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The BIG Picture Transcript
September 8, 2007
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Part 2 Real Player | Win Amp | Windows Media | Mp3

  Part 1
  Reflation vs. Deflation
  Other Voices: Catherine Austin Fitts, Solari Inc.

  Part 2
  Investing In Oil:  What Has Changed?
  The Catalyst
  Q-Calls

 Part 1

 Reflation vs.  Deflation

JOHN:  Well, the good, the bad and the ugly.  I was amazed at what I was hearing on CNBC here this week, Jim.  Number one, they’re talking about recession. But don’t tell anybody.

JIM:  The R word.

JOHN:  They’re using the R word.  And everybody was using the word ‘ugly’ this week.  So apparently, they’re going, “hmm, we’re not doing this little rebounder that everybody is talking about.” But, if we go back to the beginning of the year and stare into the crystal ball of the great James Puplava, we’re finding the guru made three prophecies at the beginning of the year:  Number one, real estate would fall apart; number two, the economy would slow down; and number three, the capital market would be in great crisis.  Oh great guru, now tell me.  I am trembling as I ask you, is this the end?  Is this the big one?  Should I grab the children and run for the hills?

JIM:  Listen my little midget friend…

JOHN:  I’m going back on vacation.  I don’t want to be here.

JIM:  Well, I think it’s dawning on everybody that we’re in the midst of a crisis.  And that crisis I believe is not through yet.  It has much further to play out.  But there is one thing that you're seeing develop beginning last Friday when we were off the air with the president’s bail out program.  I believe you're going to see a massive reflationary effort.  That is coming.  That is going to involve all of the world’s top central banks coordinating a reflationary effort to bring us out of it.  In other words, the Fed is going to be cutting interest rates, they're monetizing debt right now, and the real question is:  can they cut interest rates, restimulate the economy without collapsing the dollar?  And even though central banks can control interest rates through their policies, the side effect of that is it does have an impact on the currency.  And right now on the Friday you and I are talking, the dollar is breaking down to an almost 23 year low.  So anyway, I do believe we’re going to see a massive monetary, fiscal and currency reflation effort.  [2:38]

JOHN:  How far did this break when it went.  Which banks are primarily involved.  European central banks?  What about Japan, the Bank of England?

JIM:  I think they're all involved.  Japan is involved in the carry trade.  Every time the yen starts to appreciate against the dollar you’ll see Japanese officials come out – whether it’s government officials or central bank officials – they'll start jawboning the market.  So I think they're working in conjunction with the Treasury here in the United States.  You've seen, as the liquidity crisis has hit Europe, massive injection of liquidity in the European markets and you've seen it elsewhere – whether you're looking at Australia or other places around the globe.  So it’s not just something that’s impacting us here in the United States, they've got these problems in Europe and elsewhere.  [3:28]

JOHN:  Well, what about a deflationary debt collapse anyway?

JIM:  I don’t think we're going to see that.  I do think you're seeing deflation of some of the asset classes that were inflated during the last boom – primarily real estate.  But the difference today is we live in a fiat world.  There are absolutely no constraints on the Fed’s ability to run the printing presses.  And we also live, John – and you've seen it if you're watching the news and monitoring it as you do – we live in a society today where there is absolutely no tolerance for economic pain.  The financial and political system also fully subscribe to that belief system of government intervention.  You’ve got a problem, you have a bust, all right, government will do something about it.  We've seen presidential candidates, from Hillary Clinton to even members of the Republican side come out and recommend some kind of bailout.  Last Friday we saw the president come out with his version of a bailout program.  We've got Senator Dodd, we've got various Congressmen coming out with programs.  So you're seeing this pain that is unfolding, and rather than allowing the economic system and the market to cleanse itself we're not going to allow that to happen.  There is strong indoctrination in both our economic and political thinking that we can’t allow pain to take place.  So it’s kind of like if I could use the analogy, you just went on a drinking binge, and, you know, all of a sudden you start to get a headache, and you're saying do something about it.  And that’s exactly what we’re seeing unfold right now.  [5:05]

JOHN:  it’s not going to be “take two aspirin and go to bed, eventually the pain will go away.” It’s “fix it for me now” – is sort of the trend.  Which I guess basically leads us to your belief that we're really headed for another effort of reflating the whole thing. 

JIM:  Absolutely. 

JOHN:  I mean when you look at it, the deflation is like someone banged on a wasp nest. The deflationists are coming out of the wood work everywhere else, and they're trying to make their case.  And we've seen sort of a deflation in asset prices recently, and that’s what they're trying to use to pump their case here.  But you're still holding on to the reflationary side. 

JIM:  I really am.  And the reason is we've changed our economic thinking in this country.  That is we've seen it evolve over the last 100 years as we've gone from a gold-backed currency and a free market system, to today’s fiat-based currency that is supported by government intervention in the market place and in the economy. 

JOHN:  You're really covering a real wide swath of economic thought, so we need to lay some groundwork. 

JIM:  Well, in order to set the stage of where we've come and how we've evolved over the last one hundred years, prior to the US going off the Gold Standard the economy would go through these booms and busts.  And typically, during a bust after the boom the financial excesses that were in the economy – here, in the financial system –  were purged during the economic downturns.  So that after the downturn and purging, or this cleansing process, the economic system was cleansed and the economy would right itself and emerge in a healthier state. 

The problem is after the stock market crash in 1929 (which by the way was the result of monetary expansion during the 20s by the Federal Reserve) there was a belief that came into Washington that markets could no longer be trusted if left to themselves.  What was needed was some kind of helping hand, and that helping hand was government intervention into the economic cycle.  And during the early 30s, there were two prominent economic views that were being advocated at the time.  There was the Austrian school which talked about free markets, the cleansing process restraints which was being advocated by people like Ludwig Von Mises.  But on the other side of the coin was John Maynard Keynes who basically made a very strong case for intervention in the market place – a helping hand coming from government.  And unfortunately, John Maynard Keynes won the economic argument which gave legitimacy really to government countercyclical fiscal policies.  It began in the Great Depression and has carried forward up to this day.  And in that process, the welfare state was born.  And Niall Fergusson has documented this in a book that he wrote called The Cash Nexus.  And he said for the first time in history welfare replaced warfare as the primary focus of government.  [8:13] 

JOHN:  I know you mentioned that Keynes won the economic argument.  Did he really win the argument or just the political ground on which to stand, because I don’t think the argument really won. 

JIM:  No, he won the political argument because government adopted the Keynesian view, and ever since the 30s government has grown in power as a result of its intervention in the market place.  [8:35]

JOHN:  So from that point on, after the economic thinking changed in all of the colleges that were cranking out economists the goal came to be to have governments react to the boom-and-bust cycle to try to keep everything stable; that’s been the interpretation since then.

JIM:  Absolutely.  In fact, once governments discovered how they could live with the pain of a bust they no longer went through the cleansing process.  And as a result each downturn began with massive monetary and fiscal stimulus, and as a result the debt burdens of  the country began to increase with each new economic cycle.  And you can see this, looking at debt graphs – whether you're looking at government debt, individual debt, corporate debt.  It especially began to accelerate once we went off the linkage to gold in August of 1971.  In fact, as a result of these growing debt burdens which increased with the economic cycles, debt imbalances began to grow.  That is why Nixon severed the linkage between the dollar and gold, because it really paved the way for deficit spending and reflation.  In other words,  the governments said, “well, if we can’t allow this cleansing we really need to intervene more to stabilize the economy and the market place.  In order to do that we have to deficit spend.  If we deficit spend we can’t have any constraints…” Because remember, Keynes also said that when the good times come then what you do is you pay down your debt, you increase taxes and you go back to fiscal responsibility.  But the unfortunate side of this argument is it became a one-sided argument.  It was constant reflation and constant deficit spending.  So as a result the government’s budget has gotten bigger every year, it’s growing at a faster growth rate every year, and the bigger the government grows the lower the economic growth rates; and the only way you get economic growth rates today is through massive reflation because the government occupies a larger percentage of the economy.

So if I could use an analogy, picture the horses pulling the wagon train.  The horse are the private sector, the wagon train is the government and the unfortunate thing is there are fewer horses and there are more wagons that have to be pulled by the horses.  And so you get economic stagnation which is what we're going through now.  [11:02]

JIM:  Well, if the markets had been left to themselves, obviously they would have been forced into some kind of a final cleansing that would have allowed them to go on; but that politically would not fly because there would have been economic pain – let’s face it, people don’t like pain. But the system would have righted itself.  It’s almost like a ship coming back to stability after getting clobbered by a gust of wind or a wave.  And obviously we wouldn’t have experienced inflation which we’ve seen over the last half a century here in this problem.  But as it is, they’re really leaving us in this precarious position.  And what does that mean, where do we go from here then?

JOHN:  Well, I believe and you've seen this already in probably the last six weeks and especially the last two weeks, you're going to see massive reflation efforts that will make use of all government tools that the government has at its disposal.  The first one that they use is going to be monetary policy which will become more expansionary through credit pumping.  We’ve seen massive injections into the banking system, we’re seeing it on a weekly basis; you’re also going to see lower interest rates. Then that’s going to be followed…depending on whose program is adopted, but let’s put it this way, this is an election cycle and Congress is in the mood to spend money.  So you're going to see fiscal policy become massive through bailouts.  We’ve heard last Friday, the president’s bailout program; you’re going to see new fiscal spending bills and also new entitlements; and probably once the economy heads closer to a recession I think you will see tax stimulus to business.  And then also, the dollar is going to depreciate to new lower levels. 

So, you're going to see monetary stimulus, you're going to see fiscal stimulus, and you're going to see currency stimulus.  And it’s going to be a combination of all three because it will take all three of those to stabilize temporarily and move us on to the next boom before we go through another bust.  The only question going forward is: I think the next boom will not last as long, and then I think it’s going to be followed by what I call the big one. But I think we're a few years off from that.  [13:14]

JIM:  Do they really have the room to reflate this?  Obviously the head room is getting lower and lower every time that they do it. 

JIM:  Absolutely.  I really think when they cut tax revenues they criticize the government for doing that, but tax revenues are coming in at record levels.  The government deficit this year will be somewhere in the neighborhood of around about 160 billion; the Federal debt-to-GDP ratio is now below 40% (actually, it was below 38%).  I believe monetary policy also has room…the Fed has room to lower rates.

But a caveat here.  And I want to emphasize this.  This is going to take cooperation from other central banks, or else the dollar implodes.  And that is the real risk here with this next reflationary effort.  The problem with monetary policy and the Fed’s ability to run the printing presses is they can’t control interest rates and the dollar at the same time.  So, I believe the dollar is going to be sacrificed.  What they will try to do is orchestrate an orderly decline of the dollar, and for that they're going to need the cooperation of central banks.  That’s because if you take a look at the figures since July, foreign central banks have dumped somewhere in the neighborhood of 70 billion of US Treasuries which means who’s buying that; which means that the Fed has to be monetizing a good portion of that debt.  [14:37]

JOHN:  Then of course, there’s always the political issue.  That is, are the central banks of the world going to cooperate in this whole effort because they've got to be on board with this.

JIM:  I believe they will, because what we have today is really a de facto trade war that is occurring globally through currency depreciation.  Nobody really wants a strong currency.  Any time a country’s currency really starts to appreciate against another currency they start crying out for fairness, or they enact some kind of policy – either intervention or something – to depreciate their currency.  So essentially what we have right now is a trade war going on through world wide currency depreciation.  All currencies are depreciating against real money, which is gold.  And that’s what the rise in the gold market this week is.  And that’s why gold has been rising and what gold has been sniffing out.  [15:30]

JOHN:  Well, what about the credit market mess – the whole area there?  Do you still believe we have a ways to go before this thing finally clears out on the horizon, shall we say?

JIM:  Sure, the greatest amount of mortgage resets begins this month in September and goes all the way into next year.  So we’ve got a ways to go on this.  But as bad as this sounds – and if you read a lot of the commentary out there on the web today, you think Armageddon is just around the corner – it’s going to worsen but they will be able to contain it, I believe, this time.

I don’t feel as you take a look at the risk that have surfaced they're going to be as large as generally feared.  And the real key to that is preventing a severe recession.  If they cannot reinflate or they wait too long they will then run the risk of the cleansing process that we talk about – the real pain.  But with that pain the credit crisis will become much, much more severe.  And that’s what I think they're going to try to head off at the pass by reinflating massively and doing so early.  I mean if you look at the dollar amount of losses from this crisis, they're estimated to be somewhere in the neighborhood of two to three hundred billion dollars.  And on the surface that sounds like a lot of money, but it’s large unless you compare that to the total amount of liquidity out there that is available to absorb it.

And that’s one thing – the market is much larger, the amount of dollars sloshing around the globe is much bigger, and the other factor too is the risk is spread out.  There are going to be casualties; expect further hedge funds, financial intermediaries to go under; I wouldn't be surprised if a home builder goes bankrupt.  But the big boys are going to be able to weather the storm.  And you know, I have a friend in the banking industry, and I’m not going to mention the bank that he works for, but, John, he’s gone from 40 hour work weeks to 60 hour work weeks.  In fact, over the Labor Day weekend he was putting in over 12 hours a day during the week, coming in on Saturdays putting in 12 hours.  And they wanted him to work on Sunday and Monday.  He said they’ve never processed as many loans as they are doing now because they are picking up all the slack from a lot of the businesses that have been denied credit or have been closing shop or basically cutting off certain aspects of their lending business.  They're more stringent in their standards but he’s never worked as hard as he is working today.  He was telling me they were processing almost 500 loans a day.  So out of all of this I think the big boys are going to weather the storm.  They will be bigger in their size and scope.  And that’s usually what happens in these crises.  The weak ones go under; they get bought up or they get absorbed and the big guys get bigger.  [18:22]

JOHN:  What do you think about banks, are they finally going to come out of this unscathed or will they really take it at some point or other?

JIM:  Well, as I look at the mortgage situation – and I mean who makes most of the loans in this country?  It’s the banks – so banks are the most exposed to the subprime losses, at least in our view.  But I also believe their exposure is manageable although some banks, particularly outside the US have been and will probably be hurt more.  But banks are exposed in four different ways.  First, they have in-house hedge funds that they may need to bailout if those hedge funds fail.  You've seen that already on the news.  Secondly, banks are exposed to hedge funds that they have lent to through their prime brokers.  And thirdly, they are also exposed through conduits that invest in subprime mortgages because banks provide liquidity and credit enhancement backstops.

And finally banks hold subprime mortgages directly as part of their investment portfolio.  It’s estimated that they own somewhere in the neighborhood of about 25% of the riskiest tranches of subprime mortgages.  But given the size of bank balance sheets and assets these numbers aren’t as system threatening as they may sound if you just look at the numbers and take them literally as they stand.  You know, you have to take a look at their size and their balance sheet, their available liquidity and other assets that they have. 

And the other thing too is banks are kind of special because they have the capacity to sit on a lot of these assets that they're holding.  They can repackage them into different assets.  And they also can wait to actually take the mark-to-market losses until the market firms up.  So, if these securities are materially downgraded, the banks could be forced to remove them from their books in order to maintain their tier-one capital rates.  But overall, if the Fed provides the capital necessary to deliver the liquidity to pay out on these asset-backed securities there shouldn’t be any forced selling of assets on bank balance sheets.  So this all boils down to: can the Fed avert a thorough cleansing that would result in a severe recession?  And I would say, if I were a betting man, they're going to pull out all stops because they know what happens if we go into a severe recession.  That means people start losing their jobs, the more people lose their jobs that means more people will be unable to make their house payments; so in addition to high risk borrowers now you’ve got what could be, you know, a good credit risk becoming a bad credit risk as a result of unemployment growing in the economy; and that’s something they have to be seriously cognizant of and that’s the one risk to this scenario.  [21:26]

JOHN:  So to summarize the whole thing of where we stand right at this point in time and what we’re seeing in the immediate future. 

JIM:  You know, if I could use a weather analogy I would say probably one more time they’re going to be able to push back the clouds and let the sunshine through but I think the next boom cycle that’s going to come in will be brief in its duration and I think by the end of the decade all of this really starts coming home to roost; and that’s where I think we're going to see the real big one.

Interestingly enough, John, if you look at economic history here in the United States over the last half century, the more serious recessions have come about at the beginning of each new decade:  1980-81, 1990-91, 2000-01, and I would not be surprised if 2010 to 2011 is when this all comes home to roost.  [22:30]

JOHN:  That puts us right in the middle of our crisis window again, doesn’t it?

JIM:  Yeah, 2010 seems to be lining up in that crisis scenario. Whether you’re looking at peak oil, collapse of the monetary system, the currency, there are all kinds of things that sort of hinge around that year; and that’s that crisis window we see coming out.  And it’s interesting that we've been talking about this for the last couple of years as that crisis window period.  And it was interesting to see government reports coming out from quasi-governmental agencies like the IEA and they’re seeing that crisis unfold during that same period of time, 2009 to 2011.  So, in summary I think Keynes put it well when he said, you know, in the end we're all dead.  [23:11]

JOHN:  Well, let’s put it this way, Jim, the Mayan Calendar says the world ends on December 21^st, 2012, so that sort of ends the window, everybody cashes in their chips and go to your greater Valhalla or wherever that happens to be. 

So, basically, you think they're going to reflate but there are some real important caveats here to watch out for. 

JIM:  Yeah, and the two caveats are: number one, to reflate without the dollar collapsing is going to take worldwide central bank cooperation; and the Fed moving on the monetary front to prevent a major recession.  If they can’t get central bank cooperation, if they don’t move expeditiously to prevent a major recession from taking hold, then all bets are off – then it’s Armageddon.  So those are the two caveats I think I would put on that scenario.  [24:14]

JOHN:  Once again, let’s reiterate the timeframe here because we keep talking about this crisis window.

JIM:  I think we began to enter the crisis stage between 2009.  It begins and then escalates into 2010.  John, you and I have commented on this program many, many times whoever the next president of the United States will be, he is going to face a world of crises in his first term of office – as well as Congress.  So what’s really going to be key in terms of the stature and the character of the type of people that we elect in this next cycle.  What I think brings this whole thing down is it’s going to take a catalyzing event that’s going to trigger the end game.  In my opinion, I believe that catalyzing event is a supply shock.  And I believe that supply shock is going to brought on by peak oil.  [25:09]

JOHN:  And realizing that you're talking about all of these trends coming together, we have not only the oil issue, we have the geopolitical issues which all seem to be heating up and pointing into this same window; along with the United States is economic issues with all the other central banks of the world; and they're all plunging into this window right there.  It’s amazing.  It’s not just going to be one thing it’s going to be a series of things they will deal with.  But I’m actually predicting, Jim, whoever gets elected as president or whatever, sitting in Congress there, they’re going to go into the session with their agenda - you know, a big pile of papers, and almost immediately they're going to have to throw them overboard and just deal with the ongoing crises.  It will almost be impossible to deal with some of the things they want to see.

But so far, your basically saying we’re okay, you know, keep your seat belt on, we're okay till the end of the decade, right?  Which isn’t far away.

JIM:  Well, yes and no.  And what I mean by that is they're going to reflate but I think the difference in this reflationary cycle is we are going to see visibly – as we are now seeing – inflationary consequences and that goes back to what is different today.  If you go back to the last time they reinflated in 2000-01, there wasn’t as much debt in the system as there is today.  And in 2000-01, oil prices were at $20 a barrel, we were looking at 60 cents for copper, we were looking at gold prices of 250 and silver prices at around 3.50 to $4.  Today, we’re looking at $700 gold, almost $13 silver, oil at $75, copper at 3.60.  And so what you're really going to start to see, and this is going to put a limitation on in terms of how big this next reflationary boom becomes is that the ordinary cost of living for the average American and actually, for other citizens around the world, they're going to see the average cost of living – food, energy prices – is going to be going up.  There is going to be nothing that any central bank policy can do to stop that.  And so the consequences are there is much more inflation already baked into the system today that’s already existing.  Now you add new reflationary efforts.  So they may be talking about the core rate of inflation around 0.2%, but the headline inflation numbers are going to be much, much higher and people are going to experience that in a real sense on Main Street; and that’s what’s going to be different.  In fact, if you take a look at the inflationary consequences, I just got this in on Friday from John Williams’s ShadowStats.com, the M3 growth rate is now growing at over 14%.  So here we are with 14% monetary growth and we’re looking at bond yields that are below 4.4%.  All of that is a prescription for inflation.  [28:18]

JOHN:  I think one other factor that’s going to be important politically is what I call a loss of confidence in government pronouncements.  Up until now everybody has been willing to buy the pronouncements but when all of a sudden we discover the pronouncements aren’t working or are patently false, I think people will less and less be inclined to listened to what politicians are saying.  And that will mark a radical shift in politics as well; just a general loss of confidence in what they’re hearing.

JIM:  Very much like what you saw a growing distrust of government in the 70s with the Watergate crisis, government wage and price controls, mishandling of the economy, a growing double digit inflation.  They can fool around with the numbers but the guy on Main Street is eventually going to figure it out.  He’s going to turn on the television or pick up a newspaper and they’re going to say, “Well, the core rate of inflation is 2%, and he’s going to know darn well that he just went to the grocery store, chicken prices were up 10-15%, gas prices are up 4.50 to $5 a gallon; his utility bills are going to be escalating as much as his gas bills are just simply from the mistakes that governments are making, and the higher baked in cost as a result of legislation that has been passed over the last couple of years.  And by the end of the decade, as peak oil hits I firmly believe that the environmental movement is going to be totally discredited.  [29:52]

JOHN:  Because it’s restraining what needs to be done to deal with the issues confronting the country?

JIM:  Yeah, you can say, “great, save the whales – and all this kind of stuff.  But when people cannot get gasoline and put it in their tank, have to wait in line, have it rationed, the lights go out, and all the conveniences of hot water when you turn on the shower on turn on the lights, when those things are taken away, when you're restricted from moving around because you can’t have access to energy, all of this is going to come home to roost.  And I think you're going to see a very, very important sea change politically; just as you saw a very important sea change politically at the end of the 70s:  put people through enough pain and watch how attitudes change very quickly.  And this was something rather striking when I was interviewing John Rennie which was the public opinion poll taken by a major brokerage firm and Americans said, “Look, we want energy security, and we want a cleaner environment but not at the expense of it disrupting my life or causing me to pay more money, or changing my lifestyle in any way.”  And then in that same poll it showed that whether it was building a refinery, a coal plant, a natural gas plant, LNG terminal – anything to do with energy –80 to 90% of Americans disapproved of any of those things.

You can’t have that.  Something’s got to give.  If you can’t have a clean environment and you can’t go to alternative energy if you're not willing to build anything.  [31:40]

JOHN:  Yeah, you can have the clean environment and you can have alternatives but you have to make some changes.  I mean we're not saying we're going to back to belching smokestacks, but we're basically saying that there are going to have to be some radical changes.  But up until now people think you can have both because for the most part most people – unless you're doing something that directly impacts environmental legislation or controls you – they haven’t felt the impact of this.  Well, they have but it’s been indirectly.  It’s been in terms of things that you pay at the counter, or the grocery store.  They’re actually paying for it, they just don’t know it.  So far it’s been tolerable, but then it won’t be tolerable; that is what you're saying.

JIM:  And they won’t be able to shift the blame on to somebody else.  I mean people will be tired of hearing:  well, it’s the greedy oil companies; as we get into the next segment, the largest profiteer of energy is the government itself.

 Other Voices:  Catherine Austin Fitts, Solari Inc.

JIM:  Well, with the mortgage crisis upon us and making daily headlines we thought it time to bring in another voice, and especially somebody that used to work at HUD. 

Joining us on the program is Catherine Austin Fitts.

CATHERINE AUSTIN FITTS:  The honest truth is I’d much prefer to know what you think an investor ought to do.  I’ve been on the phone with clients the last two days trying to help them understand what’s happening.

JIM:  I think they're going to reinflate their way out of this.  I do not think this is the big one.  I think they're going to be able to push back the clouds and let the sunshine through one more time but it’s going to be different.

CATHERINE:  Right – that’s what I call the slow burn scenario.  And I agree with you.  I think the chances of their being able to do that are greater than not.  So I think that’s the probable case.

JIM:  I don’t think this really hits the fan for about another two or three years.  You see, I’m a big believer in peak oil, and I think when that hits, it doesn’t matter how much they print this whole thing unwinds.  And when it does, I think in the next decade we see the four horsemen of the Apocalypse.

CATHERINE:  I don’t believe that that has to happen but I agree I think peak oil is very serious.  Jim Rogers at the New Orleans conference last year said forget peak oil,  it’s peak everything.  And I do think the peak everything issue is very serious.

JIM:  It’s rather interesting to watch where we're going and if you take a look at all the movements against Fannie and Freddie a couple of years ago to rein them in and now we run into a crisis and they're now going in almost the opposite direction, wanting to increase their limits, have Fannie and Freddie involved in the bailouts.  It’s amazing to see how the pendulum in Washington goes from one extreme to the next.

CATHERINE:  I was sitting in Jack Kemp’s office when he was Secretary of HUD and listening to one of Kemp’s staffers explain to David Mackel; [phonetic] who was then the Chairman of Fannie Mae and Jim Ralf [phon.] why they wanted to centralize.  And Ralf said to them, “wait a minute, I thought as Republicans you wanted to decentralize.” And the special assistant said, “yeah, but we're here now.” Meaning we're in control of the central bureaucracy.  And I think part of what we watched with Fannie and Freddie was one group just assert control of that part of the turf, as opposed to really having a policy probably with the things that Freddie and Fannie were doing.  [35:11]

JIM:  The amazing thing that I see in all of this and you can go all over the Web today and read, “this is Armageddon, this is it,” and Catherine, I just don’t see that.  I still think in the fiat world in which we live today where there is no limitation to any central bank printing money, if you look at this credit crisis the one good thing you can say about it is it’s more dispersed rather than just one or two key players.  And even though there might be 200 or 300 billion – depending on whose figures you read – 200 to 300 billion in losses in a worldwide financial system given its size is not as scary as it first sounds when you hear that number; in other words, if you were talking 2 or 3 billion dollars of losses in 1991 that might be a more serious number. But I think there is enough room here for both the Fed and monetary policy and cooperation with other central banks and also fiscal policy that they can reflate their way out of this.  Any thoughts on that?

CATHERINE:  I think what we're watching is a shift of resources and activity from the US economy to the Asian economies and to the global economy.  So, in other words, another way of saying what you just said – which I agree with – is we can keep the global financial system clocking along with Asian and Latin American and other consumers.  The US consumer is no longer needed to support the global economy.  And so you can let the US go down without the global financial system going down.  And the $64 question though is:  it’s one thing to inflate and pump up mortgages that have collateral value, I think the $64 question which would argue the other way, Jim, is whether or not enough of those securities are really fraudulent that that’s going to make it hard for the Fed…you know, it’s one thing to inflate something that has value, it’s another thing to inflate something that has no value.  And so that’s where the problems could lie if we have them this time around.  [37:30]

JIM:  What about the Fed just going in and mopping up the stuff that is useless?

CATHERINE:  Well, to do that they're going to have to either exchange them for FHA…you know, they're going to have to give investors guarantees or they're going to have to answer to angry investors or borrowers.  And so, for example, I’ve said for a long time that a lot of the mortgages issued in the last 10 years, you know, there is a case to be made in court that they were fraudulently induced.  I think the question is will the courts be able to…what will happen as those arguments get played out in the legal discussions.  So either investors are going to take it or borrowers are going to take the losses.  And how that turns out we don’t know yet.  [38:14]

JIM:  One of the things that I see on the horizon that could play a big role in terms of reflating is every time we come out of these asset bubbles and go into a bust as real estate and credit is now they reflate and the money goes elsewhere.  So when the tech bubble deflated we got real estate, when that began to deflate we got private equity.  But one thing that I think can become the next bubble and reflate is going to be commodities as sovereign funds – I forget what the number is in size…but if you were a central bank watching the money supply figures around the globe grow at double digit rates, wouldn’t you take some of that money and buy something real?

CATHERINE:  Absolutely.  Well, for example, there was an article the other day about GE and Goldman Sachs buying water companies or making a bid for water companies in England.  That, folks, is simply getting bailed out with inflated dollars and turning around and trying to reinvest it in something real.  So, you know, you're watching the financial players pull out of the financial markets and invest in tangibles and the real thing.  So part of it is that shift.  Another shift is getting out of old industrial companies and getting into companies that are doing new technology and what some people would call sustainable solutions. 

I still think the liquidity issue in the next three to six months is something that needs to be watched because what’s happening this month in September is we have the Federal appropriations being decided for the October 1^st – the new Federal year.  And so what that means is in October a lot of folks are going to get bad news because you have a pig going through a snake.  So much of our economy has been held up with government money and that depends on more and more borrowing worldwide that is starting to get more expensive.  And so it’s not just the housing market, it’s the whole market flow that comes off of a wide range of private activities and private financing which is being held up with government money.  And I think the $64 question there is what is going to happen in terms of national politics for the Federal government to be able to keep borrowing that amount of money to keep all of these serious activities and companies afloat.

So the thing to watch, from my standpoint, is what is going to happen with the Federal budget and how is that going to play back into the liquidity issues.  [40:43]

JIM:  You know, the thing that surprised me – and we saw a bit of this last Friday with Bush’s bailout – I can’t think of whether you're looking at Congress – both Democrats and Republicans, or you're looking at the White House – everybody’s got a bailout version; and every politician I see running for office, at least for the presidency, has their own stimulus and spending program that they're going to promise the voters.  So being that we're in an election cycle, it seems to me that the mood has shifted for plenty of government intervention in the economy.

CATHERINE:  Yes it has.  And that’s too bad because there’s only one way to get productivity rates up in terms of changing government investment and that is if you reengineer government investment by place.  So, for example, many times in the Housing budgets we would see neighborhoods where the Federal government was spending 150 to 250,000 per unit to do something where you could buy and rehab a single family home for 50,000.  That would have required reoptimizing government investment by county – or county or town level.  And other than reengineering government investment in that way there is no way that more government intervention can improve productivity rates. 

In fact, the more you get the economy dependent on anything centralized the more you're going to drive productivity rates down.  [42:12]

JIM:  But you can almost see this coming, Catherine.  I’m just watching the political debate and I think Republicans are sounding like Democrats.  Everybody wants more government involvement.  I mean, you have Bill Gross who runs the largest…talking about fiscal stimulus.  Everybody is Keynesian now.  And when government creates a mess as it has with this credit bubble, making it possible with some of the lowest interest rates we've seen in half a century, then when it busts there is a further cry for more government involvement in the economy.  So everywhere I turn, whether it’s picking up a newspaper, a magazine or turning on the television, it’s a cry out there for government to do something, fix this.

CATHERINE:  Right, and ultimately that’s not going to work because any solution that lowers productivity is a temporary fix that makes things worse in the long run; and it continues to centralize the economy in ways that lowers productivity.  So the opportunity for us as entrepreneurs or private investors is where can they start to decentralize activity or shift from financial to tangible in a way that significantly improves equity in this kind of scenario – whether it’s a meltdown at some point or simply this continuous steady inflation.  So there are solutions, but I think looking to government in the short run it will certainly bailout a variety of different folks but it’s not going to solve the problems in the long run; and solutions in the long run are where the real great fortunes are going to be made.

JIM:  If you were to take out your crystal ball, Catherine, looking out a couple of years, how do you see this housing and credit scenario playing out?

CATHERINE:  I think it’s up in the air.  I think it’s a wild card.  We're going to amortize the losses in a way, that will again shift activity…I mean equity is being moved from          the United States over to Asia and we're going to go through a process where the middle class and anybody but the very wealthy in this country is going to go through a huge amount of financial pain.  We're going to digest the bust of this bubble.  But we're also going to see the capital that flowed out and did very well abroad come back in and buy; maybe not at very low nominal rates but certainly after their currency inflation they're going to be buying it ten cents on the dollar, or 50 cents on the dollar.  So we're going to see capital flow back in once we've marked to market.  And I think essentially what we're watching is the reengineering of institutions.  I once said that what we watched in the 90s was a financial coup d’etat.  But I think that’s part of what we're watching is a fundamental reengineering of the economy and the governance structures, very much through the financial system.  That’s because if I’m sitting on Wall Street and the Fed will bail me out of my mistakes but I’m a farmer in western Tennessee and nobody is going to bail me out of the drought or if I’m up in Wisconsin nobody is going to bail me out of the floods then the price of food is going to skyrocket and the guys who get bailed out are going to have the money to pay for it, but the rest of us aren’t.  [45:40]

JIM:  Well, you know, the one thing that we do know, Catherine, in periods of inflation as we're going through now and I expect that to get worse, you have huge wealth discrepancies that are developing as you just describe.  The wealthy are going to get wealthier because they will have the means to profit from that inflation, but your average middle class or poor person, who is barely making it by, are going to see their cost of living go up.  The things they need on a daily basis, whether it’s seeing a doctor, buying food at the grocery store, paying their utilities, their health insurance premiums, all that is going to put a squeeze on the middle class; and you're going to see a very big wealth disparity which is what you see in socialized structures.

CATHERINE:  Right.  Absolutely.  Once again, we agree.  [46:29]

JIM:  Catherine, if our listeners would like to find more about work and the things that you do why don’t you tell them how they could do so.

CATHERINE:  Sure.  My website is www.solari.com and Solari Investment Advisors www.solariadvisors.com. 

JIM:  As always, Catherine,  it’s a pleasure talking with you.  Please come back and talk with us once again.

CATHERINE:  Thank, Jim, have a wonderful day.

 Q-Calls

JOHN:  Welcome back to the program.  John Loeffler and Jim Puplava sitting here.  Time to go to the Q-Line.  Q-Line means the question line.  We have the question line open 24 hours a day.  There is a toll free number which works in the US and Canada as far as toll free is concerned (800)794-6480.  That number does work from the rest of the world but you have to pay for it based on whatever your international phone rates are.

And we should remind you that while we provide you some opinions here on the program and try to answer your questions the content here is for informational and educational purposes only; and you shouldn’t consider it as a solicitation or offer to purchase or sell any securities.  And because of the fact that our responses to your inquiries here are based on the information that you give us – a very limited amount of information – we don’t know about your suitability, your objectives, your risk tolerance, basically everything is simply the opinion of James Puplava; and we can’t be liable to any person for financial losses that result from investing in companies profiled or other information here on the Financial Sense Newshour.

The first question comes from Art in Calgary, Canada:

Hey, Jim, John this is Art from Calgary again.  Still can’t break my addiction to your show.  Great stuff.  Has been for years.  I’ve been listening since probably 2001 quite religiously.  First a comment:  Jim, coming from Canada I can’t believe the problems your having getting a diesel.  I sympathize with you.  You should come to Calgary, maybe move up here, we've got a labor shortage, we need good investment advisors and there are diesels everywhere.  Even Jeep is introducing a Grand Cherokee diesel powered.  I think this is a hold over from their last years depending on whether the sale goes through involved with Daimler Benz.  But they’ve got a Jeep Grand Cherokee diesel – something over 40 grand to buy it; and 30 mph SUV.  Great towing capability.

So a question though:  Commercial real estate.  There are some thinkers on the internet that think that commercial real estate can be a great hedge against inflation, if you have an acceptable level of debt and you have a locked in interest rate. That’s because, although they will admit as inflation rages there is a lag period where rents don’t catch up right away, but as the rents do increase you see leverage in the way those rents increase because you're financed with a locked-in rate.  But of course, the  cautionary tale is not to over-leverage which is unfortunately I guess what a lot of people  are doing right now even in that market.  What are your thoughts on commercial real estate if you're into a vehicle as a group of investors (or one of these kinds of companies that sets these sorts of things up) if you can get a reasonable mortgage level that allows for a downturn in the economy but you can still meet the mortgage payment but you have a fixed rate.  Will the inflation that’s coming produce increased rents at least at some point down the road that will enable you to stay ahead of the inflation rate?  Thanks. 

JIM:  Art, one of the problems with real estate in an inflationary period is most commercial rental contracts are for three and five-year periods, and they might be tied, for example, to CPI.  And the unfortunate thing is by the time let’s say you lock into a five-year contract with your tenant and it’s tied to CPI, the first problem I have is the CPI numbers are jerry-rigged –that’s number one; and number two, the lag effect the inflation rate is running much higher and so there is a lag effect with real estate.

Your real benefit with inflation with owning real estate is if you have debt that debt is inflated away, and especially if you have a fixed rate debt.  But in periods of inflation because rents don’t go up as fast as the inflation rate, you make up that rent and make money by depreciating debt which is inflated away and through the use of leverage. 

But once again, you've got to make sure your cash flow and your tenants are strong enough because leverage is a two-edged sword.  So you've got to strike a nice balance between what you're getting in cash and the amount of leverage that you're able to carry.  But once again, the chief benefit is the leverage that you have in real estate and also that the fact the debt is depreciated away.  [51:41]

Hello, Jim and John, this is Rob calling from Niagara Falls, Ontario, Canada.  I love your show and I’ve been listening for about a year.  I've actually got to the point now where I’d like to invest my money with you guys.  I really don’t understand PE ratios. And to be honest, I’d be too afraid to suddenly start playing the stock market or doing any of my own investing.  So I looked at your website and saw that the minimum investment was 50K, which is, well, I can’t afford that much, so I’m wondering if you were planning on lowering your minimum investment for people like me that would like to invest and use your knowledge and take advantage of it and say here’s 10 or $20,000 to grow it or do whatever.  But are you planning on lowering your $50,000 minimum.  Thank you very much.

Rob, no we're not going to be lowering our minimum and unfortunately my business could double if we could take business from Canada but we're not allowed to take accounts from Canada.  It has to do with securities laws between our two countries.  [52:39] 

Hi Jim and John, this is Mark from Reno, and a question I have had for some time is I don’t quite understand how the great inflation is going to work.  If 75% of the GDP is domestic consumption and residential fixed investment how is the government going to put money in people’s pockets so they can buy jeans and tires and milk at $4 a gallon and bread and everything else?  All the super wealthy – and so much money has already been transferred – just can’t buy all the cars and all the other consumer goods that the rest of country can no longer afford.  Neither can the Federal Reserve or the Federal government take over and pick up the slack on the 75% of our economy which of course is terribly imbalanced.  But since real incomes adjusted for inflation have declined for the past seven years where is the money coming from.

JIM:  Well, the government can get money into people’s hands through various wealth transfer schemes, and your generally talking about, Mark, here the welfare state.  But if you look at all these great inflations, you know, the basic goods, and especially a society that is a debtor nation as we are and dependent on foreign imports – I mean look at everything you get in the store, it’s not made here – and if it’s not made here there are certain basic things that we need to have; energy being one of them.  And it’ll mean that a lot of the discretionary items that you're able to afford, you know, I don’t think people will be buying big screen TVs, going out to restaurants, buying consumer goods.  Instead of shopping at Nordstrom’s, the JC Penney’s or Walmart, they may be shopping at thrift stores.  But nonetheless, when you are totally dependent on foreign made goods for the things that you need outside of food and even in the area of food when you devote so much of your farm land to energy as we are now doing with ethanol, people aren’t going to stop eating.  So government will create money and inflations do take place in society; just look at Argentina recently in this decade, take a look at Russia, Turkey in the last decade – inflations take place.  [55:03]

Hi Jim and John, this is Russ in Denver.  I’m the founder of “Austrian Enginomics” which is a blend of Austrian economic theory and engineering where I incorporate an order of magnitude to the Austrian logic.  I would like to respectfully challenge your prediction of a direct transition in to hyperinflation as we enter the depression we both predict will occur soon.  I believe we will experience a deflationary entry into the depression over the next year or two, then enter the hyperinflationary phase which will prolong the depression for another six to ten years.  My logic recognizes two gorilla-sized forces opposing each other:  Over-valued markets on the one hand and the power of the central banks and the financial cartel on the other.  In my work I've calculated the magnitude of the aggregate bubbles including equities, bonds and real estate to be in the range of $30 trillion dollars.  This excludes any unfunded liabilities.  I believe this over-valuation delusion of wealth will be discovered over the next one to three years and nominal valuations will drop below the mean during that time.  That represents a nominal devaluation force of approximately $3 trillion per month.  if we consider the other, opposing force of the Fed and cartel liquidity injections, we know some of the most massive injections in the history or the Republic occurred after 9/11, Katrina and a few weeks ago when in early August, on the order of a weekly rate of approximately 100 billion, or about 1 trillion per month.  This pales in comparison to the opposing nominal aggregate valuation force.  Clearly after the nominal valuations have depressed, the Fed inflationary gorilla will become the dominant force and will send us into hyperinflation.  I look forward to your thoughts on this very critical prediction.  Thanks.

You know, Russ, I disagree with you.  If you take a look at the 2000-2001 period even though we had an asset bubble deflating as we did in the stock market you never had a contraction of the money supply; and if you study Austrian economics you know it’s the money supply or the movement of that money supply that determines real deflation.  And just take a look at the figures at M1, M2, M3 which are now growing at double digit rates and there is no contraction in the money supply that would give us real deflation.  Some might argue if you get a debt collapse or they stop lending, then you get credit contraction and the money supply begins to contract.  But let me give you an example going back to 1990 and 91 when the Fed was loosening and you couldn’t loan money at that time because of what was happening with the S&L crisis.  What the Fed did is inflated the economy, injected reserves into the banking system, steepened the yield curve and enabled the banks to borrow from the Fed discount window, much as they're doing today at a much, much lower rate.  At the same time, banks were able to go around and invest in Treasuries which really gave rise to the carry trade in the sense they were borrowing short term from the Fed and investing longer term in Treasuries – both helping out the government.

And if you look at all great inflations – whether you look at Turkey, Argentina (and listen to the segment in the first hour with James Turk) you all experience rising stock prices.  I just don’t see the deflation coming about.  I haven’t seen even in this rate-raising cycle a contraction of money and credit, which is what really brings about deflation.  When money and credit contract it’s actually the fall in prices that enable a shrinking money supply to buy the same goods and services.  And I haven’t seen that.  [59:29]

Hi, Jim and John, this is Mark in Colorado.  Hope you had a good vacation by the time you get this.  I’ve been a long time listener, first time caller, and as such, I hate to be critical since I rarely disagree with you, but you guys are just too plain nice – especially to someone like that caller last week who’s got the hubris to imply that some folks not as brilliant as he, just won’t understand why his command economy plan for an oil floor price, let’s just say, is not a good thing.  My response is this:  we used to have this thing called the Constitution; there’s simply no power given in Article 1 section 8 (or anywhere else for that matter) for the action that he proposes.  And furthermore, why say $50 oil price, why not $100 or $200 and really get those great bennies.  Hey, maybe the lobbyists will have some good input on that one or even some persuasive tactics to bring to bear.  That is why a market knows better than government.  As Ron Paul points out:  the answer is more freedom, not more government.  Finally, the guys who brought us corn ethanol shouldn’t be trusted with the laundry, much less oil prices.  Maybe the Founders even knew that.  Your comments?  Thanks guys.

I’ll just say this, Mark, I agree with just about everything you say.  [1:00:74]

Hi Jim and John, this is Matt calling from California.  Jim, you've mentioned several times you wouldn’t be surprised to see silver exceed the $100 per ounce level.  But I don’t think I’ve heard you throw out gold figures that are in line with that kind of an increase in silver.  So at the current silver to gold price ratio, a $100 per ounce price for silver would represent roughly $5500 price per ounce for gold.  So my question is do you expect silver and gold to maintain their price ratio as they increase? So at $100 would you expect gold to be selling at over $5000 an ounce? And if not, is their something in particular you think might cause a divergence between the relative pricing of silver versus gold?  I look forward to your comments.

Matt, I don’t expect the current silver to gold ratio to be maintained.  As we move and escalate that ratio will narrow.  At times it’s been as low as 16.  I do expect it to get lower from where it is today and the gold prices we're looking at, somewhere north of 2000, or 2500 to 3000.  And if the crisis gets severe enough, you know, even north of 5000.  And that may sound kind of crazy today but I think if you go back to the 70s when gold started out at $35 and if you would have said gold was going to $850, or when silver was 25 and 30 cents and it went to $50, those figures sound just as crazy.  But I do think in the end, things will get crazy as they always do.  They always go to extreme and extreme prices.  If we’re talking about $100, $150 silver, we could be talking about gold somewhere in the neighborhood of 2500, 3000 to 5000, depending on the gold to silver ratio.  [1:02:29]

Hello, Jim and John, this is John from Philadelphia.  I heard you guys mention that book by Murray Rothbard.  The name of the book is What Has Government Done To Our Money.  I did take a look at Amazon and the book is there and I noticed also that if listeners go to www.mises.org, there they can find a section called resources, and then under resources search for authors and find Murray Rothbard.  They have to page through several web pages because the author has written quite a bit but that book is available for free in PDF format.  Enjoy.  Thanks a lot.

John, thanks for reminding me about the Mises Institute, one of the best economic sites around.  Thanks for mentioning it.  [1:03:18]

JOHN:  You know, it was interesting I spent most of last week in British Columbia, Canada.  We happen to like going up there and talking to the people.  And I like to ping them on all sorts of issues like the Security and Prosperity Partnership and how the economy is doing.  And we ran into a nice lady with her daughter there who said they were in Mexico a few years they’d love to move to Mexico but they were afraid to lose their, quote, free healthcare.  You know, they only pay about $40 a month or something, and then they’re totally covered.  And then they began to complain to me about how high the GST and the GSP (the two sales taxes – the national and provincial sales tax) are; they are running at around 12%; plus income tax, plus the cost of items up there.  Canadians from this part of Canada are running down here to buy building supplies for anything they’re building because they can get them for a third to literally one-fourth of the price they would pay for them in Canada, even taking them across the border and paying the GST.  They go back to Canada with the supplies.  And she said, “I don’t know why everything is so expensive.” And the answer was, “you're really paying for your healthcare. You’re just doing it indirectly, you know.”  And it was interesting how once you blur the tax path so to speak, Jim, politicians can sell all sorts of things – United States or Canadian politicians – to the public because the actual path of who pays for what is blurred.  And so why is the cost of living so high?  It’s because you're paying for all this stuff.  And the companies have to pay it too.

JIM:  Yeah, that’s I think the real genius of politicians is they hand out cookies and candy to the voters but they tell them it’s a free lunch, that it doesn’t cost them anything.  It does cost them and it costs them in the form of inflation.  [1:05:07]

JOHN:  And in other areas.  Anyway, I just thought I’d mention that.  Let us move on.  You're listening to the Financial Sense Newshour at www.financialsense.com.

 Part 2

 Investing In Oil:  What Has Changed?

JOHN:  Well, here we sit on this Friday.  It’s so comforting to know oil has gone back to its normal level of $50 a barrel, Jim.  Right?

JIM:  You wish.

JOHN:  Well, that’s what they’ve been promising me since 2003 or whatever.  “Oh, don’t worry, it’s going to go back to its normal level.  Well, let’s see.  It’s actually about $75 a barrel.  Inventory levels are dropping, energy stocks are a top-performing sector right now, within the Standard & Poor’s.  You've been bullish on oil for the last seven years, and given this environment what are you doing right now as a matter of fact – buying, holding on, dumping, running for the border, what?

JIM:  Well, if you take a look at the evolving energy sector we’ve been changing our strategy on energy stocks over the last two years.  If we were to go back to, let’s say 2000 and 2001, we were with most of the majors, the Exxons and the Texacos; but what we're seeing, John, from our perspective there are new dynamics that are playing now globally.  And one of them – which I wish our Congressmen would wake up to this fact – is that the national oil companies are the new energy titans, not the international oil companies.  Most of the oil that we import into this country does not come from Exxon Mobil, that oil came from some Middle Eastern country and their national oil company.

A second dynamic that I think is playing out is oil is moving away from control by the West.  And what I mean by that is there is a new oil order that is emerging.  And what we're doing is we're going back to long term fixed contracts.  So the global oil pool is shrinking, and if I may stop for a minute and just talk about the implications of that.  When Katrina and Rita hit, when a lot of our refineries were knocked off line, the US was able to go into this global oil pool in the futures market.  We could buy oil internationally and have ships crossing the ocean with finished gasoline products within weeks.  So as this oil pool shrinks this means we could be subject to sudden supply shocks. 

Also, another factor that is happening is pricing of oil will be wrested away from the West, and what I mean by that the pricing of oil is dominated by the New York and London markets.  What I think you're going to see is new markets emerge in Dubai, St.  Petersburg – maybe Caracas.  And these oil bourses that are emerging will compete with New York and London.  In addition to that, I think you're going to see national oil companies will begin to husband their resources and I just don’t think you're going to see the same motivation to accelerate and increase production as let’s say an international oil company would.

If you take a company like Exxon, when they go out, they explore, they find oil they want an return on investment as fast as they can.  And so they’re going to pump as much oil out of the ground and recover that investment.  Whereas a national oil company might say, “you know what, this is all we've got, we're going to hold back and if we hold back we can sell our oil at higher prices and we can sell less of it.  We can get more revenues for selling less and hold on to what we have which is becoming more precious.”  So they don’t have the same motivation. 

And another factor that is coming into play here is the fastest area of oil consumption globally is an OPEC countries where oil consumption is subsidized and that means that OPEC consumes more of the oil that it produces and they do not increase production significantly to not only offset what it is that they consume – the increase in consumption domestically – but also to meet future demand.  That translates into fewer exports which also translates into higher prices.  [4:15]

JOHN:  Okay, if we're making investment decisions how am I going to factor all these into making some wise ones?

JIM:  Well,  first of all I think the major international oil companies are not going to be the place to be in the future.  In effect, they're becoming royalty trusts.  As oil peaks, and as world oil production declines the industry is going to face four strategic choices – and this is if you believe in peak oil which I think is becoming a more dominant theme.  There are more and more voices that are now starting to recognize it.  But there are going to be four strategic choices that oil companies are going to face:

One is try to become a dominant participant.  In other words, consolidate, buy other companies and maintain your production through your dominance of ownership of reserves;

Two – become a special niche player, whether it’s tar sands, heavy oil, shale oil, even natural gas;

Three – harvest your assets;

Or four – self-liquidate.

So these are the four strategies that I think oil companies are going to be facing.  And the area that I find interesting and most attractive are the niche players:  companies that are either specializing, or because of their size and expertise are able to grow their reserves.  [5:37]

JOHN:  Okay.  One of the factors in there too is, you know, we talk about geopolitics earlier, the political factors involved in oil exploration, there’s risk in exploring for oil, but now we see a changing chess board, so to speak, in terms of the risk to companies going into various parts of the world and exploring.  Not just from a security issue but also from a financial one.  You put all of this money into infrastructure and then the local government thinks, “thank you very much for doing that, now get out.”

JIM:  Political safety is another factor I think that’s going to come to the forefront, whether you're looking at Venezuela, some of the countries in the Middle East, Latin America even in Asia.  It is also something we're looking at because as oil prices cross $100 a barrel and eventually $200 a barrel governments are going to become more rapacious, including our own, and I think nationalization of oil fields will become the new reality facing the industry.  Host governments are going to want to have control over their own resources.  [6:37]

JOHN:  It sounds like if you see these trends crunching against each other this is going to a tough environment for these companies to operate in.

JIM:  You're right on that because one of the most difficult tasks that companies are facing today is reserve maintenance and especially for oil, in addition to controlling costs.  That’s because if you look at operating metrics from last year, one of the things that have happened is it’s becoming more difficult and costly to find oil and to produce oil and also natural gas.  And especially in a very fierce, competitive environment which these are going to be some of the other issues besides.  It’s not just that there are fewer places to look wherever you are allowed to look for oil; but trying to find it, extract it and produce it is becoming more expensive and that’s one of the key factors and metrics that we found in looking at last year’s performance of major intermediate and even small cap oil companies.  [7:37]

JOHN:  Shouldn’t higher oil prices take care of that?

JIM:  You know, on the surface it would appear we're looking at $75 oil but not entirely.  If we look at, for example, last year the price of oil rose along with revenues but last year finding and lifting costs rose even faster.  So what you're seeing as a result of that is there’s a growing pressure on margins within the industry.  Lifting costs rose 31% last year driven by high industry inflation rates.  This is the one that you never hear the media talk about:  government income tax receipts increased by 12% last year equal to 50% of pretax profits.  So it’s not just the fact that it’s costing you to go try to discover and it’s costing you more to lift it out of the ground, but on top of that the government is taking more of what you have after you pay all your costs.  So margins are being squeezed for these companies.  [8:33]

JOHN:  Maybe it’s time to thump this again if we look at all of the complaints of the greedy oil companies.  Most people – you can’t blame them because the media is not harping on this one – don’t realize that government is the largest beneficiary of high energy prices.  They take in more money than what the industry actually takes in profits itself, so they're the biggest beneficiary but they don’t share in the risks.

JIM:  And what is really key on that when a company makes less profits either because costs are rising faster than revenues but also the fact that the government is taking more of what it is that you produce.  Profits are really essential in the energy industry because the energy industry is a very, very capital intensive business.  It’s one of the most capital intensive businesses in the world.  Last year, for example, it was the first time that capital investment exceeded cash flow for the industry and that was the first time we've seen something like that since 1999.  The industry invested over $400 billion last year; $400 billion just to produce and go out and try to discover new sources of energy. 

And that’s what I think most people don’t realize that, yes, oil prices are up, they're up over wherever they were two or three years ago, but costs of finding and lifting oil have tripled since 2002.  You're talking about inflation rates in the industry that are running high double digits.  And what we saw last year the combination of rising costs, higher taxes, margins and returns are falling.  In addition, you're also seeing reserve and production growth remaining infinitesimal; and that’s despite this higher capital spending that I was talking about.  Despite $400 billion of capital spending there wasn’t a commensurate major increase in company reserves or company production.  [10:34]

JOHN:  So the cost of production is rising faster than revenue; taxes as well are rising on the oil industry; and also it’s harder and more expensive to replace reserves.  So putting that all together, what does this mean?  The oil companies are approaching some kind of a crisis, what do we do as far as investment?

JIM:  Well, what it boils down to as cash flows shrinks as margins shrink I think you’re going to see less share repurchases as we've seen over the last couple of years; also I think there are going to be greater incentives to go out and  create value through the drill bit and that is why I like the more nimble niche players in the energy industry versus the big behemoths.  And you're already starting to see that in the performance metrics whether you're looking at major oil companies, taking a look at their finding costs are going up, their lifting costs are going up, they're not replacing their reserves. Margins are beginning to shrink for a number of reasons, not only because of the costs that we've mentioned but also the government take is starting to increase.  And let’s face it, if you’re a company the size of Exxon, or Chevron or BP or Shell or Total where can you go to replace what it is that you produce each year, because roughly about 85% of the world's remaining oil reserves are outside of access to Western companies;  75% is controlled by OPEC and the other 10% by the former Soviet union. So where does an oil company go?  And it was interesting, because in terms of that $400 billion investment that oil companies made last year, a good majority of that was made in North America and the returns on those investments are shrinking and that just goes to show you once again.  This is, to me, more evidence of the peaking oil situation that we talk about so often on the show.  [12:29]

JOHN:  Well, obviously, Jim, since you tend to stay ahead of the pack, well, I guess the easy way – there is no easy way to put this.  What are you doing?  You don't have to give everything away, I guess, but what are you doing?

JIM:  Well, I think a couple of years ago as I mentioned, we began to move away for the major international oil companies because it was clear that they were going to have difficulty replacing their reserves.  Also they were being denied access; and then also, John, and you know, we saw this in 2005 with Katrina and Rita, they have become the favorite whipping boy of politicians. Every time the price of energy comes up, you've got some politician that gets even greedier and wants to dig in the wallets of the oil companies. And so we've gotten ourselves into major companies; I'm not going to say which, but some of the national oil companies that are not going to be subject to the whims of some idiot congressman.  Also companies that have access to larger reserves so they will be able to increase their production; and then we've been moving into alternative forms of natural gas and oil with a lot of niche players.  We've got a new niche player that we're looking at that is moving very strongly into alternative forms of natural gas and oil; and also is consolidating their position mainly to North America. So they don't have the geopolitical risk.  They've sold off a lot of their riskier assets in areas that could be subject to expropriation by foreign governments – so that's another one that we've been looking at. And then some of the more nimble smaller cap names that we're also looking at.  [13:59]

JOHN:  Yeah.  It's been a pretty wild roller-coaster ride since the giving of the year.  Remember oil went back down to $50 a barrel, which we all knew was probably an artificial level, the stocks tanked, now the oil stocks seem to have rallied in this latest round of things.  But it's a pretty wild roller-coaster ride, so how do you operate in this kind of environment?

JIM:  First of all, I think you have to have the firm grasp of the fundamentals. And if you understand those fundamentals, then, well, you don't care if the price of oil goes from $70 a barrel down to 50 as it did in January or the fact if you have an oil stock and it goes from $90 down to $80. You know, what we're more interested in is focusing on a long term trend, John, and the long term trend is, from our perspective, we don't focus on oil prices being at $75 when we believe oil is going to $200 and beyond.  So we tend to take a longer term perspective and that's why we sit on our oil stocks and we ride out these downturns. And I think that's what you're going to have to do because all along the way, whether you're owning gold or you're owning oil, you are going to see these price dips because money is very unstable today, and people's core belief systems are in such disarray today. 

You know, you talk to people and you talk to them about convictions and not too many people hold very firm convictions.  They tend to believe one thing on Monday, maybe something different on Wednesday; and you can see this so often on Wall Street where my belief is it that in your lifetime, you are going to see long trending investment themes that emerge – whether it's stocks after World War II, commodities in the mid 60s and 70s, Japanese stocks in the 80s, US and technology stocks in the 90s.  You know, these things tend to be long trending.  And if you look at a chart of oil, you look at a chart of gold, silver, copper, aluminum, wheat, most basic commodities, it's very clear that we're in a new up trend that goes all of the way back to the turn of this decade. So that's what I think you have to do is up to keep your eyes focused on the bigger picture and the longer term trend rather than worrying about the latest wiggle or fluctuation or the latest dip or rise on a weekly basis.  [16:26]

JOHN:  That requires courage of your convictions, though, to do because let's face is, everyone has been trained into a day-trading kind of mentality where you're in and out and riding these coasters and jumping in and out; but if you have convictions, you have to say “no, this is where I think it's going to go and we're going to sit here.” And that's really hard to do. 

JIM:  It really is, because we live in the information age and the one drawback to the information age is there is so much information out there and it changes constantly. And from my perspective, if you watch the media, typically about 95% of the time they are looking through the rearview mirror rather than looking at what's directly in front of them. So whatever is the trend the last year, the last six months or the last couple of weeks tends to be the trend going forward. And you remember this, John, as we spoke about this so often as we did in January, when we had that warm weather spell and oil prices were at 50, they were talking $40 oil: “This is it, finally a reprieve, the bull market in oil is over.” And here it is this Friday, and you and I looking at $75 oil.  And that's the problem with the information age: everything is so short-term oriented and focused and nothing is ever looked at in depth.  [17:38]

JOHN:  Is that a financial world view issue that they don't do this?  Why can't these guys see what we see here on the show?

JIM:  I don't think journalism…I was trying to think of the author that we interviewed.  He was an international correspondent for CBS out of London, and he wrote a book on the media and his industry and he said, you know, if you were to go back 20 years ago before the big corporations took over the media companies and the news business, you had huge foreign bureaus and correspondents with boots on the ground.  And today, everything is packaged so it doesn't matter what news station that you're looking at, you're seeing the same photo finish – you know, the B-Roll that goes with the stories.  Everybody is looking at the same thing and there are not as many boots on the ground internationally as there once was.  You have reporters who are taught in journalism school that it's not the story, it's the outcome that you want viewers to get from reading your story.  So there is more political motivation in the way that the news is reported today.  In other words, they want a sort of outcome-based education; there is kind of an outcome-based view point that they are trying to get rather than the real story.  And then I just think sloppiness and laziness. One of the terms often referred to the media today is the drive-by media because there isn't the in-depth journalism that you might have seen 30 years ago.  In fact, you might see the death of news – and look at evening newscast of, what? About 22 minutes out of a half hour newscast. How much of it is real news and how much of it are you getting from a world view in terms of world stories and events? And especially in this country where entertainment news is given more priority than international news.  [19:29] 

JOHN:  There is also a shift away from the evening news because at one time, remember when we had three networks plus public television, if you wanted to get the evening news, everybody tuned in at 6:00.  That's what you did for a half hour.  You don't have to do that now:  you've got news channels providing you with news on the half hour, so they’ve become archaic.  And they are not doing well in the ratings.  The other thing that’s failing badly are newspapers.  More and more people are finding that newspapers come in the door, sit on the table and go right to the recycle bin without being read or just briefly scanned to see what's going on. 

JIM:  I read an interesting article, about the Washington Post and the current heir, the grant that runs the post today and he's really trying to figure this out.  The Post readership peaked I think in the year 1993 and they’ve been moving on the internet with maybe stories combined with videos; and they are really trying to figure it out. And I think one of the reasons Murdoch made such an effort to gain the Dow Jones franchise for his portfolio is because the Wall Street Journal is one company that's charging for its internet content and making money at it. And I think that's one of the struggling things that the media is trying to figure out: How do we survive in an information age? [20:47] 

JOHN:  Right; and an information age which is a digital age, not a newspaper age.  More and more I think the days of the totally free internet are moving away from us because in order to survive financially, people are going to have to charge for what they are putting out on the internet.  It will just simply be the medium of distribution rather than everything is for free.  Before when the internet first kicked in, newspapers could afford to subsidize their online entries simply because of the fact they still had their subscribers.  That is now changing and it's changing rapidly. 

JIM:  Yeah.  I mean I can't think of any newspaper, whether you're looking at the new New York Times, the Post, the Los Angeles Times that isn't suffering a major loss of readership.  I think revenue and advertising revenue were down almost 50% at the Post last year. And actually, the Post is making a lot more money from their education services that they purchased many years ago, the Kaplan, which trains people for various designations and certifications from the CPA to the CFA.  So yeah, it's amazing how these companies are trying to struggle and find out where do we go, what can we do to survive?  It's almost like in many ways the horse and buggy whip. [22:00]

 The Catalyst

JOHN:  Well, everyone was sort of attuned to musical issues this week, Luciano Pavarotti passed way after fighting pancreatic cancer for about a year, so we'll do a restatement of theme del capo al fine – from the head to the finish.  That's Italian, by the way, Jim, if you read music. 

JIM:  I was just going say that, John. 

JOHN:  We're expecting another reflation and then a boom causing a bubble, so where will the bubble boom this time?  Remember it went into real estate previously and then into the currency markets.  Now, where are we going to see it this time. 

JIM:  You know, you bring up a point that I think is really important to understand for investors and that's every boom is a little different.  It harkens back to that Mark Twain saying history doesn't repeat, perhaps it rhymes.  So every boom has its own different characteristics and there is always an asset class, John, or a sector that dominates it.  If you look at the boom following World War Two, it was growth stocks and technology stocks, industrial stocks – because we were still a very strong manufacturing economy. And then you take a look at the guns and butter issue that came in with the Vietnam war and the Great Society where the dollar began to depreciate and eventually the government went off tying the dollar to gold, so we had a great reflation in commodities from the mid-60s to the 70s dominating the market. 

Then we got, for example, the 80s when central banks began to change their investment strategy.  Japan began to superinflate its economy, so the Japanese market from almost 1980 to 1990 was the place to be. Japanese stocks dominated.  And you remember all of the books that came out, the invincible Japan, and then we moved on the to the 1990s where US stocks, the new economic paradigm, the new economy theory.

And John, if you take a look at what has dominated the investment markets in this decade has clearly been commodities.  Here I am looking at a screen of the top ten sectors of the S&P.  And the top performing sector – nobody else even runs close to it – energy is up 20% for the year; the next best sector that comes even close to that is materials which are up 11%  – another commodity sector; and then after that technology coming in third. 

So usually what will happen when you get a reflation and a new boom, there is usually a catalyst that drives it. You know, we've had two decade long bear market in commodities, the industry consolidated, it contracted, the weak hands went out of business or were merged into other companies that became stronger but nobody was investing in new mines, trying to go out and find a bunch of new energy.  And so what hap