The expectation of lower prices is a very hard thing to break.  It is the inverse of inflationary expectations that we experienced in the late 1970’s and which required short term interest rates of over 20% and mortgage rates of 16% to finally break.  What can be done to avert deflation?  Short term interest rates are now close to zero, so they can’t be lowered.  If mortgage rates could be reduced to eye-poppingly low levels - say 2% - that might help turn around the real estate market, which is probably the first thing that is likely to turn and the thing that must turn in order to reduce deflationary expectations.  

The other prescription for defeating deflation, of course, is “the stimulus,”  the vast federal spending program that is now the focus of all discussion.  Can Team Obama turn our economic lemon into a tasty lemonade of new energy savings, environmental protection, and social reformations like universal health care insurance that we need for the long term and in the process create enough new economic momentum and jobs to bring growth back to the economy?  That is the $64 question.  Obviously nobody knows the answer; we’ll simply have to see what happens.    

My Investments

As the above logic dictates, I am largely in cash.  I’m not betting that Team Obama will or will not succeed.  I’m trying to avoid being sucked into the market by bear market rallies.

The few equity positions I have relate to special situations.  I own Lynas, (LYSCF) an Australian company that is opening the world’s largest deposit of Rare Earth Elements, minerals that are required for  many applications including nickel metal-hydride batteries (now in nearly all hybrid cars presently on the market, and still baked into many new hybrid cars planned for future introduction).  REE’s are coming into shorter supply as China - the major supplier - reduces its export quotas (recently by 32% with potentially more reductions coming).  Lynas, a 25 cent stock, is a startup with production projected for late 2009.  It seems to have outstanding management and financial backing (although, post-Madoff, who can have any confidence in judgements about people?).

I own some shares of Boone Pickens’ natural gas supply company, Clean Energy Fuels Corp (CLNE).  He is developing the natural gas supply business for truck fleets in this country.  Like everything in the market, the price of this company is way down.  Analysts expect it to become profitable this year.  I suspect there will be a slow transition toward natural gas for trucks.   

I own some SQM, the Chilean minerals company about which I have written a great deal.  In addition to its wonderful fertilizer and iodine businesses, SQM is the largest supplier of lithium, which may become a substantial part of the new electric car business. 

When the economic clouds begin to pass - some months (or years) after Team Obama’s stimulus plan is passed and implemented at a cost of trill-a-dollars - there will be a move away from fear and towards greed, an anticipation of inflationary trends, and also a revulsion at the huge amount of debt that the U.S. government has put on its books.  At that point the latest bubble, the high price of U.S. bonds, will burst, interest rates will rise, and the prices of bonds will fall.  One will want to own an ETF that rises as bond prices fall.  Such an ETF trades under the symbol TBT and I own some shares. 

TBT is part of what I call my “farm system,” a stable of stocks that I know I’ll want to own later but would like to watch the movement of in the meantime.  So I own a few shares (and I mean few) of TBT along with some real estate trusts, battery makers, and assorted “growth” vehicles - companies with business plans that make sense and/or stock prices that are crazy-low in any world except a deflationary one.  One that I own in moderate size is TBS International (TBSI), a shipping company with a unique business plan that separates it from commodity shippers and makes its revenue less tied to the Baltic Dry Index, which is now in the pooper. 

I also own some income producing stocks like Annaly Capital (NLY), Inergy (NRGY), Energy Transfer Partners (ETP), a pipeline company, and Brookfield Asset Management (BAM).   They have attractive dividend yields and I think they have manageable risks in terms of a deflationary economy.   Do your own research - on everything. 

In short, I’m trying to dance to the strange and difficult music being played by this dangerous market - a market that is now eating up equity values but eventually will provide huge opportunities.   I won’t get my cash to work at the exact bottom so I’ll miss some of those early gains.  But in an economy that seems to be falling into deflation, which can last for an indeterminate period, I want to keep a lot of my funds in cash. 

Oil Investing

With oil now sitting at the mid-$30 level investors must ask, “How low can oil go and for how long can it stay there?”   As I wrote recently, there are two conditions to the oil market - too much and too little.  At this time there is clearly too much oil.  When there is too much oil it is priced more or less at the marginal cost of production, that is somewhere above the cost of the most expensive oil needed to supply the market.  Here is a chart that provides some insight on that cost: 

It shows average costs including the cost of reserve additions, not marginal costs, and it relates only to U.S. oil imports.  What’s interesting, though, is the clear trend toward much higher costs for offshore oil, but also the rising costs in recent years for all sources of oil.  There is still a lot of OPEC oil with under $10 a barrel lifting costs, but clearly a lot of the world’s oil is getting more expensive to bring to market. It’s possible that oil prices could go somewhat lower than today’s and stay there for some time, but it seems like the oil price is getting pretty close to a bottom.  So that’s one factor.

Another central factor in determining the marginal cost of production is OPEC.  Usually as demand for a product and its price fall the highest cost producers shut down first.  But OPEC attempts to manipulate the free market for oil so that it does not necessarily follow the laws of supply and demand.  OPEC shuts down the production of very cheap oil so there will be enough demand left for the world’s more expensive oil to require higher prices for its continued production, thereby lifting the price for all oil.

OPEC countries plus Russia and Mexico, having expanded their domestic spending commitments during recent times of high oil prices, are all now encountering increasingly difficult economic stress from low oil prices.  So concerned are the Saudis about the risks of low oil prices that they have reduced their own production even below their OPEC quota.  Thus a great battle is now emerging between oil producing countries that are desperate to raise prices and oil consuming countries that see high oil prices as both an economic threat and increasingly a national security threat.  

Consuming countries are increasingly working toward using less oil and finding alternatives, such as natural gas or biofuels.  Meanwhile efforts may be growing in the U.S.