Everyone also knows that some of the key culprits behind this financial mess were the credit-rating firms like Standard & Poor’s and Moody’s Investors Service, which assigned top-tier “AAA” ratings to investments that were actually backed by subprime mortgages and other toxic debt.

Whether it was collusion or incompetence almost didn’t matter: The firms claimed that the credit ratings they issued were constitutionally protected free speech. With this First Amendment shield, S&P, Moody’s and others said they were protected from lawsuits or other liabilities.

But that’s about to change.

A federal court judge in New York last week stripped the ratings firms of that defense, a decision that could expose the companies to billions of dollars worth of liabilities from investors who were burned by the faulty ratings.

Let’s legal case involved three specific firms – two firms that rated collateralized debt securities, and an investment bank that sold the debt. Those three companies were:

• Standard & Poor’s, which is owned by The McGraw-Hill Cos. Inc. (NYSE: MHP).
• The Moody’s Investor’s Service unit of Moody’s Corp. (NYSE: MCO), which is 19% owned by Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B).
• And Morgan Stanley (NYSE: MS).

This particular case had been brought against Moody’s and S&P by Abu Dhabi Commercial Bank PJSC and Washington State’s King County. The case involved losses suffered from an investment in a structured investment vehicle (SIV) called Cheyne Finance. Although the debt securities Cheyne issued were backed in part by subprime mortgages, they received ratings as high as “AAA.”

In return for the high rating, the companies received higher-than-normal fees.

The $5.86 billion Cheyne Finance SIV went bankrupt in August 2007. The plaintiffs claimed fraud. The suit is seeking class-action status on behalf of investors who were burned when Cheyne was forced to dump securities it had issued between October 2004 and October 2007.

Since lawyers for the plaintiffs say the ruling could be applied to any deal involving SIVs, it could have a substantive impact. Before the financial crisis caused the value of these asset pools to plummet, experts estimate there were $350 billion to $400 billion worth of SIVs in existence.

“There certainly will be other cases filed – that’s the future impact of this decision,” San Diego attorney Patrick Daniels told The Wall Street Journal.

Moody’s and S&P had sought a dismissal, citing their First Amendment protections. But U.S. District Court Judge Shira Scheindlin ruled on Sept. 2 that securities ratings that were distributed to a small group of investors don’t warrant the same First Amendment protections that are afforded to the widely circulated ratings of corporate bonds.

Judge Scheindlin acknowledged that ratings constituting “matters of public concern” are typically protected from liability. That’s especially true when the ratings are distributed to the general public. But it wasn’t the case here.

“Where a ratings agency has disseminated their ratings to a select group of investors rather than to the public at large, the ratings agency is not afforded the same protection,” Judge Scheindlin ruled.

The ruling will likely be appealed. And it could end up in front of the U.S. Supreme Court.

The case spotlights the biggest problem with the business of rating securities: The ratings firms are paid by the issuers to rate them.

When you get right down to it, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. The surprise isn’t that the obvious lack of objectivity fostered abuses in the credit-rating process – it’s that the problem took so long to come to a head. The complexity of mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs) only exacerbated the investor risk.

The decision received widespread media attention. But it’s only half the story.

And the media missed the other half.

In an ironic twist that transforms the credit-rating firms into legal sacrificial lambs, the U.S. Securities and Exchange Commission (SEC) has in recent weeks acknowledged its own failure to protect the public from the same ratings firms that the federal agency mandates that investors rely upon.

This admission – combined with the legal assault on the constitutional protections ratings firms are used to hiding behind – could threaten the ratings firms’ very existence. It not only will further fuel investor ire, it could also provide litigants with additional needed legal ammunition. The ratings involve tens of billions – if not hundreds of billions – of dollars of failed securities.

A series of internal reviews by the SEC – one reaching back to last year – has highlighted some of the abuses.

About a year ago – in July 2008, to be exact – the SEC concluded a 10-month examination of the ratings industry that uncovered “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.”

According to the report, there was an obvious degree of knowledge and complicity in playing the ratings game.

E-mail exchanges between analysts at “unnamed” ratings firms back this up. In one, an analyst said the firm’s ratings model didn’t capture “half” of the deal’s risk, but said that the security “could be structured by cows and we would rate it.” In a Dec. 15, 2006 missive, a manager wrote that the ratings industry was creating “[an] even bigger monster – the CDO market.”

Confided the manager: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

In July of this year, in testimony to Congress, SEC Chairwoman Mary Shapiro said she supported proposals to impose liability standards that would make it easier for investors to sue credit ratings firms. That’s a bit ironic given that the SEC is charged with supervising the ratings firms.

According to the internal investigation conducted by the Office of Inspector General, the SEC failed to exercise its duties as the nation’s watchdog of the same credit ratings firms that many large investors are forced to trust.

By law, certain investors must rely on the ratings of a handful of companies, known as  “Nationally Recognized Statistical Rating Organizations,” or NRSROs. In many cases, the NRSROs determine what are “eligible” or “appropriate” investments. And it’s the SEC that determines who is, or who can be, an NRSRO.

For instance, most state insurance regulators say that insurance companies can only invest in assets that carry one of the top four credit ratings. And it’s the NRSROs that certify those ratings.

Similarly, money-market funds can only invest in the highest NRSRO-rated securities.

Countless institutions – public and private, domestic and international – rely on rules that determine what assets are acceptable investments. And that acceptability is determined by financial due diligence and the resulting credit ratings – as determined by SEC-certified rating agencies.

It’s not clear that any of this is really protecting investors, according to a Feb. 15, 2008 “Review & Outlook” piece in The Journal. Drexel University Finance Prof. Joseph Mason took a look at CDOs that were “Baa” (an investment grade rating) by Moody’s. His finding: They were 10 times more likely to default than equivalently rated corporate bonds.

In that same article, an S&P spokesperson was asked if they actually examined the mortgage debt that made up the investment pools that make up a CDO.

The spokesperson’s answer was not confidence-inspiring: “We are not auditors; we are not accounting firms.”

Source: The Credit Rating Firms Are Running Scared – It’s About Time

The stress-test results are expected to show that the 19 banks may have to raise between $100 billion to $150 billion – or even more – in new capital. Investors will cause the shares of the strong players to zoom northward, and will likely savage the shares of the weakest players.

“I can’t think of a time since I’ve been watching banks when there’s been so much uncertainty about the true value of a key set of assets,” Douglas Elliott, a fellow at the Brookings Institution, a Washington think tank, told Reuters.

The U.S. bank stress tests have transfixed the world financial markets for weeks, exacerbating the ongoing financial crisis – worsening the U.S. recession and shaking economies around the world. That’s escalated the burden on the still-new Barack Obama administration and on the U.S. Congress.

The banks being tested include Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), JPMorgan Chase & Co. (NYSE: JPM), Wells Fargo & Co. (NYSE: WFC), and Goldman Sachs Group Inc. (NYSE: GS). All told, the 19 banks hold two-thirds of total U.S. bank assets.

“Most banks will have to raise capital in some form,” Friedman, Billings, Ramsey Group Capital Markets Group (NYSE: FBR) managing director Paul Miller told Reuters. “The capital raises will be much bigger than people think.”

Miller said that uncertainty about what the tests might reveal has made banks stocks “uninvestable” in the near term.

The issue for investors is that “you just don’t know how the government is going to view it,” Miller said.

Public release of the stress test results is set for Thursday. The government is scheduled to brief the top officials of the banks themselves tomorrow (Tuesday).

Although all but one of the 19 major U.S. banks the government has stress-tested reportedly passed, many skeptics believe the banks are still using all sorts of accounting dodges to keep from revealing just much they still hold in toxic assets and bad loans, National Public Radio reported.

Why wait for the U.S. Treasury Department’s bank stress test when Money Morning can highlight the four secrets that will let you separate the winners from the losers in the U.S. banking system?
Call it the “Money Morning Bank Stress Test.”

Money Morning Contributing Editor Martin Hutchinson last week evaluated the 13 largest U.S. banks and rated them as either “Zombies,” “Walking Wounded,” “Risky But Proud,” and “Hidden Gems,” and concluded that nine of the banks pose some degree of risk. But he also found that four of the financial institutions are “Hidden Gems” that might be worth a look for investors.
On Thursday, we’ll finally see how it all plays out.

Market Matters

Chrysler LLC filed for bankruptcy and then forged a potentially “game saving” partnership with mighty Fiat SpA (OTC ADR: FIATY), Italy’s largest car manufacturer.  General Motors Corp. (NYSE: GM) will be saying good bye to its Pontiac brand (any interest, Fiat?).  Bank of America’s Ken Lewis was stripped of his board chair, but will continue to put out fires from the chief executive office.   Earnings season moved forward and Exxon-Mobil Corp. (NYSE: XOM) did NOT set a new record for a change.  International Business Machines Corp. (NYSE: IBM) bucked the cost-cutting trend and actually raised its dividend.

With Treasury set to release the stress test results on Thursday, rumors are circulating that Bank of America and Citigroup may be in need of additional capital, though both are pleading their cases.  Meanwhile, Citi began lobbying for permission to pay retention bonuses to key employees [it worked for American International Group Inc. (NYSE: AIG) and Merrill Lynch (NYSE: SQD)], who may seek the greener pastures of other (ailing) financial institutions.

Telecommunications firms were in the spotlight early in the week as chipmaker Qualcomm Inc. (Nasdaq: QCOM) raised its revenue outlook and Verizon Communications Inc. (NYSE: VZ) actually announced increased earnings in the first quarter.  Verizon may be teaming up with Microsoft Corp. (Nasdaq: MSFT) to develop its own touch-screen cell phone to cut into Apple Inc.’s (Nasdaq: AAPL) iPhone market share.

Drugmakers Pfizer Inc. (NYSE: PFE) and Bristol-Myers Squibb Co. (NYSE: BMY) posted quarterly results that beat Wall Street expectations, as did The Dow Chemical Co. (NYSE: DOW) and Starbucks Corp. (Nasdaq: SBUX), though the latter’s major restructuring (store closures) prompted a 77% decline in profits.

MasterCard Inc. (NYSE: MA) confirmed that 2009 will be a challenging year, though rival Visa Inc. (NYSE: V) beat earnings estimates, as debit card usage increased, resulting in greater fee income.

The Procter & Gamble Co. (NYSE: PG) struggled last quarter, with weaker sales, as shoppers traded down to lower-priced consumer goods.  Exxon-Mobil, Chevron Corp. (NYSE: CVX), and Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B) were victims of the declining global demand for oil.  Still, Exxon’s long-term outlook remains strong as the company continues pouring money into development projects to be fully prepared once the recession ends.  In fact, management even boosted its stock dividend.

Economically Speaking

While the U.S. Federal Reserve seemed to offer some “cautious optimism” about the overall direction of the economy, the policymakers avoided any sugarcoating and hedged their comments for fear of an unforeseen development (such as the “swine flu,” also known as the A/H1N1 flu).

While the virus quickly expanded across the globe, most of the worst cases have been limited to Mexico, where the already depressed economy will be further impacted from business closures and travel restrictions.

When SARS (Severe acute respiratory syndrome) hit in 2003, China’s gross domesic product (GDP) was estimated to have been hurt by about 1%; According to early projections by Moodys Corp.’s (NYSE: MCO) Economy.com, the Mexican economy will contract by 6.2% in 2009 (revised from the -4.5% estimate to account for the flu).

The Fed plans to leave rates at near 0.0% and stands prepared to purchase more Treasury and mortgage-related securities to keep the economy moving in the right direction.

The first quarter’s gross domestic product (GDP) highlighted a relatively hectic week on the economic front.  While the economy contracted from January through March at a worst-than-expected 6.1% clip, analysts found some positives deep within the release, as consumer activity actually picked up during the quarter.

The spending component rose by 2.2%, after falling by 4.3% in the fourth quarter.  Additionally, a decline in inventories hindered the release; however, economists point out that such a reduction indicates that manufacturers have scaled back production and will not be burdened with excessive supplies that may need to be deeply discounted to be sold. As demand slowly returns, they will be able to boost production once again.

Meanwhile, consumer confidence surprisingly soared to levels not seen since November 2008, which is especially good news, since the consumer accounts for about two-thirds to 70% of the activity in the economy.

Weekly Economic Calendar

Source: Market Moves Will Remain on Hold Until Bank Stress Test Results Are Released Thursday

General Growth filed for Chapter 11 seeking protection from creditors after it amassed $27 billion in debt accumulating over 200 shopping mall properties. The filing covers 158 of its U.S. malls, but excludes its joint-venture properties and third-party management business.

The Chicago-based company – the country’s second largest shopping mall owner – owns such valuable properties as Fashion Show in Las Vegas and Faneuil Hall Marketplace in Boston. It listed total assets of $29.56 billion and total debt of $27.29 billion.

“We intend to emerge as a leaner company,” General Growth President Thomas Nolan told Bloomberg News in an interview. “We want to come out as a less leveraged company. Our business model remains strong.”
In the eyes of many observers, the filing brings the U.S. real estate collapse full circle as commercial properties values are now plummeting in concert with the ailing residential housing market. Commercial real estate prices in the U.S. dropped 15% last year, according to Moody’s Investors Service (MCO).

Many commercial real estate companies have been squeezed out by the credit crunch as banks continue to curb lending.

Nolan said General Growth was a victim of “a broken capital market.” No one could have predicted the severity of “the credit markets shutting down,” he said.

Last November, General Growth warned it might have to seek protection from its creditors because it was unable to refinance maturing debt obligations. The company was trying to restructure bonds it floated to finance a $14.3 billion all-stock deal for Rouse Co., a high-end mall dealer it bought in 2004.
“It just tells you that this debt can’t get redone, especially for big properties,” RBC Capital analyst Rich Moore told Reuters.

“General Group has long been the poster child of too much debt,” said Moore.”General Growth has malls, and malls are some of the biggest assets out there.”

Analysts said the bankruptcy might allow competitors to cherry-pick some of General Growth’s more desirable properties, giving Simon Property Group Inc. (SPG) the opportunity to bolster its position as the No. 1 mall operator.

“I think Simon’s going to be able to pick up some of these assets on the cheap,” Dan Fasulo, managing director at real estate research firm Real Capital Analytics, told Bloomberg.

However, Fasulo also called General Growth’s filing “the beginning of the end,” which could lead other companies to fail.
“This bankruptcy will drive down the values of mall assets in the United States. It’s going to put, I believe, more supply on the market than can be absorbed by investors,” he said.

About $814 billion of commercial mortgage debt is expected to mature over the next two years, which will only serve to put more pressure on the market, according to real estate research firm Foresight Analysis.

Meanwhile, the residential market chimed in with its own bad news.  On the same day General Growth filed, the U.S. Department of Commerce said builders broke ground on 10.8% fewer homes in March and new permits fell to a record low, as homebuilders sought to rein in inventory amid rising foreclosures.

“Buyers seem to be more interested in picking up bargain- basement prices in the existing-home market than in the new-home market,” Robert Dye, a senior economist at PNC Financial Services Group Inc. (PNC), in Pittsburgh, told Bloomberg News.

Source: General Growth Files Biggest Real Estate Bankruptcy in U.S. History

This from Money Morning:

The Chinese word for crisisis weiji.

But get this – when translated literally, wei means danger and ji means opportunity.  So to the Chinese, a crisis – or danger – represents an opportunity.

Of course, you don’t have to actually speak Chinese to understand what this mindset means for investors.

What you’re seeing in China today is nothing less than the classic definition of a crisis presenting the profit opportunity of a lifetime.

While investors in U.S. markets are mostly concerned about saving their necks, China has been stacking the deck in favor of those who have the guts to pull the trigger on the most undervalued market in memory.

Here’s why you should consider taking an early position in China in 2009.

The Mother of All Stimulus Plans

While it’s not old news, the current crisis in U.S. financial markets is all too familiar.  The Standard & Poor’s 500 Index is down almost 40% from its 52-week high and there seems to be no end in sight.

Worse, the malaise encompassing the United States has clearly spread to the rest of the world, including China.

So it appears that what investors once considered to be the greatest investment opportunity of our lifetime has imploded – just another financial black hole where portfolios go to die.

Truth be told, however, there is ample evidence that China’s economy and markets will weather the storm and ultimately thrive in the year ahead.
The Chinese economy has been the fastest growing in the world for the last three decades, averaging double-digit growth for the last seven years.  And while the credit crisis has slammed on the brakes in terms of growth in the West, China is still on track for a solid 8% growth in 2009.

But the Red Dragon isn’t about to take any chances.  With $2 trillion in foreign exchange reserves available, China can increase the growth rate of its economy – even as it works to boost economic recovery efforts elsewhere in the world.

And that’s just what it’s about to do.

The People’s Republic of China has already announced a $586 billion (4 trillion yuan) spending package.  To put that in perspective, this plan amounts to a staggering 20% of China’s gross domestic product (GDP).  Compare that to the $1 trillion in U.S. bailouts, which equate to about 8% of GDP.

And China’s reserves won’t be doled out in dribs and drabs. The plan calls for spending the whole amount in just a few years.

To further grease the recovery skids, China has reduced interest rates five times in the last three months, and loosened lending rules.  Now China’s banks are perfectly positioned to get the ball rolling, flush with cash from a world-leading savings rate of 35%.  And because they are state-owned, the cash will flow quickly from the banks to government projects.

The convergence of the recent market swoon and the stimulus plan means you now have the opportunity to buy great companies at the dawn of the Chinese century.

But specifically, where should you look to park investment capital in the Chinese market?

Well, there are solid plays across all spectrums of China’s economy, but the best are in infrastructure, consumer goods and energy.

Infrastructure Paves the Way to Profit

The first place to look is infrastructure development, which has been the main engine of China’s explosive growth over the past two decades.

While most believe China’s economy is export driven, statistics show public works spending accounts for 4%-6 % of the country’s GDP growth. From 2007-2010, China will spend a whopping $725 billion on infrastructure improvements in a race to accommodate its rapidly migrating populace.

By 2030, 1 billion of its people will live in cities, up from 600 million today.  About 170 mass-transit systems will be needed.  Another 40 billion square meters of floor space will be built in 5 million buildings – 50,000 of which could be skyscrapers.

And all of these developed regions will be connected by new roads. Shorter transport times drive down costs, and smooth the transition to city living for China’s exploding middle class.

Plans for China’s road system call for 12 major routes across the country from north to south and east to west connecting millions to new routes of commerce, according to The Wall Street Journal.  The system will stretch 53,000 miles by 2020, surpassing the 47,000 miles of roadways in the United States.

It will take massive amounts of steel, cement, and bulk transportation to build those roads.

Money Morning Contributing Editor Martin Hutchinson believes one big winner from the infrastructure boom will be Vale (ADR:RIO) the world’s largest producer of iron ore. As the world’s leading producer and consumer of steel, China is also the world’s leading importer of iron ore, which – along with coking coal – is a key component in steel production.

And while prices and demand for Chinese steel fell sharply in the second half of 2008, they are already beginning to pick back up.

In fact, steel production in the Chinese city of Tangshan, in the Hebei province, has risen to more than 70% of capacity as companies resumed output after prices stabilized, the Tangshan Evening News reported Dec. 26. About 39 out of 57 iron and steel factories in Hebei, China’s biggest steel-producing province, are operating now, compared with 25 in August.

Tangshan is an industrial-level city in that steel-rich region.

“The iron-ore stocks have been overly poorly treated in the past couple of months with all the fear over China,” Michael Heffernan, a client adviser with Austock Securities Ltd., told Bloomberg News.

“Negativity over the Chinese situation is overdone,” Heffernan added. “In the past couple of months the Chinese may have been posturing to get the best possible deals they could when negotiations over contract prices reopen.”

That’s good news for Vale, which looks attractive with a Price/Earnings (P/E) ratio of only 8.6.

A big source of China’s iron-and-steel demand has to do with the country’s commitment to railroads. A full $100 billion of the stimulus package will be spent on rail services.

That makes Guangshen Railway Co. Ltd. (ADR:GSH) a good play.

Guangshen Railways is the biggest rail operator in China with cargo and passenger operations between Guangzhou and Shenzhen, as well as Hong Kong.

There is an acute shortage of rail capacity to carry raw materials from China’s western provinces to manufacturing centers on the Red Dragon’s East Coast. Right now, cargo capacity is only 35% of demand, according to the Chinese Railway Ministry.

That helped revenue at this $94 billion company to jump 17% in the first three quarters of 2008, despite a crippling snowstorm in January.  Guangshen also yields about 3%, rewarding investors who are willing to hold the shares as they wait for the stimulus to kick in.

China’s Urban Migration and Growing Consumer Class

The opening of new highways is providing greater mobility to China’s population, accelerating the massive move from the hinterlands to the cities. Incredibly, China will have 221 cities with more than one million inhabitants by 2025 – compared with 35 in Europe and nine in the United States today.

Quite simply, that urban migration is responsible for creating the largest consumer class the world has ever seen – a middle class greater than the entire population of the United States.

Retail sales in China are estimated to have risen about 21% in 2008, according to the Ministry of Commerce. And now that weakness in the global economy has dented exports, the government is making an even greater effort to boost domestic consumption.

That’s why Money Morning Contributing Editor Horacio Marquez likes China Life Insurance Company Ltd. (ADR: LFC).

China Life is experiencing continued growth for reasons unique to government regulations.  Without a social security system, Chinese consumers must fund their own retirement – one reason the Chinese save an amazing 35 cents of every dollar they earn.

Also, China Life’s investment portfolio hasn’t been hit by the market meltdown, because government regulations prevented the company from owning subprime-related mortgages and securities. With 43% market share, Moody’s Corp. (MCO) expects premiums to grow between 30% and 40% in 2008.  And right now, only 3% of China’s consumers own life insurance, leaving plenty more room for growth.

Another company worth looking at is China Mobile Ltd. (ADR: CHL).

With 443 million subscribers, China Mobile is the dominant provider in the world’s largest mobile telecom market.  And in terms of growth, an additional 3 million to 4 million consumers become mobile phone subscribers in China each month, according to the Chinese Ministry of Information.

The company’s earnings per share (EPS) increased 31% in the first three quarters of 2008 and China Mobile stock yields a healthy 3.2%.

Now, the mobile services giant is in talks with Apple Inc. (Nasdaq:AAPL) to introduce the iPhone to the burgeoning Chinese market.  And with the global slump hurting smaller players, it’s on the hunt for acquisitions with attractive valuations in emerging markets.

Soaring Energy Demand = Growing Profit

Despite a slight slowdown in the economy, China’s energy appetite continues to grow at a ravenous pace. And even though the country is building one coal-fired power plant a week, China’s unable to keep up with exploding demand.

China’s electricity consumption rose 5.2% in 2008 and investment follow.  A total of $84 billion (576 billion yuan) was invested in the sector in 2008 – a 1.52% over to 2007.  Power grid spending rose 17.69% to $42 billion (288.5 billion yuan).

As with other forms of infrastructure, China plans to up its investment in electricity over the next several years. China has already announced $29 billion in new energy projects, including a new natural gas pipeline, construction of 10 new nuclear power plants, and a new coal mine, set to produce 14 million tons of coal a year.

Here are two solid profit plays on the new infusion of cash:

Money Morning Investment Director Keith Fitz-Gerald likes Yanzhou Coal Mining Co. Ltd. (ADR:YZC).

China burns more “black rock” than the United States, Japan and Europe combined, and this company is one of China’s biggest coal suppliers. It produces lots of high-grade, low-sulfur coal, which burns cleaner and fetches a premium price.  The company also boasts profit margins of 22% in an industry where the margins average about half that amount.  For the first three quarters of the year, the company posted profits that were up 364% from a year ago.  This kind of growth, in a stock that’s trading at three times earnings, is a big time potential bargain – especially given its dividend yield of 4.3%.

Both Fitz-Gerald and Hutchinson recommend like Huaneng Power International Inc. (ADR:HNP), as well.

Huaneng is the largest utility in China, and is a virtual lock to benefit from growth in any form. It owns 16 operating power plants, and has controlling interests in 13 others. As a state-owned enterprise, it has the contract to produce the power for the entire eastern region of China, including Shanghai and Beijing.  Although it’s been generating losses lately due to high coal prices, the power company is likely to increase output and profits with any economic expansion.

If you’re leery of investing in individual stocks you might want to look at the Templeton Dragon Fund Inc. (NYSE:TDF). Over 80% of the closed-end’s assets are directly invested in China. And with roughly 50 positions, it provides ample diversification.

PS. This is the tenth installment in Money Morning’s “Outlook 2009” series, which looks at the global investing outlook for the New Year.
Source: China’s Red Dragon Turns Financial Crisis into Opportunity

After such a wrenching plunge, many analysts believe the outlook for the “black gold” remains bleak – and in the short term it certainly is. In the long run, however, dwindling supplies, resurgent demand, and a lack of investment will cause crude oil to double, triple, or even quintuple in price over the next few years.

In fact, the Paris-based International Energy Agency (IEA) – energy advisor to 28 industrialized nations – says oil will rise to $100 a barrel by 2015, as a result of a major “supply crunch,” and will ultimately soar to $200 a barrel.

But before it does, prices are likely to sink even further, perhaps falling as low as $20 a barrel in the first quarter of the New Year.

Indeed, much of Wall Street expects oil prices to average about $50 a barrel in 2009. Some of the firms and their specific forecasts include:

• Deutsche Bank AG (DB, which says oil prices will average $47.50 for all of next year.
• Merrill Lynch & Co. Inc. (MER), which predicts that prices will average $50 even.
• Moody’s Investors Service (MCO) also says crude will average $50 a barrel in 2009, but says that average will increase to $55 a barrel for 2010.
• Goldman Sachs Group Inc. (GS) is slightly more bearish, predicting that prices will average $45 for all of next year – after falling as low as $30 in the 2009 first quarter. (It’s worth noting that Goldman – just five months ago – predicted oil prices would hit $200 a barrel in 2009).

But analysts also agree on something else: When the recessionary tide finally recedes, all of the factors that drove oil to its record high last summer will once again be exposed, and crude again will again soar to record highs.

“We may see prices drop lower – into the twenties, even – but there’s a better-than-average chance that they’ll be back over $70 a barrel by the end of next year,” says Money Morning Investment Director Keith Fitz-Gerald. “That’s where firms like Goldman and Merrill are getting all of these ‘middle-of-the road,’ $50-a-barrel estimates. And it’s why investors who buy in through the first quarter could enjoy compelling returns at the end of the year.”

In the meantime, however, low oil prices are crimping investment in new capacity, a reality that will lead to much higher prices down the road.

Just ask the IEA.

IEA: Rising Demand + Lack of Investment = ‘Supply Crunch’

According to widely respected energy advisor, global oil demand will slide 0.2%, or 200,000 barrels per day (bpd), this year, falling to an average of 85.8 million bpd. But the IEA also says that oil demand will advance by an annual average of 1.6% between 2006 and 2030.

The bottom line: Regardless of any short-term pullback, daily demand will rise from the current level of 86 million barrels to 106 million barrels in 2030. In other words, daily demand in 2030 will be 23%.

To meet that demand, the agency estimates that the world needs $26.3 trillion in supply-side investments over the next 21 years.

China, India and other developing countries, alone, will need investments of $360 billion a year through 2030, the agency said.

About 7 million bpd of additional capacity needs to be added to the market by 2015. And right now – because of marketplace changes – the financial incentives to make that happen just don’t exist.

Exploration costs have more than quadrupled since 2000, as oil producers have been forced to take on more complex projects, and the costs of both labor and materials have skyrocketed. At the same time, the steep drop in oil prices has put even more pressure on energy companies to curtail their investments rather than increase them.

Earlier this year, for instance, ConocoPhillips (COP) and Saudi Arabia Investment Co. (ARAMCO) were forced to postpone bidding on the construction of a 400,000 bpd export refinery at the Yanbu Industrial City.

“We see and hear about energy investments being delayed … this is a major worry and could lead to a supply crunch and much higher oil prices than we’ve seen before,” said Fatih Birol, the IEA’s chief economist.

The IEA predicts that, by 2015, a lack of investment and rising demand will create a “supply crunch” – that will once again send oil prices up into the triple digits.

“There remains a real risk that under-investment will cause an oil supply crunch in that time frame,” the IEA said in an executive summary of its “2008 World Energy Outlook.” “The gap between what is currently being built and what will be needed to keep pace with demand is set to widen sharply after 2010.”

The agency predicts that crude will average more than $100 a barrel from 2008 to 2015 and rise above $200 a barrel by 2030, as demand far outpaces supply.

“While the situation facing the world is critical, it is vital we keep our eye on the medium to long-term target of a sustainable energy future,” Nobuo Tanaka, the Paris-based agency’s executive director, told reporters in London. “While market imbalances will feed instability, the era of cheap oil is over.”

While it’s probably true that the “era of cheap oil” is in our rearview mirror, a new question has arisen: Just how high do oil prices go?

According to some analysts, the IEA’s target price of $200 a barrel is far too conservative.

$500 Oil?

The lack of exploration and development is certainly a problem. But a much bigger issue is the fact that output from the world’s existing oil fields has sharply declined.

“The future rate of decline in output from producing oilfields as they mature is the single most important determinant of the amount of new capacity that will need to be built globally to meet demand,” the IEA says.

And output from the world’s oilfields is declining faster than previously thought.

In its “2007 World Energy Outlook,” the IEA estimated that output from the world’s existing oilfields was declining by 3.7% a year. But in its latest report, published in November, the IEA revised that estimate to an annual decline of 6.7%. (The November report was based on the first major study of the world’s 800 largest oil fields.)

Unfortunately, the IEA is behind the curve.

For nearly a decade, Matthew R. Simmons has said that the world’s oil production was nearing – or already at – an “inflection point.” While his book “Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy,” was scoffed at when it was originally published back in 2005, Simmons is now viewed as perhaps the preeminent expert on the so-called “peak oil” movement.

“Like most people who ignore conventional wisdom, he was scoffed at, ridiculed, and denied,” commodities guru Jim Rogers told Fortune magazine. “And now, of course, people are starting to say, ‘Oh, well, I thought of that.’”

Simmons, chairman of the Houston-based investment bank Simmons & Co. International, poured through hundreds of technical documents submitted by Saudi oil geologists to the Society of Petroleum Engineers over the past 50 years.

“I finished reading the last paper on a Sunday afternoon,” Simmons told Fortune, “and I sat back and thought, ‘Holy crap, this is unbelievable. I’ve just discovered the biggest energy illusion ever in the world. We’re in big trouble. I’m going to write a book.’ ”

Much of the alleged Saudi Arabia subterfuge has to do with a complete lack of transparency with respect to the Organization of Petroleum Exporting Countries. After OPEC decided to base its production quotas on reserve figures in the 1980s, several of the cartel’s producers suddenly raised their levels of  “proven reserves” by 40% or more.

Back in 1988, for instance, Saudi Arabia raised its proven-reserve figure from 170 billion barrels to about 260 billion barrels. That figure has remained more or less constant since then, despite the fact that billions of barrels of oil have been pumped out of the ground.

“Saudi Arabia has announced for 20 years in a row that they have 260 billion barrels of oil in reserve,” Rogers told Money Morning during an exclusive interview in Singapore recently.  “It’s astonishing.  The figure never goes up and it never goes down.  They have produced dozens of millions – billions – of dollars of oil in that period of time.

“Every oil country in the world has declining reserves except Saudi Arabia,” Rogers said. “And I know that every oil company has declining reserves.  So unless somebody discovers a lot of oil very quickly in very accessible areas, the surprise is going to be how high the price stays, and how high it goes.”

Simmons thinks oil prices could hit $300 a barrel – and could possibly even surge as high as $500 a barrel – during the next several years.

“Black Gold” Profit Plays

When it comes to investing, the oil sector poses some very clear risks, especially given the murky near-term outlook. However, there are a number of large-cap integrated oil companies that may offer some truly compelling values at current prices.

Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX) are currently trading at multi-year lows, making them exceptionally cheap in both relative and absolute terms. These companies also have strong balance sheets (Exxon is “AAA”- rated and has more cash on its balance sheet than debt), generate strong cash flows, and have traditionally increased their dividends on a regular basis.

Chevron was actually recommended as a “Buy” by Money Morning Contributing Editor Horacio Marquez in his “Buy, Sell or Hold” column earlier this year.

“Chevron is the kind of company that is capable of continuing to post large profits – propelling its share higher from current levels – even if oil-and-gas prices were to drop from current levels over the next three years,” Marquez said. “That’s because Chevron’s business is well cushioned, since refining, marketing and chemicals margins would expand dramatically if market ‘spot’ prices were to decline. Also, the company’s production is poised to expand strongly and Chevron uses some selective hedging that works very well in downside oil markets.”

Offshore drillers, particularly those capable of drilling in the deepest waters, also offer value at current levels. Petroleo Brasileiro (PBR), also known as Petrobras, is particularly appealing, as it recently discovered one of the largest offshore oil fields on earth off the coast of Rio de Janeiro. Known as Carioca, the field could hold 33 billion barrels of oil and gas, making the world’s largest discovery in at least 32 years.

Fitz-Gerald, the Money Morning investment director, suggests investors look at China National Offshore Oil Corporation, or CNOOC Ltd. (ADR: CEO). The Hong Kong-based company recently got approval for a $29 billion exploration project in the South China Sea. The company expects to produce 50 million tons of oil equivalent per year from that region during the next 10-20 years. That would equal the production of China’s biggest project, the Daqing Oil Field.

Petrobras and CNOOC are also attractive because, as foreign companies, they will also get a boost from any devaluation in the U.S. dollar.

All of these companies have been hit hard by the combination of commodity-price weakness and credit market turmoil. But these operators do not require peak-cycle commodity prices to generate stellar results and have little or no credit-market exposure.

For a more direct play on oil prices, you might also try an exchange-traded fund (ETF), such as the United States Oil Fund LP (USO), the iPath S&P GSCI Crude Oil Total Return Fund (OIL), or the United States Gasoline Fund LP  (UGA).

Source: Why Crude Oil Will Present Investors with a Golden Opportunity in 2009

Editor’s Note: This is the ninth installment of our “Outlook 2009” series, which looks at the global investing outlook for the New Year.

According to World Steel Dynamics, a U.S. steel consulting firm, steel production could fall next year by 13.9% compared with this year. This downturn comes after a long period of growth in the steel industry. In fact, output has grown every year since 1998 – soaring from 777 million metric tons a decade ago to 1.34 billion metric tons in 2007.

The catalyst behind the expansion has been a robust world economy and a steep rise in demand in China – by far the world’s biggest steel producing and consuming nation, accounting for more than a third of global steel output.
But the sector has been among those worst hit by this year’s financial storms, with share prices in many steel companies having fallen by more than two-thirds since the middle of 2008.

“The reduction in demand we’ve seen in steel goes beyond typical cyclical downturns given the level of distress in global financial markets and tight credit conditions,” Carol Cowan, a U.S.-based analyst at Moody’s Corp.(MCO)credit rating agency, told the Financial Times.

Steel companies’ share prices have been hit hard. Severstal OAO, Russia’s biggest steelmaker, has seen its shares fall almost 90% since July, ArcelorMittal (MT) has dropped more than 70 per cent; and United States Steel Corp. (X), the United States’ biggest steel company is down 79% over the same period.
Meanwhile, China’s steel industry, the world’s largest, is sitting on a stockpile of 63 million metric tons, or about 13% of annual production.  Baosteel Group Corp. General Manager He Wenbo said in November that his company was facing the “most difficult” period since it was founded 30 years ago.

But China is making noise about a shift in trade policy meant to rekindle its steel mills and keep its economy humming.  The government is considering measures, including buying unsold inventory and raising export rebates, to help steelmakers weather the slowdown, Minister of Industry and Information Li Yizhong told Bloomberg News on Dec. 12.

That represents a dangerous shift in policy that could hinder international trade, according to Myron Brilliant, vice president for Asia at the U.S. Chamber of Commerce in Washington.  The economic crisis has prompted China to turn back to “export-oriented policies that could lead to an increase in the trade imbalance” and new tension with the United States.

Treasury Secretary Henry Paulson has spent more than two years smoothing over U.S.-China trade relations.  Part of those efforts focused on the value of China’s currency, the yuan, to redress what U.S. officials saw as an unfair price advantage for Chinese products.  The yuan rose 21% versus the dollar from 2005, but its steady rise stalled in July, and has barely budged since.

Before leaving for trade talks in Beijing this month, Paulson told business representatives his biggest concern was that China would revise policy and reverse moves it had made during the past year to cut aid to exporters and stimulate domestic consumption.

China’s five-year plan through 2010 aims to rebalance growth away from exports and increase domestic consumption, but so far it has met with dismal results. Household consumption declined to slightly more than 35% of China’s gross domestic product (GDP) last year from 45% in 1993.  By comparison, consumer spending represents almost 70% of the U.S. economy.

“What separates China from the rest of the world is its incredibly low level of consumption relative to GDP,” Brad Setser, a fellow at the Council on Foreign Relations in Washington, told Bloomberg News. “What can China do that would most directly help the world economy during a period of very severe weakness? Get its consumption back up to 40% of GDP.”

A shift in Chinese policy is bound to meet with resistance in U.S. business circles, especially among steelmakers.  Lawyers representing Nucor Corp, the second-largest U.S. steelmaker, and smaller steel pipe makers say they are considering new trade complaints against China.

Shift in China Trade Policy Could Accelerate Western Steelmakers’ Slump

Regardless of any formal announcement of whether or not the United States drops into an actual recession, the ongoing credit crisis guarantees a contraction of the American economy by virtually every measure we know. That period of darkness will be marked by a dramatic slowdown in economic activity, as well as by rising unemployment, additional declines in U.S. stock prices, and constant volatility. It could last as long as 12-18 months.

But when the dawn does come, it will be one to remember. If U.S. President-elect Barack Obama gets it right – and I have every reason to believe that he will – then investors will be presented with the greatest investment opportunity of our generation. At that point, shares of American companies will be at such low levels that wholesale buying by individuals, mutual funds, pension funds, institutional money managers, and foreign-controlled sovereign wealth funds, will generate gains that will not only make us whole, they will make us rich once again.

A Market Mandela

Creating an analysis of the U.S. economy’s outlook for the New Year is akin to creating a mandala, a geometric work of art whose pattern, symbolically or metaphysically, represents a microcosm of the universe from the human perspective. In some Buddhist temples, mandalas are made of tiny colored beads, painstakingly created by several monks as a form of meditation. In celebration of the ever-changing nature of the universe, the mandala is then joyously shaken by its creators, until it is once again nothing more than chaos embodied in a box of colored beads.

Regardless of the big picture, analysis of a mandala – or the economy – always starts at the center and emanates outward. With the U.S. economy, that centerpiece is credit. The credit crisis has shaken the complex mandala that is our economy and transformed the United States economy into chaos. It’s complex because this economic-forecast mandala derived its form from thousands of individual pieces – in the case of the economy, from scores of data points, many of which are currently dark and foreboding.

The credit crisis we are experiencing results from the contraction – or worse, the cessation – of lending. Under normal circumstances, institutions and markets freely facilitate capital movement between lenders and borrowers. But that’s not happening, now.

Because of a lack of transparency into the balance sheets of borrowers holding such complex and illiquid securities as collateralized debt obligations, credit-default swaps, and non-performing loans, and because of increasing recessionary fears affecting businesses and households, lenders don’t want to increase their loan exposure. Banks are holding onto the cash and liquid securities they control, using them as a cushion against their own potential losses. The U.S. Treasury Department’s direct-to-bank capital injections do not alter these banking realities. In fact, as a Money Morning investigative story recently demonstrated, instead of using these taxpayer-provided infusions to increase their lending, these banks are using the money to finance takeover deals.

The Recipe for a Recession

Whether or not the United States is technically in a recession ultimately will be divined by the National Bureau of Economic Research (NBER). The business-cycle dating committee of this privately run, nonprofit economic research group is right now studying five factors in an attempt to determine if the United States has entered a recession and, if so, when that downturn started, MarketWatch.com reported. Those five factors are:

• Gross Domestic Product (GDP).
• Industrial production.
• Employment
• Income.
• Retail sales.

Regardless of any formal announcement by the NBER of whether we’re in a recession, the credit crisis guarantees a general contraction of economic activity, by every measure.

“Any doubt that we’re officially in a recession can be put aside,” Anthony Karydakis, former chief U.S. economist for JPMorgan Asset Management (JPM) – and now a professor at New York University’s Stern School of Business – recently wrote in Fortune magazine. “The rapid deterioration of labor markets points to a sharp decline in hours worked and output in the fourth quarter. This is likely to lead to a decline in personal consumption to the tune of 5.0% or so for that period. Since [consumer spending] makes up about 70% of the economy, the stage has already been set for real GDP to shrink at a more than 4.0% rate in the fourth quarter.”

Confirmation of that belief is evident by looking at each of the NBER’s five key indicators.

• Gross Domestic Product (GDP): The U.S. Commerce Department estimated that the U.S. economy, as measured by GDP, rose 0.9% in the first quarter. In the second quarter, GDP advanced an estimated 2.8%. For the third quarter, GDP declined an estimated 0.3%. My own econometric models suggest that GDP actually contracted at a 1.5% pace in the third quarter and will decline another 2.75% in the fourth quarter. For the year, that would mean the U.S. economy actually fell 0.55%. The U.S. economy last posted a full year’s negative GDP in 1991, when it declined 0.2%. Verdict: Recession.
• Industrial Production: This measure of output by the nation’s factories and mines dropped 2.8% in September, and a very steep 6.0% in the third quarter. Verdict: Recession.
• Employment: The U.S. Bureau of Labor Statistics announced Friday that October’s unemployment rate was 6.5%, a jump of 0.4%, which was double what most economists expected, and also its highest level in 14 years. The economy has now lost a total of 1.2 million jobs since the beginning of the year, with nearly half of those losses occurring in the last three months alone, pointing to an acceleration in the pace of erosion in labor markets. Karydakis, the Stern School professor, wrote in
  Fortune : “By way of comparison, during the 2001 recession and in the sluggish growth that followed in 2002-03, the unemployment rate reached a peak of only 6.3%, in June 2003. We’ve already exceeded that mark and, given that we are still in the early phase of the current recession, the unemployment rate should be expected to push toward the 7.5% range – and possibly higher – during the next three months to six months.”
  Verdict: Recession.
• Income: Personal income increased $24.5 billion, or 0.2%, and disposable personal income (DPI) increased $25.7 billion, or 0.2%, in September. Personal consumption expenditures (PCE) decreased $33.6 billion, or 0.3%. Excluding the rebate payments made to U.S. taxpayers under the Economic Stimulus Act of 2008, DPI increased $30.3 billion, or 0.3%, in September, and increased $44.0 billion, or 0.4%, in August. Verdict: Too close to call.
• Retail Sales: October retail sales are coming in well below already-diminished expectations, and some reports have been downright depressing – including The Neiman Marcus Group Inc. -26.8%; The Gap Inc. (GPS) -16%; The Nordstrom Group (JWN) -15.7%; J.C. Penny Co. Inc. (JCP) -13%; Kohl’s Corp. (KSS) -9%;  Ltd. Brands Inc. (LTD) -9%; Target Corp. Inc. (TGT) -4.8%; and Wal-Mart Stores Inc. (WMT) +2.4%. In a report last week, Moody’s Investors Service (MCO) projected that the retail sector’s woes will continue into 2009 as consumers cut back on buying apparel, footwear and accessories “in order to save money for essentials.” The credit rating firm said in a separate report that holiday spending “will prove even weaker than expected,” amid October’s financial-market swoon. Verdict: Recession.

If U.S. exports are taken out of the GDP calculations going back to January, it’s apparent that there has been very little domestic growth in the economy. And when revisions are finalized in the next few months, we’ll be looking back at the recession that we’re all but certain is upon us right now. Until the credit markets are freed up and borrowers are extended credit at reasonable rates, it’s unlikely that credit, the centerpiece of the economy, will be anything other than a major cog in the wheel.

There are some signs of a thaw, but not anytime soon. The U.S. Federal Reserve’s lowering of the Fed Funds target rate to 1.0%, and coordinated rate reductions by the Bank of England and the European Central Bank, as well as other major world-wide central banks, may start to ease the stranglehold gripping the worldwide credit markets. The London interbank offered rate (Libor), a critical interest rate against which trillions of dollars of mortgages, bank loans and derivatives are priced, dropped to 2.39% last week from a high of 4.82% on Oct. 10.

The prospect of President-elect Obama’s choosing a different means of attacking the credit crisis will be closely watched and, by itself, may create an air of confidence that perceptions will change. But changed perceptions will not be enough.

The truth about our economic outlook is that it is predicated on demonstrably better transparency. If U.S. banks follow the lead of their European counterparts, which have recently been freed from fair-value, mark-to-market accounting, and which may retroactively mark assets to “internal models” back to July, then balance-sheet clarity will continue to be cloaked in darkness. Lack of confidence in the banking system will persist, especially among the banks themselves. The first order of attack needs to be the creation of a fundamental leadership position that leads to an open, transparent and accountable measure of balance sheet assets and liabilities. As long as failing banks are being propped up, this cycle of credit contraction will persist.

The outlook for the economy is inextricably tied to the price of oil. The run-up of benchmark crude this summer to the record $145 a barrel level, and its subsequent fall to half that level, has wreaked havoc throughout the economy. Similarly, the run-up in commodity prices, and their subsequent fall, also has caused a lot of damage. Together, the dramatic rise and fall in the pricde of oil and other commodities is a harbinger of greater volatility in the future.

Follow the Money

Follow the money. Capital rapidly inflated the tech-stock bubble. When that bubble burst, capital flowed into and flooded the hard-asset world of real estate. When that bubble burst fast, speculative money dove into oil and commodities. When the U.S. and world economies looked weak, those bubbles burst. The looming threat of inflation this past summer instantly gave way after the drop of oil, gold, metals and agricultural commodities. And now, deflation is seen as the looming threat on the horizon.

Which threat should we worry about?

The answer is – both. The prospect for near-term deflation seems all too real. As raw material prices fall and finished good prices fall due to a lack of purchasing power resulting from lack of credit and world-wide recessionary fears, the U.S. consumer has fundamentally changed his or her collective psychology. Is U.S. consumerism, which is responsible for 70% of GDP, in full retreat? If it is, as all measures project, then it’s likely that government stimulus efforts will overshoot their intended mark.
Just look at what the United States has done already as it battles this financial crisis. It has:

• Handed out more than $150 billion in stimulus rebate checks.
• Floated a $700 billion financial bailout rescue plan – almost $160 billion of which has already been placed.
• Bailed out American International Group Inc. (AIG), to the tune of $125 billion.
• Covered JP Morgan Chase & Co.’s bet on taking over
  The Bear Stearns Cos. – to the tune of $29 billion.
• Looked to lend struggling automakers $25 billion.
• Agreed to guarantee depositors at all banks.
• Stepped in to buy commercial paper that no one else will buy.
• Guaranteed money-market-fund investors.
• And backstopped the Federal Deposit Insurance Corp. (FDIC), Fannie Mae (FNM) and Freddie Mac (FRE).

And now we’re getting wind of another stimulus package and more help for everyone.

If, in six months to a year, the credit markets are facilitating borrowers again, the massive buildup of U.S. debt will result in a falling dollar and higher interest rates.

That spells inflation.

A massive re-inflation of the economy portends another flood of speculative money into oil and commodities. The cycles are increasingly condensed, more volatile and will be increasingly more disruptive.

Welcome to the brave new world of global finance and speculation.

The Federal Reserve’s balance sheet has ballooned from $900 billion to more than $1.8 trillion. That’s 13% of GDP. The Treasury Department has telegraphed its intention to float $550 billion of debt in the fourth quarter and estimates it will have to float another $368 billion in the first quarter of 2009. Our national debt will then be close to 49% of GDP.

If there is an easing of credit in the economy, and borrowers come to market with the pent-up demand that has not been met for the past year, the competition for funds will raise interest rates. Higher interest rates will counter any stimulus effect from government programs.

Who will buy U.S. Treasury debt if the world is less apprehensive about credit quality? Lenders will once again seek higher returns, potentially forcing the Treasury Department to increase its rates. The potential of this event may sink the dollar if investors perceive that the U.S. economy is stagnant and the world is awash in dollars. The yield curve – the spread between the Treasury’s two-year and the 10-year paper – has been steepening. A steepening yield curve, where short-term borrowing costs are low and long-term rates considerably higher, is good for banks that borrow short and lend long.

But if the perception of risk diminishes, and the perception of future inflation increases, the yield curve will invert and the threat of rising rates will cause a sell-off in the short end of the curve and a rush into longer-dated maturities. Any increase in short-term interest rates would be painful for struggling banks. An inverted yield curve would be devastating, and inevitably would lead to more bank failures.

Home on the Range …

At the core of the U.S. economy sits a desperately ailing piece of the mandala – the U.S. housing market. The once bright prospect of home ownership, which historically formed a beautiful economic picture, right now doesn’t exist. For most Americans, the family home constituted the bulk of their wealth. Or at least it did. And this family financial portrait will get worse before it gets better, since the real estate collapse is far from over. Goldman Sachs Group Inc. (GS), for instance, projects another 15% drop in housing prices.

I think that’s conservative. Mortgage rates are actually rising as Fannie and Freddie have to pay higher interest on their short-term notes and bonds. Thirty-year fixed-rate mortgage paper averaged 6.47% last week, up from its 52-week low of 5.36%. The 15-year fixed paper was trading at 6.18%, up from its 52-week low of 4.91% (based on Bankrate.com (RATE) rate surveys). This trend is definitely not our friend. As housing prices continue to fall, and inventories stagnate and grow in many areas, homeowners are increasingly underwater and are increasingly entertaining foreclosure as a viable economic alternative to indentured servitude.
The Hope for Homeowners Plan, which looks to lower interest rates and reduce principal on mortgages, and which makes homeowners pay a share of the appreciation on their home to their lender when they sell it, was initiated in October and was expected to garner some 400,000 takers. As of last week, according to The Wall Street Journal, there had been only 42 takers. That’s not a misprint – 42 – I even checked with The Journal.

In the real estate realm, the proverbial “other shoe” hasn’t dropped yet, but certainly is dangling – and that’s commercial real estate. As homeowners writhe in agony and stop spending, retailers will go out of business, businesses of all stripes will suffer and commercial real estate will implode. The leverage left over from just the private equity foray into commercial real estate in the acquisitive 2006-2007 period is staggering. Refinancing will be impossible. Banks are stuck with hundreds of billions of dollars of leveraged loans that they took on as bridge and mezzanine financing from the private-equity shops alone, at the time believing they would  be able to securitize those loans and sell them off to investors.

There’s no chance of that, now.

One deal in particular illustrates this entire mess.  Private equity behemoth The Blackstone Group LP (BX) took Hilton Hotels Corp. private for $26 billion. Blackstone put up $6 billion of its own money as equity and borrowed the other $20 billion from Bear Stearns, Bank of America Corp. (BAC), Deutsche Bank AG (DB), Goldman Sachs, Morgan Stanley (MS), Merrill Lynch & Co. Inc. (MER) and Lehman Brothers Holdings Inc. (OTC: LEHMQ).

Based on a current analysis of the deal at the multiple of seven times projected cash flow that the market currently puts on Starwood Hotels & Resorts Worldwide Inc. (HOT) -  Hilton’s nearest rival – if Blackstone values its property comparably, it will have to mark its Hilton holdings down 50%, because it paid 13 times projected cash flow. That wipes out all of Blackstone’s equity in the deal. What’s more, the $4 billion portion of the loan that Bear Stearns took on, courtesy of JP Morgan Chase casting off Bear’s orphaned liabilities, now sits on the Fed’s balance sheet – and isn’t likely to go anywhere anytime soon.

Until the real estate cycle completes its implosion and begins to stabilize, there’s nothing that will fundamentally alter the outlook for the economy. This is Ground Zero. President-elect Obama must resist creating only a political solution to the overwhelming economic problem of declining house prices and declining real estate prices in general. Any attempt to put a band aid on this economic plague will only delay the day of reckoning. I regret deeply the conclusion that the lake must be drained before we can realistically climb out of it. But there just aren’t enough ferrymen to get us all to shore.

Always a Silver Lining – My Forecast

The outlook for the economy is not rosy – and that’s an understatement. But there is a silver lining. Even in the near term, the stock market will present innumerable wealth-creation opportunities.

• First, there are plenty of shorting opportunities out there now, and more will present themselves in the future.
• Second, in due course – in perhaps 12-18 months – we will be presented with the investment opportunity of our generation. If President-elect Obama gets it right, and I believe he’s got the potential to bring us all together and get the country through this (and if you’re reading this Mr. President-elect, I’d like to put in my vote for [New York Fed President] Timothy Geithner as next U.S. treasury secretary), American companies will be able to be purchased so cheaply that fortunes will be made. The recovery will not only make us whole, it will make our people and our nation rich again.

I have absolutely no doubt that the United States will lead the world back into balance. The sea change that has arrived is the result of the conservative experiment having lost its true moorings, pushing the economy into disaster. Not that a wholesale swinging of the pendulum to the other side would be good. In fact, it would be disastrous. We have the potential to end up with a new, fair, transparent and judiciously regulated environment where capital formation can again spread its wings and the U.S. economy can fly.

There are new hands reaching into the colorful box of beads that comprise the American landscape and economy. From any human perspective, the United States is more than a microcosm of the universe; it is the center of the world as we know it. It will take time to construct the new mandala. We all need to meditate on the process to ensure that the design we embrace will ultimately be inclusive, forward-looking and – like all great art – an inspiration to all who view it.

For the U.S. Economy in the New Year, the Pain Will Precede the Promise

Editor’s Note: This is the second installment of a new series that looks at the global investing outlook for 2009.

This from Money Morning:

Oil prices have fallen 70% since hitting a record $147.27 a barrel in July, which means in just five months, crude has given up all the price gains it made in the past four years.

After such a wrenching plunge, many analysts believe the outlook for the “black gold” remains bleak – and in the short term it certainly is. In the long run, however, dwindling supplies, resurgent demand, and a lack of investment will cause crude oil to double, triple, or even quintuple in price over the next few years.

In fact, the Paris-based International Energy Agency (IEA) – energy advisor to 28 industrialized nations – says oil will rise to $100 a barrel by 2015, as a result of a major “supply crunch,” and will ultimately soar to $200 a barrel.

But before it does, prices are likely to sink even further, perhaps falling as low as $20 a barrel in the first quarter of the New Year.

Indeed, much of Wall Street expects oil prices to average about $50 a barrel in 2009. Some of the firms and their specific forecasts include:

• Deutsche Bank AG (DB, which says oil prices will average $47.50 for all of next year.
• Merrill Lynch & Co. Inc. (MER), which predicts that prices will average $50 even.
• Moody’s Investors Service (MCO) also says crude will average $50 a barrel in 2009, but says that average will increase to $55 a barrel for 2010.
• Goldman Sachs Group Inc. (NYSE:GS) is slightly more bearish, predicting that prices will average $45 for all of next year – after falling as low as $30 in the 2009 first quarter. (It’s worth noting that Goldman – just five months ago – predicted oil prices would hit $200 a barrel in 2009).

But analysts also agree on something else: When the recessionary tide finally recedes, all of the factors that drove oil to its record high last summer will once again be exposed, and crude again will again soar to record highs.

“We may see prices drop lower – into the twenties, even – but there’s a better-than-average chance that they’ll be back over $70 a barrel by the end of next year,” says Money Morning Investment Director Keith Fitz-Gerald. “That’s where firms like Goldman and Merrill are getting all of these ‘middle-of-the road,’ $50-a-barrel estimates. And it’s why investors who buy in through the first quarter could enjoy compelling returns at the end of the year.”

In the meantime, however, low oil prices are crimping investment in new capacity, a reality that will lead to much higher prices down the road.

Just ask the IEA.

IEA: Rising Demand + Lack of Investment = ‘Supply Crunch’

According to widely respected energy advisor, global oil demand will slide 0.2%, or 200,000 barrels per day (bpd), this year, falling to an average of 85.8 million bpd. But the IEA also says that oil demand will advance by an annual average of 1.6% between 2006 and 2030.

The bottom line: Regardless of any short-term pullback, daily demand will rise from the current level of 86 million barrels to 106 million barrels in 2030. In other words, daily demand in 2030 will be 23%.

To meet that demand, the agency estimates that the world needs $26.3 trillion in supply-side investments over the next 21 years.

China, India and other developing countries, alone, will need investments of $360 billion a year through 2030, the agency said.

About 7 million bpd of additional capacity needs to be added to the market by 2015. And right now – because of marketplace changes – the financial incentives to make that happen just don’t exist.

Exploration costs have more than quadrupled since 2000, as oil producers have been forced to take on more complex projects, and the costs of both labor and materials have skyrocketed. At the same time, the steep drop in oil prices has put even more pressure on energy companies to curtail their investments rather than increase them.

Earlier this year, for instance, ConocoPhillips (NYSE:COP) and Saudi Arabia Investment Co. (ARAMCO) were forced to postpone bidding on the construction of a 400,000 bpd export refinery at the Yanbu Industrial City.

“We see and hear about energy investments being delayed … this is a major worry and could lead to a supply crunch and much higher oil prices than we’ve seen before,” said Fatih Birol, the IEA’s chief economist.

The IEA predicts that, by 2015, a lack of investment and rising demand will create a “supply crunch” – that will once again send oil prices up into the triple digits.

“There remains a real risk that under-investment will cause an oil supply crunch in that time frame,” the IEA said in an executive summary of its “2008 World Energy Outlook.” “The gap between what is currently being built and what will be needed to keep pace with demand is set to widen sharply after 2010.”

The agency predicts that crude will average more than $100 a barrel from 2008 to 2015 and rise above $200 a barrel by 2030, as demand far outpaces supply.

“While the situation facing the world is critical, it is vital we keep our eye on the medium to long-term target of a sustainable energy future,” Nobuo Tanaka, the Paris-based agency’s executive director, told reporters in London. “While market imbalances will feed instability, the era of cheap oil is over.”

While it’s probably true that the “era of cheap oil” is in our rearview mirror, a new question has arisen: Just how high do oil prices go?

According to some analysts, the IEA’s target price of $200 a barrel is far too conservative.

$500 Oil?

The lack of exploration and development is certainly a problem. But a much bigger issue is the fact that output from the world’s existing oil fields has sharply declined.

“The future rate of decline in output from producing oilfields as they mature is the single most important determinant of the amount of new capacity that will need to be built globally to meet demand,” the IEA says.

And output from the world’s oilfields is declining faster than previously thought.

In its “2007 World Energy Outlook,” the IEA estimated that output from the world’s existing oilfields was declining by 3.7% a year. But in its latest report, published in November, the IEA revised that estimate to an annual decline of 6.7%. (The November report was based on the first major study of the world’s 800 largest oil fields.)

Unfortunately, the IEA is behind the curve.

For nearly a decade, Matthew R. Simmons has said that the world’s oil production was nearing – or already at – an “inflection point.” While his book “Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy,” was scoffed at when it was originally published back in 2005, Simmons is now viewed as perhaps the preeminent expert on the so-called “peak oil” movement.

“Like most people who ignore conventional wisdom, he was scoffed at, ridiculed, and denied,” commodities guru Jim Rogers told Fortune magazine. “And now, of course, people are starting to say, ‘Oh, well, I thought of that.’”

Simmons, chairman of the Houston-based investment bank Simmons & Co. International, poured through hundreds of technical documents submitted by Saudi oil geologists to the Society of Petroleum Engineers over the past 50 years.

“I finished reading the last paper on a Sunday afternoon,” Simmons told Fortune, “and I sat back and thought, ‘Holy crap, this is unbelievable. I’ve just discovered the biggest energy illusion ever in the world. We’re in big trouble. I’m going to write a book.’ ”

Much of the alleged Saudi Arabia subterfuge has to do with a complete lack of transparency with respect to the Organization of Petroleum Exporting Countries. After OPEC decided to base its production quotas on reserve figures in the 1980s, several of the cartel’s producers suddenly raised their levels of  “proven reserves” by 40% or more.

Back in 1988, for instance, Saudi Arabia raised its proven-reserve figure from 170 billion barrels to about 260 billion barrels. That figure has remained more or less constant since then, despite the fact that billions of barrels of oil have been pumped out of the ground.

“Saudi Arabia has announced for 20 years in a row that they have 260 billion barrels of oil in reserve,” Rogers told Money Morning during an exclusive interview in Singapore recently.  “It’s astonishing.  The figure never goes up and it never goes down.  They have produced dozens of millions – billions – of dollars of oil in that period of time.

“Every oil country in the world has declining reserves except Saudi Arabia,” Rogers said. “And I know that every oil company has declining reserves.  So unless somebody discovers a lot of oil very quickly in very accessible areas, the surprise is going to be how high the price stays, and how high it goes.”

Simmons thinks oil prices could hit $300 a barrel – and could possibly even surge as high as $500 a barrel – during the next several years.

“Black Gold” Profit Plays

When it comes to investing, the oil sector poses some very clear risks, especially given the murky near-term outlook. However, there are a number of large-cap integrated oil companies that may offer some truly compelling values at current prices.

Exxon Mobil Corp. (NYSE:XOM) and Chevron Corp. (NYSE:CVX) are currently trading at multi-year lows, making them exceptionally cheap in both relative and absolute terms. These companies also have strong balance sheets (Exxon is “AAA”- rated and has more cash on its balance sheet than debt), generate strong cash flows, and have traditionally increased their dividends on a regular basis.

Chevron was actually recommended as a “Buy” by Money Morning Contributing Editor Horacio Marquez in his “Buy, Sell or Hold” column earlier this year.

“Chevron is the kind of company that is capable of continuing to post large profits – propelling its share higher from current levels – even if oil-and-gas prices were to drop from current levels over the next three years,” Marquez said. “That’s because Chevron’s business is well cushioned, since refining, marketing and chemicals margins would expand dramatically if market ‘spot’ prices were to decline. Also, the company’s production is poised to expand strongly and Chevron uses some selective hedging that works very well in downside oil markets.”

Offshore drillers, particularly those capable of drilling in the deepest waters, also offer value at current levels. Petroleo Brasileiro (ADR:PBR), also known as Petrobras, is particularly appealing, as it recently discovered one of the largest offshore oil fields on earth off the coast of Rio de Janeiro. Known as Carioca, the field could hold 33 billion barrels of oil and gas, making the world’s largest discovery in at least 32 years.

Fitz-Gerald, the Money Morning investment director, suggests investors look at China National Offshore Oil Corporation, or CNOOC Ltd. (ADR:CEO). The Hong Kong-based company recently got approval for a $29 billion exploration project in the South China Sea. The company expects to produce 50 million tons of oil equivalent per year from that region during the next 10-20 years. That would equal the production of China’s biggest project, the Daqing Oil Field.

Petrobras and CNOOC are also attractive because, as foreign companies, they will also get a boost from any devaluation in the U.S. dollar.

All of these companies have been hit hard by the combination of commodity-price weakness and credit market turmoil. But these operators do not require peak-cycle commodity prices to generate stellar results and have little or no credit-market exposure.

For a more direct play on oil prices, you might also try an exchange-traded fund (ETF), such as the United States Oil Fund LP (NYSE:USO), the iPath S&P GSCI Crude Oil Total Return Fund (NYSE:OIL), or the United States Gasoline Fund LP (NYSE:UGA).

Source: Why Crude Oil Will Present Investors With A Golden Opportunity In 2009