Today Rio secured a massive 97% price increase from its Asian steelmakers – piling the pressure on BHP to get an even bigger increase. BHP claims that Rio’s agreement isn’t enough to cover extra shipping costs.

BHP Billiton, Rio Tinto and the American Civil War

Dan Denning

Let’s get the ugly part out of the way first. The S&P ASX/200 limped home yesterday to finish the fiscal year down 16.9%. Let’s call it 17. It was the first down year since 2002, or 1 BB (Before the Boom).

If not for the iron-ore solid performance of BHP Billiton (ASX: BHP)-up 24.7% on the financial year-it would have been much worse for the ASX 200. Rio Tinto (ASX: RIO) did its part to hold the line for the resource sector as well. Rio was up 38.2% for year, from $98 to $135.50.

But wait, why is BHP’s 24.7% gain more weighty than Rio’s 38.2%? Is this some weird new math? Some sleight of hand or trickery? No.

The ASX/200 is a market-cap weighted index. A stock is judged not by the colour of its performance but by the content of its market capitalisation. BHP’s market cap went from $194 billion to $244 billion in the last twelve months. Rio went from $98 billion to $135 billion.

You reckon Rio’s CEO Tom Albanese will not be happy to hear that BHP still means more to Australia – at least the performance of its share market index-than Rio. Yet Rio is not unattractive. The Financial Times reported yesterday that ArcelorMittal (AMS: MT) – the world’s largest steel company – may be interested in buying a piece of Rio.

Does that kind of deal make sense? Arcelor is trying to bring its resource supply chain back on to the balance sheet. Buying the world’s second-largest iron-ore maker sure would do that. But Rio’s biggest customer is China. So does Arcelor just want a piece of Rio’s growing earnings? Does it want the ore? Or does it want a piece of Rio’s assets in a post-BHP merger carve up?

Who knows? Lakshmi Mittal does probably. But he’s not telling.

Yesterday we mentioned we’d look at the markets geopolitically. What we meant by that is that most pundits are assuming the resolution to the credit crisis will come in form of a normal economic cycle or some change in monetary policy, or a currency readjustment. But maybe it will end in bullets.

This current state of affairs is not just a friendly tilt between inflating commodities and deflating financial assets. An allusion is in order. At the First Battle of Manassas on July 21st 1861 the American Civil War got underway. Everyone thought it would be a short, quaint affair. Manassas is not far from Washington D.C.

Today, you take Interstate 66 to Route 50 West, if memory serves (our brother used to live in the area). But back in 1861, day-trippers from DC took carriages out to watch the opening of the war. They brought picnic baskets and clapped. They anticipated a Union rout of the rebel troops led by Confederate General PGT Beauregard.

It was all going the Union’s way until a bunch of Virginians under General Thomas Jackson held the line at Henry House Hill. “There stands Jackson like a stone wall,” said Brigadier General Barnard Bee Jr. The Southerners rallied and won the battle and the war was much longer and bloodier than anyone expected.

We mention the battle for three reasons. One, it was a nice way to think of BHP and Rio in your portfolio, buttressing it against a larger route. Two, the Civil War was much worse than anyone expected because it was really the first war where industrial production mechanised warfare. You had tremendous firepower concentrated in large masses of men. The result was industrial scale slaughter and a preview of World War I fifty years later.

No one went into the war thinking it would be newer and deadlier. And no one has gone into globalisation believing that there were drawbacks as well as benefits. The obvious drawback now is that a synchronised global asset bubble has become a synchronised global asset bust, with falling asset values leading to reduced consumption, lower corporate earnings, and more falling asset values… all in a downward spiral.

The third reason brings us to Clausewitz, the German military strategist. He wrote many famous things. One of them is that, “war is a continuation of politics by other means.” Clausewitz used the German word Politik, which can mean either policy or politics.

One reader writes in that our theory of a seamless migration of wealth and capital from West to East is rubbish. “People never relinquish what they have easily,” he writes. “If Asia is to become rich and the West poor, we will see war, actually many wars, first. The history of man is war.”

This is the other possibility, then. The economic tensions created by globalisation turn into hot resource wars, via both politics and policy. It’s no coincidence that the oil price has gone up since the Iraq war began.

Will Americans under John McCain or Barrack Obama take their new position in the world with good grace? Or are they going to fight it? What is China’s ultimate resource policy? Does Australia even have one? Should it? Will markets take a back seat to geopolitics in the coming years?

Let’s not be so dire. We could be in the midst of a painful but necessary financial adjustment.

Dan Denning
The Daily Reckoning Australia

Source: BHP Billiton, Rio Tinto and the American Civil War

The boom is reflected in the climb of the Australian dollar. Bloomberg reports today that the Aussie dollar “rose to its highest level in 25 years as prices of the nation’s iron ore and coal exports climbed to new records.”

The Coming Boom in Australian Resource Stocks

Dan Denning

It takes nearly five hours by plane to get from my new hometown of Melbourne, Australia, to the Timor Sea, the body of water that lies off Australia’s northwest coast.

I’ve made the trip several times now on my way to Singapore and other destinations in Asia, Europe and Africa.

Out the plane window, it looks like a lot of nothing. But all that space you fly over between Melbourne and the northwest coast… now that’s what today’s investor needs to know about.

In America, some people jokingly call it “flyover country,” as if everything between New York and Los Angeles was just an afterthought.

America’s so-called “flyover country” is home to rich corn and wheat fields, the massive coal deposits in Wyoming, the remnants of the Mesabi iron range in Minnesota, and of course, what’s left of the producing oil and gas fields in Texas and Oklahoma.

Australia’s “flyover country” today is on the verge of the same kind of boom that took hold in America 100 years ago. You see, Australia is home to nearly all the valuable mineral and metal deposits needed for the industrialization of China and India.

How much mineral wealth is buried in the Outback?

Australia ranks No. 1 globally in economically demonstrated resources (EDR) of zinc, nickel, lead, thorium, tantalum and mineral sands (rutile and zircon). It ranks in the top six EDR for bauxite, black coal, brown coal, copper, gold, iron ore, manganese ore, niobium, silver and uranium. The Olympic Dam Mine (in South Australia) is home to nearly 476,000 tons of uranium — 18% of the world’s known reserves.

Let me be clear, though. It’s not just what Australia is capable of producing that excites me so much. It’s what the country is already producing. Amid rising commodity prices, resource producers in Australia are benefiting right now from the scorching supply/demand dynamic.

Export earnings from Australian commodities should rise by 30% in 2008, thanks to demand for iron ore, coking coals, gold and crude oil. And Australia is the world’s largest shipper of coal, iron ore and wool.

As an investor, you must pay attention to two factors at work here. First, many small and unknown (at least in the U.S.) Aussie companies are sitting on assets that are rising in value. That alone is extremely bullish.

The second factor is that the companies that own the assets and can produce them will almost surely report massive earnings growth in the last three quarters of 2008. The stocks of these producers — based on our analysis — don’t fully reflect that earnings growth.

It’s clear that the bull market in resources is alive and well. I see three main factors driving this bull market. The first, as you probably know, is that commodities are coming off a low base. The bear market in commodities lasted 20 years. The second reason is supply has still not caught up with demand. A decade of low commodity prices resulted in chronic under-investment in new productive capacity. The third factor is what makes this resource cycle different from the rest — it’s the strength of new demand from China.

How can you participate in this opportunity in Australia’s resource stocks?

Of course, you can buy the big institutional favorites, like BHP Billiton (BHP). But I think the really huge money will be made here by owning junior miners and mining infrastructure stocks.

The iron ore juniors and coal companies aren’t hated, but they are even better… unknown!

The nice thing about the resource sector here is that there are far more stocks than analysts. With all the underlying resource prices in an uptrend, it’s just a question of who’s willing to do more homework to find small companies with economic resource assets.

I think the opportunity in small Australian resource shares is so exciting, I actually moved here to learn as much as I can and find the best investments. While I don’t expect you to do the same, I can encourage anyone interested in making money in resource stocks to become familiar with the place immediately.

Best Regards,

Dan Denning

Source: The Coming Boom in Australian Mining Stocks

Dan is referring to the Australia’s decision to postpone for 90 days the takeover of iron ore miner Murchinson Metals LTD (MMX) by Chinese firm Sinosteel.

Australia’s natural resources are attracting considerable attention from Asia’s emerging economies. But this has set off some political alarm bells about handing control over the country’s best assets to a foreign government.

But, says Dan, junior mining companies need access to foreign capital. Without it, they’ll won’t produce iron ore anyway…

Foreign Investment in Australia, How Much is Too Much

By Dan Denning

What is the Australian Federal government’s position on Chinese investment in Australian resources?

Yesterday the Foreign Investment and Trade Board told Sinosteel to cool its heels for 90 days while the government figures out how much of Australia it will sell to foreign investors. Sinosteel, which, as you might guess, is a Chinese steel company, already owns 43.6% of iron ore junior Mid West (ASX:MIS) and was given permission earlier this year to buy all of the company.

Sinosteel also owns about 2.4% of Murchison Metals (ASX:MMX). Sinosteel applied to buy Murchison as well. It wasn’t rejected. But as you can see from the official looking note below from the Treasury, published yesterday in something called the Government Gazette, the government basically told Sinosteel to go away for 90 days while it figures out what to do.

You can’t have the benefits of foreign capital without giving up some ownership. The whole development of the Mid West region WA will depend on foreign capital and joint venture partnerships. Sinosteel is active there because all the good ore in the Pilbara has been locked up by BHP (NYSE: BHP), Rio Tinto (NYSE: RTP), and Fortescue (ASX: FMG).

If the Mid West is to emerge as an ore producer at all, it will need Chinese investment. The government probably knows this. But it’s nervous about how things will look to the public. After all, Sinosteel is owned by the Chinese government. You would have the most promising non-Pilbara ore project in the country owned lock, stock, and barrel by a foreign government.

So what’ll it be Wayne Swan? Matthew Stevens reports in today’s Australian that the government may set a 49.9% ownership ceiling on how much a foreign entity can own of an Aussie share. While mathematically pleasing because it suggests a foreign investor would not own a majority of shares in any Aussie company, in practical terms it’s not a large limitation on how much influence foreign investors would have on the locally-listed firm.

The concern is that if state-backed Chinese firms take a controlling interest in Australian mining companies, those companies will no longer be run for the benefit of shareholders, but will be used to deliver raw materials at low prices to industrial consumers in China. Is that a valid concern? If China Inc. really runs like a vertically integrated manufacturer, it probably is a valid concern.

But perhaps the Rudd government should ask Australian companies what they think. In our investigations at our small cap letter, and in Al Robinson’s research at Diggers & Drillers, we’ve talked to plenty of small mining executives who have made access to foreign investment part of their business plan. Many small Aussie miners will not get their projects off the ground without importing capital and even labour from abroad.

The government hasn’t done anything stupid yet. But give it time. It seems to be an unofficial law in human affairs that people find a way to deliberately sabotage their own success. Governments, being large institutions, are especially good at this. The U.S. government, standing unchallenged militarily at the beginning of the millennium, found precisely the way to get involved in two costly wars and simultaneously drive up the price of energy from historic lows.

Maybe nature abhors a surplus. Until recently, most human beings went through their whole life with very little margin for error. Prior to the twentieth century, most people worked growing food and scratched out a living as best they could. It wasn’t until labour-saving devices and cheap energy allowed people to move off the farm and into the city that real abundance became possible for ordinary people.

Now, 150 years into the world’s energy revolution, all that abundance and surplus is being challenged by massive demand growth in the developing world. More people want more calories, more leisure, and climate control. Australia looks like it’s in the position to ride this boom until something derails it…or until the country finds a way to shoot itself in the foot. We wonder which will come first.

But wait! Have we gone all soft in the head here at the Old Hat Factory? A reader quotes Sir John Tempelton over at our website, “Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.” “You’re in there hard,” the reader says.

We have no idea what that means. But we think he means that we took a rather bullish tone in yesterday’s letter. He would be right about that.

There are still plenty of risks to the boom. Being too casual about them would be a mistake. Let’s say industrial production declines world wide as energy prices bite into globalisation. At some point, reduced industrial production leads to lower commodity prices and lower earnings for Aussie producers. Perhaps the revaluation of BHP and Rio from cyclical stocks to growth stocks gets undone if there’s a major global contraction.

We may also be overestimating the ability of Asian consumers to replace American consumers on the world stage. It’s clear it won’t be a seamless transition. But an increasing amount of Asian exports go within the Far East. Losing America as the big customer will hurt. But it will not be a deal breaker for the region’s development.

We are also trying to keep things exceedingly simple from an investment perspective. It was complexity and derivative value on financial instruments that undid so many people on Wall Street in the last ten years. By comparison, the resource industry is a breath of fresh air.

The value of projects is a function of costs and commodity prices. Companies can be held accountable for how well they execute strategies. Smart people don’t usually get involved in dumb mining projects. So following the smart people isn’t a bad start.

Are we overly euphoric? Nope. But there is a certain relief that comes when you have a clear investment strategy. Your strategy has to adapt to changing conditions. But the long-term conditions we see driving the resource boom (and the deflation of the global real estate bubble) are pretty favourable for Aussie investors.

Nothing is risk free. But Australia is on the right side of what we called “The Money Migration” a few years ago. It is the vast transfer of wealth, incomes, savings, capital, and standards of living from the West to the East. Maybe it’s overly simple as a metaphor. But for some reason-usually because it’s right in front of their face-people often miss the most obvious explanation for events.

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Source: Foreign Investment in Australia, How Much is Too Much

Matt says Hirsch is a nut who is ignoring demand and only looking at supply.

Recent developments support both sides of the argument.

Today’s Financial Times reports that “oil prices dropped sharply yesterday as traders reacted negatively to evidence that record retail petrol prices above $4 a gallon were damaging demand in the US.”

AP reports that oil prices have soared “after the president of OPEC, Algerian Energy Minister Chakib Khelil, said crude could hit a record 170 dollars this year owing to a weak US currency and geopolitical unrest.”

Oil prices are currently up above $137 on the Nymex.

Commodity Q&A: $500 Oil

by Matt Badiali

Q: I heard someone on CNBC call for $500 oil in three years? Do you think prices will go that high? – N.B.

A: Dr. Robert Hirsch is the Senior Energy Advisor at Management Information Services, an economic and energy research firm. He’s a peak oil guru.

And frankly, I think he’s a nut.

When he was on CNBC, he was “talking his book,” calling for huge price increases in oil. But Hirsch made a mistake common among scientists: He fell in love with his theory and forgot his basic principles.

Now, Hirsch probably forgot more about economics than I’ll ever know. However, I think when he predicts oil at $500 a barrel, he’s ignoring demand and only looking at supply.

If you think supply is inadequate, like Hirsch, then you extrapolate nightmare scenarios of skyrocketing prices. To strengthen his argument, Hirsch adds growing populations around the world and claims that they will also compete for oil.

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But think about what $500 oil by 2011 would mean – gasoline at $12 to $15 a gallon… not to mention jet fuel, diesel, and so on. Cars would sit idle in driveways. We couldn’t afford to ship packages or buy produce from outside our own zip code.

Hirsch ignores the basic fact that demand must fall off long before oil hits $500.

Let’s look at a simple statistic: Drivers consume more than 60% of all the oil used in the U.S. That demand can be cut… radically. Take my parents, for example. They work about four blocks apart… but take separate cars. That’s an easy fix if gas prices go nuts.

And the Energy Information Administration (EIA), a division of the Department of Energy, thinks the U.S. population is already making those choices. It predicts U.S. petroleum consumption will fall by 440,000 barrels per day over the next year.

That’s only a fall of 2.1% in 2008. But the EIA originally predicted a fall of less than half that. I expect the actual decrease will be larger than even this estimate.

Same thing goes for demand in China. The government just cut its oil subsidy. Guess what? Demand is going down.

Dr. Hirsch needs to rethink his theory.

Source: Commodity Q&A: $500 Oil

But Dan Denning in The Daily Reckoning Australia sees two threats on the horizon that could derail Australia’s commodities boom. One possibility is that Australia’s boom will end where America’s depression begins. The other, more likely, scenario is an inflationary melt up.

The extent of the boom was underlined yesterday by an Australian government report predicting export earnings from commodities would rise a whopping 40% $201bn in the financial year to June 2009, led by a 48% surge in mineral exports to A$178bn — the biggest rise in four decades. This from the Financial Times:

If these figures are achieved, commodity exports will have more than doubled in value terms since 2003-04 when the current commodity supercycle started.

The forecast, in Abare’s quarterly review, is 10 percentage points higher than its prediction issued just three months ago and comes in spite of the continuing strength of the Australian dollar and weakness in the US economy. It highlights the breadth of the global commodities boom.

While the sharp rises in oil and food prices are firmly on the global agenda, Abare predicted that world prices for metallurgical coal would be three times higher in 2008-09 compared with this year.

The Future of the Australian Resource Market, Two Ways the Boom Could End

By Dan Denning

Australia is about the luckiest country on the planet when it comes to the resource boom. Gold to India. Coal to Korea and Japan. Iron ore to China. And windfall earnings for the Australians involved in digging up pieces of this country and shipping it off overseas.

Yesterday we mentioned the big increase in the value of Aussie exports announced by the Australian Bureau of Agricultural and Resource Economics (ABARE). But let’s take a look at the glorious details, shall we?

In total, ABARE reckons that minerals, metals, and agricultural exports will grow by $61 billion in the next year. The total export haul for the fat of this lucky land is $212.3 billion. Energy earnings will grow by 81%. Minerals and energy earnings combined will be up 48%.

Even that figure might be low, depending on the contract price for iron ore. That price, as you know, has still not been set (although Rio Tinto (ASX: RIO) seems to have reached an agreement with Baosteel…more on that below). BHP Billiton (ASX: BHP) and Rio drew their line in the red dirt of the Pilbara. They want at least an 85% increase over last year’s price. It looks like they may get it, and then some.

Iron ore isn’t even the biggest contributor to the Australian resource market. That distinction belongs to coking coal (sometimes referred to as metallurgical coal). The world’s steel boom (steel prices are soaring, along with all those new skyscrapers in China and the Middle East) is fuelling the demand for the high quality black coal from Queensland’s Bowen Basin.

ABARE estimates that the country will export $39.1 billion in coking coal in the next fiscal year. Let’s call it $40 billion. That’s a 123% increase in the value of the exports over last year.

But keep in mind the chronic infrastructure bottlenecks along the Eastern Coast mean that the volume of coal exports will only increase by 7%. The big kicker is the 206% increase in coal prices earlier this year. You can make up on price what you lose on volume. Oh to be lucky.

Iron ore will deliver nearly $36 billion into the coffers of the ore titans of the Pilbara (and some of the minnows too). Today’s Financial Review reports that Rio Tinto has secured an 85% rise in next year’s iron ore contract price. The agreement was reached with China’s Baosteel, China’s representative during eight months of entertaining and sometimes cranky negotiations.

Thermal coal-the kind you burn to generate electricity-will deliver $15.9 billion in exports, mainly on the back of a 74% increase in thermal coal prices. And thanks to the soaring oil price, Australian crude exports will generate around $15.3 billion. That should benefit Woodside Petroleum (ASX: WPL) and BHP.

Good news for Aussie gold production, too. It’s headed up after declining the year before. The rising gold price will account for most of the 14% increase in gold export earnings. But if the gold price moves higher in the next 12 months-a whole other story about money and the dollar-some new Aussie projects should benefit.

AngloGold Ashanti (NYSE: AU) and Independence Group (ASX: IGO) are set to bring their Tropicana joint venture on line by 2010. It’s considered one of the biggest gold finds in Western Australia in the last ten years. In 2009, Newmont and AngloGold will begin production at the Boddington mine expansion.

If it all seems too good to be true, well maybe it’s worth wondering what could derail the Australian resource market. What could derail the biggest export boom in Australian history? There are two answers. But only one of them can be right.

One answer is that Australia’s boom ends when America’s depression begins. This argument is based on America’s economic situation getting much, much worse as the housing bust deepens. In this argument, Australia is the first link in the global chain of consumer demand. The middle link is Chinese manufacturing, which turns Australian raw materials into finished goods. The final link is the American consumer, who buys what China builds.

If the final link is broken – if the American consumer is on the edge of his own private bear market – then eventually it will work its way back to Chinese demand for Aussie resources. No final demand, no initial demand. Bust goes the boom.

The reason this argument is bogus, in our humble opinion, is that it overstates the role of American consumption in the future demand for Australian resources. A thorough (and slightly mind-numbing) survey of the ABARE export data show that Korea, Japan, and other Asian countries are also big consumers of Aussie resources.

These are all large, developed, industrialised (or industrialising) economies. They all export to America. But they will not go in the tank of America slows down.

And in any event, if you want to know what we really think, we think the world is witnessing a slow realignment. The entire global model has favoured American consumers. Entire nations designed their economy to produce cheap things for Americans to buy. America had the world’s reserve currency. And American stocks, bonds, and real estate were considered the most attractive and safest on the planet.

All that is slowly, inexorably, but undeniably changing. By sheer weight of numbers, the markets of Asia are bigger. On a purchasing power basis, they are getting stronger year-by-year. Per capita incomes are rising. Savings rates are higher. And capital investment by the business sector sows the seeds for future income growth.

With higher incomes, Eastern consumers will drive global tastes. Producers will cater to what kind of hand bag middle class housewives in Shanghai want (hint: it will probably still be Yves St. Laurent). Maybe General Motors will become a Red Chip. China’s boom could end up swallowing a lot of global brands, or producing new ones.

That brings us to the second and more likely of the risks to Australia’s boom: an inflationary melt up. All economic cycles end with rising prices. Already we see high food and energy prices causing economic and political problems all over the world.

The real risk to Australia’s boom is that soaring energy and food prices slam the brakes on Asia’s emergence as the world’s economic engine. Growth can be awkward and destabilising too. Just watch a bunch of teenagers at the high school prom and you’ll see what we mean.

Taking 3 billion people from subsistence incomes to even a modest level of surplus in just a few generations is no easy task. It causes massive social and economic change. That change can be destabilizing. Food riots. Fuel riots. Or just riots because you have millions of young men with no jobs and no wives.

But in the big picture, it’s hard to see the role of the Australian resource market in Asia’s emergence changing or diminishing. If resource prices go too high, commodity consumers will look for cheaper substitutes. Is that a threat to Queensland’s coal and the Pilbara’s iron ore?

Even when substitution is desirable, it’s not always possible. For example, China played its own iron ore card in the last eight months. It claimed that it could feed local steel mills with local iron ore. And in terms of total production, the Chinese iron ore industry is a lot more formidable than just five years ago.

The trouble is, China’s ore industry is fragmented into dozens of smaller producers. And China’s iron ore grades are generally much lower that what Australia is endowed with in the Pilbara. BHP and Rio have enormous economies of scale on their side. There’s lot’s of high grade ore in one place. That makes it easy to produce in the volumes required by China’s steel industry. That is also why, though rocky, the marriage of Aussie ore and Chinese steel will probably be a long one.

As with ore, so with other things. There’s lots of high grade everything in this place, come to think of it. Copper, gold, LNG, lithium, tantalum, coal, molybdenum, bauxite, rare earth elements…the list is very long. If Australia ever developed the capacity to build finished goods, it would be a formidable manufacturing giant.

The labour dynamics of globalisation have set the country on a different but lucrative course. It will provide resources for the foreseeable future. For investors, it’s great news.

While the indexes (and mostly the banks) will be dragged down or sideways by ongoing credit worries, the fundamental demand for Australia’s minerals, energy, and farm products doesn’t look like it’s going to get much weaker any time soon. With earnings set to rise, the Australian resource market is a stock picker’s delight.

Dan Denning
The Daily Reckoning Australia

Source: The Future of the Australian Resource Market, Two Ways the Boom Could End