Power, energy, and the debt-fuelled model of modern economics...
LET'S TALK about power, says Dan Denning in his Daily Reckoning Australia.
Where does it come from – the barrel of a gun? From a lump of coal? From the sun? From an unshakeable inner self belief that allows you to question the entire scientific establishment about man-made global warming...?
Wherever it comes from, the Chinese economy is now using more of it than the American economy. According to Faith Birol, the chief economist at the International Energy Agency, China consumed 2,252 million metric tons of oil equivalent in 2009. It took a mix of energy sources like coal, natural gas, oil, nuclear, and renewables to reach that level. Meanwhile, Birol says Team America used 2,170 million metric tonnes.
Obviously on a per capital America still lives an extravagant energy lifestyle. It will take a lot of nuclear plants and windmills for the Chinese to catch up. But they don't even have to catch up on a per capita basis to make you wonder where all the energy is going to come from. And obviously, as an investor, the natural question is how to profit?
This may seem like an odd question if you're expected a major deleveraging in the global financial system and sovereign debt defaults. After all, this argument follows from the idea that the expansion in global trade since 1971 – an expansion that roughly mirrors China's economic re-emergence as a global power – was mostly result of an expansion in global credit, and not, fundamentally, driven by sustainable growth.
If that's true, it means the level of demand for energy in the world should fall with economic activity and deleveraging. And before you go dismissing the foregoing idea – that this last 30 years of globalisation has been driven by excessive credit growth – have a read of this article in The Economist about John Law, the Scottish gambler and father of modern central banking:
"Credit growth since the adoption of fiat money in the early 1970s has helped to push up asset prices at a rate much faster than that of nominal GDP..."
Thus, with lower credit growth you should get falling asset prices. And as falling asset prices put pressure on household and business balance sheets, you should also get lower and slower GDP growth, resulting in lower energy demand.
Incidentally, the Economist article shows why the leveraged property boom in Australia – both commercial and residential – is another example of asset prices driven by excessive credit growth. It also shows that central bank efforts to prop up prices with interest rate cuts inevitably fail. But what does it tell you about the oil and energy stocks right now?
Well, if you believed the giant expansion in global trade since 1970 was mostly the result of a credit bubble and that we're now in a credit depression, it would argue for NOT buying oil and energy stocks. Granted, Bloomberg reports that China's oil imports were up 48% last year to 5.4 million barrels and have doubled since 2005.
But even with a larger base, should you buy energy shares if you expect global demand to fall? That's the question we're taking up in the July issue of the Australian Wealth Gameplan. It's partly a question of valuations and partly a question of reserves and partly hinges on the question of what is going to constitute capital in the next twenty years. The last part is kind of complicated. But we'll explain what we mean briefly.
"From the Seven Years' War through the American War of Independence through the Revolutionary Wars in Europe to the Napoleonic Wars, the great conflict between the French and the British was a fiscal, as much as it was a naval or military, conflict," says British historian Niall Ferguson. "This was a conflict that the British emphatically won."
Ferguson's point in those remarks is an expansion of the same point he has made previously: the key element to the success of the growth of the Western Nation State in the last three hundred years was a financial system that could raise debt in bond markets and pay the interest through taxation. This fiscal innovation helped the British beat the French and it's been working ever since.
Ferguson's latest work though, along with that of Ken Rogoff and Carmen Reinhart in their book, This Time is Different: Eight Centuries of Financial Folly makes the point that the credibility of government borrowing depends on the ability to pay interest in your debt. He makes the argument that when interest payments on sovereign debt exceed military spending, a nation's great power days are behind. This ratio of interest on the debt to GDP is one of his "metrics of doom."
So does power come from the bond market? And is it true that confidence in government debt can be lost as the government spends a rising share of tax revenues on debt payments? If it is true, is it possible, as Ferguson says, that when things go wrong in the realm of public finance, they can also go wrong geopolitically...resulting in wars, debt default, and hyperinflation?
Obviously we wouldn't be writing this if we didn't think all those things were possible and, at this point, inevitable. Public finances in Europe have already deteriorated significantly. But on paper, judging by the projected debt service payments as a percentage of GDP, the prospects are even more alarming in the US and the UK.
To me here in Melbourne, this means that the huge capital base of the West built up in the credit boom years is literally paper thin. On the balance sheet, the English-speaking countries have over-invested in housing and shifted resources to the financial sector of the economy. This is what's behind the nervous campaign to recapitalise banks and buttress the financial system before further falls in house prices and securities linked to them.
In this kind of world, then, when assets bought with borrowed money are going to fall, what constitutes solid capital? Upon what can you build the foundation for your personal wealth survival strategy? That brings us back to energy.
We read in today's Australian that Korea Gas has agreed to purchase up to 1.5 million tonnes of liquefied natural gas (LNG) each year for the next twenty years from the Wheatsone project off Australia's Northwest coast. We also read that the first exchanged traded fund tracking lithium prices is set to launch this week and that China's pursuit of hybrid and electric cars could, "impose the manufacturing line on the rest of the world," creating huge demand for lithium dioxide. Hmm.
So what are we on about? Well, as we wrote a few years ago in London...in a world where the financial system has essentially set its own bed on fire...it seems like energy itself might be a kind of economic capital. You can't have growth without it.
In fact, about the only upside of a general deleveraging that decimates publicly listed energy shares is that it will leave some companies with very large energy reserves and resources selling for a song, provided they don't have too much debt and aren't carved up to appease creditors.
Those are the companies we might be keen to buy. The recapitalization of the world's economy can't truly begin until the misallocated capital and bad investments of the previous boom are written off. But when they are, it's going to leave some very cheap energy assets. And not only are those assets crucial economically, they are crucial geopolitically too, where the contest for them is heating up.
And then? We'll, we're writing the rest of the investment story tomorrow. But in the meantime, the moral of today's reckoning: power comes from sound money, sound fiscal policies, and transparent law. When that system of prosperity is perverted, power then comes from the possession of ownership of tangible assets without which you can't have a growing economy.
No, Australia doesn't have the same public debt problems as other countries. But it depends on those countries for access to capital. That's a weakness. But its massive energy abundance is strength and a real boon to investors.
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