability to scale the business and offer better prices to customers than any of its regional competitors. The revenue breakout is about 73% rendering and 27% restaurant services.

Operating margins favor the rendering segment as the most recent quarter saw a figure of 19.7% compared with 15.3% for the restaurant services. In addition, margins are improving as the prices at which the by-products can be sold have outpaced the increased manufacturing costs. In the most recent quarter, Darling earned $0.28 per share which compares favorably with the year prior where it earned $0.15. Revenue over the same period jumped to $236 million from $171 million.

A knock on Darling is that its business is capital intensive. The company has to constantly maintain/replace its large fleet of vehicles and heavy equipment for rendering and processing plants. That said, Darling is financially sound, sporting strong free cash flow, a good interest coverage ratio and a net cash position. Management has done a tremendous job of using the strong cash flow to pay down debt and accumulate cash as just last September Darling was showing a long-term debt number that was ten times its cash position.

The valuation for Darling is enticing as it trades for 4.5 times trailing-12-month earnings and for 35% of sales. We recognize that earnings will decline in 2009, but we think that that the nearly 80% decline in the share price since the end of July has been overdone. For those who share our long-term, three-to-five year investment time horizon, we are buyers of DAR up to $5.46 based on an LG/FG pair of $10/$11.

Earnings Season: AMS reports results

Back from two weeks of hectic travel, I have some time to go over my investment portfolio. I like the way it is set up right now. I am out of most of the more dangerous plays I was in over the past 12-15 months, especially in the financial sector. Most of what I have now is energy, primarily Canroys, emerging market funds and small cap high tech and medical plays.

Because the small caps typically report 4-6 weeks after the end of a quarter, it is just now that we are able to review the 3rd quarter results for the small cap stocks, including the Canroys. I will go over my favorites the next few days, in separate reports. From what I have seen, I am very happy with the performance of my picks.

First, I would like to take a look at American Shared Hospital Systems (AMS). This "microcap" has a market cap of only around $8M. It has 5M shares outstanding, but $10M in cash. So, it has more cash than market cap, which would be great under any circumstances (some of this cash will be used to service loan payments). Today (Monday) you can buy a share for $1.50, give or take. Being this small, it takes very little buying or selling action to move the price. A buy of $5,000 for 3500 shares, will have a material impact on price. The price moves by 10-20% almost every day. It was as low as $1.01 on Oct. 10.

But there is a lot more to this company than cash on hand. It also owns many radiation therapy machines of different types, which it has leased to major cancer treatment hospitals for their tumor therapy centers. Currently, AMS has $45M of assets on its balance sheet for equipment at medical centers, this is net of depreciation. So, on the $8M market cap, there is a lot of financial leverage in the form of equipment owned and under lease. But there is almost no risk of default considering to whom that equipment is leased. The leases cover the depreciable life of the equipment. There is zero residual value at the end of the term.

Against the leases, securities and cash is $22M in long term debt and another $13M in short term or current debt that is completely covered by cash on hand. This all leaves a very healthy $20M of shareholder equity or book value (assets less liabilities) that is 1/2 in cash. With the current market cap of $8M, AMS is selling at less than 50% of tangible book value, which is cheap in any era, the 1930s or the 2000s. The Directors like their own stock and announced on the investor conference call they will buy back 500K shares, or 10% of stock outstanding, which will support the stock price.

Oh, one other thing, there are $1.5M in preferred shares listed under assets. These are the Still River Systems shares and account for about 20% of SRS's equity. SRS has a decent chance to become a major player in radiation therapy, alongside Siemens, Varian and Phillips Medical. That position alone could someday be worth more than 10X the current AMS stock price ($80M). This stock is a bargain by any standard. Check it out: http://www.ashs.com/investors.html

The Great Debate: Is the Fed Too Loose or Too Tight?

I have had a running debate with other blogsters regarding the current Fed policy of loose money. Being a student of history, especially the Great Depression, I know that one of the biggest factors contributing to the Depression was the fact a conservative (Hoover-led) government, Treasury and Federal Reserve kept money tight after the stock market broke down in October 1929. In fact, the Fed raised its Federal Funds rate in 1930 as it reacted to the perceived inflationary threat showing up in reports from data generated in 1928 and 1929 during the Roaring 20s Bubble.

I have contended that as assets aggressively contract, primarily real estate the past two years, some offset is needed to balance the national books. Otherwise, we have a deflation by definition (to little money chasing too many goods) and deflation is never a good thing as it causes people to save excessively (hoard) and not spend. This stops the economy and also feeds on itself. Some of my blog opponents feel that we should just let Free Markets work; that the market will do a better job of solving our problems than government. But history shows otherwise. A free market is a great thing during normal times, but it is too severe a master during times of stress.

To help me make my point, I am borrowing a column from "Barrons Online" posted yesterday. It says all that I have been trying to say, but more eloquently. Here it is:

TUESDAY, OCTOBER 28, 2008
UP AND DOWN WALL STREET DAILY

Pushing on a String or at the End of Their Rope?
By RANDALL W. FORSYTH

Sado-monetarists decry the doubling of the Fed's balance sheet, but is it enough?

THE FEDERAL OPEN MARKET COMMITTEE begins a two-day policy meeting Tuesday amid what now is conceded to be the worst financial crisis since 1930s. And, as in the Great Depression, the U.S. central bank is being criticized for being too easy and risking inflation amidst a severe debt deflation.

The Fed has doubled the size of its balance sheet in just seven weeks to attack the crisis. That has elicited squawks from what Barron's much-missed late friend and colleague, John Liscio, called the "sado-monetarists" who think that the central bank's efforts to cushion the pain of credit contraction invariably puts us on the road to perdition. As when he coined the phrase back in the early 1990s, the Fed is expanding its credit to offset the contraction in credit in the private sector.

Michael T. Darda, chief economist of MKM Partners, notes the Fed has expanded its balance sheet by $900 billion since early September, a seeming eternity ago when the Mets were cruising to the post-season and temperatures were sizzling. But that seemingly Zimbabwe-like 206% annual rate of increase in the Fed's assets in the latest 26 weeks hasn't ignited a monetary inflation. Quite the opposite, in fact.

A record percentage -- nearly 25% -- of the high-powered money the Fed has provided effectively sit idle as excess reserves, Darda points out. In other words, banks are sitting on a huge precautionary cushion. Banks are hoarding cash and are loath to lend to each other except for overnight periods.

That means banks are unlikely to unleash a new, inflationary wave of lending; quite the opposite. Yet the high levels of excess reserves in 1937 caused the sado-monetarists of the day to sound the inflation alarm back then and spur the Fed to tighten. That aborted the recovery and extended the depression, resulting in a resumption of the bear market. (Note: check out long term stock price charts and you will clearly see how the stock market cratered in 1937 due to this Fed tightening).

This time around, the deflationary symptoms are everywhere. Industrial commodity prices have been halved while the 30-year Treasury bond yield has sunk to its lowest level ever, under 4% last week. Gold has plunged to around $700 an ounce from $1,000 while the dollar has surged. And risky asset classes have melted down, he notes.

While the Fed is pumping more reserves into the banking system, less is being transformed into broad money and credit. And that money is turning over more slowly (velocity is falling, to use the economists' jargon.) The combination renders Fed policy "far less potent than it would otherwise be," Darda concludes.

That leaves the question, what's the FOMC to do at this point? The consensus of Fed watchers and the futures market is that the panel will cut its federal-funds rate target another 50 basis points (half percentage point) to 1% when it announces its decision Wednesday at 2:15 PM EDT. That would leave the Fed's main policy rate at its previous nadir touched in the past cycle and would, in effect, leave it relatively few basis points left to cut before the funds rate reached zero.

"The question is what the Fed does next," write ISI's Washington policy analysts, Tom Gallagher, Andy Laperriere and Melissa Loesberg. "We think it might have one more conventional rate cut before resorting to unconventional measures. But the real answer is that the Fed will wait for fiscal policymakers to take their turn," they conclude. (Note: this will come in the form of another national "special rebate" of around $1000-1500 that will be passed by Congress during a special session in November and distributed in time to impact Christmas spending, so I predict).

Goldman Sachs' economists also look for a 50 basis point cut from the FOMC but think a 75-basis-point slash, halving the fed-funds rate to 0.75%, is a 33% possibility. An important factor in the FOMC's decision will be the results of the Fed's latest quarterly survey of bank loan officers, which Goldman notes the policy makers will have in hand. This survey, taken in September, will be made public next month. The previous survey released in August showed a sharp tightening in credit standards for consumer, mortgage and business loans.

In other words, the Fed has been pushing on a proverbial string.
More than pure quantitative measures, price indicators show persistent credit tightness. Spreads between market interest rates and risk-free or administered rates have come in from their peaks, but remain elevated.

In particular, the three-month London interbank rate has come down to around 3.50% as of Monday, from the peak of about 4.80% on Oct. 10, but this benchmark remains above the 2.80% that prevailed in September before the Lehman bankruptcy and the Fed's 50-basis-point cut, to 1.5%, on Oct. 8. (Note: Why is Libor still so high, when the Fed keeps pushing the Funds Rate lower? The answer is that banks don't want to lend to each other, or are afraid to, after so much bank carnage. This means that what interbank lending does occur, does so at a higher interest rate than in a freer, less risky market. This impacts us because Libor is the index for many consumer loans and mortgages, and is also a barometer of economic health).

Three-month Libor also remains elevated against OIS -- the overnight interbank swap rate, which reflects the market's view on the fed-funds effective rate. The Libor-OIS spread is down to 263 basis points from a peak of 366 basis points on Oct. 10. But before the crisis, when banks were willing to lend to each other, Libor-OIS was a relatively trivial handful of basis points.

Getting Libor down is a more important, though less visible aim of the FOMC. The Fed's program to purchase commercial paper, which commenced Monday, should take further pressure off the money market. The Fed initially set a rate of 1.88% for top-grade three-month paper Monday, far below Libor, which should help to continue pull the interbank rate lower, according to Banc of America Securities' head of credit research, Jeffrey Rosenberg.

The Fed's unprecedented push of liquidity may have nearly doubled its balance sheet but it still has not offset the private sector's need, according to Bridgewater Associates. The world has accumulated so many dollar debts, and the ability to refinance and expand these debts was so ingrained in the financial system that its breakdown requires an unprecedented response from the Fed. But with so much of the global financial system out of the reach of central banks, the risks to policy makers are numerous.

With debt deflation engulfing the credit markets and the economy here and abroad, the sado-monetarists should get over their Whip Inflation Now fetishes.

After the Bottom, Then What?

Some day soon, maybe today, maybe in a month, the stock market will find its bottom. Some technicians are predicting 7500, which is the same as the market lows in July 2002 and March 2003. Those form a natural line of resistance for the DJI. Others, like Art Cashin, the CNBC old-timer floor trader, thinks it might be 7000. It is very unlikely the market would crash down to 5000 or 4000. That would require the economic depression scenario, since it will require much lower aggregate corporate earnings to drive stock prices that low. Most think a depression is possible only if the global bankers do not respond with aggressive money creation. So far, the central bankers have responded.

What will be the investment class that does best coming out of the market slump? If you think that all the liquification to unfreeze the financial markets comes with the price of much higher inflation, as I do, then the best place to be will be asset classes that benefit from inflation: hard assets / commodities.

Have you noticed how the global deflationary environment rewards currencies that are doing the most to reinflate their economies, like Japan and the USA? The dollar has soared the past two months from $1.60USD per 1 Euro, to $1.20USD to 1 Euro, a 25% move. The turnaround in Japan is even more dramatic. The yen is now trading at 92Y per $1USD while it was at 120Y per $1USD just a few months ago. The Euro has weakened against the Dollar and the Dollar against the Yen. The Euro has weakend by 40% to the Yen in just a few months. Amazing! And disruptive! How can Japanese export goods compete in Europe after such a currency move? The answer is, they can't. This is why the Japanese Nikkei stock index dropped to a 26 year low today.

This is all about the unwinding of the "Yen Carry Trade" where global investors borrowed the very cheap yen, with interest rates in Japan at only 0.5%, and loaned the same money in other countries at much higher rates, or used the funds to finance commodities futures transactions, which helped drive up commodity prices. With the trade now in full-speed reverse, all that borrowed money is flowing back to the Yen as traders and hedge funds sell their positions and repay their Yen borrowings. As they do so, they convert some / most of their Yen back to US dollars, which strengthens the dollar. Because they are preparing for fund redemptions, they put the funds in very short term, super safe US Treasury bills. This causes competition for Treasury bills causing the interest rates on those instruments to drop to ridiculous low levels of less than 0.25%.

Even the Canadian dollar has gotten into the game, and has gone from parity at $1C per $1USD to $0.78C to $1USD in just a couple months.

On this last point, it has made the performance of the Canroys and other Canadian stocks more dismal when converted to $USD. My Canroy stocks, like Pennwest, Pengrowth, Provident, Canadian National Resources and Daylight Energy, are all down 50% or more the past two months. So is DHG, the closed end high dividend fund that is heavily invested in Canroys. About 1/3 of this decline, though, is the exchange rate. The other 2/3 of the decline can be attributed to the decline in the price of oil, which itself is because of the unwinding of hedge and mutual fund positions. That is a temporary phenomena, so long as I don't have to sell. Since mine are (now) completely unlevered retirement funds, I can hang on till the environment changes. Most of the Emerging Market stocks (Brazil, Mexico, Russia, etc) share with Canada their reliance on commodities for their economy and currency strength. So, emerging markets will also benefit from a global change in sentiment.

What will cause this change? Reflation. Once the markets, and then the economy, bottom, and economic growth reappears here in the USA, but even more dramatically in the emerging markets, global demand will once again increase for all things commodity: energy, grain, metals, chemicals and gold. I do not believe that the global banking system is nimble enough to take all the liquidity back out of the market that has been put in to save the financial system, as fast as will be necessary to avoid inflation. I think inflation, maybe relatively high inflation of over 5%, is a certainty within 24 months. The pain to avoid inflation will politically be just too great, as it will require buying back the financial instruments issued to flood the economy with money. When central banks buy back financial instruments, they raise interest rates in the process and make capital more scarce. It will be hard to take actions that will hurt the economy almost as soon as it starts to get repaired.

So, if you can stomach the volatility, and if you are still invested today, then I guess you have proven you can, hang on to your energy and commodity stocks. If possible, buy more, or at least reinvest dividends to capture more stock at the current low prices. The next couple years will not be much fund. But eventually the sun will shine. And if the 1970s are any precedent, it will shine most brightly on asset classes that benefit from too many dollars chasing too few goods.

Bill Gross, the oft quoted chairman of PIMCO Advisors and global bond guru, agrees with this perspective. Today on CNBC he made took a similar position (I was just happy to be aligned with his perspective, certainly not the other way around). I have posted his appearance for your viewing pleasure (see right hand bar).

www.cnbc.com/id/15840232?video=906626482

What is Next for our Economy and Currency?

Reading Barrons today, I came across a good piece by editor Thomas Dolan. It reflects on where we are as a nation and world in respect to our economic system(s). It questions what will be the new-world order for exchange. I will paraphrase and add my own comments:

""The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism." The French president, Nicolas Sarkozy, has announced, with neither a trace of an accent nor a trace of sarcasm, that "Laissez-faire is finished."" And that is good, isn't it? Laissez-faire as a recipy for economic disaster. Humans are driven by greed and fear. Left alone in a capitalist economic system, people will try to maximize their own personal gain at the expense of their fellow man, the definition of greed. SOME regulation is required to keep man from hurting himself in his primative drive for economic gain.

As Dolan quotes and interprets, correctly in my opinion: "In one of the more lucid passages of Das Kapital, Karl Marx said, "In every stockjobbing swindle everyone knows that some time or other the crash must come, but every one hopes that it may fall on the head of his neighbor, after he himself has caught the shower of gold and placed it in safety. 'Après moi le déluge!' is the watchword of every capitalist and of every capitalist nation.""

America is painted by some as the land of greed, and in fact, many in this land act greedily and without regard for their fellow man, as will most people given the opportunity and means, and with NO limits or regulation. It did not help that after World War 2, America's was the only significant economy left standing in the world. Because America had the only functioning industrial complex, by lieu of geographic isolation and friendly status with the border nations of Mexico and Canada, when world finance leaders met in New Hampshire in 1944 to repair the world financial system, the decision was made to index all other currencies to the US Dollar, and the dollar to gold in what was called "Bretton Woods".

http://en.wikipedia.org/wiki/Bretton_Woods_system

As Thomas Dolan continues: "(The agreements reached at "Bretton Woods" were) dictated by the United States. It reflected the astounding dominance of America in the world economy (near the end of) World War II. The U.S. accounted for 40% of global economic output and had at least 80% of the gold reserves. Only the dollar was credible enough to be pegged to gold; other currencies could be pegged to the dollar. Thus, the U.S. became the world's creator and judge of money."

"The U.S. eventually abused its power to create the world's money, flooding the globe with unwanted dollars in such profusion (during the Johnson Presidency years of "guns and butter" during Vietnam and civil unrest), that it couldn't redeem them for gold (when foreign Central Banks so tried in 1971). In 1971 (the US governmnet) admitted that, went off the gold standard and left the world and itself with no restraints on the creation of money and credit."

I don't think it is possible to go back on the gold standard, nor is it wise. Gold and other forms of hard asset economic regulation do not reflect the ability of mankind to grow its economic value. Humans are creative and productive. We can make more with less as we apply intellect to practical problems of life. A currency fixed to a finite amount of gold does not reflect this fundamental truth. This is why gold as financial proxy does not now and never has worked.

What is needed is a GLOBAL method to measure in real time, human productivity and growth, and index the sum of tradable financial instruments to the sum of all productive capacity. This will allow economic growth without artificial restraint, but will also allow expansion without risk of inflation and currency devaluation. Accompanying this new form of financial index should be investing and banking regulations that are tight enough to ensure transparency of all financial structures and transactions, along with limits to leverage; but still loose enough so as to not choke off risk taking that leads to economic expansion and opportunities for everyone.

How can this be done across all economies around the planet? Greater minds than mine will need to figure this out. But it is worthy for global leaders to try to find a way. Do we need a Bretton Woods 3?

Buffett Believes in America, Shouldn't We?

This editorial from the NY Times has already received a lot of public attention. But in case you did not have a chance to read it in full, I thought I would make it available to you. I have my arguments with Buffett on his politics, but regarding his investing acumen, there is no doubt.

If American stocks are good enough for him now, they are certainly good enough for me. So I am 100% invested in the stock market as of today, mostly large cap, secure and high dividend producing stocks and mostly in the energy / commodities space, since I am fairly certain we will have price inflation in commodities when the economy rebounds.

"Buy American. I Am. "
http://www.nytimes.com/2008/10/17/opinion/17buffett.html

By WARREN E. BUFFETT
Published: October 16, 2008

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.

Here is What is Wrong with our Economy

Rep. John Culberson came on Fast Money today and showed us why we are in an economic disaster. Watch and listen to this guy. He doesn't understand what he is saying and shows he is incapable of even listening to the experts on the show. We have no chance if this is who we have running our country.

http://www.cnbc.com/id/15840232?video=872233203&play=1

The Deal is Done

Monday morning, Sept 29, and the Deal is Done. We are going to get our $700B "bailout" of the American, if not world, financial system. But is this too little, too late to save the economy. This is what we have yet to find out.

There is no doubt in my mind, that if a deal hadn't been done by last night, we would have had an immediate devastation of the world stock markets. The backstop of the financial system will just allow the air to be let out of the balloon more gradually and less catastrophically. But the market is headed lower, maybe much lower, as the full effect of financial deleveraging and consumer angst is felt.

Another theme is developing: we will have many fewer banks in the next year, than we have had in the recent past. There is a deliberate effort by the Treasury and FDIC to consolidate banking assets to a few strong, or less weak, banks so that the crisis can be better managed. The "chosen ones" are apparently: USBank, Wells Fargo, JP Morgan, CITI and Bank of America. Goldman Sachs can also be added to the list as the only major investment banker left standing. I am somewhat vindicated in that I have long said (since last August) that I thought BAC and C would be considered "too big to fail" and would be protected by the Feds. I have to admit, though, that I have lost some money on this bet as even when I am right about their solvency, I have been wrong about the stock price.

All other banks are at risk. We know this because of the pattern that is developing. The FDIC just can't afford any more IndyMacs, which went bust in an uncontrolled way, leaving FDIC on the hook for $14B (or so) of insured deposits. FDIC only has around $45B of assets, so it can't afford to have all the banks go bust without some pre-emptive efforts. In the past week, it has overseen the dissolution of WaMu (assets only assumed by JP Morgan) and now, today, Wachovia (assets and liabilities assumed by Citi). Both banks were heavily exposed to the residential mortgage market.

On the investment banking side, Bear Stearns and Lehman have already been taken out with the help of Federal agencies. Morgan Stanley took itself out by selling itself off to Mitsubishi Bank.

What is next? The wave of banking failures is spreading around the world. Fortis and another less well know British bank were also dissolved over the weekend with assets transferred by European banking authorities. There is plenty of toxic exposure in China and other major Asian economies. The total effect of all this banking damage will be very negative for the world economy for many quarters to come. The markets must take a hit to reflect this reality.

Advice: it is too late to run for the exits, IMO. But, a little short side protection on existing positions is called for. I will buy SDS, the inverse and doubled short on the S&P500 index, in the next couple days. There may be an additional benefit of this action as I think when the Short Sale prohibition on many Financials comes off next week, that short positions may pop as a result of pent up demand into such a weak market.

A Look Back to Help Find the Way Forward

I have spent some time during recent days in remorse. "How did I not see all of this coming and get into cash?", I ask myself. But I am being unfair to myself, because I did see all of this coming, but could not bring myself to believe that it would actually happen or pull the trigger to sell out and get 100% into cash.

I looked to see what I was saying in January 2004, and low and behold, I thought all of this was a possibility, though in early 2004 I did not yet fully appreciate how much the real estate bubble would affect the future. By the end of 2005, I understood that was the true danger. But if our financial system was not so inherently weak prior to that bubble, it would not have brought the system down. Looking back on this advice, it sounds as relevant today, as it did almost five years ago.

Here is what I said in my annual letter, January 2004:

REAL ASSETS

This category was not mentioned in previous reports, but is an area of great interest. The base materials (natural resources) markets have outperformed many equities and all bonds in 2003. Gold, like oil and other natural resources, has reversed a 25 year downtrend. This is very significant. It was only two years ago that many central banks decided to liquidate gold reserves, pressuring prices with the anticipation of increased supplies. Now, gold has gone from $250, to well over $400/oz. in 18 months. What does this mean? Is it a portent of things to come? Gold has been the “Anti-dollar” since 1971, when the USA (and by extension, any central bank with currency linked to the dollar) went off the gold standard and onto a paper based standard (the USD). Gold prices went from $35 in 1971 and eventually to $850 in 1980, during the height of inflation. Then as now, gold strengthens when the dollar (and other paper currency) weakens, as gold is the alternate form of world financial exchange.

Gold and other commodity prices are considered by many economists to be predictors of future inflation. Inflation is created by excess debt leading to declining currency valuation. If government and consumer debt and money supply is again in excess, then inflation and declining purchase power of the USD is on the way (Boy, sure got this one right!!). The deficit spending of the past 3 years rivals the late 60s, during Johnson’s “Guns and Butter” program, as a percent of GNP. But the story is really worse this time. Unlike the 60s, when the USA was still the world’s creditor nation coming out of World War 2, with positive balance of trade, now, the USA has severely negative balance of trade. Continued build up of national and personal debt is doubly troublesome. Unlike the 1970s, now have nothing to offset our debt, except more paper.

Potential “Doomsday” scenarios come out of this ominous situation. At best, as hoped for by me, the large national debt will result in a price inflation, a stagnant economy, flat stock market, and declining bond prices in concert with increasing interest rates. See the 1970s for an example. I believe this is what the Fed is now trying to engineer: dollar devaluation and price inflation. The dollar devaluation makes exports more attractive and imports less attractive, helping our trade balance. Price inflation reduces the impact of long-term debt for both government and consumer at the expense of the creditors: mortgage holders in the case of consumer debt and foreigners in the case of government Treasury bonds.

In the worst case scenario, the dollar’s value will disintegrate taking the USA and many other dollar-denominated economies with, leading to a global financial crisis and depression that could last for 10 or more years. From this depression will emerge a new global financial power, China, which would de-link its currency from the USD, and make the China Yuan as the new global currency standard. As the new creditor power, replacing the USA role from the 50s and 60s, China will dictate world policy.

The end result of these concerns is the need to own either commodities in the form of mining, energy or other natural resource companies, and rare metals: gold, silver, platinum, etc, in certificate or in fact.

Energy stocks are another commodity that would do well in an international financial crisis. Asia (China) continues to increase consumption of energy products, like oil and coal. Supply is limited and requires years of effort to expand. Commodities will also do well during a period of global inflation, or deflation, as during the 30s. Raw material values may not increase in absolute terms during periods of deflation, but they do not decrease much, either. So, if currencies increase in value, as they do during a period of deflation, then commodities appreciate in relative terms.

Hold on for a Ride Up

Looking at the market before the open this morning, of course I wish I had a lot more Financial stocks than I do. The UYG and XLF will explode higher this morning. I had been short financials by selling the puts of SKF, a short fund. But I closed out my position yesterday because I hoped the actions that took place would happen. I closed it with SKF running very high on fear at $140. Today, SKF may open below $90. Boy, that was close. That would have been expenisve if I had not gotten out yesterday.

Meanwhile, the very large Goldman Sachs position I hold is looking a lot better. It was trading as low as $85 midday yesterday. I own it at $172 (actually, the options, but the loss would be the same). Today, it looks like it will open above $140 and could go to $160 during the day, getting me back close to even.

So, though I won't have a chance to get back into my long UYG position (the opposite of SKF), because it is soaring in the pre-market, I am happy for what I have. Hopefully you will also have a very nice market day with the action in front of us.

Be glad you are not a professional short seller with big short positions in Financials (hedge funds, Al Queda?) They will be wiped out if naked (not covered by equal long positions)

Short selling in crosshairs of world market regulators (recapped)

It didn't take long for the government and large financial institutions to respond as I thought they might, to the biggest financial crisis of our lifetime (at least for those of us under 75). There were a lot of actions taken today from the list I posted yesterday, which itself was culled from a number of sources and common sense. I thought this article on short selling was important enough to recap given the current market situation. It sheds a lot of light on the problems of weakened companies that are targeted and attacked by groups of short sellers, punished in spite of strong financials.

Late breaking news, today, has the Congress, Treasury and Fed working together on a plan to implement a modern day RTC, another of the actions I thought were necessary, and likely in the works. I will post more on this once the details are known.


SAN FRANCISCO (MarketWatch) -- Gathering anger over short selling of vulnerable financial stocks exploded into the open Thursday as top market regulators and industry giants took steps to limit the practice and begin investigation into possible abuses. Britain's stock market regulator on Thursday banned short selling in financial companies and said it might extend the ban to other sectors.

The move followed the Securities and Exchange Commission's curbs on the practice that went into effect Thursday morning. Read full story.In other steps aimed squarely at the bearish practice, the country's largest pension fund, the California Public Employees' Retirement System, said it was taking steps to limit the practice on three financial stocks and the New York attorney general called for a wide-ranging investigation of the short selling of some prominent financial companies, including Goldman Sachs (GS) and Morgan Stanley (MS).

The concerted reaction followed two days of sharp declines in global stock markets, triggered by mounting fears that the credit crunch would spin out of control and deepen the financial crisis. As stock declines have deepened, the role of short sellers has come under fire. "The moves should help restrain the abusive short-selling practices lately rampant in the stock market," said analyst Thomas Brown of Bankstocks.com. "Short sellers can no longer deceive their brokers about their intention or ability to deliver shares. "The SEC on Thursday put a ban on so-called "naked" short selling, while Calpers said it won't allow lending of shares of Goldman Sachs, Morgan Stanley, and Wachovia (WB).

The California State Teachers' Retirement System made a similar move and it called on 60 other funds to follow suit. "We don't want to inadvertently contribute to the instability of these companies or the market," Clark McKinley, a Calpers spokesman, told The Wall Street Journal. Calpers has one of the largest securities lending programs in the country, at $38 billion.

Much of the concern in the U.S. focuses on naked short selling. Naked shorting can allow market manipulators to force prices down much lower than would be possible in a legitimate short sale. In an abusive naked short sale, according to the SEC, the seller doesn't borrow a stock, as would happen in an ordinary short sale. The seller also fails to deliver the stock to the buyer.

Bill Stone, chief investment strategist at PNC Wealth Management, supported the SEC ban on naked shorting. "They don't let me go out and buy stocks without paying for them, so they shouldn't be able to do that selling them. Fair is fair," said Stone. Brown and others want the SEC to take its authority even further. They argue the SEC should re-impose the so-called "uptick rule" that prevented traders from selling short unless there was a higher bid price in the stock. "They shouldn't outlaw shorting but putting more controls on it is necessary," said John Langston, analyst at Hodges Capital Management. The SEC repealed that the uptick rule in July 2007.

They also want the SEC to dig into the option and credit default swaps strategies used by short sellers. Short selling itself isn't illegal. Some investors contend short sellers are a reality check for the market, in some cases, shining light on possible accounting shenanigans at corporations. "Short selling provides market liquidity and keeps management honest," said money-manager Russell Glass at RDG Capital.

In a regular short sale, the seller borrows a stock and sells it, with the understanding that the loan has to be repaid by buying the stock. New York Attorney General Andrew Cuomo plans to investigate rumor mongering and illegal conduct. "The markets need to be stabilized," Cuomo said. "One way is to root out short sellers who spread false information."

In further moves that should rattle short sellers, the SEC is expanding its push into the trading records of hedge funds, which are less-regulated than mutual funds. The agency said it is sending subpoenas to at least 50 big hedge funds, seeking trading records and communications about trading in specific companies.

The SEC is considering a rule that would force hedge fund managers with more than $100 million invested in stocks to report their daily short positions. This is drawing the ire of famous short-seller Jim Chanos, who helped expose the accounting gimmicks at Enron. "For investment managers such a requirement is akin to the government suddenly requiring Coca-Cola to disclose their secret formula for free to all their competitors," Chanos said.

SEC Chairman Christopher Cox has been under scrutiny for his handling of the financial crisis sending shockwaves through the market. On Thursday, Republican Presidential candidate John McCain said SEC Chairman Christopher Cox should be fired. McCain said Cox "serves at the appointment of the president and, in my view, has betrayed the public's trust. If I were President today, I would fire him."

Is this Market Wreck an Attack by Al Queda?

This is just my speculation, but I wonder if this chaos is being initiated by Islamic extremists. There is enough money from oil sales in the hands of Iran or other anti-American oil nations to precipitate this crash.

Think about it: the entire goal of hitting the WTC on 9/11 was to collapse the Western world's financial system. Knocking down buildings didn't work, so I am sure Al Queda and other extremists went to work on a new plan to do the same.

There was evidence of short selling by Islamists against the American market on the days leading up to 9/11. They know how to use that tool. To make the case more compelling was the attack on the US Embassy in Yemen yesterday. Al Queda likes to conduct attacks on multiple fronts to undermine confidence in the Western economic system.

Today, I just heard that there is a short selling campaign against State Street Bank, which is a major clearing house for Wall Street, based in Boston.
If this is the case, it can be stopped by a concerted effort of the Central Banks and regulators. The terrorists know that we are very reluctant in a free economy to employ controls. They are counting on us allowing our free markets to solve the problem. But they are manipulating short selling against major banks, one at a time, first the weak, and then the strong. We should be suspending all short sales, period, against money center banks and major financial institutions. That will freeze the market, but at least it will get rid of the speculation.

Then, there should be an intense effort to trace every significant short sale against banks on record to trace back the transaction to its source. If those sources are foreign, the accounts that transacted the business should be frozen. If we find it is terrorists, we should do everything possible to eliminate those people. If the transactions are domestic, the FBI should be sent to question the transactors to find out their intentions. If the intentions are found to be manipulative rather than speculation, the transactors should be prosecuted on federal racketeering charges.

This is what I hope is happening today behind the scenes.

Back to Reality

I was at my annual boys golf tournament the past 3 days. We call it "Party At The Pines" at a resort in northern Minnesota. This is the 14th year we have gone north with 16 or 20 guys and played non-stop golf for 3 days. It is a great way to get away from it all. You can't think stocks or trouble at work, when you are focused on hitting that little white ball about 400 times over those 3 days.

Now that I have missed all the stock market fun this week, I have a little chance to consider what has happened and where we go from here. One thing is for sure, the market has left its moorings. It has entered the irrational phase when anything can happen. The one thing I know from all the reading I have done, is that at times like this, it is best to just stand still and do nothing.

I am not a disinterested bystander, by the way. I thought I was fairly well protected from this eruption (which I suggested was a possibility as early as 2005, based on the housing bubble bursting), but I have been more or less fully invested since I believe it is impossible to pick a bottom. And honestly, this market situation is at the extreme end of what I thought was possible. There has always been a doomsday scenario suggested by some analysts, that would be triggered by this type of loss of confidence in the financial system. But I never really thought it would go as far as it has.

You know that I have been buying high dividend stocks and funds and reinvesting the large dividends in the same stocks to average down my cost if the price goes lower. I am very diverse in my holdings so that the risk is spread. But still I am getting hurt badly in this market because even the babies are now getting thrown out. Even cash is no longer safe, as some big money market funds are now "breaking the buck" and unable to return $1 of principal.

But this has all the look of capitulation. VIX peaked at near 40 today, which is its highest level since the 2000-03. Generally any spike over 30 signals fear in the market and a buying opportunity, though note how long high market volatility went on in the Tech Bust:



What needs to happen to change the direction of the market? There are a few basic actions to look for. The basic need is to break the vicious feedback loop in which the market is now engaged. The actions need to come from the government as they are regulatory in nature and in most instances, the government initiated the rules or regulations that have precipitated this crisis.

1. Suspend the "Mark-to-Market" rule: It came out of Sarbanes-Oxley legislation and was implented by the accounting board, FASB. Mark to Market is the primary culprit for circular market action, since the action of marking down assets weakens the capital structure of a bank and causes it to decline in value. As assets decline in value based on the weakness in the institutions backing the financial assets, the market price declines requiring another round of markdowns. This has gone on until some banks have broken their statutory capital requirement level and become insolvent in the process. This must stop to repair the market, so look for a loosening here and the option of "Marking to Model"

2. Clamp down on short selling: Although I have been doing some short selling to provide protection, and believe in it from a free market perspective, but it can really exacerbate the snowball effect of a downward spiraling market. Because financial institutions use the equity on their balance sheet as capital against their book of bank financing, they are exposed to damage by short selling more than other businesses which don't leverage their equity to do business. The "uptick" rule should be reinstated and I see that there are further restrictions on Market Makers put into effect by the SEC today so that shorts have to have claim to the physical stock in order to short it (that is, no naked shorts).

3. Continue infusing liquidity into the market: The Feds need to continue flooding the market with capital so that the financial engine does not seize up. Money is like a lubricant to financial institutions and business in general. If it ever stops flowing, then business freezes. The Feds have many ways to put money back into the financial markets.

4. Back more institutions with capital as needed: AIG and Fannie/Freddie were both bailed out with large US government loans. But these are not necessarily bailouts that will cost the taxpayer over the long term. This is the modern equivalent of the Resolution Trust Corp (RTC). The Feds are giving capital loans at a high percent interest ($85B at 12% in the case of AIG). This paper can later be sold on the open market at a big profit once the market panic passes and the company's balance sheet is repaired, just as any bond can be sold.

Goldman Sachs (GS) and Morgan Stanley now look like the two that need the most help, though they were thought to be top of the heap a few weeks ago. GS just beat expectations with its earnings report on Tuesday. Apparently their CDSs (credit default swaps which are like loan insurance) sold to other banks to hedge risk in loan portfolios, are jumping in cost. The Fed can help them here by buying the CDSs onto the Fed's balance sheet and later reselling to the market at a profit, to the taxpayer's benefit.

Even though they have so far avoided attack by the short sellers, USB and Wells Fargo are not out of the woods. In this market, the shorts can ruin any bank.

5. Coordinate Central Banks globally to take a similar approach with their own national banking companies. There is so much linkage in the financial system this is not an exclusively American problem, though it may have started here. The Central Bankers should be talking to each other (I am sure they are) to coordinate actions for the maximum positive effect. The Euro can be used to prop up European banks and the Chinese and Japanese central banks are flush and should do the same for their home banks.

6. The Central Bank should not worry about inflation right now. Everything happening right now (not 6 months ago) is Deflationary, not Inflationary. Financial contraction, in terms of deleveraging of financial institutions and dropping real estate prices, is inherently deflationary. The Fed can pump as much money into the banking system as it wants without adverse effects today. Once there is recovery, the Fed then would need to take money back out of the financial system by calling its loans, or selling them off.

7. Shut down the ratings agencies: Moody's, S&P, and other ratings agencies are doing more harm than good. They were big contributors in blowing up the real estate bubble by rating sub-prime securities as AAA, thereby attracting cheap money from abroad into our housing market. And now they are over-reacting the other direction and are dropping ratings on good companies because their stock price is declining and it is decreasing capital ratio coverage (see points 3 and 4). The function of agencies is to provide constructive guidance to investors based on their research departments. But the agencies have not lived up to that promise for more than a decade. They missed the Tech Bust as well.


8. Finally, remember that when the market does get over its panic, the rebound will be substantial. It may not bounce back to 14,000 Dow anytime soon, but it could bounce back to 12,500. The Financials that are left standing can double or triple over a 6-12 month period as they regain the irrational / non-fundamental losses. So, financial index UYG, as one suggestion, will do very well at some point.

I hope Bernanke and Paulsen work quickly on the above, plus anything else they can think of that I have not. They need to do so to keep us from crashing into a Depression. I think we have the right people at the top to avoid a real crash with Bernanke an expert on deflations and Paulsen an expert on investment banking finance. Watch for any or all the above and when you see action taken, it should solve the problem.

Until I see what comes from the Fed, I am sitting on my hands trying to avoid doing any more damage to my accounts by selling low, but also not sure if we are at the bottom, so not willing to buy, other than through the methodical reinvestment of dividends that I have set up.

Watch VIX Today

I think VIX will cross 30 today and on a bit of panic will set a new market low. This low will be in the same range as the market low on July 15 at around SP500 (1180-1200) and will set up a reasonable period of market recovery. This is a continuation of the bottoming process that started back in March, with the Bear Stearns takeover by JPM. Because of the severity of the financial crisis, and its continuing ripple effects around the world, this bottoming can take a long time.

If we remember back to the 2000-2003 market decline at the end of the Tech boom, there was ripple after ripple that unwound separate excesses, from the Teleom sector, to the Internet sector, to the Large Cap growth sector, to Enron and Tyco. One after the other of these segments came apart until all the previous excess was exhausted.

This is what we are seeing again. It started with the riskiest of the mortgage companies (those specializing in sub-prime) and has continued through home builders, banks, insurance companies and then spread overseas causing export declines in Asian and European economies, leading them to recession and market declines (check out China, FXI, which has declined by 70% from its peak last year). Now, the energy, metals and commodities sectors, which were overheated, are getting taken down because of the reversal of the Yen and Euro carry trades against the US dollar (with the strengthening dollar). The Hedgies are dumping their commodity positions and some of those hedge funds will crash.

But, we are getting closer to the end of the chaos. It is hard to think about any other sectors that were run way up that have not already come down. So, the bottom will likely hold (1200) and we will rebound once again. Eventually, I am saying after the election uncertainty is eased in November), the market will rebound and continue working its way higher. The Fed is now in a position to drop interest rates (with spreads stabilizing with the GSE rescue) and the Euro in trouble with recession in Europe. That should signal the turnaround. Expect the Fed to drop by at least 0.25% by year end.

Is Fannie / Freddie Takeover the Last Shoe?

On Friday, at the market close, and less than 6 hours after the Financial stocks tanked on the bad employment data from August, Treasury Chairman Hank Paulsen let leak that the Feds would be taking over Fannie and Freddie on Sunday.

My reaction was: DARN! or something close to that. I had been waiting for this to happen and knew it would create a trading opportunity on the financial indexes that I have been trading. But unlike the Bear Stearns bailout in March, where the rumor was on the net a couple days before the event, this one was very well guarded. Some people must have known as after the financials tanked Friday, they worked their way higher all day from about 10am on. Then, at the close, when the press release about the meeting on Sunday was announced, the UYG popped by 10% and I knew my goose was cooked, at least for a few days.

I would have loved to have been on the right side of this trade, but the financials had not dropped enough for me to cover my short position (SKF) and take a new long position (UYG). I was close, but about 5% away from pulling the trigger. And, as I have a day job, I did not have a chance to watch the financials move higher all day long into the close and the Fed press release. Had I been a full time trader, I would have looked into that counter trend movement (against the backdrop of the bad employment data in the morning) and might have found enough information to get me to switch direction.

But all is not lost! This is NOT the proverbial "other shoe dropping" signaling a change in direction for the financials, the stock market and the economy. In fact, I was stunned that the market reaction was so dramatic this morning. The fact that the Fed would have to intervene in Fannie and Freddie has been known for many weeks, really since the July 15 bottom when Paulson asked for and received authority to make this move. Most market followers expected this move sooner than this, so there should have been no "surprise factor" here.

In fact, the deal went down just about as expected. Fannie and Freddie common share is basically wiped out. This was necessary to eliminate concern of "moral hazard" where investors get taken off the hook by taxpayers. But Paulsen did not stop at common shares, he also took out the preferred shareholders. He did not actually bankrupt the company, but by giving warrants to the US government / taxpayers that give 80% of the equity to the government, with no dividends until Fannie and Freddie get profitable, for practical purposes, the stock is worth very near zero.

Worse for the financial market, many banks hold Fannie and Freddie preferreds as part of their capital structure. This was an arrangement with the bank regulators where FNM and FRE stock was considered as safe as cash, so avaiable as collateral for capital. But, it was not so safe and has now been written down to nothing. In fact, the preferred was not convertible to common, so its only value is for the dividend, which has now been eliminated for the forseeable future.

This is a material surprise. And it has a materially negative impact on many banks. That information will get back into the stock price in the next few days. I still think the Financials will continue to go down, with bounces along the way. I would use this opportunity to get short on Financials, which I am doing by selling more puts on SKF.

What $300 a Barrel Oil Means for us

Even though energy prices are down for the time being, and perhaps going lower, I have maintained that they will eventually go much higher. I say this because the marginal cost of extracting oil keeps increasing, and cost becomes the floor for price. So, as long as energy demand continues to increase through growth in Asia and other developing markets, the price of oil must continue to increase to encourage additional supplies.

The only thing that will stop the increase in petro energy is the growth of cheaper alternative energy sources, especially that can be used in transportation. With the advent of fuel cell or other electric powered vehicles, substitution of energy sources will eventually reduce demand. But the alteratives are many years away from practical and widespread use. So, for the next 10-20 years, petro energy will continue to be our most important source of energy. Here is an article from this week's Barrons. Read on:


What $300-a-Barrel Oil Will Mean for You
Charles Maxwell, Senior Energy Analyst, Weeden & Co.
By LAWRENCE C. STRAUSS

AN INTERVIEW WITH CHARLES MAXWELL: He correctly predicted the recent price spike -- and he sees an eventual move to around $300 a barrel.

CHARLES MAXWELL, WHO BEGAN HIS CAREER in the energy business in 1957 working for Mobil Oil, is no stranger to Barron's readers. In an article he penned nearly four years ago, Maxwell predicted that oil prices would move sharply higher by 2010, and then higher still. Maxwell, 76, got the timing and trend right, though his top price of $60 a barrel by 2010 proved far too low. "Oil is unique in that when it begins to disappear, there really aren't any good substitutes, which there are for so many other commodities," Maxwell says. "It's that lack of substitutes that forces the pricing mechanism to balance supply and demand." "Only price will slow the use of oil; the rising price tells us we don't have enough. So, we are now beginning a bitter, bitter competition for fuels that will see the price rise to ridiculous levels."

Maxwell has worked since 1999 as senior energy analyst at Weeden & Co., an institutional brokerage firm in Greenwich, Conn., having started as an energy securities analyst in 1968. Oil prices came down last week, trading at around $108 a barrel, but he predicts an eventual sharp move upward -- to around $300 a barrel -- owing to a lack of available supply. Barron's caught up with Maxwell recently for his latest assessment.

Barron's: What's your prediction for the price of oil over the long term?

Maxwell: I see it heading on an upward slope. Around that long-term line, there will be a lot of ups and downs. I thought the peak on this cycle might be somewhere around $100 a barrel, but it turned out to be a lot higher, more than $145 in early July. But like a child's blocks piled one upon another, you finally reach a point where at $145 they were beginning to sway. It had gone far beyond the fundamentals. So the questions are: 'What are the fundamentals and what should the price be?' The answers depend on where you are sitting and what you own.

Barron's: What's your view?

Maxwell: I would put the price of oil today at somewhere between $75 and $115. That implies quite a fast rise, given that we were averaging about $32 a barrel for West Texas Intermediate in 2003. However, it is perception that really is changing, not the true value of oil throughout the system. The perception change involves whether we are going to move into an era where oil supplies will be generous and easy to find and, therefore, relatively cheap -- or whether those supplies are going to be closed off for both political and geological reasons.

Barrons: Which scenario do you see?

Maxwell: We are not going to have enough oil, and we are going to have to start a huge switch in which we make do with a number of other fuels that are not so easy to convert to our immediate energy needs, mainly for transportation.
It sounds like this comes down to not having enough supply to meet demand.
We will have enough coal supply to meet demand, but the real question there is, 'Can we afford to substitute a great deal of coal given the emission problems?' The carbon footprint of coal is very high. We will be forced to use some more coal, but until we develop clean-burning coal technologies and underground gas fields to store carbon dioxide, we are going to be under very tight restrictions on its incremental use. That doesn't seem to be such a bad thing until you look at, say, nuclear power, which would be another big alternative, and you realize that it's being used effectively by the French, the Japanese and the Germans. But for various reasons, nuclear power has become a political football in the United States. If we committed to nuclear power today, we wouldn't have it up and running for another 10 years or longer.

Barron's: Does the tight oil supply, coupled with a lack of enough viable alternatives, make the U.S. vulnerable in terms of having enough energy supply?

Maxwell: It does, probably between about 2010 and 2025, thanks to a lack of sufficient power to drive our economy on an upward course. We haven't yet seen declining energy supply at a time of growing GDP. So for the moment, we will need more power to drive the world economy higher.

Barron's: What's been constraining the supply of global energy, oil in particular?

Maxwell: There are several factors, one being resource nationalism. The Russians are the classic example. They are not against us, but they simply want to develop their own supplies in their own way, on their own timetable, with their own money and with their own methods. Another example is Iraq. I said once to a junior minister of that country that Iraq would be producing 9 million barrels a day with the full development of reserves that most of us think are here, as against the 2½ million barrels a day they were producing at the time. And he said to me, 'Could we do that? Yes. Would we do that? No.' He said, 'I predict you will never see more than 6 million barrels a day coming from Iraq, ever' [to preserve the supply].

Another constraint is political instability in various places, including Nigeria. There's also refining, which is probably one of the easier constraints to solve. The world is using a great deal more lighter crudes, and we are actually producing more of the heavier crudes. We have to continue to change the refining system to handle the heavier crudes in order to give us the lighter products.

Barron's: What other constraints exist?

Maxwell: Many countries, for political reasons, don't want to allow oil companies to come in and do business. They don't like us, the U.S. in particular. Venezuela is an example where they do allow you to come in, but under terms that are so harsh that companies don't. The remaining constraint relates to geology, although it's not the primary issue today. It is the geopolitical and the instability issues that are stopping the biggest part of the development.

Barron's: How would you sum up the geological issue?

Maxwell: The easy places to find the oil have been, in most cases, tested, proven and produced. This occurred in the continental U.S. in the 1920s and 1930s and, on a worldwide basis, in the 1960s and 1970s. Now we are looking for oil in places like the Arctic of Russia or the Arctic of Alaska, where costs are much higher. It is not only more difficult to operate in those places, but it is a long way to transport the oil. There may be a great deal of oil under Antarctica, but, because it is a land mass, unlike the North Pole, which is water, we can't see through the ice sheets that cover Antarctica. So we don't know where to drill there.

There's also the issue of existing fields that are diminishing. The classic example is that in 1985, the North Sea produced 2½ million barrels a day from nine fields, compared with about 1.7 million barrels today from nearly 100 fields. We are running desperately on a treadmill on which it is very difficult to stay up, because they are not finding as many new fields as old fields are being depleted.

Barron's: At some point, doesn't it come down to lowering consumption or tapping alternative sources of energy?

Maxwell: Right, and we will probably do both. Ten years ago, 40% of the world's energy was in oil, versus 39% in 2006. It should reach 38% in the next five years -- and 37% three years after that. So oil is slowing, and I expect it will stop its growth around 2015, at which point the supply begins a slow retreat.

Barron's: Then what?

Maxwell: We will either have to reduce our economic growth around the world, which has all kinds of political and social repercussions attached to it, or we will have to find a substitute for oil. But it turns out that oil is a remarkable type of energy, as it doesn't spoil when you keep it overnight in a warm dish. It transports easily. It stores easily. It is very fluid. You can pump it across long distances. Oil has been the basis on which we have made a remarkable economic expansion, and now we may be tested by something a lot more serious, which is a coming shortage of oil and a need to start using other forms of fuels, which are not naturally the ones that we have developed.

Barron's: Where does natural gas fit in?

Maxwell: Its supply should last another 40 or 50 years before it runs into the same problems of peaking that we have in oil. Natural gas has a very low carbon footprint, meaning it's a cleaner type of energy, and it has wonderful petrochemical adaptability. But it doesn't help at the moment to solve our principal problem, namely oil supply, particularly for transportation uses.

Barron's: The dependence of the U.S. on foreign oil has grown significantly. Where do you see that going?

Maxwell: Dr. M. King Hubbert, the great geophysicist for Shell who gave his name to the Hubbert's Peak, said that we would reach the limit of domestic production of oil in the continental United States in the early 1970s. That, he said, would touch off a major change in the way we lived, the way we drove, where we lived, and so forth. But when we actually got there -- and he was correct that it was the peak of American oil in November 1970 -- the transformation to the use of foreign imported oil was almost seamless. There was no great change in people's habits. He thought the American public would never be stupid enough to fall for the concept of foreigners continuing to give us all the oil that we wanted.

Barron's: Could you elaborate on why you see the price of oil going much higher?

Maxwell: The price is eventually the only thing that will slow down the use of oil; the rising price tells us that we don't have enough of it. So, we are now beginning a bitter, bitter competition for fuels that will see the price continue to rise to these ridiculous levels.

Barron's: How high do you think the price of oil will go from here?

Maxwell: We will see $300 a barrel -- or roughly $250 in today's dollars -- because oil supply will be so short. If you want that oil, that's what you will have to pay for it. That will be in 2015, after the peak of oil [supply]. But even earlier, around 2010, more than 50% of the non-OPEC world will have peaked in its production of oil so the dependence on OPEC will become extreme. That will give OPEC a chance, I'm afraid, to lift prices rather more quickly on us than they are doing today.

Barron's: What concerns you the most about such high oil prices, assuming that turns out to be the case?

Maxwell: One thing is that people are going to be asked to change much faster than they are willing to.

Barron's: What's on the horizon over the next two years?

Maxwell: Supply and demand will be equal temporarily. There are three or four Saudi oil fields coming on stream, but there won't be any more low-sulfur crude fields coming on after the end of 2010. There's also the recession, which takes away some demand, but oil prices will remain high.

Barron's: Where do you see energy investment opportunities right now?

Maxwell: The tar sands, particularly those in western Canada, will be one area where the oil industry will continue. That includes companies like Suncor Energy (ticker: SU) and EnCana (ECA), both of which are on my buy list. They are integrated energy companies with big exposure to natural gas. EnCana has a deep asset base, huge North American land holdings and a disciplined management team. My target price, which is for the next 18 months to two years, is $112, compared with around $67 recently. My price target for Suncor is $90 (versus about $50 last week) but it might take three or four years to get to that level.

Barron's: Any other investment themes?

Maxwell: I see other types of opportunities developing in energy, although not in the traditional areas. It is going to be a lot easier in the next 10 years to reduce demand than it is going to be finding new supplies to substitute for oil. That's a very big principle. It will require increasing amounts of energy, particularly electricity, to run the new world.

Barron's: Can you be more specific on companies?

Maxwell: There are going to be so many new companies and so many new technologies that it boggles my mind at the thought of identifying all of them. There are going to be a lot of new industries coming in and wonderful opportunities in the stock market. But the old names in energy that I've covered for years won't be what they were. Most of the oil companies will be swallowed up by the larger ones. Then the larger ones will be broken up into trusts or new corporations. I don't think the oil industry can go on as it is now.

Barron's: What kind of world can we expect to live in with all of these changes?

Maxwell: It will be a little simpler. Your friends are going to be a little closer to you than they were before. Your vacations are going to be a little closer to home. You are going to have lower temperatures in the house. We will drive smaller cars with less horsepower, but they will get 60 to 80 miles to the gallon, enabling us to stretch gasoline supplies a lot further. There are going to be thousands of new adjustments leading to new investment opportunities. But the adjustment to that rising oil price, which could take as long as 20 years, will be a very harsh social experience -- not only for our society, but for every society.

Thanks very much, Charley.