The
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March 29, 2008
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Part
1
The
Crisis Window
Other
Voices: Gabriel Stein, Director & Chief International Economist
Lombard Street Research
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2
The
Return to Pac Man
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Q-Calls
JOHN: I’m sure you browse the internet, especially the news sites and the intelligence sites and have you noticed, Jim, that there is more and more talk about this – we coined the term crisis window. But more and more people seem to be getting on board with the term. We’ve been talking about the window which should be globally between 2009 and 2012. It’s a series of different issues coming together. There are financial issues, geopolitical issues, energy issues and food issues. It’s something that you’ve called the Perfect Financial Storm. It will impact the markets, the economy and the currency markets. And obviously it will impact the global political system for the very same reason. But the trigger mechanism in this, and the thing that is probably likely to take it over the edge will most likely be peak oil. And last summer the IEA (International Energy Agency) issued a report calling for an energy crisis to open up in the same period we’re talking about between 2009 and 2012.
And as I remember reading the report, Jim, it was more like a ramp – in other words, it gets worse and worse as you go on. It doesn’t just hit all of a sudden but it does move rapidly. And recently a few others have joined in predicting a geological crisis during the same period so that is the opening topic today as we feel there is a growing evidence to support this thesis that there are converging trends here which will make this a very, very turbulent time.
JIM: You know, something that I have discovered probably in the last three or four months that goes along this line as you just mentioned, there’s been a number of reports from major investment banks over the last few months on this subject of energy and what I find fascinating is more and more informed people are coming to these same conclusion whether you’re coming at it from an investment perspective, whether you’re coming at it from a political or geological or even a scientific perspective. But a window is opening up beginning next year, and probably over the next four years for an energy crisis to erupt the likes we haven’t seen since the oil embargo back to the 73, 74 period. And the evidence is mounting, and it’s becoming harder to ignore anymore.
You remember, John, we’ve been doing this program together for seven years now and every time we’ve seen this spike in energy they always told us this was a one off event, well, it’s due to the Iraq war, or it’s due to the hurricanes, or it’s due to traders and speculators. We’ve always been told a reason why it’s temporary, but here we are now getting into probably the sixth year that we’ve seen rising energy prices; on the day you and I are talking oil prices are close to $106. So the evidence is mounting. It’s becoming harder to ignore and there is just too many telltale signs of this approaching crisis. [3:19]
JOHN: Well, this may be somewhat of a review for a lot of our listeners, but we really need to enumerate and review what these telltale signs are. It’s interesting too, Jim, how if you’re looking and you understand what you’re looking at you can see what’s coming. Most people aren’t looking.
JIM: Yeah, I think if you look at telltale signs, probably the most obvious one, at least that stands out going back to probably several decades ago and this is something that the peak oil people have addressed to the optimists and they tend to ignore this or dismiss it, but we stopped finding enough oil to replace what we consume each year. The last time we covered our consumption with new discoveries was about 1985. In 2006, we consumed somewhere around 27 billion barrels of oil and we only found 6 billion barrels of oil. In fact, the last major oil frontiers go back to the 1960s: we had Western Siberia in 1967; we had the North Slope of Alaska in 1968; the North Sea was discovered in 1969. So since the 1970s there has been a reduction in the number of discoveries and a drastic reduction in the size of those discoveries. In the 1960s, we discovered over 500 oil fields. In the 1970s it was over 740 fields; in the 1980s it rose to 856 fields; in 1990 it was 510. Any idea what we’ve discovered in this decade? [5:03]
JOHN: No
JIM: 65. And it is not just that the number of discoveries have dropped dramatically, but the average of these fields it was 6 million in terms of collectively what we discovered in the 60s, it was around six million in the 70s, it dropped down to about half of that in the 80s. Then it went up again in the 90s to about 3 ½ million, and now not only have discoveries dropped to only 65 in this decade, but the average size of these discoveries are roughly about 147,000 barrels in the 2000s. So the first and most alarming sign is we are discovering fewer fields and what we discover is smaller in size. So to me this is probably the biggest warning sign out there in a decade where the price of oil has risen five-fold as we have seen oil go from $20 a barrel to over $100 a barrel, we’re discovering fewer fields and those fields we discover are much smaller in size. [6:11]
JOHN: You would think that this would get somebody’s attention somewhere, but the media – despite the sign of an emerging problem – for some mysterious reason doesn’t elevate this important event, especially when you compare to say the attention being given to global warming where the whole debate is now shifting sort of against the man-made proposition very slowly at the scientific level. And here we’re looking at something which may come over a period of time, you know, 20, 30, 40, 50 years as it emerges; this oil issue is right on our doorstep. And you’re right: everybody is yelling and screaming about the oil.
There are no celebrities right now using their fame to announce the arrival peak oil production and what this means. And the public, including the politicians, are actually totally oblivious to it. But let’s face it, most of what our politicians deal with is largely media and public driven. The politicians are sort of the last to get it, not the first.
JIM: That has amazed me as well, and especially given the consequences of peak oil which will lead to – just think of the consequences of skyrocketing oil prices, shortages of oil-derived products. People don’t realize how much from the plastics to materials in our homes to pharmaceuticals. And think of what we’re beginning to see as geopolitical tensions heat up. Instead, the topic is covered on an emotional level with escalating oil prices, John, you see this all the time when they spike up. It’s due to some kind of conspiracy orchestrated by let’s say the oil companies and OPEC. [7:50]
JOHN: There is going to be a shock factor, let’s face it. Sooner or later this radical paradigm changes and it’s going to jolt the media and then all of the focus is going to be on it. But we are not there yet. All right, you mentioned one tell-tale sign; there are other signs that are coming together as well, which point how this is sort of an emerging storm not just a trend.
JIM: I probably think the next important issue is the number of countries that are now past peak oil production and are now in decline. Now, if memory serves me it’s somewhere around I think it’s 54 or 56 producing countries out of a total of 64 are now past peak production. If you take a look at the United States for example, the lower 48 states peaked in 1970, the North Slope peaked in 1989; there’s a question now whether the Gulf of Mexico has peaked; we’ve seen Indonesia which has gone from an oil exporter to an oil importer; Mexico’s Cantarell field has declined about 41% in the last three years – and that by the way, was the second biggest producing oil field in the world. And here’s one that should get everybody’s attention: Conventional oil production peaked at around 74.3 million barrels a day. That level was reached in May of 2005, it hasn’t been surpassed since and in fact, it has declined to just over 73 million barrels a day. And the longer this record stands, the more likely this is establishing the peak oil date. [9:31]
JOHN: And how do we get to the 85, 86 million barrels a day figure that analysts always talk about in terms of daily world consumption? If we produce only 73 million barrels of oil a day, what gets us to 86? And are these figures real or are we just dealing with some modeling figures or what?
JIM: No, if you take a look at conventional oil production is around 73 million barrels a day, then you add to that natural gas liquids – we’re taking natural gas and converting it into liquid fuels. That gives you about 8 million barrels and then you add biofuels, refinery gains which gets you another roughly 5 million barrels and that’s how you get to this 86 million barrels. If we weren’t converting natural gas to liquids, coal to liquids, biofuels, refinery processing gains we would be experiencing shortages. [10:29]
JOHN: Right, but these are not surplus things on top of the oil supply, they are part of it. That’s the important thing to recognize. So as world demand keeps going up it’s outstripping what we are able to produce. And the alternatives are far from coming online at any time in the near future. But what about technologies since we’re talking about alternatives, technology or new discoveries as far as oil goes which the CERA folks are always talking about, isn’t this going to get us the growth levels that we need?
JIM: You know, it helps but it doesn’t get us there. The world gets – and here’s a remarkable fact – the gasoline you’re probably burning in your car comes from an oil field in the Middle East that was probably discovered 50 or 60 years ago. The world gets 20% of its oil from just 14 giant oil fields and then we get roughly another 27% of our oil from just 100 oil fields; then the other 53% comes from 5,000 plus oil fields that are much smaller in size. So in effect, we’re getting the majority of our oil from only 114 oil fields. The biggest ones were discovered 50 to 60 years ago. Today, the largest oil field in the world is Ghawar, the king of all oil fields which accounted for one-half of Saudi oil production which is in decline along with Burgan in Kuwait. Alaska’s north slope, Mexico’s Cantarell, China’s Daqing, Venezuela’s key oil fields – these fields are what people in the oil business call the elephants. And since the 1960s, we’ve discovered very, very few elephants. In fact, the last one was discovered in the Caspian which is the subject of this week’s special interview which was Kashagan which will come online probably in the next few years and reach peak oil production somewhere in the mid next decade around 2015. So we need to find more fields to make up for the large ones. The problem is when you have a large oil field like Ghawar that produces 5 million barrels a day and that goes into decline, and then what you’re finding the new oil fields produce a little over 100,000 barrels; we’ve got to find a lot more of those oil fields to make up for the big ones and that is simply not taking place. And most of world’s large oil fields have peaked and we haven’t discovered a major elephant and it’s been that way for a long time. [13:07]
JOHN: Perhaps that’s one of the reasons why prices are really up five-fold if we take a look at it because the facts – the real world reality – are catching up with the price. And so despite the reasons which the experts have given us in the past as to why prices are abnormally high such as the Iraq war, hurricane Katrina, Rita, speculators in the market etc., in reality if we go back to 2002 we can see that the price has steadily risen since 2002, not spiked because of all these different issues per se. Now, are there any other factors that have relevance to higher prices?
JIM: Well, probably at the top of the list –and this is one that you keep hearing – is the demand factor. You know, you take a look over the last decade demand grew by 18 million barrels a day and that growth is being driven by China, India, and surprisingly most people don’t even factor this is within OPEC itself, that fastest area in consumption of energy is within OPEC and the developing world. OPEC countries subsidize energy; it’s almost like an entitlement. In many Middle Eastern countries people are buying gasoline at little over 45 cents a gallon. And the other thing as oil rigs, people scarcity grew, old assets have rusted, they’ve broken down. Look at all the refinery shut downs we experience because a lot of these refineries were built 50, 60 years ago. And when something gets that old, you know, things break down; things rust. The oil industry uses a lot of steel and a lot of that steel is rusting. And you know, you take a look at finding costs which have gone up between 5 and 10 fold. And this is something that Matt Simmons points out because everybody points out “well, we’ll have new technology.” Well, technology just put a bigger straw in the ground so we sucked the oil out faster and it created faster decline rates and that’s the issue that we’re really not addressing here. Yeah, we’re making new discoveries as the optimists will tell you, but they’re not taking into account depletion is running much faster so we have to keep running faster and faster to just remain even. So as demand grew and supply failed to keep up with demand essentially what we’ve seen over the last decade is our spare capacity has shrunk, so today we’re at that tipping point heading into a crisis window as demand overwhelms supply globally. [15:43]
JOHN: And to emphasize this whole concept of a tipping point and a crisis window, first of all, when tipping points happen they are usually unexpected, they sort of come out of left field even though the whole conditions have been building for a long time. It doesn’t take much to drive prices higher. I mean this could be a geopolitical event and we know things are growing more and more unstable say, for example, in the Middle East if you look at everything from what’s going on in Israel’s border to Pakistan; it could be a weather incident and you can’t always predict those far in advance; or a statement made by an OPEC official or even oil dictator.
JIM: You know, today, you’re right, it could take an unexpected random event. You saw that last year with a terrorist attack on a large Saudi Arabian oil field; it could be a hurricane in the Gulf of Mexico; we’ve seen this periodically this year, last year unrest in the Niger Delta; strong winter storms in China this winter that drive up demand; earthquakes in an oil-producing region; big heavy storms in the North Sea; eruption of violence in the Middle East of which I think it’s looking more and more that we’re heading in that direction. Any one of these kinds of events or a combination of these events is what’s going to set off the crisis and take us into that perfect energy storm made up of rapidly rising demand, falling supply, a decay in infrastructure. And more importantly, we don’t have substitutes. And that is why we are sitting here talking about oil prices at $106 a barrel despite a recession in the world’s largest economy. [17:27]
JOHN: Yeah, you wonder how long it’s going to be before this starts getting some political traction because if we look at the three remaining presidential candidates for example – two on the Democratic side, Barack Obama and Hillary Clinton; on the right, John McCain with the Republicans – I think if you look at Hillary and Barack’s plan you’ll discover they are pretty much the same. There’s not a lot of difference between them. I’m not sure what McCain’s plan is? And it seems like at the moment it’s not on the radar as being a critical issue. We keep hearing talk about healthcare and what the poor guy is going through and who’s going to bail out who from the mortgage situation, but in fact what we do know about some of these plans if they were to be put in effect what we know so far even though a lot of this is vague would make the whole thing a lot worse. None of them are aware of the crisis that faces the presidency. Remember Matt Simmons saying he’d go into the Oval Office, sit down and cry because he knew what was going to happen. There are solutions which we’re not implementing, things that we need to be doing now but we’re not really doing; we’re not even talking about them to a large degree in the public arena. There are people on the side talking about it and trying to get attention to this. The solutions from the candidates don’t even come close to the issues. T Boone Pickens was on the cable channels this week and one of the anchors asked him to comment on the presidential candidates and their energy programs and this is what he said:
I haven’t seen a one of them with an energy policy yet. I’ve got Obama telling me biofuels is a big deal. It’s not a big deal. It’s a zero deal almost. And you’ve got Senator Clinton telling me she’s going to have $60 oil and tax the oil companies. That’s no plan at all and she won’t ever see $60 oil. They don’t know anything about it. They’ve got to get informed as to what the energy problems are for the country.
[19:15]
JIM: You know I think what T Boone Pickens was getting at what are politicians and the media doing. There are a number of issues here. The first is that the majority of our consumption of oil is in the transportation sector so it becomes a liquid fuel problem. Cars, trucks, boats, planes – all of them run on liquid fuels; a jet will run on jet fuel; trains, boats and trucks run on diesel fuel, cars on gasoline. And if you listen to these energy programs they are proposing, solar and wind will not fly a plane, it’s not going to power a freighter or keep the trains running. So all of this talk about green energy, you know, that’s fine and dandy but it has mainly to do with the electricity system not the transportation system and that’s where the problem is going to surface. And using corn to produce ethanol won’t solve this problem. It’s about the dumbest thing that we’ve come up with in solving our energy problems. In a few years it’s going to create a crisis and that crisis is going to be we’re going to have to choose between eating and driving. So I’m not sure that’s a really smart thing. And then if you talk about renewables they only account between 3 and 7% of our US fuel base either for powering a plant or transportation. So the issue – the big ones such as oil, natural gas, nuclear power and coal – those are the things that we should be talking about but nobody wants to talk about these things and that’s why we’re headed for a crisis. [20:55]
JOHN: Yeah, when you realize that, right now, there’s no way to like you say plug your car in – we could bring hybrids online – plug-in hybrids, you know, you can plug in and do 50 miles around town doing your errands and things – but can you imagine millions of cars coming home wanting to plug in. Where is that energy going to come from in California say in the middle of summer when you’ve already got a power shortage and we won’t build power plants. See, we’re shorting ourselves on either side of this. But that was only one issue, what are the other two issues anyway?
JIM: The other two issues are the resource base of hydrocarbons, who owns them, who controls them and the concept of substitutes. I mean 85% of the world’s energy reserves are owned by OPEC and the former Soviet Union. Western oil companies own and produce only about 15% of the world’s oil production, so let’s get rid of this idea “Big Oil.” Big Oil isn’t as big anymore. And the other thing – the national oil companies (NOCs) which own and control the world’s oil are falling behind. I mean they don’t operate under the same assumptions and motivations as western oil companies. They’re not making the needed investments to keep production growing outside of maybe let’s say Saudi Arabia. So the NOC countries consume a significant amount of the NOC cash to run the government and pay for their entitlement programs. So they aren’t making the needed investment to maintain or expand production.
A good example is in Mexico where Cantarell, the second largest oil field’s production as a result of depletion has dropped by over 40%. They need to make more investments but there is a state or country policy that they won’t allow foreigners to come in and take an interest to make the investment. Well, if the state isn’t going to make that investment the consequence of that is that you’re seeing falling production in Mexico. So those that own the oil don’t have the motivation to invest in and expand production in order to drive down prices for western consumers. I mean, why should they? We’ve been playing – a lot of western governments are going to these producers and saying: “Please! Produce more so you can bring the price down.” But from their perspective the less they produce the higher prices they are going to receive. So this is something that I think a lot of our politicians still don’t understand to this day. And we’re crazy, absolutely crazy to talk about increasing taxes on our oil companies or constantly bashing or demonizing every time the price of oil spikes. It’s a geological as well as a political problem. We should be treating our national oil companies as national treasures. One of the reasons we’re heading into this crisis window is that the last of the discoveries made in the 90s by western oil companies are coming online last year, this year and the first part of next year; but after that, because of the dearth of discoveries in this decade western oil production in the OECD countries goes into decline. The only OPEC producing country that can increase production (if they can, and there are some that question this) is Saudi Arabia. [24:27]
JOHN: This brings us right back full circle to the depletion issue.
JIM: Exactly, because the CERA folks put the worldwide depletion rate at 4 ½. And what that means is conventional oil peaked at around 74.3 million barrels back in 2005, then by 2012 we drop to roughly 66 million barrels on conventional oil; and that’s assuming we’re still adding roughly about 2 million barrels with non-conventional adding roughly about 10 million barrels. So by 2012, we could be down to 76 million barrels of production. If the decline rate is closer to 8% which is what many oil company executives and oil service companies such as Schlumberger maintain then conventional oil drops to roughly about 56 million barrels; non-conventional takes it up to roughly about 64 and that’s assuming we’re adding still around 1 ½ to 2 million barrels of oil because of new discoveries. So either scenario gets you to a crisis which we are utterly unprepared for. And that’s why I think the oil prices are going to hit $125 this year – that’s our target; and if we get any in a series of interruptions, be they geological, weather, or geopolitical you could see prices spike to 150 very quickly. [25:56]
JOHN: It’s really interesting to see that even as oil prices spike recently to over $110 a barrel but you’re still hearing talk about much lower oil prices or there’s somehow going to be a blow-off in this and everything will go down again.
JIM: And this is coming mainly from the economists who think of economic widgets. I mean they don’t understand depletion. In fact this week’s issue of Barron’s had a prediction by one economist that we’re going to see $80 oil. I mean if global warming and peak oil production are both occurring, here’s the question that needs to be asked by the media and it’s not being asked: If global warming and peak oil production are both occurring which of the two poses the most immediate threat? And that’s a question you’re just not seeing being asked today. [26:47]
JOHN: We hear from listeners all the time, “I’m just a little guy.” What should people be doing right here because it’s not enough to describe this to people but obviously this is going to affect us individually? What do we do at our personal level to at least deal with this emerging situation?
JIM: You know, the first thing that you need to do is you need to own at least one fuel-efficient car – be it a hybrid, the Smart Car, a diesel, a Honda Civic, or Toyota Corolla that gets good gas mileage. And for goodness sakes, devote a portion of your portfolio to energy. I mean we just started an energy account last November that focuses not only on alternative energy, a portion on companies that can grow production despite peak oil and energy infrastructure. I mean if you’ve listened to this program for the last eight years hopefully you own energy stocks in your portfolio. And if you don’t, it’s time to start buying them. And I would start right now, especially with the energy sector correcting as a result of deleveraging of balance sheets that we’ve seen in the first quarter this year. And hopefully you’ve done that, especially now since we’ve had a correction. But whatever you do, and I see this and we get this in emails, the energy stocks are down, they’ve corrected – whatever you do, don’t sell or trade out of your positions or panic during that correction. [28:17]
JOHN: Yeah, maintain a bearing on where things are coming from and going to before you do anything. And I’m sure we’re going to be talking about this in the future. We are going to narrate this right into the crisis window.
JIM: Yeah, in fact the IEA is doing a bottom up survey of the world’s top 250 oil fields which account for over 75% of our oil production. Even the IEA has begun to question the data. This is something that Matt Simmons has been harping on. Every single year if you read the BP Statistical Review, OPEC production goes up or they produce all this oil and their reserves never change. The IEA is now beginning to question that because they’re trying to say, “why are we at $100.” They’re not buying all these arguments, “well, it was the hurricanes, it was the war,” because oil has been going up relentlessly. And that report will be out some time later in the year and I’ve also noticed recently that some of the energy analysts at some very, very large investment houses are doing the same thing.
It amazes me how ahead and prescient Matt Simmons has been. He did a study of the major oil fields almost a decade ago and of course that eventually led him to do a study of Saudi Arabia. We’d have these demand forecasts and everybody just assumed that OPEC would be there to produce the oil to meet the demand. And his study of the oil fields led him to study Saudi Arabia which led to his book Twilight in the Desert. Now there are major institutions that are trying to play catch up doing the same thing. So Matt has really been a pioneer here and there are many of us that owe him a debt of gratitude and I hope to have Matt back when any of these major reports are released. [30:05]
JOHN: You always wish that some of the people that gave you all of the flak while you were saying those things could come back and say you know, you were right. But unfortunately that almost never happens in the business. But we’ll be talking more about this as we go. You’re listening to the Financial Sense Newshour at www.financialsense.com.
Other
Voices: Gabriel Stein, Director & Chief International Economist
Lombard Street Research
JIM: Well, there’s a growing consensus in the United States that the US economy may have gone into a recession at the end of the fourth quarter of last year. But there is some hope that international growth outside of the US could still hold the economies together. Joining us from London today is Gabriel Stein, he’s Director and Chief International Economist at Lombard Street Research.
Gabriel, let’s begin with the US economy. From your perspective, is it a goldilocks economy, slow growth or indeed, has the US entered a recession.
GABRIEL STEIN: Well, it certainly isn’t goldilocks. And in a sense I think we should be grateful for that because goldilocks was based on some parts of the world wanting to save much more than they spent and therefore some others had to spend much more than they saved. And the Americans very kindly and generously and with some help from Australians and Brits stepped up to the bat and said, okay, we’ll overspend. The problem is it was based on an asymmetry. There is no limit to how much you can save but there is certainly a limit to how much you can overspend and go into debt. And I think we’ve reached and in fact probably passed that limit in the United States; you simply cannot have an economy where in order to have trend growth you have to spend 107% of your income year in, year out. That being said, I’m not entirely sure if there’s going to be a recession in the sense that there will be two quarters of falling GDP. There may well be, but what is equally likely is that there will simply be a year or more of very, very weak growth as the US economy comes to terms with the fact that it simply cannot continue – basically that debt capacity has been reached and consumption will slow; and whether it is a recession in the sense that GDP is falling or not, it is certainly going to feel bad. [32:45]
JIM: Gabriel, what about the one bright spot in the US economy which has been US exports; what about that aspect? Is that what’s holding it up?
GABRIEL: That is certainly one of them. Another thing that is holding it up of course is that consumer spending has been remarkably resilient. In fact, so much so that I and some other people are worrying that it is overstated partly because spending on services tends to be estimated a couple of months at a time and so it’s overestimated in a downturn and underestimated in an upturn. And it may well be that when we get final data a few months down the line we’ll find that spending was much weaker around autumn and winter than we think. But yes, exports have been very beneficial and that is likely to continue.
The other source of strength that we’ve had in the US economy has been corporate investment and that is of course far less likely to be kept up. Companies are not going to engage in massive investment and expanding their capacity if people aren’t buying their products. And for all that exports are important, of course the US is a relatively closed economy; it’s domestic spending that matters. But exports are doing fantastically well, and will benefit from the continued weakness of the dollar. [34:05]
JIM: What about some of the other regions of the world. Let’s talk about Europe and then next Asia.
GABRIEL: Well, there’s a lot of talk as I’m sure you know and I’m sure listeners have heard this, a lot of talk about decoupling. Now decoupling seems to mean many different things, but the common theme seems to be that we don’t have to follow what the US does. But it’s a bit of a strange situation because what you have in the world is a mirror situation. In Asia, most Asian economies, even if domestic demand is picking up right now they still are intent on pursuing export-led growth. And if what you want to do is grow thanks to strong exports then you cannot by definition decouple from your most important export markets. The US is one of the most important, the other is Europe. But you’re clearly dependent on what’s happening in the rest of the world. Where Asia has decoupled is in it financial markets, they’ve developed in their own special way or have recently and are not necessarily affected by what happens in the United States.
By contrast, if you shift to Europe, financial markets – US and European – are thoroughly integrated, it’s really one seamless market. Nothing that happens in one cannot but affect what happens in the other. But in terms of actual GDP growth, Europe both can decouple and has in fact decoupled. If you look back over the past 20 years or so, the instances of European growth being synchronized with the United States are very rare. More likely they are decoupled from each other. The problem for the export-driven countries is of course that Europe even though it is going to do better than the United States, both in absolute terms and relative to its capacity, is still slowing down a bit. So you have a situation where Europe has decoupled in growth but not in financial markets and in Asia it’s the other way around. And I’m not quite sure if that has really been understood by a lot of commentators. [36:09]
JIM: Well, certainly if you look at last year there was a lot of money flowing into the international markets and if we look at this year in terms of performance the European markets have been hit hard – most of the markets are down anywhere from 15 to almost 20 percent, and the Asian markets equally hard hit in comparison to I guess the epicenter of the problem which is the US.
GABRIEL: It is a strange situation. You know, we’re supposed to say that markets are always right and frequently markets are right but not one hundred percent of the time. The resilience of US markets has in fact been rather surprising given what has been happening and it’s very unlikely that it can continue. But in terms of if you look slightly beyond the very near past, if you look back over the past five years or so, Asian markets have really developed in their own way relative to US and European. [37:10]
JIM: Gabriel, given the circumstances where other economies seem to be holding up on their own, where would you be investing money in this kind of market. If I look at bond yields, especially if I look at Treasuries right now, they don’t look appealing when you have interest rates on two year notes, where they and 10 year notes. What kind of investment strategy would you pursue?
GABRIEL: Well, I suppose there are a couple of different strategies. I suppose the classic answer would be I would go defensive but then some financial stock has of course become rather cheap in recent months as we know and with good reason. And some of the classic defensive stocks are more expensive. I think given how much of this centers around the credit side and the banking system it would probably be better, if you went into equities, to do large caps rather than small or medium. In terms of geographical areas, I would not find the United States particularly attractive at all. The Nordic countries, Sweden, Denmark, Norway, Finland probably somewhat more attractive and maybe things like Australian bonds, very high bond yields there and very high interest rates. Also my own personal – I’m very convinced that one of the things that will happen is that the currencies of the Persian Gulf Emirates will be revalued and probably decoupled from the US dollar this year; and of course so there is probably a certain amount of currency appreciation one can gain there. But I must say at the moment the investment climate doesn’t look very attractive anywhere really. Though I would avoid commodities I should say. [38:54]
JIM: And your reason for avoiding commodities?
GABRIEL: There are different classes of commodities. Oil is very much driven by demand-supply and geopolitics. Gold of course very much a hedge for the dollar, but as for other commodities, certainly hard commodities it’s our contention that they are very much hyped; there has been a lot of speculation in there. Possibly soft commodities – agriculture might be more interesting given that we’re seeing an upward march through the prices now. [39:24]
JIM: All right, well, listen Gabriel if our listeners would like to find out more about Lombard Research tell them how they can do so.
GABRIEL: Well, we have a website which strangely enough begins with w-w-w and then it’s LombardStreetResearch.com. You can look at that and there are contact details there. We have an office in New York, we have an office in London and you can always send us an email or give us a call if you’re interested in our products.
JIM: All right, well, listen Gabriel, I appreciate you joining us on the program and all the best to you, Sir.
GABRIEL: Thank you and to you as well. Have a nice day. [40:08]
JOHN: Jim, a long time ago I used to do classical music shows. I put myself through college as a matter of fact, you know, you could put a symphony on and it was 40 minutes long and you could study. Yeah, you do; you can study during a symphony and run over to the mic and say “that was Mozart’s 40th symphony blah, blah, blah and now Mozart’s 41st symphony with Eric Leinsdorf and Philadelphia Philharmonic and that type of thing. And I’ll be back in an hour.” And when we go into the history of music I would say that the Baroque period technically ended in 1750 – that’s when the classical period of music started because in that year both Bach and Handel died. The two key figures of the Baroque period. But the funny thing is in that time if you were living on that day, you didn’t get up and on January 1st 1750, say, “hmm, well, look at this, we’re in the classic period today.” You know.
You always see these things in retrospect. And the same thing happens in terms of changes of paradigms. Those things which cultures accept to be true, or are what I’d call the operating rules. And classically, when periods are inside of paradigm changes the majority of people don’t recognize that the rules have changed. They actually only recognize it in retrospect. Only a few prescient people seem to catch ahead of time and quite frequently these people are ridiculed as the whole country or the world is passing through these paradigm changes.
JIM: That strikes home with me because I got into the investment business in the latter part of the 70s and John, you remember, the US: we had the misery index, inflation was running around 14%, oil prices had gotten to as high as $40 a barrel; we had gold in the 800 range, we had the Hunt Brothers cornering the silver market; and everybody was talking about inflation. But in 19- – I think it was 1979, Jimmy Carter appointed Paul Volcker as head of the Fed and as soon as he takes over – they called it the Saturday Night Massacre because over the weekend he raised interest rates a full two percentage points. Just imagine what would happen if a Ben Bernanke or Alan Greenspan would have done that today – just imagine what would happen to the markets. And then on top of that, you had a Ronald Reagan come into Washington so there was a major, major paradigm shift. And the first four or five years that I was in the business everybody was talking about inflation. In fact, we had a brief blip I think it was in 1984 where the Fed raised interest rates, but when I got in the business, gosh, in the early part of the 80s we experienced two back-to-back recessions, within the three-year period back in 79 and then in 81. And in the summer of 1982, Volcker began to cut interest rates because we had a Latin American debt crisis, a lot of these countries were going to default on loans to US banks and the bull markets in financial assets began. I mean when it began the Dow was in the 700 range, you had dividend yields at roughly over 7%, you had bond yields at 15, 16%; I can remember one of my first clients we put in a 10 year Treasury note that we were getting over 15%. And the market was shifting but we had people talking about inflation, taxes and inflation all the way through much of the decade in the 80s, and so here was this big paradigm shift. I had people coming to me, John, in the 80s who still wanted to buy gold even though gold was now entering a bear market.
And here we are in this decade where we’ve seen interest rates come down to levels we have never seen before, I mean the money supply M3 growth rate in the United States is the highest it’s been in nearly 40 years. We have seen the advent of manufacturing powerhouses emerging in Asia, especially China; we’ve seen India also move in the same direction and we’ve seen commodity prices at levels that we haven’t seen in more than several decades. So there has been this major, major paradigm shift here and I think that if you look at a lot of the analysis, whether it’s commentary on commodities, commentary on gold prices or commentary on energy prices, they’re all looking at this from sort of the paradigm that existed for almost two decades in the 80s and the 90s when we had stable prices. And what people don’t realize is the world has changed. [45:15]
JOHN: The interesting thing though is if you look at it, the reason that a number of people are successful in investing is because of that phenomenon. That’s the weird thing that if you catch on to something that somebody else doesn’t then you had a unique opportunity to do something with that.
JIM: Sure, and this was something that Jim Rogers has been very prescient in doing. I think it was 1999 he took off for another worldwide tour that lasted three years and as he went around the world and saw what was going on in Asia, what was going on in the developing world in India and places like that, he saw the growing demand for the consumption of commodities, that there was this tremendous growth that was taking place. And that’s how bull markets begin. They begin with the simple demand and supply fundamentals where supply had shrunk – our stockpiles had shrunk in commodities over a two decade bear market; commodity companies had disappeared, gone out of business, the sector was consolidated so there wasn’t a lot of new mines, new acreage being brought on board. And that’s how bull markets begin; they begin with the issue of supply and demand imbalances.
And usually the first phase of a bull market you get the smart money coming into the sector realizing and spotting the opportunities. And then prices go up to levels that at some point you get a pull back. Then the next phase of the bull market begins and that’s where it gains institutional acceptance and this second phase is usually the longest lasting; you really see prices go up to levels you’ve never seen before. And then at some point you’ll get a correction and then the final phase, John, of any bull market is when the public catches on to the idea and the public comes into the sector just as for example the bull market in stocks that began in the summer of 1982. It wasn’t until 95 as interest rates came down that the public moved into the equity market and when they did they moved in big time. Over 90% of the money that came into the market by the public came in after 1995, but from 1982 to 1995 the public was totally absent. [47:05]
JOHN: But isn’t that when the lead investors are getting out at that very same time?
JIM: Well, you don’t want to get out too early. When the final phase of a bull market when the public comes in, that is usually the most explosive phase, like, for example, if you went back to the commodity bull market in the 70s between 1978 and 1980 I mean gold went from the 3-, 400 range all the way to 850 even though it only hit 850 briefly and then silver prices just skyrocketed. But you are right, when the public starts coming in and starts driving prices to just crazy levels, that’s when you want to start distribution. In other words, that’s when you want to start exiting your positions, but we’re nowhere near.
I mean you and I have been doing this program since 2001, and we’ve been talking about energy, we’ve been talking about precious metals, we’ve been talking about food, we’ve been talking about water. And last week we interviewed Jeff Christian with the CPM 2008 Gold Book – eight years running record gold buying. But I think if you were to talk to your average fund manager and ask him how much of his portfolio is in energy, how much of his portfolio is in precious metals – and I’m talking about significant amounts. And you’ve got to remember, at the end of the 90s I saw equity mutual funds that had 60 to 70 percent of their portfolio in technology stocks because that was the place where everybody was making money, you were seeing stocks like AOL go up 100% in a single month or Amazon do the same. And so the fund managers and the public couldn’t get enough of it. You take a look at your average equity fund today, there is no way you are seeing funds – unless it’s a sector fund – but your average equity fund is very little allocated. I mean I even take a look at some of the major oil stocks and I take a look at the percentage ownership by large institutions.
I’ll just give you an example. I’ll take a large cap oil stock. I’ll just take the largest which is Exxon and as I look at the top holders out of the top 20 holders, most of them have been net sellers of this stock. Now, you don’t know if that’s been due to forced liquidation, but at the end of the fourth quarter last year when things were going well most of these fund managers were trading out of energy stocks. And if you look at these funds and take a look at the individual funds, energy is still a small component and goodness, when it comes to precious metals they hardly exist. Maybe they might own a Barrick or a Newmont, but John, I’m just looking at one of the large gold stocks and you’ve had some sellers here by these mutual fund companies. It’s gaining some acceptability but in terms of is it widespread; we’re not even close. [50:40]
JOHN: Well, as we mentioned before when we started this segment on paradigm shifts, when paradigm shifts occur most people don’t really recognize what is happening while it is in transit. They only recognize it once they get through the first part of the paradigm shift when they look back and say, “hey, something changed back there.” And that’s almost one of the hallmark issues of paradigm shifts.
JIM: Absolutely. And I think a lot of this has to do with human psychology as human beings we are creatures of habit. You drive the same path to work each day, you go to the same stores on the weekend – we have these routines that we build into our life. And analysts and people on Wall Street do the same thing; they build these models or these concepts of how the economy works, how the markets work and we tend to analyze these things from that perspective. I was reading some of the pronouncements made by people calling for lower oil prices and it’s all from this paradigm of everything centers around the US economy, there if the US economy is slowing down and we are seeing some actual slow down in energy consumption by consumers here, therefore the price of oil has to go down. And you see this, John –who’s famous for this? – is every time we see an oil spike you’ve got Bill O’Reilly and that’s the thing he says, “gosh, I was talking to Harry at the local gas station and people are buying less gas and consuming less so why isn’t the price down?” That’s a US-centric point of view. And what we’re not thinking about is the other 3 ½ billion people who live on the other side of the planet. So we are seeing these paradigm shifts and unfortunately we’re resistant to these changes because they just don’t line up with this model that we’ve constructed of how economies work, how the world works; and here is this change and transition, the US is declining in terms of an economic power and force in the world – we’re still a major economy but instead of being 25 to 28 percent of world GDP, we’ve fallen to 22% of world GDP. On the other hand, China and India are now grabbing a larger percentage of the economy. [53:00]
JOHN: Obviously this is going to have a long term impact. We’re talking about this paradigm change on energy and other related things as well into how you invest because if you keep trying to make investments based on the old paradigm you are sure to be disappointed.
JIM: Absolutely. And we’re going to get into this in a segment that we’re starting. We won’t get into it today, but we’re going to do a four part series on retirement planning; and as we get into planning for income during retirement, the type of investments, the type of environment you’re going to be living in during your retirement years obviously impacts you in terms of how you should be setting up your portfolio. And the trouble is – and we’ll get into this probably next week but you have these standard formulas that people give you, “oh you’re getting ready to retire, you put 60% of your portfolio in fixed income investments and you put 25% in cash and you put 15 to 20% in equities.” And this is the formula. Unfortunately these formulas, these pat formulas the cookie cutter program that they give people, that was fine for the 80s and the 90s when we were in a totally different type of operating environment. But today, as you take a look at and you see this right now people keep saying, “well, the economy is slowing down, that’s going to take pressure off demand - inflation is going to go down.”
And John, it hasn’t happened. The Fed raised interest rates from 2004 all the way to 2006 and you know what, inflation rates did not come down and now everybody says it’s a lagging indicator; and they keep making reference to the old formula, the way the economy worked, the economy would go through a boom, the Fed would raise interest rates the economy would contract, and with it down would come inflation rates. Well, you know, what? It hasn’t worked this time around. And they keep pushing it off and one of the things we’re predicting is by the end of the year a surprise that’s going to be taking the markets –and this gets back to the Oreo theory – is the inflation rates will be heading higher. You cannot expand the money supply, you cannot bail out financial institutions, you cannot run the magnitude of budget deficits with this tax rebate and stimulus program and now they’re working on a bailout of homeowners – there’s a bill in the Senate sponsored by Chris Dodd, and then there’s also a bill in the House sponsored by Barney Frank. You can’t be doing these kind of things without having some kind of adverse effect with inflation whether you see it in rising commodity prices or asset prices or services. So there are consequences to these kind of things and what we’re trying to do is we keep trying to analyze these in the framework of the old paradigm that existed in the 1980s and 90s. I mean we’re moving in uncharted territory at this point and especially in this financial crisis. I mean one of the things that has shifted here is if you look back over the probably what, the last two-and-a-half decades, the crises were always centered some place else in the world. Where this time, the epicenter of the crisis is the United States with the real estate and mortgage crisis. [56:25]
JOHN: You’re listening to the Financial Sense Newshour at www.financialsense.com.
JOHN: Welcome back to the second part of the Big Picture. And speaking of welcome back, back in 2003, there was an article penned by one James Puplava called Pac-Man, clicks & bricks where you laid out the acquisition or Pacman theory. There were two large discoveries on the horizon. Large mining companies were having trouble replacing their reserves, and so you laid out the Pacman strategy whereby, if you recall, large companies would acquire the mid-tiered companies. Mid-tiered companies would acquire small producers, and small producers would acquire juniors and other undeveloped properties. This sounds like a food chain more than it does Pacman. It does. It’s like these evolutionary things you see. That scenario has pretty well played out so far since 2003 just like you outlined it back then late in the year. If our listeners want to read it, they can find it at our website under the Market Wrap archive dated December 15th, 2003. That's at www.financialsense.com. Now, do you really believe that another phase of Pacman is just about to begin?
JIM: Yeah. I really do. The reason I see this happening is because of divergences that I'm seeing in the gold market right now. I mean if you take a look at what has happened to gold stocks, since last August when the price of gold took flight, the share value of major gold producers has risen while the share value of most juniors has actually fallen. Part of this, I think, reflects the recent liquidity issues, and part of it, I think, reflects hedging strategies. For example, you go long the producers and you short the juniors. And part of it in some degree, I think, is lack of understanding or knowledge of juniors. I mean it's much easier to take a look at a Barrick, even Value Line covers the large gold producers like Agnico, Barrick and Newmont. So what we've seen is a tremendous rise in the market cap of the major gold producers and a drop in the market cap of the juniors. And you can see this develop. In fact, last year, bullion out performed gold stocks and then large cap stocks under performed small cap stocks; and even in the large cap sector in the HUI, it was mainly a handful of stocks. [2:24]
JOHN: Well, could you explain or give us an example of what exactly you're going to see here.
JIM: Well, you can see this if you take a look at a chart in the rise of the HUI and XAU (that's the AMEX Gold Index and the Philadelphia Gold and Silver Index) versus, let's say, we have a junior mining index, the FSO Junior Mining Index. The HUI has gone from a low of 300 in August of last year to a high of 514 this year. Currently, the HUI index is roughly at around 450. I mean it's up around close to 10% for the year. And some of the leaders within the HUI, they experienced even larger gains. I mean if you take a look at some of the big large cap stocks, Agnico hit a low last year of 33 bucks. It went all of the way up to almost $84. Currently, Agnico is roughly around 69 dollars. You've got Barrick which had a low of 2770. It hit a high of $54.74. You had Goldcorp go from 21 to 46, Kinross go from almost $10 to over $27, and Yamana go from $8 to almost $20.
So even though we've seen a pullback in price, you have a situation where the market caps are high and their paper has become more expensive. I mean Agnico’s market cap is 10 billion. It's selling at over 600 an ounce in the ground. You've got Barrick's market cap rising to 40 billion. It's selling in the mid $3,100 an ounce in the ground. You've got Goldcorp's market cap at 29 billion, and it's selling at $730 an ounce in the ground. Kinross is 14 billion. Yamana is almost 10 billion, and Yamana is selling at almost $730 an ounce in the ground. So if I'm a smart CEO and I want to grow my production and create value for my shareholders –remember, growing production is what investors are looking for in a bull market – I would take my expensively priced paper and buy cheaply priced paper using my stock as a currency. You've seen it occur in the energy industry. You saw it occur in, for example, the technology boom in the 90s where you had companies like Intel, Cisco, that were using their stock which had appreciated tremendously, they were using it as currency to buy growth by buying and going on the acquisition trail; so that's why I think this divergence is going to create this setup. [5:05]
JOHN: Well, I know you've long favored juniors and you've done well investing in them. Do you think it's going to happen this year because the juniors really haven't done well over the past year?
JIM: Well, that's precisely the point because that's what sets up the opportunity where you can take expensive priced paper in ounces and use it to buy cheap, depressed paper. I mean that is how you can create value. In other words, if you want to grow your reserves, increase your production and cut down your lead time to production in half, there is no better way to do that than to go out and take somebody else that has already done the work. That’s because it takes 7 to 10 years from the time of discovery to the time you bring a mine into production; but if you go out and buy somebody who has already done all of that work, you can cut your lead time to production in half, you can take it down to 3 years. I mean Agnico bought Cumberland and within three years, 2011, they will take Cumberland into production.
At least that's what I would do if I ran a gold company, and if my paper was expensively priced, that's how you're going to add value and create growth for your shareholders and that's how you get rewarded. [6:13]
JOHN: Well, Jim, are there any signs of that given what we're seeing out there?
JIM: There have been a few minor take-overs this year, nothing noteworthy yet, but we've had a lot of market volatility and turbulence, but most of the CEOs that I've talked to believe gold prices are heading higher. So there are plenty of incentives to go out on the acquisition trail. In fact, in a recent financial post report of a Bloomberg dispatch, Sean Boyd of Agnico-Eagle said the company was scouting for as much as 1.6 billion in acquisitions as bullion trades higher. In fact, Sean said the company favored deposits selling at a discount to their net asset value, and he said his bids would be more likely to be friendly. In fact, if you take a look at Agnico offers the last three years, they have made almost $730 million in acquisitions which added 9 million ounces of gold reserves to the balance sheet. So yes, you know, I do think you're going to see Pacman can return. And especially, I want to point out here if the price of bullion heads higher and this disparity in value that we're seeing between majors and juniors continues which it looks like it has. I mean if you take a look at the HUI this year, it's up about 10%. The XAU is up about 4%, but if I take a look at the FSO junior mining index, it's still down this year. [7:39]
JOHN: What do you believe they'll be looking at? In other words, what would be the criteria here?
JIM: For most of the companies that I've seen make acquisitions and then also talking to company CEOs, they are probably looking at deposits in the 2 to 3 million range. That's what makes a deposit economic, but also with the opportunity on the upside to expand. So they would also want, let's say they buy a candidate that has two million ounces, they would want to see some blue sky potential because if they can double or find more ounces, it's a chance for the company making the acquisition to use some of their own exploration and production expertise which would add value and cut their cost. I mean, for example, let's say they bought a junior that had 2 million ounces at a price between 100 and $200 an ounce, but let's suppose the junior had a large land package so that they could do additional exploration and they found an additional one to two million ounces from the blue sky potential, they can cut their acquisition cost in half. And that's exactly what we've seen over the years where a lot of these acquisitions were made; they were buying the junior not just for their existing reserves but also for their upside potential because if they can buy ounces in the ground that immediately adds to their balance sheet and immediately cuts down their time of taking that company into production, but also if they can also continue with the exploration work, they can find additional ounces which they get for free and that goes a long way to cutting down your acquisition cost. [9:20]
JOHN: What about any other criteria?
JIM: Well, I think one of the very important criteria today probably centers around where the deposit is located which is very important. You heard in the energy roundtable that we had the idea of nationalization. I mean just pick up the papers or turn on the evening news; the world has become a more hostile place. Governments are becoming more rapacious. Nationalization is on the rise, so a friendly mining country that respects property rights would be very, very important for a lot of these mining companies because you don't want to make an acquisition and it turns out you get this deposit, you put in the mill, you do all of the infrastructure and then all of a sudden the dictator in the country says: “You know what, I kind of like what you did. It's mine now.”
So Mexico would probably be at the top of the list in terms of acquisitions. It has a mining culture and it goes back centuries. It has an respect for property rights and here is another important factor too. Mexico's currency is not going up against the dollar, so what that does is it keeps cost down which is very, very important because part of the problem that we've seen over the last couple of years for producers, the problems they've experienced is that their costs are going up in local currencies which are rising against the dollar while their product, which they sell, is denominated in dollars. So what makes Mexico attractive is not just the fact that it has a mining culture, it has a respect for property rights, but if you take a look at the Sierra Madre gold and silver belt, it's probably one of the most prolific gold and silver regions in the world. I think it was a little over a year ago the Discovery Channel did a special on the Sierra Madre gold belt as probably one of the richest gold and silver deposit ranges geologically in the world today. [11:12]
JOHN: Well, what about any other areas other than Mexico?
JIM: If you're thinking of a mining culture, friendly, respecting property rights, Canada would probably be second on the list; I love the Yellowknife region would be second. Recently you had Newmont take over a junior company up there called Miramar mining, so that area looks particularly tempting. Then there are probably a few countries in South America that look attractive such as Argentina. [11:37]
JOHN: So if I were to summarize this, you think this divergence between the majors and the juniors really is an opportunity here. That's what it spells.
JIM: Yeah. Because no trend continues indefinitely. You would have to be almost blind if you're a CEO of a major producer and you're seeing your stock market value just increasing to the point where, you know, your paper is selling for almost $750 an ounce and then you're looking in the junior sector and you're seeing these large deposits develop, large land packages that are selling at 40 and $50 an ounce at a time when gold is over 900 and silver is at $18 an ounce, so I do think that you're going to see the return of Pacman this year. There are juniors out there that are selling at very steep discounts to their net asset value, some of which are expanding their deposits through either enlarging their land package or claims and they are also growing their resource space. When you have gold selling at prices that we do today, you can go out and buy ounces in the ground at 40 and $50. This becomes an opportunity not only just for the mining companies, but also in my opinion, an opportunity for investors. [12:58]
JOHN: Well, I know you believe in juniors, but we see bank credit tightening right now. And so for them to obtain capital, is that posing a risk area?
JIM: Not really because money is going to go where it can find a high return. And one of the highest return areas is natural resources now with the hundreds of billions of dollars that have been moving into this sector, both institutions, you have CALPERS announcing that it is going to devote, I forget what percentage of its portfolio and you're talking about a pension fund that manages a quarter of a trillion dollars. I mean I'm involved with a junior mining company and we just recently did a financing. It was over subscribed and we had three institutions –a large cap North American mining company and two other financial institutions – that took down almost 75% of the offering and it was over subscribed. So if you're in a good area, you have an attractive deposit, you have an attractive story there is no shortage of capital because we were actually surprised at the amount of oversubscription into the project.
And it's not just the company that I was involved in, I've seen this with some other juniors that had no trouble getting financing. In fact, one company that we were going to finance, we stepped back when we saw that they were playing the dump-and-pump game and we were able to pick it up for a much cheaper price. But there is no shortage of capital today and even with the liquidity crisis because once again, money will go where it can find an attractive return. And let's put it this way, the gold market is operating at a deficit. A lot of our commodities whether it's ags, base metals are operating in many ways at a deficit. We don't have enough mines. We don't have enough new discoveries to keep up with demand. So I think this area is easily financeable. [14:44]
JOHN: Well, anything else besides juniors or other criteria? I know when you look at juniors you look at a company that either could become attractive enough to be taken over or large enough to eventually go it alone as producer.
JIM: There is another idea I've sort of been kicking around. It's sort of been percolating lately. And that is in the silver space. Seven or eight years ago when Dave Morgan first started coming on the program, we were talking about silver producers, you could count them on almost one hand. But today because of the money going into the sector, you've got a lot more producers coming in, but you've got a lot of small emerging silver producers in the two to three million ounce range whose stock prices – just as juniors have struggled so have junior silver producers.
And so there are companies with the potential to grow, I don't know, maybe they grow from two to three million ounces, maybe they grow to a five million ounce producer. But here is the problem. They are selling at steep discounts given the price of silver. On the other hand, you have a company such as Pan American silver that last year produced about 16 million ounces and this year they'll probably move their production up to close to 18 ½ million. But Pan American has a market cap of 3.2 billion where you could take the top three or four small silver producers who collectively produce the same amount of silver but they have a collective market cap of around 600 million. So you know, in my mind this is just market inefficiency; 600 million versus 2.3 billion. So you don't need a whole bunch of 2 to 3 million ounce producers. So I think what you could see here is consolidation of this industry makes a lot of sense. I mean you consolidate the sector and create another Pan American. Which would you rather have? 600 million market cap split between three or four producers or a $3.2 billion company. So I believe that you're going to see consolidation especially as silver prices head higher and the cost of production goes up, so I see Pacman also coming into the silver sector. [16:52]
JOHN: And you're listening to the Financial Sense Newshour at www.financialsense.com.
I'm Andy Looney. Did you ever watch one of those crazy science fiction movies, you know, the ones where they go back in time and fix a big mistake and save the present, which is really the future when you're in the past only to have it change something in the future from the present. What? I bet the brokers and bankers wish they could go back in time and refuse to lend to all of those subprime borrowers, you know, date it and claim it. Just think how much easier things would be today if we had never heard of the subprime melt down. What do you think? I do.
Maybe they could drain the excess liquidity from the system by floating all of Ben Bernanke's money back through a time space continuum wormhole into Greenspan's time. Boy, Alan Greenspan would wonder where all of those dollars came from considering that they were dated three years in the future. You know, Greenspan could go back and tell people not to take out adjustable rate mortgages, and then he wouldn't have to be embarrassed by saying he didn't see it coming. I bet his book would be a lot more boring. What do you think? I do. I'll bet that if Bernanke could go back in time, he'd tell Bush he didn't want to be the Fed chairman, and then he could sleep a whole lot better at night. I know I would. Wouldn't you? I think you would. I guess we won't invent a time machine any time soon even though it worked for Governor Schwarzenegger, but I think it would a great investment if we could. Think about all of those horse races you could put bets on and win. It's better than investing in Treasuries.
For Financial Sense, I'm Andy Looney. [18:56]
Planning
for Retirement - Part I
JOHN: If you recall, Jim, in the first part of the program, we were talking about paradigm changes. And one of the areas where this concept of a shift in paradigms is going to be very dramatic is the fact that the baby boomers –not just in the United States but also in Japan and Europe – are going to retire. However, the financial state of the world today is far different than when their parents retired, you know, with defined pension plans. They'd been with the same company for 45 years and they get the gold watch and whole bit. This is not going to happen this time. Plus we're in turbulent waters and so it's a whole different concept that has to go into planning. I mean just imagine the quantity of people that are going to try to be retiring and not producing into the system.
JIM: Yeah. Think of the impact of boomers heading into retirement, what that's going to mean to consumption because it's usually household formations. I mean think of what happened, everything the baby boomers did when they got out of college, moving into college the expansion and building of universities and the household formations, the housing market, the consumption market, and going into retirement. And you're absolutely correct – you look at our parents, our parent’s generation might have worked in a union job. They might have had – they went to work for an industrial company when America was a manufacturing economy, so they had defined benefit pension plans and, you know, after 25, 30 years, they got a pension from the company that was defined so they knew what it was going to be. They got Social Security. Hopefully they’d have accumulated some savings and most of them did because that was the savings generation.
Now, you look at our generation. Both you and I are boomers, John. We didn't -- well, I have had my own business now for almost three decades but other than that, most boomers have had three or four, five job changes, maybe two or three career changes in the sense that you may have started out in one field, you moved over to another field. The pension systems changed in this company. Companies downsized as the country changed from a manufacturing to a service to a financial economy, so a lot of these structural changes in the economy have taken place. And now, you have the largest population in US history heading into retirement. That's going to have a profound change, I think, both economically and in the financial markets. [21:41]
JOHN: But a lot of people are just plowing into this time without a lot of thought. There was a time when I think Social Security could recover a lot of retirement, and as we know, the currency is being inflated so the value of Social Security is being diminished. Everybody will get a check, but not everybody will have the same buying power that generations 10 years, 20 years, 30 years before them would have.
JIM: Yeah. And I think also you're going to see in the next decade as we get into this crisis window that not everybody will get a check. In other words, if you've been diligent, you've saved, they will start phasing out your Social Security benefits based on your other income because there isn't a trust fund to begin with. They've spent the money. And it's just going to be overwhelming. I mean the unfunded liabilities for Social Security and Medicare are currently about five -- what is it? 54 trillion going up by trillions of dollars each year. It's just going to become unimaginable. So there are a lot more things to plan for today when you're considering retirement, and what I find is we're getting emails from people, people are coming in, and for some people, John, this is a shock. It's, like, wow, the kids have -- you put the kids through school and all of a sudden, you wake up one day and you say “oh my goodness, I'm a couple of years away from getting Social Security.” And you can see sometimes how panic begins to set in. [23:02]
JOHN: Let's start from the beginning, then, and say what can you do to prepare yourself. And maybe at some point during this four part series we're going to be involved with here, we need to look at what happens if you do wake up in a moment of panic and say what do I do now. I mean obviously, you can't rewind the clock. But anyway, as far as practical preparation, let's start from there.
JIM: Well, I'm going to mention a dirty word. People aren't going to like me saying this, but all retirement planning begins with a budget. In step one in a retirement planning process is an expense inventory. I imagine people listening to this, this isn't probably the funnest thing to think about, “hey, we're going to get together and look at our budget over the weekend.” But you have to do that. You have to come up with a budget and take a look at your expenses and then, it's not just a budget that you put together and okay, this is what I spent. You're going to have to take that budget and divided it into two components. One is called essential. These are things that you have got to have. Food, housing, clothing, health care costs, insurance and then you're going to have another category called discretionary (travel and entertainment).
Then I would add two other columns next to those categories and that is fixed or variable because maybe you're fortunate enough and you have a paid-for home or maybe you're fortunate enough and have a low interest rate mortgage and it's fixed and it's 30 years so you know exactly what your housing payment is going to be every single month. You have certain expenses that maybe you have a car payment that's fixed, so you're going to have to break your budget into essential items number one, and two are discretionary, and then you're going to have to put columns under each category within that budget. In other words, will this item be going up? In other words, is there an inflationary impact or is it fixed. It will always stay the same. And then you have to take a look at that and then start saying, okay, working today, I can cover these expenses.
And we'll get into income inventory as part of this because then you know what your expenses are, but then you have to draw an inventory of all sources of income. Okay, what is my social security going to be or maybe you have a government pension or maybe you have a company pension. You can take a look at what sources of income. You really have to do that, John, because until you take a look at that and get it down to a budget how are you going to plan for retirement if you don't look at what your expenses are because I can tell you this: They are going to change. [25:47]
JOHN: You know, someone once asked, Jim, when does life begin, and the answer is when the dog dies and the kids leave home, you know. So after that, the size of the house that you're going to require isn't quite as large as it was before, so probably one of the areas of expense is that you're going to have to look at is where you're actually living, the size of the house, Do you need it? Possibly it's the actual location because look at the property tax, size of other factors, maybe it would be better somewhere else.
JIM: A lot of the retirement magazines and financial magazines that talk about retirement address this issue because you may live in a East coast city or West coast city where the cost of living is almost prohibitive today when you take a look at housing cost, property taxes, sales taxes. And one of the big trends that is emerging, and what I’ve seen, is that a lot of people are selling the big home that you raised the family in in the big city and they are moving to smaller cities. Sometimes in the Midwest and even on the eastern sea board in small towns and states where maybe it's a 25, 30 or 40,000 population town where the cost of living is cheaper, the taxes are cheaper, the housing costs are cheaper. This is factoring in as a major review point for retirement in terms of where people are living. In fact, just about every survey that I see on retirement planning – the top ten areas to retire, John – and it's surprising, it's not the big cities that you and I think of. It's not San Francisco, San Diego, New York city, Chicago. It's usually some place somewhere else, and it's 9 out of 10 times, it's a small town. [27:37]
JOHN: And a lot of times, the lifestyle there is even nicer than the big city. It's a lot slower, it's less hectic, but also you're going to want to look at things like availability of medical facilities, things like that.
JIM: Sure. Availability of medical. Another thing that's very popular are college towns so you can continue your learning activity. So access to medical is one; access to cultural type things. A lot of the lists that I've seen on popular places to retire have to do with like college towns so maybe you take courses of interest. And also, John, the possibility, and especially when you start looking at income inventory is you may spend part of your retirement working in some field. Maybe it's something different than what you did when you were working full-time, but as a means of supplementing your income to make ends meet because of taxes and inflation, it's getting harder and harder to just say, “okay, that's it, I'm retiring, I'm going to sit back and relax and I'm on easy street.” I think you're going to see more and more boomers end up as part of their retirement planning program, they will end up doing some kind of part-time work to supplement income. [28:51]
JOHN: You know, one of the things that just pinged into my mind talking about conserving costs, right now every year over a certain age, you get a statement from the Social Security Administration saying, “well, if you were to retire today, you'd get x amount of dollars,” but ah-ha, they are already talking about means testing and other factors which will affect Social Security. Which means when you get to the time to retire and they go well, you thought you were going to get x dollars. Well, you're getting x minus 1500 or something or 15, whatever it is. And that's going to really upset the planning right there.
JIM: Oh, absolutely. I almost guarantee you the next decade when the surplus revenues coming in from Social Security taxes goes to a deficit, John, that's exactly what they are doing to be doing. And just as we talk about breaking down your budget to a category of essential and discretionary, and then adding columns for is this fixed or is it subject to inflation and another thing you need to do is take a look at your income. Maybe you have a government pension or maybe you have a company pension or maybe you have some kind of annuity plan or something, but you also have to take a look at your income. Will your income be going up because in the environment that we're living in now I can tell you: You are going to experience cost of living increases. Your health insurance is going to go up, and especially as Medicare becomes more problematic and runs more and bigger deficits so you can see maybe the government increases the co-pay. Maybe you're going to see your food costs go up.
So these are kind of things that you have to factor in not just on the balance sheet side in terms of what you're going to spend. But also on the income side how much of the money that I have coming in is fixed because what you don't want to do is when you retire and let's say you have your money in fixed income and you're doing okay the first year you retire but because the income doesn't go up five years from now with increases in the cost of living, you start running into a problem. And as many Americans are feeling that pinch right now with their pay increases not keeping pace with the cost of living increases that they are running into in the real world on Main Street. [31:08]
JOHN: Doesn't that say something about where your income will be derived, like you say, no fixed income, but the one desire I think of people when we talk about our parents generation was security. That was always it. In other words, your income was locked and secure and it was a known value and you could go from there. That may not be really possible in the way we've known it in the times past.
JIM: There is more uncertainty that has been injected into the retirement process which to me just calls upon the