Slow Boat to China

Basic Points
A Slow Boat to China

April 16, 2010

Published by Coxe Advisors LLP
Distributed by BMO Capital Markets

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Don Coxe THE COXE STRATEGY JOURNAL

A Slow Boat to China

April 16, 2010
published by

Coxe Advisors LLP Chicago, IL

THE COXE STRATEGY JOURNAL A Slow Boat to China
April 16, 2010 Author: Editor: Don Coxe 312-461-5365 [email protected] Angela Trudeau 604-929-8791 [email protected]

Coxe Advisors LLP. 190 South LaSalle Street, 4th Floor Chicago, Illinois USA 60603

www.CoxeAdvisors.com

A Slow Boat to China OVERVIEW
Our theme this month is the worldwide industrial recovery, which has sparked a new boom in prices of industrial raw materials. Across most of the world, factories are humming tunes of rebirth. Lehman’s collapse was the final shock to an over-levered financial system, crashing prices of equities, corporate bonds and commodities. However, while OECD economies survived on life support from panicky politicians and stunned central bankers, China and India never made it as far as hospital parking lots, let alone the triage desk. The quick stimuli in both those economies kept banks and factories functioning, and GDP growth remained strongly positive. Thus history was made: The Old, Old World came to the rescue of the Old and New Worlds in their worst economic collapse since the Depression, nearly drowning in the real estate and financial engineering debts accumulated to finance the excesses and miscalculations of the previous cycle. We have been cautious since September about the runaway US and European equity and junk bond markets because of their heavy dependence on astounding ingestions of what we termed “financial heroin.” If there were a Financial World Olympics, the organizing committee would have long ago disqualified them from further competition, and awarded the gold medal to China, the silver to India, and the bronze to either Indonesia or Brazil—with a special award of merit to Canada and Australia—whose economies and stock markets had been growing—to great extent—based on the commodity price increases spawned in Asia. In recent months, the global swing in inventory cycles from panic liquidation to modest accumulation confirms that the industrial recovery has legs, even though house prices remain weak and unemployment remains strong across most of the US and Europe. We are therefore rebalancing both our Recommended Asset Mix (for US Pension Funds), and our sector weightings for commodity stocks. Because we see the divergence between Canadian and US financial assets as a longer-term phenomenon, we are introducing a new portfolio for Canadian pension funds. We have added a new category “Commodities and Commodity Equities” for all pension funds, financed, in the case of American pension funds, primarily from bonds and cash. We discuss the background to this recommendation under “Recommended Asset Allocation”, page 51. When those assets are added to the Funds’ stock investments, the equity-equivalent weighting for pension funds has moved back to near-normal territory at 59%. Those patients who barely survived a long stay in the Intensive Care Unit are back at work— part-time. We expect major central banks to begin slowing the rate of their heroin injections soon—and will watch anxiously to see whether the US and European economies are able to stand on their aging feet when they discard the crutches provided by government financial health care. April 1

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A Slow Boat to China
Industrial recoveries are known by the symbols of their leadership. The brief mid-1930s recovery was symbolized by the speedy new production lines, with the hapless Charlie Chaplin (in Modern Times) frantically trying to keep up. The wartime economy was symbolized by Rosie the Riveter. The postwar recovery was symbolized by roaring blast furnaces and the noisy assembly lines converted from manufacturing tanks and armored personnel carriers to producing cars and trucks. The Seventies were the decade of Oil, with the oil derrick its symbol. The Eighties were the decade of the Japanese Miracle, symbolized by pictures and reports on those scarily smooth— almost surreal—production lines in Japan, whose output of reliable products challenged the very survival of factories in the West. The emblems of the Nineties were the chip-machines churning out the brain cells and blood cells of the information revolutionaries. The “Noughties” were marked by the relentless outpouring of exports from China, that were the stimulus of the most dramatic industrialization and urbanization the world had ever seen. Its symbol: the TEUs (Twenty-Foot Export Unit), the intermodal container that carried an increasing supply and increasing range of products across the world. Our theme comes from a Frank Loesser classic. I’d like to get you On a slow boat to China, All to myself alone…. Melting your heart of stone… In this decade, China’s global impact has, at the margin, switched from exports to imports, as weak OECD economies can no longer absorb sustained increases in purchases of Chinese products. China’s imports are mostly the raw materials needed for infrastructure and urbanization. The symbol of the second decade of the commodity boom is a ship going to, not from, China—the bulk dry cargo ship carrying raw commodities, notably iron ore and metallurgical coal.

Melting your heart of stone…

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Iron Ore (Steel China Iron Ore Spot) January 1, 2007 to April 13, 2010
1,400

“We will bury you!”

1,300 1,200 1,100 1,000 900 800 700 600 500 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 990.00

Source: BMO Capital Markets

Hot Cold-Rolled Steel January 1, 2007 to April 13, 2010
1,200 1,100 1,000 900 800 700 600 500 400 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 665.42

Source: BMO Capital Markets

The steel industry was a bastion of the American economy from the days of Henry Clay Frick and Andrew Carnegie, but it grew complacent after World War II, and, like its biggest customer—the auto industry—succumbed routinely to union contracts whose generosity was based on the arrogance that the rest of the world could never really compete with Pittsburgh. In reality, the new global steel leader was the USSR, and its symbol was the brawny Stakhanovite worker, whose heroism and productivity had been so crucial in winning the war against Hitler and was now winning the war against capitalism. Khrushchev’s famous taunt at the UN, “We will bury you!,” accompanied by his boastful bang of his shoe, was the live geopolitical version of the Stakhanov posters.

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No such romance attaches to the iron ore and steel industries today. In particular, the major iron ore deposits in Australia and Brazil owned by BHP, Rio Tinto and Vale are mined with gigantic scoops that are more reminiscent of Sauron’s monster machines launched in the assault on Gondor than the tools of miners and steelworkers.
BHP Billiton (BHP) January 1, 2002 to April 13, 2010
100 90 80 70 60 50 40 30 20 10 0 Jan-02 Nov-02 Sep-03 Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09 81.20

No such romance attaches to the iron ore and steel industries today.

Rio Tinto (RTP) January 1, 2002 to April 13, 2010
550 500 450 400 350 300 250 200 150 100 50 Jan-02 Nov-02 Sep-03 Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09 241.00

VALE (RIO) January 1, 2002 to April 13, 2010
45 40 35 30 25 20 15 10 5 0 Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09 34.14

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So the imagery in this iron age isn’t brawn, sweat and vigor, but a long ship at sea loaded with sand—62% iron—or the metallurgical coal which will be added to the iron ore in some Sino-version of “Satanic Mills.” We remain of the view that the major US and European equity indices are heroically priced on heroin... “But why,” the reader may ask, “Are you publishing this analysis now? Haven’t those Chinese mills been pumping out steel with growing gusto for months while you were expressing caution about the financial system and the economic conditions in the US and Europe? You kept talking about a coming correction in the S&P from the time in September when it crossed 1,050 and it’s 1180, and now you tell us about the deep meaning of slow boats to China?” Good question. We remain of the view that the major US and European equity indices are heroically priced on heroin, and the health risks for those patients newlyemerged from financial hospitals are under-priced. However, we are now inclined to the view that the US and major European economies should improve enough that they will not drag the global economy into a new recession. We therefore recommend that investors orient their equity and equity-equivalent portfolios to Oriental demand. A roaring recovery in US stocks usually means many—or most—sectors of the economy have regained pricing power. This time, the equity rally is mostly based on hope for pricing power, and hype that investors must get on the train before it leaves the station. Those who seem most conspicuous in demonstrating pricing power include 3-D movies, ad rates on Fox News, producers of copper, crude oil, iron ore and metallurgical coal, and members of government unions, but collectively these do not seem the stuff of a robust recovery. We note that the famously slow National Bureau of Economic Research remains unwilling to assert that the US is out of recession. Yes, these economists are renowned for their desire to maintain their sublimely accurate record by waiting until just before their caution becomes ridiculous. However, some committee members still openly proclaim their fear of a double-dip recession once the stimulus programs expire. Nevertheless, we think both the strident pessimists and the starry-eyed optimists could be wrong.

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Here are three charts that argue that a US recovery that looked too tentative and heroin-dosed to be worth Dow 10,000 (when we suggested clients might well anticipate a correction) has recently moved from the Intensive Care Unit to the recovery ward and is back to work, at least part-time:
KBW US Regional Banking ETF (KRE) January 1, 2007 to April 13, 2010
55 50 45 40 35 30 25 20 15 10 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 28.28

a US recovery... has recently moved from the Intensive Care Unit to the recovery ward and is back to work, at least part-time...

KBW US Regional Banking ETF (KRE) relative to S&P 500 January 1, 2007 to April 13, 2010
110 100 90 80 70 60 50 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 65.49

KBW US Bank Index ETF (BKX) relative to S&P 500 January 1, 2007 to April 13, 2010
110 100 90 80 70 60 50 40 30 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 56.81

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These charts show how the BKX (dominated by the big, bad, bonused, bailout banks, that we call the B5) and the KRE (the equally-weighted index of fifty geographically-diverse commercial banks) signaled the coming crash and how well they have been performing since then. The KRE has hugely and consistently outperformed the S&P for nearly six months, with its outperformance going to a new high last week. It is still outperforming the BKX on a cumulative basis, although its outperformance peaked in January. The thrust of these charts is that the financial sector of the US economy is in better health than it has been since June 2008, the last time Barney Frank dismissed Republicans’ increasingly urgent concerns, insisting that Fannie and Freddie were in sound shape, were no risk to the taxpayers and should not be subject to increased regulation. We now know that the bailout costs for F&F will be greater than all the other financial bailouts combined, because the TARP program of bailing out real financial institutions—rather than heavily-politicized bastard children of government at its most venal—is getting refunds, with interest, at an impressive rate, (with Citicorp and AIG the only remaining big holdouts, and even they are looking better than seemed possible a year ago). We have been insisting since we first warned in early 2008 of an apparent breakdown of both the BKX and KRE that we would not be able to proclaim a new bull market until those indices had outperformed the S&P for at least six weeks, and the KRE—the index of banks behaving in the socially useful ways most of the time, the way nearly all banks used to behave all the time—had outperformed the BKX during that period. After the Crash we said that six weeks wouldn’t be enough this time, because (1) this crash was bigger than any we’ve had since WWII, and (2) the bailouts and financial heroin that saved the banking system from large-scale implosion meant that we had no precedent to use in evaluating endogenous risk within the banks relative to the rest of the stock market. Citicorp went from $55 in 2007 to $1 in 2009 and was rescued with the kind of money previously expended only for victims of only the biggest hurricanes—Andrew and Katrina.

...the financial sector of the US economy is in better health than it has been since June 2008...

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That it is up 400% from its low after all that cash is not necessarily evidence that the banks are outperforming the broad stock market. That its top trio of leaders included the once-magisterial Robert Rubin might possibly be reason to take it seriously, but not to cite its survival after a $50 billion bailout as an argument for buying US stocks generally. The leader who became the boss at the financial world’s biggest morass after Chuck Prince danced away with a pay packet that could have financed four Fred Astaire movies—Vikram Pandit—is likely underpaid at his current rate of $1 a year; however, he was paid more than $100 million to take the job, and is given stock options on a penny stock that the government will not let fail. Messrs. Prince, Pandit and Rubin told Congress they could not have anticipated the Crash and are therefore not to blame: they are in company with the Best and Brightest Banker, Alan Greenspan. Mr. Greenspan introduced a novel concept in his defense: he admitted—sort of—that the Fed might have kept rates too low for too long, but said the problem was in low mortgage rates and the Fed doesn’t set those—the market does. Nobody challenged him on that assertion. Presumably, Ben Bernanke has been given the all-clear to boost fed funds rates soon, and no Congressperson will blame him when mortgage rates rise.

Messrs. Prince, Pandit and Rubin told Congress they could not have anticipated the Crash and are therefore not to blame...

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The Iron Ore Oligopoly
Iron ore has been, for investors, for most of the past fifty years, the least glamorous of the base metals. When we came into the business, we got to know a veteran geologist who gave us one of the most useful maxims we ever learned: “An iron ore deposit is like a belly button—everybody has one.” That saved us from betting on some big, undeveloped Canadian orebodies that remain moose pasture today. There were many reasons for this skepticism: • Major steel companies built on the US Steel model of full backward integration had their own supplies—such as the giant operations at Wabush. • The startup steel companies that were challenging the aging, heavily unionized majors, were using a new technique that substituted readilyavailable scrap for raw iron ore—or the 33% iron pellet products fabricated out of low-grade ores. • Steel was losing market share, year-by-year, to aluminum and plastics. (The classic scene in The Graduate in which a drunk tries to convince the anti-hero to seek a career in plastics was well-grounded: the American steel industry hymned earlier by Ayn Rand was yesterday’s story and yesterday’s career.) • America’s progression from a no-car to a one-car, to a two-car family was complete. • The Cold War was, post-Vietnam, not really a shooting war, which meant there was no inbred growth in demand for steel for weaponry; the new, high-tech Pentagon sought specialty metals for its leading-edge products. • There were huge undeveloped ore bodies across the world—particularly in India—that could meet such demand as might arise from the former colonies. The one constant we have experienced during the eight years since we proclaimed the greatest-ever global commodity boom has been the regularity of analyses from another growth industry—the China skeptics. The names on the reports may change, but a month never goes by that we don’t receive screeds from experts who’ve just been to China, or who’ve talked to important insiders whose names they can’t reveal, that the China boom is about to

“An iron ore deposit is like a belly button— everybody has one.”

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become a bust that will make the tech collapse look like something between a hiccup and a belch. The allegations routinely include fraud in Chinese GDP statistics, predictions of the coming collapse of Chinese banks, local revolts that are precursors of a coming civil war, sheer incompetence among government officials and Chinese industrialists, a real estate bust bigger than has occurred in any Western nation, massive overproduction, phony statistics on metal consumption, gigantic hidden inventories of oil, copper and fertilizers, etc., etc. There have been recent variations on these themes. The latest China expert is James Chanos, an American hedge fund operator who made a fortune shorting mortgage-backed CDOs. Seeking the Next Big One, he proclaimed, without even visiting China, that he just knew it was about to implode. Alan Abelson, the witty, articulate super-bear of Barron’s, regularly publishes these “devastating” insider reports of the coming China crisis, because they fit so well into his doleful views that any bull market of our time faces castration at best, slaughter at worst. That he has been right about the phony American bull markets of our time may make his readers conclude that he has to be right about China. Many of those who swallow these predictions of the Great Fall of China are victims of wishthink: either they fear, on nationalistic grounds, China’s growing challenge to US pre-eminence, or they’re upset that they missed the commodities boom, or they’re just eager for the next great short story. And so to the iron ore story: According to the Financial Times, the recent history of annual contracts for iron ore prices is: Price ($ per tonne) 2000 - 2001 2002 - 2003 2004 - 2005 2006 - 2007 2008 - 2009 2010 - Q1 and Q2 17-18 17-19 19-22 38-46 50-90 60-110

...the China boom is about to become a bust that will make the tech collapse look like something between a hiccup and a belch.

Last month, the system of annual contract prices set in negotiations between leading Chinese, Japanese and Korean steelmakers fell apart. Hereafter, quarterly prices will be set with reference to the still-small—but soon-to-begigantic—spot market.

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As metals analysts agree, this is a momentous event. With much of the global economy still struggling to emerge from recession, the hottest of all major commodities is the most basic of all metals—iron ore. That a product never traded on any exchange is the new Wonder of the World argues against the conspiracy theorists who dismiss soaring prices in metals traded on public exchanges, such as copper, nickel, zinc and aluminum. All those investigations into price manipulations through futures markets should soon become irrelevant. There is no argument that iron ore’s pricing and demand have been set by China since the onset of the commodity boom. In 2000, China’s seaborne imports were 72 million tonnes, less than half Western Europe’s. By 2005, they were 276 million, with Western Europe buying 191 million. In 2009, China’s estimated purchases from those slow boats were 615 million tonnes, and the entire rest of the world drew only 289 million. The collapse of the fixed contract system has produced chaotic iron ore markets. Spot iron ore deliveries to China last week were priced as high as $163 per tonne. Already, global steel prices have started to soar. With iron ore uncapped and running wild, metallurgical coal could not be far behind.
Metallurgical Coal Prices January 1, 2005 to March 31, 2010
Met Coal Contract Price (US$/tonne) Seaborne Supply 2005 $108 227 2006 $117 224 2007 $101 239 2008 $305 239 2009 2010E 2011E 2012E 2013E $129 202 $200 207 $200 212 $190 220 $180 228

That a product never traded on any exchange is the new Wonder of the World argues against the conspiracy theorists...

Source: IEA, BMO Capital Markets

As contract prices climb, so do prices of stocks levered to coking coal:
Teck Resources (NYSE: TCK) April 13, 2009 to April 13, 2010
50 45 40 35 30 25 20 15 10 5 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 44.85

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Alpha Natural Resources (NYSE: ANR) April 13, 2009 to April 13, 2010
60 55 50 45 40 35 30 25 20 15 10 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 53.00

Remarkably, in recent weeks, so are steel stocks:
US Steel (NYSE: X) April 13, 2009 to April 13, 2010
75 70 65 60 55 50 45 40 35 30 25 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 64.37

Arcelor Mittal (NYSE: MT) April 13, 2009 to April 13, 2010
50 45 40 35 30 25 20 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 45.63

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In other words, although China has almost single-handedly forced the biggest cost increase in history on integrated steel companies, overall industrial activity is at levels allowing significant cost pass-through. It is different this time... Even the mini-mills relying on scrap—not ore—that compete with the major integrated companies are facing painful cost increases. According to the last two months reports of the US Producer Price Index, steel scrap has been the star performer in the crude goods category. The doubters—including some members of the National Bureau of Economic Research—still warn of a double-dip recession. To our knowledge, there has never been a recovery from recession marked by (1) low overall CPI and (2) modest top-line GDP growth with (3) high unemployment, when (4) no major shooting war was raging, yet (5) steel scrap and finished steel prices were rising sharply driven by non-OECD demand—that succumbed quickly into a new recession. It is different this time, because this time the pulling power for global recovery comes from Emerging and Emerged Economies—not the established Industrial Economies. We admit that skeptics might well reply, “When can you find a slow economic recovery accompanied for more than a year by near-zero nominal interest rates? Wouldn’t you expect the Crude Goods component of PPI to give the first signal of higher prices in the economy? Besides, the overall economic cost—and economic drag—from somewhat higher steel prices is trivial compared with what’s been happening to crude oil.” That, we believe, is a realistic concern.

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NYMEXIFYING the Recovery?
Crude Oil January 1, 2002 to April 13, 2010
160 140 120 100 80 60 40 20 0 Jan-02 Nov-02 Sep-03 Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09 84.09

...oil shock returned with a vengeance.

When the economic recovery from the tech-crash-induced recession began in 2002, crude oil prices were still where they were in 1986. That was the year the Saudis grabbed OPEC cheaters by their throats. This was the first time since the Yom Kippur War shutdown of production that the Saudis chose to demonstrate their power to control world oil prices. The combination of slowly-collapsing oil capex across most of the world during the 1990s, a slow recovery in Russian production from its depths after the sudden defeat of Bolshevism, the collapse in Iraqi production, a global economic recovery and, most importantly, surging demand from China, yanked control from the Saudis and their OPEC colleagues, handing it to the spot markets. By 2007, as Russian and Saudi output were finally climbing toward record levels, and Iraq was returning to production, oil shock returned with a vengeance. Crude oil prices staged their wildest ride in three decades—soaring to $145 a barrel, followed by sudden financial and economic collapse across most of the OECD, sending crude to as low as $35.

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There are those who argue that the biggest US economic stimulus came not from Obama, Pelosi et al but from Saudi-led OPEC, which did almost nothing to halt the ski-jump plunge in crude prices, and thereafter cut production only modestly, so that average oil prices in 2009 were roughly back to where they were in 2006. Result: US gasoline prices were briefly halved, and only recently have begun to climb back to levels that could in themselves constrain overall consumer spending. Arguably the only help the beleaguered airline industry received to avert disaster was cheap jet fuel. Even now, the airlines’ fuel costs are well-covered by its ticket prices. (As for private jets, a sector that was decimated by a financial collapse that wiped out so many of its owners and lessors, the plunge in jet fuel prices was Heaven-sent. It sharply reduced the Copenhagen kaffeeklatsch costs for those Greens whose private aircraft filled up most of the available airport space as they met to get global agreement on carbon taxes and offsets on which so many of them expected to receive revenues appropriate to their secular saintliness.) If $45 oil was at least as big a stimulus as $2 trillion in Obama deficits (if not as big as zero interest rates), then will $85 oil shoot the green shoots dead? Our take: it is certainly bad news for consumers, who don’t need new bad news. But we do not believe that it signals the onset of an economy-garroting attack on the OECD from OPEC and Chinese consumers. Energy prices could well remain reasonably subdued for the next few years, and therefore act as a source of modest stimulus—not drag—on the global economy. Here’s why: • Saudi Arabia believes $70-$80 oil is the “perfect price”—the Goldilocks range that is high enough to encourage exploration and production, but not high enough to choke the global economy, (or to stimulate massive new high-cost non-OPEC production that could challenge the cartel’s pricing power). • Saudi Arabia claims to have 5mm b/d of excess capacity to enforce its campaign for petroleum pricing perfection. Apart from Matt Simmons and a few other prominent skeptics, that claim is widely respected.

It sharply reduced the Copenhagen kaffeeklatsch costs for those Greens whose private aircraft filled up most of the available airport space...

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• Triple-digit oil prices have left scars on the minds of governments and consumers across the world. Energy conservation isn’t just something that Greens applaud. Gasoline consumption has been falling across the OECD and the next generation of low-consuming vehicles will be hitting showrooms within two years. Airplanes keep becoming more fuelefficient. • Iraq managed to get oil companies to agree to astonishingly onerous pledges and astoundingly low pricing to develop its vast reserves—said to be second only to Saudi Arabia. If Iraq does not dissolve into another civil war, it could more than double its production within five years. • Brazil’s giant offshore fields will begin producing later in this decade. • Angola, a ghastly kleptocracy about which we seem to hear little, has quietly taken in Chinese “supervisors” and joined Iran in the list of China’s top three oil suppliers. • One important—and rarely remarked—aspect of the functioning of the oil futures curve is that it takes into account expected increases in future production. In part, this is because oil companies help finance costly well development by selling production forward to generate funds now. But it is also because both producers and consumers make their estimates of how much oil will be produced at various times in the future and make their own guesses about how much will be consumed. So those big new oilfield developments get plugged into oil price forecasts, and that tends to drive prices downward in intervening years as well. Oil futures curves don’t tend to have humpbacks…as do long bond yields at times investors anticipate future declines in inflation.

Triple-digit oil prices have left scars on the minds of governments and consumers across the world.

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We find it significant that the apparent upside breakout in spot oil has not been confirmed in the futures curve. Indeed, the curve has been narrowing for months. Not long ago the oil curve was almost as steep as the Treasury yield curve, and was assigning a very high relative value to reserves in the ground compared to the Saudi-set spot prices. Not any more:
Crude Oil Futures (at April 13, 2010) December 2010 to December 2018
120 110 100 95.42 90 80 70 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18

We find it significant that the apparent upside breakout in spot oil has not been confirmed in the futures curve.

Crude Oil Futures (at April 20, 2009) December 2008 to December 2016
90 80 70 60 50 40 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16

77.48

But there’s more…. Or should we say “less…?”

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Cheap Gas
Natural Gas January 1, 2005 to April 13, 2010
16 14 12 10 8 6 4 2 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 4.15

Natgas...has long been a boon supplying lush pickin’s to oil companies’ financial reporting.

Natural Gas Futures (at April 13, 2010) December 2010 to December 2018
8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 8.26

Natgas may be the only commodity that trades at a far lower price today than at year-end 2008. Its coupling with oil, which was solemnized by the SEC in 1982, has long been a boon supplying lush pickin’s to oil companies’ financial reporting. However, this obscure accounting practice has gone from the subliminal to the ridiculous.

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It may soon be recognized as perhaps the most dubious financial distortion since thousands of putrid mortgage packages got Triple “A” ratings from fee-hungry rating agencies back in the days when Wall Street was still respected. ...the most dubious financial distortion since thousands of putrid mortgage packages got Triple “A” ratings... We have been complaining about this institutionalized overstatement of oil company reserve life indices for five years. Perhaps we risk boring our loyal clients by returning to discussion of this misleading practice. To date, no one of prominence has joined our calls for fair reporting. However, since it is part of the new, potentially huge, story about the likelihood of sustained cheap gas prices, we need to allude to it again. Moreover, our longheld view about gas prices seems to be confirmed by recent major strategic moves among big oil and gas producers. Here’s how the accounting has been handled: • Oil companies generally produce both oil and gas. Most oilfields contain both fuels. So oil companies use an industry formula to report their combined gas and oil reserves in a single, simple, blended number in their announced Reserve Life Indices. • The Reserve Life Index is to oil companies what an actuary’s liability valuation is to a life insurance company or pension fund. It discloses how long the company can continue to produce at its current rate, based on stated assumptions. The most important of these assumptions is that natural gas reserves are included as oil equivalents based on 6 mcf of gas being equivalent to a barrel of oil. The companies report their combined oil and gas reserves in one number—the barrels of oil equivalent, or boe. That is a scientifically-based law of industry accounting, because 6 mcf of natgas produce as much energy as an average barrel of crude oil. The formula worked well for many years. But then, as oil prices kept climbing to new higher ranges and natgas stayed lower-priced, it ceased to be pure science in the service of pure reporting. Big Oil in general, and Exxon Mobil in particular, have always been comfortable with this rule. Exxon bought Mobil in the 1990s primarily because of its huge gas reserves and LNG operations in Indonesia that were supplying 34% of Japanese gas imports a time Lee Raymond believed the Saudis would keep oil prices below $35 a barrel for decades.

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The supermajors’ liking turned to love of the SEC formula in recent years as they failed to replace their oil production with major new discoveries, and had big chunks of their published reserves looted by Chavez, Putin and other such leaders with whom they had—naïvely—struck seemingly advantageous deals in the 1990s. That love has become a perverted passion in recent months, because US oil and gas companies are finding so much shale and tight natgas, while their reserves of oil in the ground in politically-secure regions of the world continue to dwindle. So the six-to-one formula (which, in terms of financial windowdressing might be better labeled “sex to one”) with oil at $84 effectively prices natgas reserves at $14 per mcf while the actual market price is around $4. Since the only time natgas has ever sold at $14 was right after Katrina, the oil companies would appear to be straight-facedly predicting Katrinas as the norm for years to come. We await with interest Big Oil’s defense of this accounting rule if, as some prominent bulls maintain, oil gets back to $96. Its natgas in the ground will then be valued at $16 per mcf—a price it has never experienced. This audacious overvaluation of assets that will not be actually sold for years recalls how Wall Street was valuing its subprime-laced CDOs before the Crash. Those valuations were legal according to the SEC, and even according to the rules of Basel II, because they were backed by Triple A ratings from the supposedly clear-eyed and unbiased ratings services. One reason we routinely recommend that clients overweight exposure to the oil sands companies is that what they produce and sell is oil, and one of their biggest production costs is natgas. To be long oil and short gas is a superb business model—except in oil industry accounting models. One reason we have never recommended Exxon Mobil (as efficiently managed as it famously is) for commodity stock portfolios is that its Reserve Life Index stated in barrels of oil equivalent (boe) is heavily weighted to gas, and its oil reserves, (apart from the heavy oil and oil sands its owns in Alberta through its 69% ownership of Imperial Oil) are dwindling, and include levels of political risk ranging across the spectrum from low to absurd. When geologists and petroleum engineers at companies such as Devon Energy, Chesapeake and XTO cracked the code on producing vast quantities of gas through fracking (fracturing of tight rocks) and horizontal drilling, they transformed the outlook for energy prices.

...love has become a perverted passion in recent months... the six-to-one formula (which, in terms of financial windowdressing might be better labeled “sex to one”)

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We have been telling clients for more than a year to invest in oil producers, and to avoid gas producers. The more we have learned about the humongous quantities of natgas that exist in the Lower 48 states of the US and much of Northern and Central Europe, the more we have been inclined to view natgas as a blessing for gas consumers in the US and Europe, and bad news for investors in natgas stocks—and for Messrs. Putin and Chavez. (Yes, Virginia, there is some good news in this story.) Nothing we have written in the past two years has evoked such strong opposition from clients—including some of the smartest investors we know. We start with the obvious: • Investors in Natgas futures and the Natgas ETF have lost money during a commodity bull market, while investors in oil have won handsomely. Why should things get better for those who’ve been gas-bagged for so long? • Seemingly the only constraint on putting more gas into storage is that almost all the storage space is allocated. • We are finally escaping from one of the roughest winters in decades, yet natgas prices languish at $4. How cold does it have to get to absorb all the gas being developed? • The government, (which is, we admit, not necessarily the most reliable source), estimates that recoverable reserves of natgas are enough to meet the nation’s demand for the rest of this century, whereas oil reserves may only last for another four decades. • Perhaps the only thing that could get gas to go to profitable levels is for some big players to go bust or slash their shale exploration budgets and write down the value of their reserves. The clients point out: • Average decline rates of shale gas production are far above oil—roughly 70% in the first year. • The well-managed companies which acquired big land spreads before the operational challenges to horizontal drilling and fracking were fully resolved are profitable at $7 gas.

How cold does it have to get to absorb all the gas being developed?

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• The US Energy Dept’s production statistics aren’t credible. A Wall Street Journal story (April 5, 2010) reported that the Department now realizes “it has been overstating output…The Energy Information Administration, the statistical unit of the Energy Department has uncovered a fundamental problem in the way it collects data from producers across the country—it surveys only large producers and extrapolates findings across the industry…the EIA plans to change its methodology this month resulting in ‘significant’ downward revisions in some areas.” Some of the big gas producers, such as EOG Resources, argue that the EIA’s overstatements “helped push prices to seven-year lows in 2009….the EIA data showed that gas supply rose 4% in 2009 despite a 60% decline in onshore gas rigs.” The margin for error is said by industry people to be about 10%. “’It’s getting ridiculously large,” said Ben Dell, analyst with Sanford C. Bernstein.” We have read some of Bernstein’s well-researched and strongly bullish studies on natgas and can understand why they would be upset about the government’s sloppy work. This recalls our oft-told tale about the OECD’s energy division, the Parisbased International Energy Agency, which under-estimated oil consumption, year after year. They finally admitted that they hadn’t bothered to research China’s consumption carefully, “because it isn’t a member of the OECD.” We have routinely characterized the staff of this agency as tax-exempt boulevardiers living splendidly in Paris, luxuriating in enviable job security, because, although they were always wrong, they still managed to live well in an expensive and beautiful city. We don’t know whether the Washington-based staff of the EIA are frères sous la peau of those boulevardiers, (although Washington was built on a Parisian model), but we aren’t surprised that those worthies find it pleasanter to make a few phone calls to people they know at EOG, XTO and other biggies, rather than trekking around Midland, Henry Hub, and other such oil centers to talk to bosses of small operating firms who may lack a proper appreciation of the intelligence and insight of experts from Washington, and may actually not understand the nuances of Obaman energy policy.

They finally admitted that they hadn’t bothered to research China’s consumption carefully, “because it isn’t a member of the OECD.”

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But, just as those sustained UN faux pas didn’t hold back the oil boom, we’re not sure that rectifying the EIA’s data will drive gas prices skyward. Natgas for delivery during the prospective mid-December chills of yearend 2012 is only priced at $6.20—a week after the release of the Wall Street Journal story— which had no apparent effect on gas prices. What counts is gas in storage, and those numbers presumably aren’t fiddled, because that would constitute fraud. What also counts is published industry estimates of how much gas that wasn’t counted in the national inventory five years ago is now counted as probable and possible because of technology breakthroughs—and it is huge. Again, clients tell us all that gas won’t be hitting the market because so many small operators will go bankrupt. But we like scarcity stories, not surplus stories where only the fittest and the fibbers survive. From our perspective, the following tentative conclusions can be drawn: 1. Natgas will remain alluringly cheap relative to oil, and will gain market share where substitution is feasible—such as in chemicals and plastics. 2. Natgas will gain market share in industrial heating from residual oil. 3. Those gigantic LNG projects in Qatar and Iran will not proceed as rapidly as had been assumed. 4. There will be no further LNG deals that involve shipments into the US east coast or California. 5. The native groups that managed to stall the various Arctic pipeline projects have done a big favor to Big Oil, and have done great disservice to Sarah Palin and the taxpayers of Alaska. Those projects will not proceed. If and when the pipelines are eventually built, it will be because the Chinese owners of the resources will have ordered the construction and obtained compliance from any unruly natives. 6. If, as industry experts expect, there are huge shale and tight gas opportunities in central Europe, that will be splendid news for the Eurozone and will offset some of the economic problems from grunting and growling PIIGS.

But we like scarcity stories, not surplus stories where only the fittest and the fibbers survive.

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7. In that case, Putin’s power over pusillanimous politicians in Western Europe will shrink sharply. This could turn out to be the best news for Western European lovers of liberty since the Fall of Bolshevism in Russia. 8. If natgas remains plentiful and cheap, it will begin to invade oil’s dominance in transportation. Already, thanks to T. Boone Pickens-promoted subsidies, it is attracting interest from government-related trucks and buses. Perhaps Washington will make natgas the next ethanol, replete with subsidies, tariffs, and forced allocations—in which case demand would soar and prices would rise. As this was being written, we got some news about how EOG, a well-run oil and gas producer and one of the shale kingpins, is rebalancing its strategies. It is apparently not content to rely on the phantom valuation of reserves the SEC accepts. According to The Wall Street Journal, “It plans to boost production of crude oil, particularly unconventional shale oil. Those plans require higher capital expenditures of $5.1 billion this year. True, that is much more than the $3.5 billion Citigroup expects the company to make in operating cash flow. But EOG plans to sell up to $1.5 billion of gas assets to help bridge the gap.” Who will buy those assets and how will they be priced? We have some personal experience with this process because the only American shale gas-levered stock we held in the Coxe Commodity Strategy Fund (TSX: COX.UN) was XTO Energy—our hedge against being completely wrong about gas prices. We were pleased to be able to sell it very profitably when Exxon Mobil made its first major corporate acquisition since it bought Mobil. How profitable all that shale production will be for XOM remains to be seen, but those assets will do wonders for the acquirer’s Reserve Life Index, whose oil component has been falling almost as fast as the reserves in the Social Security Trust Fund. Sustained cheap gas and restrained oil prices are together good reason to feel more confident about the pricing outlook for industrial metals—and about the future profitability of some of the major gold mining companies. It is also a reason to feel more confident about farmers’ net incomes—which bodes well for the farm equipment manufacturers and fertilizer and seed producers. Perhaps Washington will make natgas the next ethanol, replete with subsidies, tariffs, and forced allocations...

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Greeks Bearing Gifts to Barack and Ben
Although the big mainstream media have been assuring us—day after day—that the best thing that has happened to his Presidency was getting the health care entitlement bill passed, we are inclined to the view that the best thing that has happened to his Administration—and to the Fed—is the sudden surge in support for the dollar.
US Dollar Index (DXY) January 1, 2002 to April 13, 2010
130 120 110 100 90 80 70 Jan-02 Nov-02 Sep-03 Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09 80.49

US Dollar – Yen January 1, 2002 to April 13, 2010
140 130 120 110 100 90 80 Jan-02 Nov-02 Sep-03 Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09 93.26

Euro – US Dollar January 1, 2002 to April 13, 2010
1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 Jan-02 Nov-02 Sep-03 Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09 1.36

Gold January 1, 2002 to April 13, 2010
1,200 1,100 1,000 900 800 700 600 500 400 300 200 Jan-02 Nov-02 Sep-03 Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09 1,152.40

Canadian Dollar – US Dollar January 1, 2002 to April 13, 2010
1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 1.00

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Since February 2002, when we announced at the BMO Resources Conference the dawn of the commodity era, we have been counseling clients to minimize their risks to the US dollar and to emphasize—in particular—Canadian dollar investments and gold. For most of the intervening period, the dollar has been weak against major tradable currencies. The exception came during the financial crisis, when overlevered players were forced to unwind exposure to American debt instruments. That process, plus a general tendency in panics to rush to the biggest of the alternatives, produced a powerful dollar rally. However, as the financial markets stabilized, and as publicity about the drastic deterioration in US finances became a weekly event, the dollar resumed its bear market. In recent weeks, the dollar has been rallying powerfully, despite continuing flows of negative reports about the Fed’s balance sheet, Washington’s deficits, Washington’s spending, the likely cost of major new programs (such as health care and cap and trade), and that the Social Security Trust Fund cash flow has gone negative six years ahead of schedule. In its time of need, the dollar is being rescued by the dramatic revisions of global investors’ appraisals of Greeks and other PIIGS. That term covers members of the Eurozone whose finances are as bad—or worse than—the US, including Portugal, Italy, Ireland, Greece and Spain. But the greatest of these is Greece, where the weekly news ranges from union leaders bewailing a new kind of Greek tragedy or commentators across the world musing about a new kind of Greek comedy. Greece’s fiscal deficit is listed at 12.5% of GDP, whereas eurozone members’ deficit is supposedly capped at 3% of GDP and its national debt is said to be near 130% of GDP. Those numbers would not, in themselves, constitute disaster if there were any evidence that Greece could, with short-term aid, become credit-worthy without reliance on the productive eurozone members and the IMF. But almost nobody believes that Greece can rein in its massive public sector with its massive benefits—including early retirement. Nor does almost anybody believe Greece can kickstart its economy by suddenly becoming strongly competitive. On the macro level, Greeks are better known for their charmingly casual approach to paying taxes and working efficiently. However, they share space in the world’s largest free trade zone with such industrious and thrifty people as the Germans, Dutch, and Austrians. In its time of need, the dollar is being rescued by the dramatic revisions of global investors’ appraisals of Greeks and other PIIGS.

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Greece has a storied past, as the founding culture of what would become the West. But its record since Alexander the Great’s time is of 22 centuries in which most of the news was bad, and heroes were few—or nonexistent. The rest of Europe is willing to buy Greek art treasures and Aegean islands, but little else that is Greek. The Glory that was Greece lives on in our neighborhood: atop the former Board of Trade Building that now houses the CME is a splendid statue of Ceres, the Greek goddess of agriculture. (Thankfully, those atheist activists who rage against any public religious displays have tolerated Ceres.) Greece’s economy is tiny, so why is its seemingly hopeless and half-hearted attempt to escape from its self-spawned Laocoönesque coils good news for Washington? Because, in foreign exchange markets, there are only three major trading zones—the dollar, the yen and the euro. Roughly 80% of all trades involve the dollar on one side. Until recently, investors wishing to escape from the dollar’s highly-publicized problems could choose the yen or the euro. Those escape routes are closing rapidly. The yen is the zero-yielding currency of a country whose demography is the worst in human history. Its population is set to fall by 50% by 2050— the equivalent of two waves of Black Death in slow motion. By 2100, the whole nation will resemble its Cabinets—average age over 65. This could, in theory, be a time of bliss and harmony, because Japanese have traditionally venerated the aged, who are assumed to be wise. However, it will not be an economy that could service today’s level of debts, let alone the stratospheric heights of the future. Soon the birth rate will be exceeded by the berth rate for desirable storage slots of ancestral ashes. Anyone with a yen for long-term Japanese bonds? Eurobonds were obviously a better bet—no matter the name of the borrower. Until Greece went from the obscurity which allowed it to peddle its bonds to investors abroad—and to the European Central bank—to Page One status as the Wastrel of the Western World, the euro was the currency of choice for currency traders and investors wishing to reduce their dollar risk. Investors are now beginning to realize that Greece is just the first and most malodorous of the eurozone’s PIIGS. Result: more and more foreign exchange funds and institutional investors are almost compelled to buy US-denominated debt.

The yen is the zero-yielding currency of a country whose demography is the worst in human history.

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Looking Ahead
The sad reality is that the eurozone outside the traditionally Protestant (and therefore traditionally capitalist) northern industrial states and France is uncompetitive. Apart from tourism, much of Europe has bad demography, bad public finances, and few competitive advantages. The US situation would surely be seen as grim by holders of Treasurys were it not being compared to the worsening situations in Japan and Europe. Britain is not in the eurozone, but its demography and public finances are almost as pitiful as the average PIIG’s, and the country is in an election campaign that matches a tired Labour government with whom the voters are fatigued, against a young Etonian whose resemblance to Thatcher is no greater mentally than it is physically. This callow candidate of great ancestry and even greater ambitions has been known to praise Saul Alinsky, the Marxist community organizer called “The Father of modern American radicalism” who inspired ACORN and the young Obama. The voters do not get to choose “None of the Above.” Tony Blair, driven from office by his support of Bush in Iraq, looks better and better—but he is only slightly more available as a rescuer than Churchill.
British Pound – US Dollar January 1, 2006 to April 13, 2010
2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 1.54

Apart from tourism, much of Europe has bad demography, bad public finances, and few competitive advantages.

Switzerland is not part of the EU, but even the classic haven Swiss franc risks looking less and less Alpine and more and more like what Hannibal’s elephants left behind. Its bailed-out banks are reporting robust trading profits redeploying their government-guaranteed deposits, but much of the economy is high-cost, and Swiss demography resembles the rest of aging Europe.

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Swiss Franc – US Dollar January 1, 2006 to April 13, 2010
1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 0.95

So which tradable paper currencies are still stores of value?
Canadian Dollar – US Dollar January 1, 2006 to April 13, 2010
1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 1.00

Australian Dollar – US Dollar January 1, 2006 to April 13, 2010
1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 0.55 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 0.93

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The only heavyweight among the tradable currencies is the Indian rupee:
US Dollar – Rupee March 1, 2008 to April 13, 2010
53 51 49 47 45 43 41 39 Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10 44.32

...the US dollar is now first among the worst big alternatives to gold.

We have no chart on the untraded renminbi, which is likely going to be revalued upward modestly. Conclusion: the US dollar is now first among the worst big alternatives to gold. The turnaround in the dollar has already had its effect on some Asian central banks. They had begun unloading greenbacks in favor of euros—partly because they have more trade with Europe than the US, but mostly because the dollar’s highly-publicized problems scared them at a time when total global forex reserves were roughly two-thirds in Treasurys. So we’ve seen greater central bank participation in some recent Treasury auctions. This must please Barack and Ben. When you know that in the next year you’re going to be rolling over more than a trillion in outstanding Treasury paper and adding another trillion to the supply, you’d like to think there are some buyers other than local banks who are buying your stuff because they are so financially emasculated they can’t make new loans.

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A Commodity Bull Market Coexisting With a Dollar Bull Market?
The shrewd Jim Rogers was once asked why anyone should buy gold when there was seemingly no inflation. He cited the current account and Treasury deficits and said, “Just do the math.” As a general—and very useful—rule, the days the dollar is strong are days commodities and commodity stocks are weak. History shows that the greatest commodity bull market—the 1970s—was a time of severe dollar weakness, and the Triple Waterfall Crash of commodities came during a long, strong dollar bull market. So, we are asked, can we have a commodity bull market coexisting with a dollar bull market? In a word: Yes. We have come to believe that this Odd Couple can coexist if investors conclude that bonds are no haven, and economic growth remains much stronger in the key Asian economies than in the US or Europe. Why? Because the 1970s commodity boom was an inflation-hedge boom. US inflation surged from 4% to 14% and there were three recessions within a decade. That commodities other than gold performed well was because investors learned that buying “out month” commodity futures was a hedge against inflation. Result: base metals piled up in storage because of inflation fears, while demand was erratic because of recessions. We try to resist “New Era” thinking, but current conditions are collectively unique: 1. OECD government fiscal deficits totaling more than $4 trillion. 2. Government bailouts totaling more than $1 trillion. 3. Debt/GDP ratios at unheard-of levels—both government debt/GDP and total debt/GDP. 4. Global economic leadership now coming from China, India, Korea and Taiwan, not from the US and Europe.

“Just do the math.”

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5. Housing bear markets across much of the OECD with government housing price supports at unprecedented and unsustainable levels. 6. US State and local debt ratios at horrendous levels even before realistic costing of liabilities under employee pension and medical plans. We live in Illinois, which ranks just behind California for the scale of its unfunded employee pensions. A Stanford team recently costed out the unfunded portion of California’s state pensions at $500 billion—which is roughly seven times the total amount of state general obligation bonds outstanding. Illinois and California would need years of GDP growth at China’s rate to make their existing debts manageable—and many other states are in similar crises. One example of why the Canadian dollar is so strong relative to the greenback: Everyone has always known that Social Security was headed for trouble, but we were told its cash flow wouldn’t turn negative until 2019; then 2016. It goes negative this year and that means the “fund” is evaporating quite rapidly. (Remember when the Democrats savaged Bush’s plans for Social Security savings accounts by telling frightened voters that Bush would be taking their money from its safe piggy bank where it was being kept for them? Great politics.) The Social Security Trust Fund, which is a mere bookkeeping entry, “invests” in Treasurys at the approximate duration of the national debt. We appeared before the US Senate Finance Committee in 1988 to testify about what was wrong with the Fund. We criticized its investing strategy, pointing out that any private plan with long-term liabilities that invested in what was then a 7-year duration would be shut down. We argued the Fund should be getting the benefit of the high interest rates available on long Treasurys. Senator Moynihan called our testimony “powerful,’ but told me he couldn’t rally any votes for it because the Treasury was saving money by paying such low yields into the fund, and if Social Security invested in long bonds it would increase the reported fiscal deficit. Result: all those years of double-digit and high-yielding Treasurys came and went and Social Security only briefly prospered.

A Stanford team recently costed out the unfunded portion of California’s state pensions at $500 billion...

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Compare that experience to the Canada Pension Plan, which for its early years (until the 1990s) invested in 20-year provincial government bonds whose blended real yields were high, then switched, as the bonds mature, to investing in market instruments managed by skilled professionals at the Canada Pension Plan Investment Board. The CPP isn’t fully-funded, but its market rate returns mean that its assets will keep growing for decades. Chile and Norway may be the only nations with better-financed public pension systems. We conclude that the US will continue to look somewhat attractive compared to Europe, and so there will continue to be demand for Treasurys relative to bonds issued by European governments other than the leading countries. The commodity bull market in this decade will be driven by (1) industrial demand for raw materials; (2) sustained demand for petroleum; (3) continued protein upgrades in diets in emerging and emergent economies, and (4) greater reliance on precious metals as stores of value—not necessarily as hedges against actual inflation. Inflation could in fact come with a rush if the global economy turns strong, government deficits stay high, and real yields on government bonds turn sharply negative. At the moment, measured inflation remains subdued because of heavy unemployment and large percentages of unused capacity across the OECD.

...what is the difference between a store of value and an inflation hedge?

Gold
What is the difference between a store of value and an inflation hedge? Answer: a store of value at least maintains its market value under widely varying economic conditions and widely-varying or steadily-rising inflation; an inflation hedge is an asset bought and held to produce big profits when inflation is high and rising—and investors think it’s going to rise even faster. Gold ran from $38 to $850 when inflation ran from 5% to as high as 14%, but annual inflation during that period averaged in the high single digits. Once gold’s price was running far faster than inflation, it ceased to be a true store of value and became a speculative hedge—ultimately against inflation that Paul Volcker was about to terminate.

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The Changing Scene on the Farms
We have made Agriculture an investment priority since 2006. One reason it deserves inclusion in all commodity portfolios is that its drivers are not closely correlated with those influencing prices of metals and energy. What drives agricultural stock price performance is farm incomes—notably those of the producers of corn, wheat, and soybeans. Although farmers’ costs can—and sometimes do—rise faster than grain prices, stock price changes are more closely correlated to grain prices than to GDP growth, employment data, overall corporate profits or the performance of the S&P.
Monsanto (MON) January 1, 2005 to April 13, 2010
140 120 100 80 60 40 20 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10 67.75

...stock price changes are more closely correlated to grain prices than to GDP growth, employment data, overall corporate profits or the performance of the S&P.

Potash (NYSE: POT) January 1, 2005 to April 13, 2010
250 225 200 175 150 125 100 75 50 25 0 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10 112.21

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Mosaic (MOS) January 1, 2005 to April 13, 2010
180 160 140 120 100 80 60 40 20 0 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10 56.78

Deere (DE) January 1, 2005 to April 13, 2010
100 90 80 70 60 50 40 30 20 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10 61.54

CNH Global January 1, 2005 to April 13, 2010
70 60 50 40 30 20 10 0 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10 32.84

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Corn January 1, 2005 to April 13, 2010
850 750 650 550 450 350 250 150 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10 350.50

Soybeans January 1, 2005 to April 13, 2010
1,700 1,500 1,300 1,100 900 700 500 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10 968.00

Wheat January 1, 2005 to April 13, 2010
1,250 1,150 1,050 950 850 750 650 550 450 350 250 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08 Feb-09 Sep-09 Apr-10 476.00

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As the charts show, the world’s realization that its crop carryovers were shrinking slowly took a while to translate into a bull market for grains. In part, there was complacency: there’s always more corn and wheat than we need; in part, there was investors’ multi-decade conviction that grain farmers were pampered by governments so outrageously that there would always be surpluses; in part, there was sustained good weather: the kind of short growing seasons seen during the mid-1970s were rarely repeated. We said after our trip to India in 2006 that agriculture would be the next commodity bull market. It was clear to us that steadily-increasing demand for higher protein diets was inevitable. Since total hectares under cultivation worldwide were increasing almost imperceptibly, what was needed was sustained increase in per-hectare output. Needed: genetically-modified seeds, more fertilizer (and more precision in its usage), and greater use of advanced farm machinery. For a while, that concept became a financial cornucopia for clients. And then came the Crash, and suddenly the surpluses were back. This year’s global grain crop of corn, soybeans and wheat looks like a record, and it comes at a time of carryovers reminiscent of the grim old days. This is profoundly good news for the human race. The last thing we need would be a major food crisis that sent prices of basic grains to levels that drove millions into starvation and derailed the powerful economic recoveries in China, India and Indonesia. But what is good for the human race and for investors in other commodities is bad news for investors in agricultural stocks. We have been recommending in Conference Calls that clients reduce their exposure to farm inputs (other than machinery), and invest in companies which win from cheap grains—producers of beef, pork and chicken.

But what is good for the human race and for investors in other commodities is bad news for investors in agricultural stocks.

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Tyson Foods (TSN) January 1, 2009 to April 13, 2010
21 19 17 15 13 11 9 7 5 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 20.07

Sanderson Farms (SAFM) January 1, 2009 to April 13, 2010
60 55 50 45 40 35 30 25 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 57.93

Smithfield Foods (SFD) January 1, 2009 to April 13, 2010
24 22 20 18 16 14 12 10 8 6 4 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 19.94

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The ethanol story, which has long been a colorful tale of politics, mendacity and greed, has recently taken a new twist. Look, Ma, it’s for real! Ethanol’s profitability depends on the spread between gasoline prices— which are driven by oil prices, and the cost of corn and natural gas. (This formula ignores the subsidies paid to refiners and the punitive tariffs against Brazilian cane sugar ethanol, which is in line with the rule that ethanol is The fuel that dare not speak its cost.) The Upper Midwest became dotted with ethanol plants in the days of cheap corn, and many of them went bankrupt when corn and natgas prices rose more than oil prices. Our enthusiasm for agricultural stocks that collectively contribute to reducing the global shortage of vegetable and animal protein has been reflected in these pages and in our public involvement in conferences about global food problems. For example, we wrote the analysis of the global food situation used by the participants in the 2009 G20 meeting in Pittsburgh. Because of our strong conviction of investing in companies whose products and services alleviate hunger and promote health worldwide, we have avoided investing in ethanol companies in our Fund. In our view, corn ethanol contributes to the global shortage of food, and remains in the market only because of the toxic combination of bad politics, bad science, and bad propaganda. However, we are modifying that view slightly. First, we realize that not all our investors share our passionately-held views about the evils and false pricing of ethanol. Secondly, low corn and natural gas prices now combine with high oil prices to create a market for ethanol that is at least partly based on honest economics—a remarkable novelty for ethanol. So we have made an investment for the Fund in a large ethanol producer. When we then read of Brazil’s retaliation against the US ethanol industry for its punitive tariffs on Brazil’s sugar-based ethanol, we felt the first guilt we have experienced in making investments for the Fund. Nevertheless, we are forced to recommend these stocks to clients who believe that “Conscience doth make cowards of us all.”

...ethanol is The fuel that dare not speak its cost.

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Jimmy Cartesianism?
The health care bill is now law, and the nation will soon be discovering the true size of the bills it must pay. There was a long-felt national consensus that no one should be denied health care through inability to pay, and that the US must cease to be the only major industrial nation lacking universal health care. Those are commendable sentiments—and we share them. As Canadians, we are well aware of the benefits and the limitations of that nation’s universal system—depending in which province one resides and which maladies one suffers. We also have several personal experiences with the high quality of emergency services that system provides, and can attest that it is a far, far better thing to visit an emergency room in downtown Toronto than its counterpart in Chicago. We also find much of the Republican oratory about the “horrors of socialized medicine” to be the kind of tired, toxic demagogy we had long believed to be the preserve of the gaseous Left. Nevertheless, what the sausage-making process in the Democratic-controlled Congress finally excreted is execrable. Not only because—like Mitt Romney’s Massachusetts Medicare program that he doesn’t want anyone to remind Republican voters to think about—it encourages people with health problems to take out health insurance just before seeing a doctor—and lapsing it thereafter. And not just because of the deals done with doubting Democrats to buy their votes—such as the Second Louisiana Purchase and the Cornhusker Kickback. But because it not only failed to address the most serious malignancy in the US health care system—but it built in provisions that will make that horror far worse. We speak of the tort law system, which is unique in the world, and uniquely vile in the world. How? By (1) failing to assign legal costs to losers in lawsuits, thereby stimulating vexatious suits, and (2), by allowing judges’ election costs in the many “hellhole” judicial districts to be financed largely by the plaintiffs’ lawyers who practice in those courts, and (3), by requiring juries—rather than judges—to make fact-findings on extremely technical medical questions in response to seductive sob stories—the kind that made John Edwards a multi-millionaire. Result: the system is shot through with extra costs for extra tests, and extra costs for liability insurance for hospitals and doctors. We understand that,

...the tort law system, which is unique in the world, and uniquely vile in the world.

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next only to money from unions, the Democrats’ biggest funding support comes from tort lawyers. Obama did nothing to cut off such a rich vein of support for him and his party, and for health care’s contribution to making America the most over-lawyered economy in the world, and its health care system the costliest in the world. Actually, he did a lot to make the situation worse—by introducing hundreds of new rules and claim categories that will be fertile future fields for litigation against doctors, hospitals and health insurers. History may conclude that this was among the more successful job-growth-creating laws he sponsored. Meanwhile, as fighting the health care battle was forcing the President to cancel trips abroad to see allies fighting with his troops in Afghanistan, the world was reviewing the President’s various foreign policy initiatives and drawing its conclusions. The clearest pattern, as so many critics have noted, is Obama’s urge to ignore, rebuke and/or be openly rude to long-time friends and allies of America, while playing up to nations that have been long-time problems to America. His treatment of Gordon Brown and Britain has received the widest press coverage. It began when Obama sent back to London the bust of Churchill Tony Blair had presented to America. He didn’t offer it to any other government offices—or even to any major universities or foundations. He just sent it back. He made no attempt to rebut press reports that this was because his Kenyan father, who may have had Mau-Mau connections, was badly treated by British officials during the long Kikuyu-led rebellion. When Brown visited the White House, and presented him with some wellchosen gifts, Obama responded with 25 DVDs of popular American movies. Brown returned to Number Ten and tried the first, and found they were unplayable on British TV sets. Had Obama made any effort to contact any of the 90% or so of the Hollywood glitterati who supported him, they could doubtless have warned him of a digital incompatibility that could trigger some other kinds of incompatibility. In Central America, he backed the outgoing, unpopular leftist President who proposed, Chavez-style, a referendum to overturn the constitutional provision that he could not remain in power. The Supreme Court had declared that challenge unconstitutional. The legislature had installed a

...the Hollywood glitterati who supported him... could doubtless have warned him of a digital incompatibility that could trigger some other kinds of incompatibility.

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successor who agreed to run in the scheduled election in November. Despite attempts by Venezuela and Cuba to intervene, Hondurans held firm, and the temporary President, Porfirio Lobo, was resoundingly re-elected. Obama was forced to accept the clear democratic decision in Honduras, which was against the enthusiasm of the more vocal American Left who wanted to back up the neo-Chavista. (These are the same people who continue to prevent Congressional ratification of the free trade deal with Colombia, which is in bad odor with the global Left for winning its long guerrilla war with the Chavez-backed FARC Marxists.) His relations with Israel’s Premier Benjamin Netanyahu rather rapidly deteriorated from cordiality to leaving him alone at dinner on a White House visit. The issues were the building in Jerusalem of new housing for UltraOrthodox Jews—who are known both for their un-Israeli fertility rates (vast) and their un-Israeli attitude to military service (exempt). Netanyahu was blindsided while Biden was in Jerusalem by the public announcement that the controversial building project was approved: in his diverse and raucous coalition, the various parties divide up the Cabinet posts and patronage and power appurtenant thereto. Obama understood that Netanyahu had been caught off guard, but chose to make this a full-scale confrontation. The governments of Czechoslovakia, Eastern Europe and the Baltic region were given no advance notice of his sudden decision to deny them the Bushpromised protective coverage against attack through a US-developed missile warning system. Not being an historian, Obama probably had not realized that the date of his revocation of a US pledge of protection was 70 years to the day that Germany invaded Poland. But the people in those nations certainly did. Symbols sometimes count. Other long-time friends and allies of the US have been complaining about coolness or rudeness from Obama. In sharp contrast, he has actively and almost slavishly courted some of the most troublesome nations and odious leaders in the world. He nearly fawned on Ahmadinejad of Iran and then stayed silent as the regime was beating, gassing and torturing demonstrators against its brutalities and usurpations. He was seen smiling with Russian Premier Medvedev, as they signed a nuclear arms reduction agreement in which the US gave up far more than Russia.

...Colombia, which is in bad odor with the global Left for winning its long guerrilla war with the Chavez-backed FARC Marxists.

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It came after Obama announced an “historic” change in American nuclear policies, including an announcement about limiting the kinds of attacks with weapons of mass destruction that could trigger a US nuclear response. (Investor’s Business Daily’s cartoonist summed up the revision with a sketch of a wall plastered with warnings of protection by powerful dogs. Right in the middle was a sign saying “Welcome: we’ve locked up the dogs!”) Long-time members of the bipartisan foreign policy establishment have been reacting with dismay to this unilateral reduction in America’s proclaimed willingness to use—if necessary—its entire strategic arsenal to defend itself and its allies. Their analysis is that, at root, Obama denies what most Americans—and most Presidents except Carter—strongly believe in: American exceptionalism. Reagan spoke powerfully to this deep conviction that America is different because it has always stood for—and fought for—freedom. Obama is a Kumbaya-style new-ager with a commendable belief in human brotherhood and sisterhood. However he seems also to believe that appealing to those instincts in “the people” can make the troublesome nations of the world peace-loving, regardless of what the dictators in those nations believe. His eloquence and glamour make him a unique global force in transmitting America’s peaceful intents and support for basic human values. But then, during some of these gauzy and glorious effusions, he becomes unable to resist overenthusiasm for inclusiveness, and mixes both his metaphors and messages. His Easter message was typical: he pointed out that Easter time has always been an important part of American traditions, because of its Christian and Jewish associations. But then he said, “But Islam also always been part of American traditions.” Head-scratchers searching to find Islam in American history found the Barbary pirates, who could justly claim some credit for the creation of the US Navy and Marines, but no Islamic Congressmen, Senators or Governors or university or union presidents or Nobel or Pulitzer Prize-Winners until very recent times. We would all have applauded him had he sent greetings to Muslims at the time of this sacred season for Jews and Christians, but he wasn’t content with the exceptionalism in American historical traditions. He had to deny it.

...at root, Obama denies what most Americans— and most Presidents except Carter— strongly believe in: American exceptionalism.

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More than one commentator has observed in the past week that the core value of America to its allies since the founding of NATO has always been its announced willingness to use, if necessary, all its power to protect itself and them. Even the ban-the-bomb political leaders abroad surely slept better knowing that Russia would not feel free to invade a free ally of the US as it had Hungary and Czechoslovakia. Being the unchallenged superpower who stands ready to protect its allies has always meant basic buying power for the dollar, even when the economic and financial fundamentals were less than benign. JFK, Nixon and Reagan were, at times, explicit that those allies not making large troop commitments to NATO’s responsibilities were expected to—at the very least—offset the balance of payments costs to the US of its troops and weaponry abroad, and to make an indirect contribution for Pentagon nuclear research and modernization by their purchases of Treasurys. Part of Obama’s announcement of the drastic policy shift was abandonment of the program of upgrading the nuclear arsenal through testing, research and modernization—as Russia is doing, despite the likelihood that both South Korea and Iran will have advanced nuclear weaponry. It is no exaggeration to say that Obama’s increasing commitment to what one wit called “Jimmy Cartesianism” will surely erode the fear component of respect that so many nations unfriendly to America have long harbored. That helps explain the uncharacteristically Russian smile on Medvedev, when he proclaimed how much he approved Obama virtually unilateral offer. Not even Danny Kaye could have flashed a bigger smile. The frowns were left for friends. Writing in the Washington Post, Charles Krauthammer delivered a broadside against the new Obama nuclear policy. It asserts that if the US or any ally is attacked with biological or chemical or other weapons of mass destruction by a country that is compliant with the Nuclear Proliferation Treaty, the US will not retaliate with nuclear arms. He calls it “insane.” He notes that this is equivalent to a situation in which, if a terrorist on US soil drives a vehicle at high speed into a crowd, killing hundreds, he would face hanging unless his vehicle passed an emissions compliance test, in which case 100 days of community service might be allotted. Being the unchallenged superpower who stands ready to protect its allies has always meant basic buying power for the dollar, even when the economic and financial fundamentals were less than benign.

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Conclusion
Obama’s policy of disarming hostile nations with his charm and with apologies for everything “bad” the US has ever done, and his oft-repeated protestations of peaceful intent have undoubtedly delighted many people abroad who have been raised on the intellectual fodder that the US is to blame for all the misery in the world that hasn’t been caused by Israel and the former colonial powers. He has, in his policies toward Iran and Syria, and, to a lesser extent, North Korea displayed the faith in the sense and restraint of nations with long records of hostility to the US that characterized Neville Chamberlain’s late1930s policies toward Hitler’s Germany. Indeed, some of his most vocal American critics compare him to Chamberlain. As is so often the case with the enthusiastically under-educated, the comparison is faulty. The great difference between them is that Chamberlain was acutely aware of how unprepared Britain was for war when he agreed at Munich to the partition of Czechoslovakia, and was, in part, buying time while he frantically bought planes and ships. Had war come in 1938, he would not have had enough Spitfires, Hurricanes and cruisers to have withstood an all-out German air attack, as precursor to a waterborne invasion. As it was, his successor, Churchill, barely won “The Battle of Britain” with the increased supply that another 15 months’ production had made available. In contrast, while Obama tries to make hostile nations see the light of sweet reason, he is reducing American strategic arms, and cutting back on testing of missile defense systems—again, as evidence of good faith. Neville Chamberlain, Lord Halifax and the rest of the appeasement wing in London would have considered that policy unbelievably naïve.

...while Obama tries to make hostile nations see the light of sweet reason, he is reducing American strategic arms, and cutting back on testing of missile defense systems...

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Mr. Obama justifies the cutback in missile defense research and testing because the systems haven’t proved themselves and may never work effectively. He does not, however, apply that caution about wasteful spending to green technology; he is willing to impose heavy taxes, and bet hundreds of billions on finding and developing workable green technology because of the great risks from global warming. Now that is a risk he takes seriously. You can’t reason with Mother Nature. Some people might think there is far greater evidence that Islamic terrorism (a phrase he has banned from acceptable locution) and a nuclear Iran are greater threats to American survival than “climate change.” Are these thoughts relevant for investors, or just for foreign policy wonks? Warren Buffett has said publicly that a successful terrorist attack on America is almost inevitable. We can presume that the insurance companies in his portfolio are factoring in that probability.

Now that is a risk he takes seriously.

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A Slow Boat to China INVESTMENT ENVIRONMENT
1. The Improved Global Outlook The thrust of this essay is that the US is probably emerging from the black barrenness of recession into a relatively unknown territory, with hostile presences in the form of unmanageably high debt loads on Washington, the states, many key corporations, and millions of homes and consumers. There are other, more terrifying hostile presences, but there is little investors can do to hedge themselves against a drastic US foreign policy and/or homeland security breakdown. What we do know is that China is no longer an Emerging Market dependent on growing revenues in currencies stronger than its own. China actually ran a small trade deficit last month, a sign that (1) its export accounts cannot be expected to grow in the next few years—in percentage terms—as they have in the past decade, because the flaccid OECD economies cannot keep growing their purchases, and (2) that its own internal growth is proceeding far more rapidly, and absorbing more and more of its fast-growing imports of industrial raw materials. Doubtless the deficit was partly driven by heavy anticipatory Chinese purchases of metals whose prices were rising rapidly. (In addition, as reports from Long Beach show, more and more of the TEUs from China that used to go back empty are returning filled with Americanmade products. They aren’t likely to be DVDs that don’t work in China.) India’s economy keeps surprising on the upside, as does Indonesia’s. Those three nations—one largely Hindu, one largely Muslim, and the other largely capitalist—are collectively crucial components of global growth forecast. (Brazil is also large and growing, but commodity exports to China and India are core to its economic expansion, so it, like Australia, needs them to keep growing rapidly to expand its own economy.) 2. How to Play It Clients may find it very hard to accept a revised investment strategy aimed at participation in global economic growth that leaves exposures to US equities at the minimal levels that we have been recommending right back to the recession. We missed the most recent leg of the S&P rally, but our commodity emphasis has served investors well.

India’s economy keeps surprising on the upside, as does Indonesia’s.

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What we are doing now is expanding the cyclical component of our investment portfolio strategy with the 12% allocation to commodities and commodity stocks. Pension funds have been building increasing exposure to commodities, mostly through the big, diversified funds that roll over their contracts as they near expiry. That program worked extremely well during the years of the Commodity Triple Waterfall, because commodity futures were nearly always in backwardation. That has not been the case for many commodities as a new bull market unfolds: out months sell at higher prices than front months, in what is called the contango formation. We continue to believe that the continuance of contangos is injurious for pension fund commodity fund investors, (who are classed by the regulators as Large Speculators). As long as front-month oil contracts are priced at a big discount to near-month contracts, speculators participating in the traditional commodity funds used by pension funds will continue to lose as their managers roll over the expiring contracts. We argue that the best way to participate in rising commodity prices is through investment in well-managed companies operating within one or more of the commodity sectors of global stock markets. The underlying value of those with long-duration, unhedged reserves in the ground in politically-secure regions rises as commodity prices rise. In addition, well-managed commodity companies deliver the benefits of other kinds of well-run companies, as their earnings gains will tend to rise faster than commodity prices—and they can also pay dividends and buy back stock. (Commodity companies resemble other kinds of business enterprises except that they have little or no control over the prices of their products.) 3. Geo-Political Risk? The combination of a strong rally in both the dollar and gold, accompanied by a strong rally in spot oil, without follow-through in the distant years of the futures curve, suggests to us that many investors and strategists have been analyzing President Obama’s strategic policies and believe that he has made Israel believe it’s alone facing Iran. That would sharply increase the chances of a desperate Israeli strike. Which would presumably be good news for holders of gold, crude oil, and near-term oil futures. We continue to believe that the continuance of contangos is injurious for pension fund commodity fund investors...

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And very bad news for most other asset classes. We, for no particularly well-thought-out reasons, remain hopeful that there will be no new military action involving Iran. But we would hardly be shocked if the Israelis were to launch a defensive strike tomorrow. We do not counsel hoarding oil and gold against purely geopolitical risks. Our advocacy of commodity stock investing is based on a best-case outcome of mostly global peace and rising global prosperity, with the engines of that growth located in Asia. Commodity stocks are still labeled “deep cyclicals” and are widely considered appropriate investments only when the US is experiencing very strong GDP growth and inflationary pressures are working into pricing models. For our story we just need the US and non-PIIGS Europe to putter along. The global scarcity statistics, heavily driven by the double-digit growth of China, will virtually guarantee good performance from well-chosen commodityoriented equities. Stage #2 of the Great Commodity Bull Market—in which China and India remain strong exporters but become even greater commodity importers—has begun. We recommend clients write tickets on slow boats to China.

For our story we just need the US and non-PIIGS Europe to putter along.

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A Slow Boat to China RECOMMENDED ASSET ALLOCATION
Our New Category for Asset Allocation
In this issue, we have recommended that pension funds respond to the evidence of sustained global growth without increasing their exposure to equities categorized by geography—a typical way pension funds structure their portfolios. Our Recommended Asset Allocation for US Pension Funds has always addressed capital market assets, and not real estate or the growing diversity of real asset investments. Together, globalization and technology have transformed the capital markets, and the traditional approach to classifying pension assets no longer fits our investment outlook. This month marks a dramatic shift—some might say a sea change—in the capital markets. We needed a fresh approach to express the investment asset allocation—and opportunities. We have added a new category “Commodities and Commodity Equities”. Although commodities are regarded as “real assets” and commodity stocks as “financial assets”, they have inherent commonality: like equities, commodities are publicly traded; they are equity-equivalent investments in the same underlying asset: a resource. Our new category brings these assets together to address an investment objective: investment in the industrialization of emerging markets: the greatest efflorescence of human economic liberty in history. Our experience with managing the Coxe Commodity Strategy Fund, a global fund, is that investors can add it to their existing equity portfolios and increase their exposure to commodity-oriented stocks with a targeted approach, rather than merely increasing exposure to Canadian and Australian indices and adding commodity subset ETFs from some other markets. We believe well-chosen commodity stocks will solidly outperform the traditional commodity funds—most importantly and obviously—as long as contangos are in force for key commodities such as oil. When one owns the shares of well-managed commodity producers with unhedged reserves in the ground in politically-secure areas of the world, one benefits more from a sustained commodity price increase than passive owners of that commodity. We shall be discussing the implementation of this strategy in greater detail next month. For now, we are recommending that clients’ portfolios be upgraded for greater global growth led by “Chindia” through this new category in the Asset Mix—rather than through simply allocating more money to regional stock markets that may or may not capture favorable commodity activity. This month we are introducing a new portfolio for Canadian pension funds because we see the divergence between Canadian and US financial assets as a longer-term phenomenon.

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A Slow Boat to China RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation Capital Markets Investments US Pension Funds
US Equities Foreign Equities European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Commodities and Commodity Equities Bonds US Bonds Canadian Bonds International Bonds Long-Term Inflation Hedged Bonds Cash Allocations 17 4 2 11 13 12 12 8 6 10 5 unch unch –5 unch –5 Change unch –1 unch unch –1

Bond Durations
US Canada International Years 5.25 5.00 4.50 Change unch unch unch

Global Exposure to Commodity Equities
Precious Metals Agriculture Energy Base Metals & Steel
We recommend these sector weightings to all clients for commodity exposure—whether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

32% 25% 22% 21%

Change –1 –5 unch +6

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A Slow Boat to China RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation Capital Markets Investments Canadian Pension Funds
Allocations Equities Canadian Equities US Equities European Equities Japanese, Korean & Australian Equities Emerging Markets Commodities and Commodity Equities Bonds Canadian Bonds - Index-Related - Long-term RRBs International Bonds Cash 20 10 3 3 14 10 Change

18 10 7 5

Bond Durations
US Canada International Years 5.25 5.00 4.50 Change unch unch unch

Global Exposure to Commodity Equities
Precious Metals Agriculture Energy Base Metals & Steel
We recommend these sector weightings to all clients for commodity exposure—whether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

32% 25% 22% 21%

Change –1 –5 unch +6

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A Slow Boat to China INVESTMENT RECOMMENDATIONS
1. Increase your equity-equivalent exposure through commodity stocks, emphasizing the mining stocks at the expense of agricultural and oil & gas stocks. 2. Canadian investors who use TSX-linked equity products should, nevertheless, increase their total exposure to commodity equities to reflect the better global outlook. 3. American investors who use S&P-linked products to participate in a strengthening global outlook are underweight commodity exposure and should adjust exposure upward accordingly. 4. Big Oil stocks are a blend of commodity companies and industrial companies. They dominate the raw materials section of the S&P, giving investors a false sense they have good commodity exposure. Underweight integrated oil companies in commodity portfolios 5. The accounting wheeze that equates six units of natgas to one of crude oil makes Big Oil in general and most oil and gas producers look like better commodity investments than their true product mix would justify. Overweight oil production and underweight gas production. 6. The oil sands companies are moving from open pit mining to SteamAssisted Gravity Drainage (SAGD) production methods, using natgas as fuel for melting the bitumen. Result: they are long oil and short natgas, which is a splendid strategy for investors. This week’s Sinopec purchase of Conoco Phillips’ 9% interest in Syncrude confirms the strategic value of that treasure trove that fashionable Greens love to deride. Continue to overweight the oil sands companies. 7. The combined strength of the KRE and BKX is more than mildly reassuring. We believe investors should feel quite safe in their equity commitments as long as that relative strength holds. The test may come when Bernanke withdraws the heroin, but most economists think that remains far off. This is a good time to emphasize cyclical equities within US portfolios—and to add to commodity exposure.

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8. Within agricultural stock portfolios, emphasize the equipment and logistics companies. Reduce exposure modestly to grain production, and increase it to production of meat—poultry, pork and beef. 9. Gold and silver have held up well in the face of strength in the dollar. Remain overweighted in the precious metals. The royalty and streaming stocks offer special attractions, because relatively few investors understand the companies’ beautiful business models, and the excellent execution of those models by shrewd managements. 10. Within global bond portfolios, continue to emphasize Canadian bonds. Within US bond portfolios, emphasize inflation-hedged TIPs. Within retail portfolios holding high exposure to cyclical stocks, hold some long-duration bonds as a hedge against a double-dip after the heroin is withdrawn.

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© Coxe Advisors LLP 2009. All rights reserved. Unauthorized reproduction, distribution, transmission or publication without the prior express written consent of Coxe Advisors LLP (“Coxe”) is strictly prohibited. Coxe is an investment adviser registered with the U.S. Securities and Exchange Commission. Nothing herein implies that the firm is recommended or approved by the United States government or any regulatory agency. Information, opinions, estimates, projections and other materials (referred to collectively herein as, “Information”) contained herein are provided as of the date hereof and are subject to change without notice. From time to time, Coxe publications may contain Information with regard to securities, commodities, derivatives or other investment assets (each referred to herein as an “Investment,” or collectively, the “Investments”), or investment strategies. Due to staggered publication dates, any Information contained herein may differ from Information contained in prior or subsequent publications. Information discussed herein may have been obtained from various unaffiliated third party sources believed to be reliable, but has not been independently verified by Coxe. Coxe makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions which may be contained herein, and accepts no liability whatsoever for any loss arising from any use of or reliance on such third party Information, whether relied upon by the recipient or user, or any other third party (including, without limitation, any customer of the recipient or user). Foreign currency denominated Investments are subject to fluctuations in exchange rates that could have a positive or adverse effect on the investor’s return. Unless otherwise stated, any pricing information in this publication is indicative only. No Information included herein constitutes a recommendation that any particular Investment or investment strategy is suitable for any specific person. Coxe publications are not intended as, and Coxe does not provide, investment advice tailored to the particular circumstances, investment objectives, and risk tolerances of any entity or individual. Coxe does not continuously follow any Investments or their issuers even if mentioned in a Coxe publication. Accordingly, users must regard each Coxe publication as providing stand-alone analysis as of the date of publication and should not expect continuing analysis or additional reports related to such Investments or their issuers. The Information contained herein is not to be construed as a solicitation for or an offer to buy or sell any referenced Investments, or any service related to such Investments, nor shall such Information be considered as individualized investment advice or as a recommendation to enter into any transaction. Coxe and any officer, employee or independent contractor of Coxe, may from time to time have long or short positions in any Investments discussed. Coxe’s principal, Mr. Coxe, and other access persons privy to information contained in a Coxe publication prior to publication, are restricted from entering into any transaction concerning any Investments discussed therein for the five days before and after publication, and are required to hold any such positions for a minimum of one month. Coxe may enter into distribution agreements with various unaffiliated third parties to redistribute its publications. To the extent that any publication is reproduced, redistributed, or retransmitted, Coxe is not privy to, and makes no representations regarding, such unaffiliated third parties’ positions in any Investments discussed therein. Any distributor authorized by agreement with Coxe to redistribute this publication is not affiliated with Coxe. Third parties having permission to reproduce, redistribute, or retransmit Coxe publications may offer to effect transactions in some or all discussed Investments. Coxe makes no recommendation with respect to the use of any particular brokers or agents, and no such recommendation should be inferred by virtue of any distribution agreements that Coxe may enter into with third parties.

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