Table of Contents:

• Oil Production: Why OPEC’s Keeping a Lid on Production
• Oil Prices: Why Crude Thrives on the Diving Dollar
• Oil Outlook: The Coming Oil Price Shock
• Investing in Oil: The Best Companies, Stocks and ETFs

Oil has staged an impressive rally since dropping below $35 a barrel in mid-February.
And while there remains a risk that prices will retreat further due to sluggish demand, there are also three very compelling reasons why oil is still a safe long-term bet:

• OPEC has made substantial progress in reducing the amount of oil on the market.
• The dollar has been made vulnerable by the U.S. Federal Reserve’s aggressive policy of quantitative easing.
• And low oil prices and tight credit have reduced global energy investment, putting future supply at risk.

There’s no question that downside risk remains. On April 13, the Paris-based International Energy Agency (IEA) lowered its demand forecast by 1 million barrels a day, and now expects the world will use about 83.4 million barrels per day in 2009. That would be 2.4 million barrels a day, or 2.8% less than last year.

But so far dwindling demand has failed to contain oil prices.

As Money Morning predicted in its annual outlook series, the first quarter was a volatile one, in which oil prices tested the low $30s before surging over $50 in recent market rally.

And analysts are almost completely united in the view that, despite its short-term volatility, declines in production, exploration and development, and the value of the dollar will drive oil prices substantially higher in the years ahead.

Oil Production: Why OPEC’s Keeping a Lid on Production

The members of OPEC generated tremendous revenue from oil prices that soared over $147 a barrel last year. However, just as the world’s top oil producers began looking for ways to spend their massive stockpiles of cash, prices began a plunge that would see crude lose more than three-quarters of its value.

In a desperate effort to put a floor under oil prices, OPEC – supplier of 40% of the world’s oil – has issued three production cuts totaling 4.2 million barrels per day (bpd), or nearly 12% of its capacity, since September.

While the cuts have not yet been able to return oil prices to the group’s desired price range of $60-$70 a barrel, the cartel abstained from making any further reductions at its latest meeting in March and even voiced optimism that crude would reach $60 a barrel by the end of the year.

“That suggests to us that not only does OPEC have the firepower to support this oil price, but there’s enough internal agreement between OPEC members that they can actually achieve it,” Tom Nelson, an analyst for the Guinness Atkinson Global Energy Fund told BusinessWeek.

Many analysts had speculated that OPEC members would ignore the quotas and continue to produce oil to generate income, thereby rendering the cuts ineffective. But OPEC’s discipline has proven many critics wrong.

Despite foot-dragging from Iran and Venezuela – two countries that rely heavily on oil revenue to fund massive social programs – OPEC has gotten about 80% compliance on the 4.2 million bpd production cut. Historically, the cartel only gets about 60% compliance on such cuts.

As of February, Saudi Arabia accounted for about 46% of the 3.4 million bpd decline in production, according to PFC Energy. And the United Arab Emirates have fully complied with their share of the cuts. Iran’s compliance by that time was only 33% and Venezuela had only adhered to half of its commitments.

Still, Abdallah El Badri, OPEC’s Secretary General, estimates the production cuts will take about 800,000 bpd of supply off the market, significantly reducing the overhang in global markets, BusinessWeek reported.

OPEC officials from Libya, Algeria, and Iraq have all said that oil prices will reach $60 a barrel by the end of the year.

“One of the reasons why OPEC felt able to roll over quotas was that they do appear to have set a floor for prices,” Mike Wittner, an analyst at Societe Generale SA (ADR: SCGLY), told Reuters. “According to a lot of the balances, including ours, if you have OPEC holding steady or cutting a bit more, you get a big, counter-seasonal stock draw in the third quarter.”

Oil Prices: Why Crude Thrives on the Diving Dollar

Crude futures doubled from July 2007 to July 2008, soaring from about $74 a barrel to a record-high $147 a barrel. Much of that rise can be attributed to supply and demand, but there was another catalyst for the soaring prices that few investors recognized: The rapid decline of the dollar.

From July 2007 to July 2008 the dollar plunged 16% against the euro. And as the dollar became less valuable the cost of commodities around the world skyrocketed.

At the time, inflation – not deflation – was the predominant concern among the world’s leading economists, as a decade of low interest rates and unconstrained lending in the United States sucked the life out of the dollar. And while inflation is nowhere near the levels it reached last year, it’s important to recognize that the policies of the U.S. Federal Reserve are no less inflationary.

The Fed has cut its benchmark lending rate to a range of 0%-0.25%, and soon after, Fed Chairman Ben S. Bernanke said the central bank would purchase up to $300 billion of longer-term Treasury securities and $750 billion of mortgage-backed securities as it pursues a policy of quantitative easing.

This announcement by the Fed, along with a corresponding rise in equities, has been the driving force behind oil’s recent rally.

Ultimately, the same fear of inflation that typically drives investors into the gold market is similarly buoying oil prices. And even though the dollar has yet to be seriously affected, there’s no ignoring the fact that the more than $1 trillion worth of government bonds and mortgage-backed securities injected into the market will imperil the dollar’s value.

Oil Outlook: The Coming Oil Price Shock

Now that a weak dollar and reduced production have bolstered oil prices, there is a growing concern about how much higher crude will climb once demand returns. Tighter lending conditions and a trough in oil prices have badly crimped investment and jeopardized future supplies.

More expensive energy projects such as oil sands have been put on hold and the number of drilling rigs at marginal shallow-water fields around the world has been scaled back to a three-year low.

Oil drilling activity dropped 43% in the 12 months through March, with year-over-year oil exploration in the United States alone down 38%. High bids for offshore drilling rights in the central Gulf of Mexico fell by more than 80% compared with last year.

OPEC has said that with oil generating substantially less revenue as many as 35 new projects could be delayed past 2013.

“I have often described unsustainably low oil prices as carrying the seeds of future spikes and volatility. In a low-price environment, the trend is often to focus on survival instead of expansion,” said Ali al-Naimi, the Saudi oil minister. “If we place a low priority on preparing for the future, that lack of action can come back to haunt us through supply shortages and another round of high prices.”

The current economic crisis could reduce future oil supply growth by 8 million bpd, according to a recent study by the Cambridge Energy Research Associates (CERA).

CERA now says that production will grow by just 7.5 million bpd over the next five years, down from the 14.5 million bpd increase it predicted last summer. According to the research group, as demand recovers throughout that span, production will struggle to keep up and a new commodities bull market, similar to the one seen in 2008 will begin.

“Seven consecutive years of rising oil prices – unprecedented in the history of the oil industry – have come crashing down, thus burying the notion that the commodity price cycle was a historical relic,” said the report.

CERA isn’t the only organization worried about the lack of investment in new oil projects, either. The International Energy Agency (IEA) – energy advisor to 28 industrialized nations – has also issued warnings about a coming supply crunch.

The IEA estimates daily oil demand will rise from the current level of 86 million barrels to 106 million barrels by 2030. 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.

“Unless sufficient companies have the will and financial ability to invest through the down cycle, there is a real risk that supply growth may lag the eventual rebound of demand, leading to substantial price increases – possibly as early as this year,” Richard Jones, the IEA’s executive director said at a recent conference in London.

Jones estimates that as much as 2 million bpd of expected new oil production has already been deferred.

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.

“Every bull market in oil is really born in the zenith of a bear market,” said Phil Flynn, an analyst at Alaron Trading Corp. “The cutbacks we see today are going to lead to a spike somewhere in the future. The big question is when it’s going to happen.”

Investing in Oil: The Best Companies, Stocks and ETFs

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 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,” Money Morning Contributing Editor Horacio 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.”USO

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.

Keith Fitz-Gerald, Money Morning’s 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: Three Big Reasons Oil Prices Will Rally Back Big Time

• A day after posting better-than-expected quarterly earnings, Goldman Sachs Group Inc. (GS) sold $5 billion in stock to repay federal bailout money. All totaled, Goldman sold 40.65 million in shares at $123 a piece, 5.5% below Monday’s closing price, Reuters reported. Goldman received a total of $10 billion from the Troubled Asset Relief Program.
• Amsterdam-based Royal Phillips Electronics NV (PHG) said its cost-reduction program will save the company more than 500 million euros ($664 million) this year, Bloomberg reported. The announcement came with its quarterly earnings report, in which Europe’s largest consumer-electronics maker reported its second-consecutive loss.

• First quarter earnings for pharmaceutical and health care retail giant Johnson & Johnson (JNJ) fell, but beat estimates by cutting costs, Reuters reported. The company $3.51 billion, or $1.26 a share, in the first quarter compared with $3.6 billion, or $1.26 a share, in the first quarter last year. Johnson & Johnson reaffirmed its 2009 profit forecast of $4.45 to $4.55 a share.

• Singapore’s economy may shrink 6% to 9% this year, the government said in its third reduced forecast this year. To counter contraction, the government will adjust the trading range of the Singapore dollar. “The situation is really dire and the central bank’s policy will improve sentiment and help the economy,” Vishnu Varathan, an economist at Forecast Singapore Pte., told Bloomberg.

• Discover Financial Services (DFS), will cut 500 jobs in May, or 4% of its workforce, Reuters reported, citing company sources. Discover, the fourth-largest U.S. credit card network, last month posted a deeper-than-expected quarterly operating loss, cut its dividend and set aside more money to cover bad loans as defaults increase.

• In a sign bankers are gaining confidence that the worst of the financial crisis is over, the London inter-bank offered rate (LIBOR) for three-month dollar loans is dropping at the fastest pace since January, Bloomberg reported. Debt strategists at Credit Suisse Group AG (ADR: CS) Societe Generale SA (ADR: SCGLY) and Royal Bank of Canada (RY), three of the 16 banks that provide the data that sets Libor each day, say the declines will continue.

• Weak demand and a supply glut could cloud the coal industry’s prospects for the rest of the year, even as U.S. coal miners are likely to show strong quarterly profits this month, Reuters reported. But big U.S. coal producers should weather the economic downturn because they sold much of this year’s production at higher prices negotiated before the recession hit last September. Coal prices are expected to stay low throughout 2009 until production cuts by major miners begin to restrict the coal supply.

• Madoff Securities International Ltd., filed for bankruptcy protection in Florida under Chapter 15 of the federal bankruptcy code. The code is designed to block U.S. lawsuits against foreign companies reorganizing overseas that have U.S. operations, Bloomberg reported. Bernard Madoff pleaded guilty last month to 11 counts including fraud and money laundering for directing the largest Ponzi scheme ever.

Source: Global Investment News Briefs Wednesday April 15, 2009

This from Money Morning:

On the surface, it appears as though the Chinese economy is suffering along with the rest of the world. The economic crisis that has ensnared Western economies is expected to dampen Chinese exports and there is already evidence of capital flight.

But the real story is that China’s foreign exchange reserves – at $1.9 trillion – remain at an all-time high, and the outflow of capital, or “hot money,” will actually deflate many of the asset bubbles that speculative investment has created over the past several years.

Ultimately, the so-called “global recession” that many analysts have projected as a virtual certainty will serve as only a temporary correction for China’s economy, which is still projected to expand by at least 8% this year and next – even as its Western counterparts sputter

Is Hot Money Leaving China?

“Hot money” refers to foreign funds that are temporarily transferred to a financial center and can be withdrawn at any time, or to the massive quantities of capital that international speculators can shift from one market to another across the globe – whipping a market into a frenzy when it flows in, and potentially leaving it flat and shattered when it’s whisked away. It’s a boom-and-bust cycle that’s occurred time and again throughout history: In the early 1990s, for example, hot money flowed into such emerging-market economies as Hong Kong, causing some stock markets to double in a year. But all those gains – and then some – were given back a year later when speculators pulled out of the emerging markets in pursuit of the next “hot money” investment opportunity.

The emerging economies have been the target of the hot-money crowd again in recent years, as investors and speculators scoured the planet for the highest-possible returns. But with the onset of the current financial crisis and drum-tight credit markets, much of that hot money is on its way back to where it came from.

The Institute of International Finance estimates that capital inflows to 30 emerging markets will decrease by nearly a third this year, from $900 billion in 2007 to $619 billion this year, before declining to $560 billion in 2009.

Analysts estimate that anywhere between $10 billion and $25 billion fled China in September, as the global financial crisis worsened.

To support this claim, analysts point to China’s massive foreign exchange reserves. Foreign exchange reserves increased $96.8 billion in the third quarter to a record high $1.9 trillion, but even though China’s currency stockpile grew, it expanded at a slower rate than previously seen. China’s broad measure of money supply grew by 15.3% last month, down from 16% in August.

China recorded a $29 billion trade surplus in September, and nearly $10 billion in foreign direct investment, yet the country’s reserves grew by just $21.4 billion – a red flag for many analysts.

“I think it’s pretty certain that we are seeing an outflow of capital at this stage,” Glenn Maguire, Asia economist for Société Générale SA (OTC ADR: SCGLY), told The Wall Street Journal. However, he said, “what we are seeing is an unwinding of the hot-money flows that occurred earlier in the year, rather than outright capital flight.”

Indeed, roughly $120 billion in hot money poured into China throughout all of 2007, and Michael Pettis, a finance professor at Peking University, estimates that more than $200 billion flooded in during just the first half of 2008. But as credit tightened over the past several months, it’s likely that many financial institutions called much of that money back in an effort to shore up their own balance sheets and ensure adequate liquidity.

“This outflow likely reflected foreign financial institutions attempting to repatriate capital and hoard dollar liquidity in the midst of the credit crisis,” Logan Wright of Stone & McCarthy Research Associates in Beijing told The Journal.

The dollar’s appreciation against foreign currencies, including China’s yuan, is another reason for the recent shift in hot money flows The yuan has appreciated 17% against the dollar since the peg between the two currencies was dissolved in 2005. It rose roughly 7% in the first nine months of the year, drawing in speculative investors looking to cash in on the currency’s continued appreciation.

However, Beijing likes to keep the yuan artificially low as a means of boosting exports, and the currency has climbed far too fast in the first half of the year for the government’s liking.

“Worries about the economy have escalated,” Yang Bin, a Beijing-based dealer at Bank of China Ltd., the country’s biggest foreign currency trader, told Bloomberg News. “A return to the fast pace of appreciation in the first half would stifle struggling export industries at this difficult time.”
Indeed, a dealer confirmed to the Economic Times, that “despite the global dollar weakness, the market believes China’s slowdown won’t allow the yuan to strengthen too much in the near future.”

Additionally, the dollar has rallied nearly 20% against the euro since April, and because China’s reserves are reported in dollars, the value of its non-dollar holdings has been shrinking. That, too, has contributed to the apparent slowdown in China’s reserve growth.

“We think the (reserve-growth) slowdown is related to the dollar’s recent strengthening,” Li Heng, a Beijing-based economist with TX Investment Consulting, told the AFP. “We believe [the] forex-reserves growth will stabilize in future. So far, significant growth in capital outflows is not happening.”

So long as there is no dramatic withdraw of cash from China – and there hasn’t been so far – a slight correction or pullback would actually be beneficial for an economy that has been growing too fast for its own good in recent years.

All of the speculative capital flowing into China over the past decade has fueled inflation, driven up stock prices, and helped accelerate a worrisome bubble in the real estate market – similar to the one created in the United States. So, in that respect, the recent outflow of capital is actually restoring fair value to the marketplace.

“The excessive influx of hot money will expand market liquidity, cause excessive money supply, and will eventually push up inflation,” Zhao Qingming of China Construction Bank told the Beijing Review. “The hot money inflow also poses more pressure for yuan appreciation. It can also create bubbles in the property and stock markets.”

Stephen Green, of Standard Chartered PLC, told the Financial Times that, given the exodus of foreign capital in the third quarter, the problem of too much hot money is “beginning to sort itself out.”

“This is certainly reducing some of the pressure, which will be welcome in Beijing,” Green said.

China’s Leaner, Meaner Economy

When China’s foreign-exchange reserves jumped to their world-record high in the third quarter, its currency holdings were up 33% as of the end of September, from a year earlier.

The Chinese market “remains liquid and the financial system is broadly sound,” said central bank Deputy Governor Yi Gang.

Indeed, liquidity is not an issue in China. Instead, the question is how will the economy hold up in the face of a severe global downturn. So far, the signs are encouraging.

Of the world’s large economies, China has fared the best throughout the duration of the current economic crisis. Whether Chinese banks were “wise, lucky, or better regulated,” they avoided exposure to the risky subprime mortgages and derivative products that caused the current financial firestorm, said Liu Erh-fei, managing director and chairman for China at Merrill Lynch & Co. Inc. (MER).

“There is no systemic risk in China’s banks that could spill over into a full blown financial crisis,” Liu said. “China is not affected by this virus that permeates the U.S. and European economies.”

Liu added that China would be able to maintain “reasonable” growth at, or above, 8% so long as it is able to tame inflation and increase domestic demand.

There are already signs that inflation is subsiding, and the outflow of hot money may be, in part, responsible for that. Another factor is the decline in commodity prices that has accompanied weaker global demand and a stronger dollar.  The price of oil, for instance, has plummeted more than 50% from its record high of $147.27, set July 11.

Inflation in China receded to 4.9% in the year to August from 8.7% in February. And Goldman Sachs Group Inc. (NYSE:GS) forecasts that it will fall as low as 1.5% in 2009. That means the biggest task ahead for China will be spurring domestic demand to compensate for a decline in exports.

Exports rose 21% in August from a year earlier, after soaring 27% in July, and that growth rate will likely continue its downtrend as economies in the United States and Europe, China’s two biggest trade partners, continue to weaken if not contract.

Fortunately for China, domestic retail sales are up, having jumped 23.2% in August from a year earlier.

According to Merrill’s Liu, Beijing is well enough equipped to steer its domestic economy towards stable growth by aiding rural development and sponsoring infrastructure projects.

“The government has all this cash and it should use it,” Liu said.

China has a budget surplus of 2% of gross domestic product (GDP), according to Standard Chartered’s Green. And public sector debt is just 16% of GDP.

Beijing already has plans increase the number of rural banks and lending firms to 100 by the end of the year, from 61 at the end of August, Bloomberg reported. This will improve farmers’ access to credit.

The government could also change current land ownership laws to give farmers the ability to transfer (lease or sell) the rights to 30.5 million acres of rural residential land, to market-oriented farm corporations. That would give those farmers looking to sell their property more access to capital and income, as well as aid companies in need of land to develop Bloomberg said.

Additionally, China still has strong growth in its burgeoning cities. Fixed asset investment in urban areas rose 27.4% in the first eight months of the year.

“Despite negative shocks of the financial crisis, China will accelerate transformation of the growth model, promote domestic demand – especially household consumption – and maintain fast and stable growth,” said Deputy Governor Yi.

The Chinese economy accounted for one-third of global GDP in the first half of the year. It could play an even greater role in 2009.

Source: Although “Hot Money” Flees China the Red Dragon Will Emerge From Financial Crisis Unscathed

Despite a flood of investment leading up to the 2008 Olympic Games, economic conditions in China have been on the decline for the entire month of August, leading some analysts to warn of a post-Olympic slowdown.

But the Chinese economy so far has proved resilient, and with policymakers in Beijing scrambling to ensure economic growth, it will likely escape a significant downturn.

The Shanghai Stock Exchange’s Olympic event was diving. The Shanghai Composite Index dropped roughly 12% between the opening and closing ceremonies of the games. It’s now down about 60% from its October high. The steep drop came as a harsh surprise to many Chinese investors who were expecting the Olympics to be a boon for the economy.

“Everybody said the market would turn [positive] in July before the Games, so we listened and stayed in it,” one trader told the Los Angeles Times. “In July, they said that the market’s spirit would return when the Olympics came. What spirit is that? Now we are all dead and have no spirit left in the market.”

There is no single explanation for the index’s decline, but it can mostly be attributed to a rash of data that suggests China’s high-flying economy is beginning to wobble in line with a global downturn.

“Recent data suggested that the slowdown has taken a firmer hold of the economy and the Olympics may present some downside risks,” Citibank economist Ken Peng said.

China’s industrial output slowed to a 17-month low in July as weakening exports hit factory production across the nation. Industrial production grew by 14.7% in July, down 16% in June and 18% percent in July of last year, the National Bureau of Statistics reported.

“The deceleration in export growth was the main reason for the slowdown in industrial output,” the bureau said, adding that export growth for the month was 26.9%, compared to 34.2% in July 2007.

Also, producer price pressures remain high even though consumer prices that climbed to a 12-year high of 8.7% in February receded to a 6.3% increase in July. Increased costs for labor, energy, and commodities caused producer prices to jump 10% from a year earlier in July – an indication that corporate profit margins are caught in a vice.

China’s gross domestic product (GDP) growth now has decelerated for four consecutive quarters. China’s GDP grew 10.1% in the second quarter, after expanding by 11.2% in the fourth quarter of 2007, and 10.6% in the first quarter of 2008.

GDP growth is expected to slow even further as economic conditions throughout the world continue to deteriorate. Standard Chartered Bank has said China’s rate of growth will slow to 9.9% in 2008 and 8.6% in 2009. China’s economy grew 11.9% in 2007.

Those rates of growth may still sound impressive but a nation as large as China needs economic growth to come along much faster than its Western counterparts.

“China needs much faster growth than an average Western country as it has to generate 10 million jobs a year,” Tao Dong, chief Asia economist at Credit Suisse Group AG (ADR: CS) told Bloomberg News. “Eight percent growth in China is equivalent to a recession. Below nine percent would make the authorities quite nervous.”

Mingchun Sun, China economist at Lehman Bros. Holdings Inc. (LEH) says GDP for the second half of 2008 will slow to 8.7% in the second half of 2008, and just 8% for all of 2009.

“If growth goes lower than 8% the government will be very worried,” says Sun, who sees only 2 million jobs being created. “This is important because unemployment is related to instability.”

Central Bank Shifts its Stance

The government is already worried. But unlike U.S. policymakers, Chinese authorities actually have the firepower to fend off a protracted slowdown.

China has a budget surplus equivalent to 1.5% of its GDP and currency reserves equal to 45% of GDP, according to Credit Suisse. That gives policymakers ample resources to keep the economy churning at a double-digit pace. And the government seems fully intent on promoting growth, despite a possible resurgence in inflationary pressures.

“Concerns over China’s export health will translate into a complete reversal of the current tightening of policy,” Donald Straszheim, vice chairman of Roth Capital Partners LLC told Bloomberg. “Maintaining economic growth is now number one.”

The People’s Bank of China made that very clear in its second-quarter monetary report, which dropped any reference to monetary policy as “tight.” Instead, the second quarter report stated the central bank would “make its top macroeconomic priorities maintaining stable and relatively fast economic growth.”

Inflationary risks “can’t be neglected,” the report noted, but added that “external demand will continue to weaken, and the negative impact on exports, economic growth and employment will emerge further.”

That’s a subtle but significant shift from he previous report, released in May, which said the central bank would “place a higher priority on containing price rises and curbing inflation, and implement a tight monetary policy.”

In July, the Bank of China followed through by raising lending quotas for national banks by 5% and regional lenders by 10%, potentially allowing banks to extend about $26.3 billion (180 billion yuan) in extra loans over the rest of 2008. Those limits previously had been put in place to crack down on excess liquidity flowing freely through the market.

There is also growing speculation that policymakers in Beijing are assembling a $58 billion (400 billion yuan) economic stimulus package. The package would be equivalent to 1%-1.5% of GDP and aimed at smaller businesses struggling with high material and energy costs, a strong yuan, and withering export demand.

“The top leadership is carefully considering an economic stimulus package,” said Frank Gong, chief China economist at JP Morgan Chase & Co (JPM). “This will include tax cuts and measures to ‘stabilize domestic capital markets’ and support ‘healthy development of the housing market’.”

A Rebound on the Way

Fixed asset investment is one of the areas already benefiting from the central bank’s new direction. Total spending on mines, factories, and land between January to July shot up 27.3% from a year earlier, while central government investment accelerated 25.3% in the first seven months of the year.

“The slight increase in fixed-asset investment (FAI) will help alleviate concerns about the magnitude of China’s economic slowdown,” said Jing Ulrich, chairman of China equities at J.P. Morgan Securities. “Targeted pro-growth policies, widely expected from the government in the second half, will have a countervailing positive impact on FAI.”

The FAI news and anticipation of further pro-growth policies sent the Shanghai Stock Exchange sailing 7.6% on August 20 – the third largest single-day gain in all of 2008. However, the Shanghai composite index lost 45.38 points, or 1.85%, over the week, to finish at 2,405.23 points.

Of course, that doesn’t mean the index will continue its decline. Investors continue to pressure Beijing to intervene, and with the central bank’s renewed focus on promoting growth, intervention – through a stimulus package or otherwise – becomes more and more likely with each passing day.

“New policy measures to support growth could include further tax rebates for low-end exporters, an easing of lending quotas, slower yuan appreciation or even depreciation,” Glenn Maguire, chief Asia-Pacific economist at Societe Generale SA (ADR: SCGLY), told Bloomberg. “China is returning to the investment-heavy growth model we saw in 2003 and 2004.”

Battered stock prices have also left some real bargains on the floor of the SSE, which could also restore investor confidence. At their October 2007 peak, shares on the Shanghai exchange were trading at prices nearly 53 times their annual earnings, according to Ulrich. Since then, the Price/Earnings ratio for Chinese stocks has fallen to about 18.

P.S. The possibility of a stimuls package is one of the reasons why Jason’s colleague at Money Morning, William Patalon III, urged investors to stay in China last week.

Source: China’s Economy Looks to Rebound After Lackluster Olympics

Switzerland-based Roche’s $89 per share cash offer is almost a 9% premium over San Francisco-based Genentech’s Friday closing price. Roche first acquired 60% of Genentech for $2.1 billion in a 1990 deal. Currently, Roche owns approximately 56% of outstanding Genentech shares.

Roche will finance the Genentech deal through a combination of new debt and $9.8 billion (10 billion Swiss francs) in cash.

“The transaction will create a unique opportunity to evolve Roche’s hub-and-spoke model into a structure that allows us to strengthen the focus on innovation and accelerate the search for new solutions for unmet medical needs,” Roche Chairman Franz Humer said in a company statement announcing the offer. “Combining the strengths of Roche and Genentech will create significant value and result in benefits for patients, employees and shareholders.”

This offer represents a reversal in Roche’s prior treatment of subsidiaries. In the past, Roche has opted to allow subsidiaries such as Genentech and China-based Chugai Pharmaceutical Co. Ltd. to maintain some autonomy. However, Roche feels Genentech’s advancement from a biotech research operation into a more full-service pharmaceutical firm makes now the right time to buy.

“There has always been a strategic view that Genentech should remain independent to guard its ability to innovate,” Andreas Theisen, who covers the pharmaceutical sector at WestLB Equity Markets in Düsseldorf, told The International Herald Tribune. “Still, from a business perspective, it’s not an irrational move. Roche has its own U.S. infrastructure, so there are straight dollar benefits to combining the two businesses.”

In addition to extending Roche’s presence in the U.S. market, the company expects cost saving of $750 million – $850 million each year after the Genentech acquisition.

“We will be better able to share technologies and expertise in pharmaceuticals and diagnostics across the group and broaden the mutual access to the external innovation networks of both companies,” Roche Chief Executive Severin Schwan said after the announcement.

The timing of the deal couldn’t be better for the Switzerland-based Roche, as the deal represents yet another foreign firm looking to snap up prime U.S. assets at a reasonable price.

“This makes a lot of sense,” Beatrice Kunz, a portfolio manager at Zurich-based Clariden Leu who helps manage $147 billion in assets, including shares of Roche. “The weak dollar and the fact that they are not paying a huge premium make this rather attractive.”

But some analysts feel Roche will have to up its offer to entice Genentech shareholders to approve the deal. French bank Societe Generale SA (OTC ADR: SCGLY) speculated in a research note that a higher offer would be needed since Roche did not meet with Genentech management prior to announcing its offer and Genentech stock had traded as high as $100 as recently as 2005, MarketWatch reported.

Source:  Switzerland’s Roche Makes $43.7 Billion Offer for U.S. Biotech Pioneer Genentech

Both ended up backtracking on previous statements, as their ill-conceived cures for the broader U.S. economy were stripped of any relevancy by a tumultuous and unforgiving credit market.

Fannie Mae (FNM) dropped $2.13 a share, or 22% yesterday, to close at $7.60 share. Freddie Mac (FRE) sank $1.77, or 25%, to close at $5.34 a share. The beleaguered mortgage giants dragged the market down with them, as the Dow Jones Industrial Average closed down 92 points, or .84% at 10,962.54. It had earlier fallen as low as 10,840.81. The S&P 500 Index closed at 1,214.91 down 13 points, or 1%.

After saying Sunday that Fannie Mae and Freddie Mac “play a central role in our housing finance system and must continue to do so,” Paulson amended his comments to the Senate Banking Committee, saying his plan “is aimed at supporting the stability of financial markets, not just these two companies.”

“Let me stress that there are no immediate plans to access either the proposed liquidity or the proposed capital backstop,” Paulson added. “If either authority is used, it would be done so only at Treasury’s discretion, under terms and conditions that protect the U.S. taxpayer.”

Similarly, Federal Reserve Chairman Ben S. Bernanke was forced to rethink his previous statements concerning the progress of the economy.

After saying in June that the risks of a “substantial downturn” had diminished and the Fed would shift its focus to resisting “an erosion of longer-term inflation expectations,” Bernanke said before Congress today, that the economy “continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil [and] food.”

Now, as credit markets tighten and inflation continues to strengthen its grip on the U.S. economy, both Paulson and Bernanke have the unenviable task of shepherding the economy through one of the most difficult economic climates of the past century.

Paulson’s Predicament

After opening higher Monday following Paulson’s remarks and a successful sale of short-term debt at Freddie, both stocks resumed their slide with each company falling more than 30% in the past two days. Fannie Mae has lost 81% year-to-date, while Freddie Mac has dropped 84.5%.

“The impact of Sunday’s announcement by the Federal Reserve regarding its mortgage bail-out plan for Fannie Mae and Freddie Mac remains somewhat derided in the market,” James Hughes at CMC Markets told the Financial Times. ”It has apparently done little more than underline the perilous state of the U.S. economy.”

Both Freddie and Fannie have cash on hand, and both meet their regulatory capital requirements. It also looks as though both firms will also be bolstered by U.S. Treasury Secretary Henry Paulson’s rescue plan, which includes generous credit lines and a pledge by the U.S. government to purchase equity in the companies as needed.

But government assistance notwithstanding, investors and analysts anticipate falling house prices and an increasing number of mortgage defaults will incinerate what little capital the companies have left. Their balance sheets are also highly suspect, though Freddie Mac looks far worse off than Fannie Mae.

At the end of the first quarter Freddie’s balance sheet showed assets of $803 billion and shareholder equity of just $16 billion, CNNMoney reported. That means Freddie has just one dollar in equity for every $50 of mortgages and other assets it holds. The company’s mortgage portfolio is even more disconcerting, as it shows just 70 cents worth of equity for every $100 worth of business on its books.

“Is this enough equity when your business consists of buying and guaranteeing mortgages?” Len Blum, a managing director at New York investment bank Westwood Capital, wrote in a recent report quoted by CNN. “How about when you conduct these activities in markets falling by 20% or more?”

Finally, according to the fair-value balance sheet, which reflects the value of Freddie’s assets rather than their cost, the company’s shareholder equity stands at negative $5.2 billion. Using fair-value accounting, Fannie Mae shareholders are still up $12 billion.

Also, as other lenders have withdrawn from the mortgage market in the face of plummeting home values and a mountain of foreclosure filings Fannie and Freddie have been left to pick up the slack to the point that they are now involved in 80% of U.S. mortgages.

With so much on the line, the failure of Freddie Mac and Fannie Mae would be cataclysmic. And not just for the U.S. market, but for global investors.

Because government-sponsored enterprises (GSEs), such as Fannie and Freddie, offer higher yields than treasuries and enjoy implicit assurances from the U.S. government, they are very appealing to foreign investors who hold approximately $1 trillion in GSE debt.

Indeed, if Fannie and Freddie were to fail, it would undermine these investments and cost international investors dearly.

German giant Deustche Bank AG (DB) and Switzerland’s UBS AG (UBS) both declared they would not need to raise further capital yesterday (Wednesday) as the bulk of losses tied to mortgage-backed securities is now behind them.

“At first glance this is some much-needed positive news for Deutsche in particular but also for the whole sector,” Helge Rechberger, head of equity market research at Raiffeisen Zentralbank in Vienna, told Bloomberg News. He said he remains “cautious” about the financial industry.

A positive note from a London-based JPMorgan Chase & Co. (JPM) analyst helped reinforce that European banks are approaching the end of the current mortgage-backed crisis.

“The worst of the markdowns seems to be over,” analyst Kian Abouhossein wrote of European banks in a note to clients yesterday, Bloomberg reported. “We do not believe that further capital raising is needed at this point.”

The JPMorgan analyst went on to say that while European banks’ need for additional capital might be over, further write-downs are still likely at UBS as well as rival Swiss bank Credit Suisse Group AG (ADR: CS). Abouhossein also expects more markdowns at French financial firms Societe Generale SA (OTC ADR: SCGLY) and Natixis SA (PINK: NTXFF).

The news boosted European bank shares, with Deustche shares up 3.3% and UBS stock up 1.6% at the close of European trading yesterday. Other European banks received a boost as well with French firms Natixis up 4.4% and Credit Agricole SA (PINK: CRARF) up 0.8%, while Turkey’s Fortis Bank AS had a gain of 2.4% according to Reuters data.

The gains could strengthen the European Central Bank’s resolve to hike its key interest rate tomorrow when ECB President Jean-Claude Trichet and the other members of the monetary policy committee meet today (Thursday).

It is widely expected that the ECB will vote to raise its rate to 4.25% from its current 4.0% to fight rampant inflation throughout the Eurozone.

“It’s pretty much a done deal” that the ECB will lift its key rate from 4%, Nick Stamenkovic, fixed-income economist at RIA Capital Markets in Edinburgh, told MarketWatch.

Source: European Banks Boosted by More Positive Outlook

“We are in a recession, this report doesn’t change that,” Ellen Zentner, an economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, told Bloomberg News. Zentner had forecast a payrolls cut of 25,000. “What it does is support the idea that the downturn will be mild. Consumer spending isn’t going to tank.”

Compared to the 240,000 jobs the domestic labor market shed in the first three months of the year, 20,000 is a marked improvement. The continued slump in the housing market and waning consumer confidence affected sectors tied to the housing market and consumer goods.

“Employment continued to decline in construction, manufacturing, and retail trade, while jobs were added in health care and in professional and technical services,” the DOL statement read.

The report was universally better than expected, as many economists had expected a slight increase in the unemployment rate to 5.2%. Many saw the moderation in job losses as affirmation that the U.S. Federal Reserve should pause in its rate-cutting campaign.

“For now, this employment trend is validating signals sent by the [Federal Open Market Committee] earlier this week to take a pause in rate cuts,” wrote Stephen Gallagher, economist for Societe Generale SA (OTC: SCGLY), MarketWatch reported. The report “lessens the fears of a deep, or prolonged downturn in the economy.”

In an unrelated report, the Commerce Department announced that domestic factory orders increased 1.4% in March on the heels of a 0.9% decline in February due largely to strong international sales. The weak dollar is helping to boost exports and offset weakening demand at home.

“The cross currents of a weak domestic economy and a strong export sector continue to keep activity from faltering sharply,” Jonathan Basile, an economist at Credit Suisse Holdings Inc. (CS) in New York, told Bloomberg.

Again, the report was better than anticipated, as economists’ had expected an increase of only 0.2%.

• Nokia Corp.’s (NOK) first-quarter earnings missed analysts’ estimates, causing the company’s stock to nosedive 13.98% to close at $28.98 in trading yesterday (Thursday). Net income for the world’s biggest maker of mobile phones rose 25% to $1.95 billion and sales increased 28%. About half of Nokia’s revenue is in dollars or closely linked currencies, Bloomberg reported.

• Nakheel PJSC, the state-own developer planning “The World” archipelago in Dubai, said its 2007 profit more than quadrupled. “We can only start recording earnings from a project after we’ve got 40% the way through construction,” Nakheel’s Chief Financial Officer Kar Tung Quek, told Bloomberg. Translation: “The World” is going to be a gold mine.

• Google Inc. (GOOG), owner of the most popular search engine, reported a 30% increase in first-quarter profit after international expansion countered a slowdown in U.S. advertising spending. Net income jumped to $1.31 billion from $1 billion a year earlier, the company said today in a statement.

• Capital One Financial Corp. (COF) said yesterday (Thursday) that profit fell 19% in the first quarter, as higher credit costs outweighed an increase in revenue, the Associated Press reported. The company reported earnings of $548.5 million, or $1.47 per share, for the January-March period, and $3.87 billion in revenue.

• Online brokerage TD Ameritrade Holding Corp. (AMTD) said yesterday (Thursday) that second-quarter profit jumped 32% on strong trading activity and growth in its asset-based revenue, the Associated Press reported. The company earned $186.7 million in the quarter that ended March 31, up from $141.1 million a year ago.

• Societe Generale SA (OTC: SCGLY), the French bank still reeling from a multi-billion dollar rogue trader scandal, announced yesterday (Thursday) that its Chief Executive, Daniel Bouton, would step down, but remains on as non-executive chairman. Frédéric Oudea, the chief financial officer, will succeed Bouton, The New York Times reported.

• Avant Immunotherapeutics Inc. (AVAN) inked a deal with Pfizer Inc. (PFE) valued at $50 million to develop a potential brain cancer treatment, MSN Money reported. Avant has the potential to earn an additional $390 million if it meets certain development and commercialization milestones. Avant shares soared 16% with a $1.67 gain to close at $11.72 yesterday (Thursday).

• Southwest Airlines Co. (LUV) profit fell 63% in the first quarter, but the carrier was still able to show a profit of $34 million for a quarter where other major airlines are posting losses due to record-high fuel costs. Southwest shares gained 11 cents, a 0.88% increase, to close at $12.61.