Petrocapita UpdateMarch 2010

1

Contents

3 “TheU.S.governmentmustmakeadjustmentsinitsspending.”

3 “Ifitwerepossibletotakeinterestratesintonegativeterritory,Iwouldbevotingforthat.”

3 WhytheUSFinancialSectorisstillnotHealthy–Morebailoutstofollow?

4 HowMuchIsTooMuch?

4 PeakOil

5 EmergingEconomyDecouplingRevisited

6 AIG–ohdear,ohdear,ohdear

6 BenBernankeTheSecondComingOfRudolfvonHavenstein?

7 AustrianDefinitionofMoneySupply

8 USInflationis10%not3%

Wecontinuetoliveinhistoricfinancialtimesandinparticularinthefirstsynchronized,global,fiatmoneyinflationeffort.Furthertothiswehavezerointerestratepoliciesinvirtuallyeverymajormarketandthemonetarybaseoftheworld’sreservecurrencyisup150percentinthelast24monthsandgrowing.

Insuchanenvironmentitcanbeachallengetodistillactionableinvestmentthemesfromthenoiseanduncertaintyinthemarketplace.Thisiswhythecompassbywhichwesteerisvalue.

Investorsmustbeinthebusinessofbuyingcashflowinexpensivelyinordertogeneratelong-termreturns.IfIhadtolabelmyapproachitwouldbevalueinvestinginformedbytheAustrianSchoolofEconomics-valuedrivenattheinvestmentselectionlevelwithAustriananalysisatthemacroleveltoprovideinsightintotrends.

ItisoftrendsthatIwanttospeakmoreaboutbecauseweareinthemidstofsomeunsustainabletrendsifhistoryandAustrianEconomicsisaguide.Ihavewrittenthismanytimesinoneformoranotherbutitbearsrepeating:

Thereisnowaytocreatecapitalandtheprosperitythatflowsfromitotherthanthroughprivatesavingsandprivateproduction.

Sadlythisisamessagetowhichourgovernments,undertheswayofKeynesianideology,areunwillingtolisten.Itisaxiomaticthatstatespendingrequiresthatcapitalisfirsttakenoutofthehandsoftheprofitmakingprivatesectoractivitiesviataxes,borrowingorinflationandthendeployedintypically,loss-makingpublicsectoractivities.

ToquoteJensParssonsfromthe“DyingofMoney:LessonsoftheGreatGerman&AmericanInflations”-“Everyonelovesanearlyinflation.Theeffectsatthebeginningofinflationareallgood.Thereissteepenedmoneyexpansion,risinggovernmentspending,increasedgovernmentbudgetdeficits,boomingstockmarkets,andspectaculargeneralprosperity,allinthemidstof

Summary

2

Summary (continued)

temporarilystableprices.Everyonebenefits,andno-onepays.Thatistheearlypartofthecycle.Inthelaterinflation,ontheotherhand,theeffectsareallbad.Thegovernmentmaysteadilyincreasethemoneyinflationinordertostaveoffthelattereffects,butthelattereffectspatientlywait.Intheterminalinflation,thereisfalteringprosperity,tightnessofmoney,fallingstockmarkets,risingtaxes,stilllargergovernmentdeficits,andstillroaringmoneyexpansion,nowaccompaniedbysoaringpricesandanineffectivenessofalltraditionalremedies.Everyonepaysandno-onebenefits.Thatisthefullcycleofeveryinflation.”

TheAustrianshavemanyusefulinsightsontheeconomicconsequencesofstateexpansion.FriedrichHayek,theprominentAustrianeconomist,wrote“TheRoadtoSerfdom”and“TheFatalConceit”asawarningagainstanexpandingstateandinterventioninthefreeoperationofthemarkets.Despitethealmostuniversalbeliefthatmoregovernmentisneeded,Hayek’sworksshouldmakeuspondertheultimatedamagecausedbysuchactions.Ithasbeenstatecontroloverthecostofmoney(i.e.interestrates)andthemoralhazardcreatedwith“toobigtofail”thatleddirectlytotheproblemswenowface.Moreofthesamewillnotsolveourproblems.Hayekoncesaid“Idonotthinkitisanexaggerationtosayhistoryislargelyahistoryofinflation,usuallyinflationsengineeredbygovernmentsforthegainofgovernments.“Youcanbringthisquoteuptodatebyaddingthefinancialsectorastheotherbeneficiary.Givethissomethoughtasyouwatchthegovernmentsoftheworldpursuetheircurrentfiscalandmonetarypolicies.

Ifyouhaven’talready,pleasetakethetimetoreadthesebooksorifyoufindthemoverlydauntingasastartingplacethenperhapsconsiderFrederickBastiat’sshortbutseminalwork“TheLaw”.Iamconfidentthatallthesebookswillcastsomelightonwhatwearecurrentlysowingandwhatwecanexpecttoreap.

Onafinalnote,wecontinuetobelievethatwithallthatistakingplacethisisamarketwhereconcernsabout“returnofcapital”shouldtakeprecedencetoconcernsabout“returnoncapital”.

3

Petrocapita Update (continued)

Chart 1: Months of shadow hoMe supply

“The U.S. governmenT mUST make adjUSTmenTS in iTS Spending.”

Inthespiritofdeliciousirony,KansasCityFederalReserveBankPresidentThomasHoenigsaidrecently“TheU.S.governmentmustmakeadjustmentsinitsspendingandtaxprograms,”(emphasismine).“Itisthatsimple.Ifpre-emptivecorrectiveactionisnottakenregardingthefiscaloutlook,thentheUnitedStatesrisksprecipitatingitsownnextcrisis”.ThiscomingfromthesameFedthatincreasedthebasemoneysupplyover150%inthelast24months.ClicktoreadHoenig’sspeech.

“if iT were poSSible To Take inTereST raTeS inTo negaTive TerriTory, i woUld be voTing for ThaT.”

SanFranciscoFederalReservePresidentJanetYellenhasbeennominatedbyObamatobeViceChairoftheFed’sBoardofGovernors.Yellen,whohasconsistentlydownplayedthedangersofinflation,isnowabletovoteontheinterestrate-settingOpenMarketsCommittee.InsupportofherviewthattheFed’sroleistocreatefullemployment,Yellenrecentlysaid,“Ifitwerepossibletotakeinterestratesintonegativeterritory,Iwouldbevotingforthat.”

why the us finanCial seCtor is still not healthy – More bailouts to follow?

ResidentialMortgageBackedSecurities(“RMBS”)-Arecentstudyestimatesthat5millionhousesandcondominiumsonwhichmortgagesarenowdelinquentwillgothroughforeclosureorrelatedproceduresthatputthemonthemarketoverthenextfewyears–themajorityoftheestimated7.7millionhouseholdscurrentlybehindontheirmortgage

Source:JohnBurnsRealEstateConsulting

payments.Basedontheaveragesalesrateoverthepastdecadethis“shadowinventory”isenoughtolastabout10months.

WhenthisinventoryisreleasedpriceswilldropevenfurtherandmagnifythealreadylargelossesonmortgagesandRMBSbeingsufferedbythebankingsector.

CommercialMortgageBackedSecurities(“CMBS”):Theotherlargeassetsittingonbankbalancesheetsiscommercialrealestateloans.ItsclearfromtheCMBSmarketthatallisnotwellinthecommercialrealestatelendingworld.

– AttheendofJanuary,arecord10%ofCMBSbybalance($72.3billionofthe$723billionofoutstandingCMBSloansintheU.S.)wereinthehandsofspecialservicers,upfrom9.43%onDec.31,2009.

METROAREA NUMBEROFMONTHS

Phoenix 15

LasVegas 18

Miami 24

Orlando 27

Stockton,CA 27

U.S.Average:10months

4

Petrocapita Update (continued)

– Thespecial-servicingrateisnowsixtimeshigherthantheyear-end2008levelof1.62%.

– The60-daydelinquencyratehasincreasedto6%.

Morecommercialloansarecertaintobecomenon-performingovertime,asoverleveragedborrowersareunabletorefinanceatmaturity.Inaddition,thepaceofmaturingCMBSloanswillaccelerateoverthenextfewyears.AccordingtotheCongressionalOversightPanel(COP)recentreportonthestateoftheUScommercialrealestatemarket:

– Between2010and2014,about$1.4trillionincommercialrealestateloanswillreachtheendoftheirterms.Nearlyhalfareatpresent–underwater!–thatis,theborrowerowesmorethantheunderlyingpropertyiscurrentlyworth.

– Commercialpropertyvalueshavefallenmorethan40percentsincethebeginningof2007.

– Increasedvacancyrates,whichnowrangefromeightpercentformultifamilyhousingto18percentforofficebuildings,andfallingrents,whichhavedeclined40percentforofficespaceand33percentforretailspace,haveexertedapowerfuldownwardpressureonthevalueofcommercialproperties.

how MuCh is too MuCh?

USFederalgovernmentspendinghasgrown7timesfasterthanreal(inflation-adjusted)medianhouseholdincomeoverthelast40years.

Governmentspendingcannotoutstripprivatesectorincomeindefinitelyunlessthegovernmentplans

todefaultorinflateawayitsobligations.WhatishappeningtoGreece,Ireland,UKandSpainisamicrocosmofthedecisionsthatrapidlyexpandinggovernmentstheworld-overmaybefacedwithinafewyears.

peak oil

Chart3isdrawnfromtheWEO-2008reportthatshowsthat“oilfromfieldscurrentlyproducing”isprojectedtoenterasignificantdeclineinproduction.Theproductionshortfallismadeupprimarilyby“oilfieldsyettobedeveloped”,“oilfieldsyettobefound”,and“naturalgasliquefaction”.However,thelowrateofoilfielddiscoverysincetheearly1960’sbegsthequestionofhowthisgapwillbefilled.

Medianhouseholdincome

Chart 2: total us federalspending v Median inCoMe

Source:HeritageFoundationbasedonUSCensusBureauandOMB,2008inflationadjusteddollars

19701975198019851990199520002005

250%

200

150

100

50

0

In1970Totalfederalspendingwas$870billion,andmedianhouseholdincomewas$38,851

Totalfederalspending

$41.355+32%

$2.79trillion+221%

5

Petrocapita Update (continued)

eMerging eConoMy deCoupling revisited

Emerging-marketconsumersrecentlyoutspentAmericanconsumersforthefirsttimeinmodernhistory.Forexample,Januaryauto-salescomparedtoayearearlierwereup:

– 50%inIndia– 33%inMalaysia– 6%intheUS

Thesourceofthisdomesticstrength–highgrowthratesandhighdomesticsavingsratesthatprovidealargepoolofproductivecapital.TheemergingeconomiesarenowlargerintotalpurchasingpoweradjustedGDPtermsthanthedevelopedworld.Inevitablythiswillmeanthattheirgrowthisincreasinglydependentontradeamongstthemselvesratherthanwiththedevelopedworld.

Chart 4: ConsuMer spending – us vs. eMerging eConoMies

Source:JPMorganChase

19901995200020052010

35%

25%

nEmergingMarkets’ConsumptionnU.S.Consumption

Chart 5: global ppp gdp in 2008

Source:EverestCapital

OtherEM26%

US21%

DevEurope21%

Japan6%

OtherDev3%

China12%

India5%

Russia3%

Brazil3%

Chart 3: iea 2030 oil foreCast

Source:IEA

19902000201020202030

120

100

80

60

40

20

0

mb/d

nNaturalgasliquidsnNon-conventionaloilnCrudeoil-additionalEOR

nCrudeoil-fieldsyettobefoundnCrudeoil-fieldsyettobedevelopednCrudeoil-currentlyproducingfields

6

Petrocapita Update (continued)

aig – oh dear, oh dear, oh dear

AmericanInternationalGroup,Inc.(“AIG”),theinsurerthathasabsorbedapproximately$180bnintaxpayerfunds,recentlyreporteditsresultsforthefourthquarterandfull-year2009.AIGreportedanetlossattributabletocommonshareholdersof$8.9billionforthefourthquarterof2009,or$65.51perdilutedcommonshare,comparedtoanetlossof$61.7billionor$458.99perdilutedshareinthefourthquarterof2008.Fourthquarter2009adjustednetlosswas$7.2billion,comparedtoanadjustednetlossof$38.5billioninthefourthquarterof2008.However,fromsection1A,RiskFactors,ofthecompany’s10-Kfilingthenarrativetakesaturnfortheworseindeed:“AIGhasbeensignificantlyandadverselyaffectedbythemarketturmoilinlate2008andearly2009,and,despitetherecoveryinthemarketsinmidandlate2009,issubjecttosignificantrisks,asdiscussedbelow.Manyoftheserisksareinterrelatedandoccurundersimilarbusinessandeconomicconditions,andtheoccurrenceofcertainofthemmayinturncausetheemergence,orexacerbatetheeffect,ofothers.SuchacombinationcouldmateriallyincreasetheseverityoftheimpactonAIG.As a result, should certain of these risks emerge, AIG may need additional support from the U.S. government. Without additional support from the U.S. government, in the future there could exist substantial doubt about AIG’s ability to continue as a going concern.”(Emphasismine)

ben bernanke the seCond CoMing of rudolf von havenstein?

DylanGriceofSocieteGeneralehasdoneareviewoftheWeimarRepublicinflationinhislatest`PopularDelusions’note.PrussiancentralbankerRudolfvonHavensteinmonetizedGermany’sdebtduringandfollowingtheFirstWorldWar,eventuallyleadingtomassiveboutsofhyperinflation.

Apparentlyeconomicthoughtatthetimeheldthatincreasingmoneysupplyhadnothingtodowiththerateofinflation.Instead,GermansweretoldthehighratesofinflationwerecausedbythewarreparationsGermanyhadtopay.Morefromthenote:

“Onemightthinkthatthebigdifferenceisthattodaywehaveagreaterexpertise.Surelyweunderstandwhathappenswhendeficitsarefinancedwithprinted

Chart 6: weiMar gerMany Cpi

01/2104/2107/2110/2101/2204/2207/2210/2201/2304/2307/2310/23

100,000,000,00010,000,000,0001,000,000,000100,000,00010,000,0001,000,000100,00010,0001,000100101

60%inflation

5,300%inflation

16,579,999%inflation

Source:SGCrossAssetResearch

7

Petrocapita Update (continued)

money,andthatitisonlybackwardandcorruptstatesthatdon’tknowanybetter,likeBoliviaandZimbabwe?Butjustafewyearsagodidn’twethinkthatitwasonlybackwardandcorruptstatesthatsufferedbankingcrisestoo?

Andanyway,howcouldVonHavensteinnothaveknownthatthecontinuedandescalatingprintingofmoneytofundgovernmentdeficitswouldcauseinflation?TheUnitedStatesexperienceofunrestrainedmoneyprintingduringtheCivilWarhadbeenwelldocumented,ashadthehyperinflationofrevolutionaryFranceinthelate18thcentury.Isn’titpossiblethat,liketoday,hewasoverconfidentinhisabilitytocontrolhiscreationandintheeconomictheorywhichtoldhimsuchcontrolwaspossible?Certainly,inanarticleintheNewYorkTimesontheeveoftheFirstWorldWar,againfromLiaquatAhamed’sbook,thereseemstohavebeenevidenceofthegeneraloptimismthattherewouldbeno“unlimitedissueofpapermoneyanditssteadydepreciation…sincemonetaryscienceisbetterunderstoodatthepresenttimethaninthosedays.”

Thefactiswedounderstandtheeconomicsofinflation.Despitewhateconomistseverywheresayaboutbeingin“unchartedterritory”withQE,weknowthatifyoukeepmonetizingdeficitseventuallyyougetinflation,andweknowthatonceyou’reonthatpathitcanbeextremelydifficulttogetoffit.Butweknewthatthen.Therealproblemisthatinflationisaninherentlypoliticalvariableandthatconcernoverdebtsustainabilityandunfundedwelfareobligationsleavesusmoredependentonpoliticiansthanwehavebeeninmanydecades.”

austrian definition of Money supply

TheTrueMoneySupply(TMS)wasformulatedbyMurrayRothbardandrepresentstheamountofmoneyintheeconomythatisavailableforimmediateuseinexchange.IthasbeenreferredtointhepastastheAustrianMoneySupply,theRothbardMoneySupplyandtheTrueMoneySupply.ThebenefitsofTMSoverconventionalmeasurescalculatedbytheFederalReservearethatitcountsonlyimmediatelyavailablemoneyforexchangeanddoesnotdoublecount.InanyeventtheTrueMoneySupplycontinuestogrowrapidly.

Chart 7: true Money supply

Source:LudvigvonMisesInstitute

6,282

5,282

4,282

3,282

2,282

1,282

282

1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

2009

billionsofdollars

8

Petrocapita Update (continued)

us inflation is 10% not 3%

Despitetherosypublicassertionstothecontrary,inflationisnotrunningatsubduedlevelsintheUS.IfyoucalculatetheUSCPIusingthepre-1980smethodologyyoucanseefromtheShadowstatsdatabelowthatinflationisapproachinglevelsnotseensincethe1970swhentheUSlastlostcontrolofmonetarypolicy.

Chart 8: Cpi vs sgs alternative

Source:Shadowstats.com

1980198219841986198819901992199419961998200020022004200620082010

15

10

5

0

-5

Year-to-YearChange%

CPI-USGSAlternateCPI

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