Why Oil at $200 a Barrel Justifies A $100 Billion Investment Saturday, 25 February 2012 – Melbourne, Australia By Shae Smith

Why Oil at $200 a Barrel Justifies
A $100 Billion Investment
Saturday, 25 February 2012 – Melbourne, Australia
By Shae Smith

* Why Oil at $200 a Barrel Justifies a $100 Billion Investment
* The Best of the Week
* Europe's Road to Nowhere (Part II)

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On 21 February, the European Union announced a phased-in embargo on Iranian oil. It will be in effect from 1 July this year.

How did Iran respond? Well it stopped oil exports to Britain and France. But this was no more than a symbolic two-finger salute. Because neither country has bought Iranian oil since last November.

However, Carsten Fritsch an analyst at Commerzbank points out,

'... Iranian oil exports to both these countries are virtually negligible, however the news is likely to have only a psychological effect, fuelling uncertainty on the oil market'.

In short, it will push up the oil price.

$BRENT
Source: Stockcharts.com

The rising oil price has concerned Didier Houssin, a director for energy markets from the International Energy Agency. He told Dow Jones Newswires,

'...there are alternative supplies that can make up for any loss of Iranian exports.'

He believes both members and non-members of the Organisation of Petroleum Exporting Countries (OPEC) will make up the loss.

Houssin added that Iran provides about 2.2 million barrels per day (mbpd) of crude oil to the worldwide market. And there's currently an extra 2.82 mbpd that could come from OPEC members.

Does that mean it's a case of panic over, move along, nothing to see here?

No.

In fact, things could get worse.

As Dr Alex Cowie wrote recently in Money Morning, Iran has threatened to close the Strait of Hormuz. At its smallest point, the Strait of Hormuz is barely 50 km wide. But it's vital to oil shipments.

This tiny bit of ocean sees more than one fifth of the world's crude oil shipped through it. Closing the Strait would cut off oil from Saudi Arabia, Kuwait, Iraq and Qatar.

And Iran knows exactly the effect it would have on crude oil prices. Societe Generale estimates closing the Strait would see oil prices spike to $150-200 per barrel!

If that happens, there's a pretty good chance America will make some serious military threats.

But Iran's not worried. Because Iran has China on its side.

Unless China joins the ban on Iranian oil, it won't have much of an effect on Iran's exports.

Iran's top oil export destinations 2010
Source: US Energy Information Administration / BBC news


The thing is, since the start of the century China's spent billions of yuan ensuring a steady stream of black gold from Iran. Why would it hurt its own strategic assets?

China Protects Iran

China has spent the better part of the last decade securing its oil supply.

In 2004, China's government-owned Sinopec signed a $2 billion deal to develop the Iranian Yadavaran oil field. It has estimated reserves of 3 billion barrels. And when production starts, it will supply over 300,000 barrels of oil a day. Funnily enough, that's the amount of oil per day that China imports from Iran.

Less than five years later, the same company signed another $6.5 billion deal with Iran. This time to build oil refineries. Iran only has one refinery to alter the crude oil into petroleum. Adding another 6 refinery's would see the country's refining capacity reach 3.2 million barrels per day. Up from the current 1.67 million.

Iran imports about 120,000 barrels of petrol. And China is responsible for refining one third of Iran's petrol needs. So, if Iran refines its crude, it wouldn't need to rely on petrol imports.

But China's outlay in Iran doesn't end there.

The other big oil firm in China, China National Petroleum Corporation, has been shopping. In four years, the company has signed three separate contracts worth $4 billion to explore, drill and pump out oil. Combined they'll add another 300,000 barrels of oil a day. Mostly for Chinese use.

And these are just the oil deals. There's also the multi-billion-dollar deals for Iran's gas fields.

In fact, over the next 25 years, China could pump over $100 billion into the Iranian economy through exploration, refinery development and oil and gas purchases.

And you can guarantee any country that spends that amount of cash in one spot will protect its assets.

According to CNN, 'China is allowed to deploy to Iran as many experts and security personal as it deems necessary. To date, over 11,000 Chinese nationals have arrive in Iran, majority of whom consisting of non-uniformed military personnel.'

In other words, China has a military presence in the region, without having a hostile military presence.

Cutting off oil supplies to other nations will benefit China, and in the long term, Iran. With few other buyers in the pipeline willing to risk American ire, China should be able to scoop up excess crude and perhaps even buy another oil field or two.

Whatever sanctions the US places on Iranian oil, you can guarantee that China will be looking after its investment. Don't expect China to jump onto the embargo anytime soon.

Shae Smith
Editor, Money Weekend

P.S. - Dr Alex Cowie, editor of Diggers & Drillers has been looking into rising oil prices for the past two months. He agrees with Societe Generale that oil could go over $200 per barrel if the Strait of Hormuz is closed. In fact, Alex's last two research reports have focused on this very subject and the two stocks he believes have the most to gain. Click here to read more.
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ACROPOLIS NOW
What the latest European bailout means for your stock investments.

And three urgent capital-shielding moves to make NOW before Greek farce turns into tragedy.

Click here.

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The Most Important Story This Week...

No matter how dire the world economy, there is always a profit opportunity somewhere. The key is to isolate it amongst the general doom and gloom: Greek default, rising unemployment, the US deficit and a possible China slowdown. However, waiting for a cheery consensus in the stock market is not a viable strategy.

You want to buy stocks when nobody wants them. That means you won't overpay. And any upside is all yours. So, which stocks will rise in the current environment? Our resource specialist, Dr. Alex Cowie, says gold explorers. These fell in 2011. Investors got nervous that the gold price would fall. But the opposite happened. It's rising. And as the gold bull market heads higher, gold explorers have the potential to send their share prices through the roof. Alex explains further in 2012 - The Year Gold Exploration Stocks Explode.

Other Highlights This Week...

Dan Denning on Aussie Implications From a Greek Default: "But the most direct implication of a Greek default will be a fall in "risk" assets. At the top of that list, from an Australian perspective, is the Aussie dollar. You can see below that the Aussie lost momentum on its way to challenging its all-time high against the US dollar."

Greg Canavan on Why the Australian Economy is Much Weaker than the RBA Thinks: "It's time the RBA come down from its ivory tower and realised that too. Although I'm not suggesting lower interest rates will fix anything. It hasn't anywhere else in the world. The central bank and other 'official' institutions should just tell it like it is."

Kris Sayce on ETFs - Why the Easiest Investment Isn't Always the Best Investment: "ETFs are a useful way to diversify a portfolio or to gain access to stocks or markets you can't easily invest in. But you shouldn't use them as your primary investment vehicle. For that, nothing beats hard work, research and picking individual stocks. In our experience, that's the only way you'll consistently beat the market."

Murray Dawes on It's a Greek Bailout... or Is It?: "The contagion that will flow from such an event will be very real. If you had euros in Portuguese banks and saw Greeks ejected from the euro and given drachmas, which would devalue massively against the euro, what would you do? If you were smart you would see the writing on the wall and start getting your money the hell out of there."

To End the Week...
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What Happens To Your Investments if Greece Defaults?

A second rescue deal worth 130 billion euro ($A160 billion) and a massive deep debt write-off for bankrupt Greece has been agreed upon.

You're probably tired of news from Greece and Europe.

But this latest rescue deal has real and grave implications for Australian investors.

Find out what they are in this new report.

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Europe's Road to Nowhere (Part II)
By Satyajit Das, Contributing Writer, Money Morning

[Ed Note: Satyajit Das is a keynote speaker at After America. You can read Part I of his essay here]

The proposed [European] plan is fundamentally flawed. It made no attempt to tackle the real issues - the level of debt, how to reduce it, how to meet funding requirements or how to restore growth. Most importantly there was no new funds committed to the exercise.

Over the next few months, the euro zone faces a number of challenges including: the implementation of the new arrangements, possible downgrading of a number of nations, refinancing maturing debt and meeting required economic targets. There will also be complex political and social pressures.

Implementation of the new fiscal compact may not be a fait accompli. The lack of agreement by Britain makes the change more complex. A number of treaties and protocols need to be amended. There are also doubts as to whether the "work around" will be legally effective.

At least four governments have indicated that agreement to the changes is contingent on the precise legal text. One key area of concern is the precise form and extent of powers granted to the EU to police national budgets.

Another relates to the structure of the ESM, where a qualified majority of 85% will have the power to make emergency decisions. Finland is currently opposed to the ESM act by super majority instead of unanimity. Others are also reluctant to pay in capital, which can be placed at risk without the right to a veto.

Given issues of national sovereignty, it is possible that there will delays in implementation. Changes cannot also be ruled out.

Wall of Debt...

A crucial issue is the ability of European sovereigns to meet maturing debt commitments and to keep borrowing costs at a sustainable level.

European sovereigns and banks need to find Euro 1.9 trillion to refinance maturing debt in 2012, equivalent to around euro 7.5 billion each business day.

Italy requires euro 113 billion in the first quarter and around euro 300 billion over the full year, equivalent to around euro 1.5 billion per business day. Italy, Spain, France, and Germany together will need to issue in excess of euro 4.5 billion every working day of 2012.

European banks, whose fates are intertwined with the sovereigns, need euro 500 billion in the first half of 2012 and euro 275 billion in the second half. They need to raise euro 230 billion per quarter in 2012 compared to euro 132 billion per quarter in 2011. Since June 2011, European banks have been only able to raise euro 17 billion compared to euro 120 billion for the same period in 2010.

Given that banks and investors have been steadily reducing their exposures to European countries and banks, the ability to finance this wall of debt is uncertain. The bailout fund and the IMF with around euro 200-250 billion each cannot absorb this issuance. Europe will be forced to resort to "Sarko-nomics" to finance itself.

The ECB has reduced euro interest rates and lengthened the term of emergency funding of banks to three years with easier collateral rules (a lottery ticket is now acceptable as surety for borrowing). The French President suggested that banks should buy government bonds, which could then be pledged as collateral to borrow unlimited funds from the ECB or national central banks.

Nicolas Sarkozy was unusually direct: "each state can turn to its banks, which will have liquidity at their disposal." He pointed out that earning 6% on Italian bonds that could then be financed at 1% from central banks was a "no brainer". At the same, ECB President Mario Draghi is urging banks to reduce holdings of government securities and to use the funding provided to meet debt maturities.

Sarko-nomics perpetuates the circular flow of funds with governments supporting banks that are in turn supposed to bail out the government. It does not address the unsustainable high cost of funds for countries like Italy. If its cost of debt stays around current market rates, then Italy's interest costs will rise by about euro 30 billion over the next two years, from 4.2% of GDP currently to 5.1% next year and 5.6% in 2013.

In many countries, Sarko-nomics will be supplemented by "financial oppression" as government increasing coerce their citizens and institutions to purchase sovereign bonds. Regulatory changes will require a proportion of individual retirement savings to be invested in government securities.

Banks and financial institutions will be required to hold increased amounts of government bonds to meet liquidity and other requirements. There may be restrictions on foreign investments and capital transfers out of the country.

Financial oppression will complement traditional public finance strategies such as direct reduction in government spending, indirect reductions in the form of changing eligibility such as delaying retirement age, and higher taxes, including re-introduction of wealth and property taxes as well as estate or gift duties.

Debt reduction through restructuring remains off the agenda. The adverse market reaction to the announcement of the 50% Greek write down forced the EU to assure investors that it was a one-off and did not constitute a precedent. Despite this, investors remain skeptical, limiting purchases of European sovereign debt.

Weaker euro zone countries may meet their debt requirements through these measures but it will merely prolong the adjustment period. It will also increase the size of the problem, locking Europe into a period of low growth and increasing debt levels.

Reality Check...

The prospects for the real economy in Europe are uncertain. European debt problems and slowing growth in emerging markets such as China, India and Brazil may lead to low or no growth.

For the nations that have received bailouts, the austerity measures imposed have not worked. Growth, budget deficit and debt level targets have been missed.

Even Ireland, the much lauded poster child of bailout austerity, has experienced problems. The country's third quarter GDP fell 1.9% and its Gross National Product fell 2.2% (the latter is a better measure of economic performance due to the country's large export/ transhipment activity).

Ireland must reduce its budget deficit from 32% of GDP in 2010 to 3% by 2015. Despite spending cuts and tax increases, Ireland is spending euro 57 billion, including euro 10 billion to support its five nationalised banks, against euro 34 billion in tax revenue.

Spain, which has voluntarily taken the austerity cure, is missing economic targets. Spain's budget deficit is above forecast (at 8% of GDP, it is a full 2% above the target agreed with the EU.)

The need to support the Spanish banking system may strain public finances further. Unemployment increased to over 21% (nearly 5 million people). Spain's economic outlook is poor and deteriorating.

Under Prime Minister Maria Monti, Italy has passed legislation and budget measures to stabilise debt. The actions focus on increasing taxes, especially the regressive value-added tax, rather than cutting expenditures.

Structural reforms to promote growth are still under consideration and the content and timing is unknown. It is also not clear whether the plans will be fully implemented or work.

If the pattern elsewhere in Europe continues, it is unlikely that Italy will be able to stabilise its public finances. The sharp drop in demand from cuts in government spending and higher taxes will result in an economic slowdown, which will result in continuing deficits and increased debt.

In the third quarter of 2011, Italy's economy contracted by 0.2%. The government forecast is for a further contraction of 0.4% in 2012. The government forecasts may be too optimistic. Confindustria, the Italian business federation forecasts the economy will contract by 1.6% in 2012.

Consumption is especially weak in many of the problem economies, with Greece experiencing falls of around 30% and Italy also experiencing large falls.

Stronger countries within the euro zone are also affected. Lack of demand for exports within Europe and from emerging markets combined with tighter credit conditions may slow growth.

German export orders are slowing, reflecting the fact that the EU remains its largest export market, larger than demand from emerging countries. Germany exports to Italy and Spain total around 9-10 per cent in 2010, higher than to either the US (6-7%) or China (4-5%).

What happens in Europe will not stay in Europe, being transmitted via trade and investment channels, negative feedback loops will complicate the economic outlook.

One complication will be the euro itself. Following his American counterparts, who insist that they favour a strong dollar inconsistent with the evidence, German Finance Minister Wolfgang Schaeuble stated that: "The euro is a stable currency." In fact, the euro has fallen around 12 % against the dollar.

Should the European debt crisis cause currency volatility, as seems likely, the effects will be widespread. One unstated element of the calls for the ECB to engage in quantitative easing is to weaken the euro, increasing the export competitiveness of weaker European nations boosting growth.

Such action risks setting off currency wars as both developed nations (US, Japan, Britain, Switzerland) and emerging countries retaliate. The risk of capital controls, trade restrictions and currency intervention is high.

Voting Intentions...

The risks of political and social instability remain elevated.

Greece faces elections in April 2012. The polls indicate a fractious outcome, with the major parties unlikely to gain majorities with significant representation of minor parties. An unstable government combined with a broad coalition against austerity may result in attempts to renegotiate the bailout package. Failure could result in a disorderly default and Greece leaving the euro.

The French presidential elections, scheduled for May 2012, also create uncertain. The principal opponents to incumbent Nicolas Sarkozy either oppose the euro and the bailout (the National Front led by Marine Le Pen) or want to renegotiate the plan with the introduction of jointly guaranteed euro zone bonds (the Socialists led by Francios Holland).

The European debt crisis is also creating political problems in Germany, Netherlands and Finland, especially among governing coalitions. The risk of unexpected political instability is not insignificant.

In the weaker countries, austerity means high unemployment, reductions in social services, higher taxes and reduced living standards. Social benefits increasingly below subsistence are widening income inequality and creating a "new poor". Protest movements are gaining ground, with growing social unrest.

In the stronger nations, increasing resentment at the burden of supporting weaker euro zone members is evident. Despite the tabloid headline, Germans have been relatively sanguine about the commitment of funds to the bailout, aided by limited disclosure of the extent of the commitment and a relatively strong economy.

A downgrade of Germany's cherished AAA rating or any steps to undermine the sanctity of a hard currency (by printing money or other monetary techniques) will force increasing focus on the costs to Germans of the bailouts. Germany's commitment to date is euro 211 billion in guarantees, euro 45 billion in advances to the IMF and euro 500 billion owed to the Bundesbank by other national central banks - around 25% of GDP.

The increasing risk of losses may even divert attention away from the 2012 European Soccer Championship where Germany is drawn in the "Group of Death" with Netherlands, Portugal and Denmark.

Road to Nowhere...

In the short term, Europe needs to restructure the debt of number of countries, recapitalise its banks and re-finance maturing debt at acceptable financing costs. In the long term, it needs to bring public finances and debt under control. It also needs to work out a way to improve growth, probably by restructuring the euro to increase the competitiveness of weaker nations other through internal deflation.

Such a program is difficult and not assured of success, but would provide some confidence. At the moment, Europe does not have any credible policy or workable solution in place.

One persistent meme is that Europe has enough money to solve its problems. This is based on the euro zone members' aggregate debt to GDP ratio of around 75%. There are several problems with this analysis.

The debt is concentrated in countries where growth, productivity and cost competitiveness is low, which is what caused the problems in the first place. The relevant wealth is in the hands of a few countries like Germany that appear unwilling to bail out spendthrift and irresponsible neighbours. A substantial portion of the savings is also invested in European government debt directly or in vulnerable banks, which have invested in the same securities.

The total debt of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) plus Belgium is more than euro 4 trillion. A writedown of around euro 1 trillion in this debt is required to bring the debt levels down to sustainable levels (say 90% of GDP).

In the absence of structural reforms and a return to growth, the writedowns required are significantly larger. This compares to the GDP of Germany and France respectively of euro 3 trillion and euro 2.2 trillion.

In addition, the stronger nations may have to bear the ongoing cost of financing the weaker countries budget and trade deficits. This does not appear economically or politically feasible.

Europe now resembles a chronically ill patient, receiving sufficient treatment to keep it alive. A full and complete recovery is unlikely on the present medical plan. Europe resembles a zombie economy, which functions in an impaired manner with periodic severe economic health crises. The risk of a sudden failure of vital organs is uncomfortably high.

In their song "Road to Nowhere", David Byrne and the Talking Heads sang about "a ride to nowhere". Byrne sang about "where time is on our side". Europe's time has just about run out. A failure to properly diagnose the problems and act decisively has put Europe firmly on the road to nowhere. It is journey that the global economy will be forced to share, at least in part.

Satyajit Das

© 2012 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk. He is a keynote speaker at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney's Intercontinental Hotel.

From the Archives...

Picking the Big Investment Story for 2012
2012-02-10 - Kris Sayce

Attention: If You Have Australian Bank Stocks - Sell Them Now
2012-02-09 - Kris Sayce

Why This Bearish Indicator Means it's Time to BUY Stocks
2012-02-08 - Kris Sayce

Why The RBA Uses The Terms of Trade Indicator... And Why You Should Too
2012-02-07 - Greg Canavan

Why the US Unemployment Rate is a Slippery Statistic
2012-02-06 - Dr. Alex Cowie


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The Implications of Middle East Meltdown

An escalation of tensions in Syria, Egypt and the Middle East could put a floor under the oil price at US$100 in 2012. No matter what the global economy does.

According to Dan Denning, high oil prices, geopolitical tension plus the US shale boom should all underpin the long-term case for the development of an Aussie shale gas industry. He already has three double-digit shale gains under his belt. To read his case for shale... and find out what type of companies he has marked as buys for 2012... click here.

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"Anywhere this Australian explorer
sticks a drill, it seems to find gold..."

This ASX-listed company operates in an emerging new gold region that already hosts more than 100 million ounces in known gold resources.

Find out why Dr. Cowie believes it could your first "ten bagger" of 2012 - plus five other hot resources stocks for the year ahead - click here.

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