What's Really Happening in Iraq - and Why it Matters to Investors

Soldiering on: Why Our Military Adventures Matter to Investors

By David Galland, The Casey Report

Recently, I read a book titled The Good Soldiers that also serves as an object lesson in the disconnect between what’s going on in Washington D.C. and reality. It was written by David Finkel, a Pulitzer-winning author, and it came to me via a friend who is going through a stage where she feels drawn to books about war, mostly about World War II. Showing flexibility, her interest has expanded to the ongoing conflict in Iraq – the theater of operations that serves as backdrop for The Good Soldiers.

Despite it going solidly against my literary preferences, I dragged the book along during a quick trip to Florida – a spur-of-the-moment thing to attend a golf school (I figured it was either that or get thrown off the local course for energetic exclamations of elaborate expletives resulting from my golf shots constantly flying off in unexpected and unwelcomed directions). Out of courtesy if nothing else, I figured I’d read a few pages of the book before putting it down – and so was surprised when it sucked me in, and kept me in, pretty much until I was finished.

The background story is that the author of the book traveled to Iraq with a battalion of U.S. soldiers sent as part of the “surge,” then lived with them for the 14 months of their deployment. As far as I can tell, he approached his topic with no overt political intentions – rather, he just wanted to document the war as experienced by a battalion operating from a small base in one of the worst corners of Baghdad.

As one might expect, as they departed from the United States for Baghdad, the soldiers and their brigade commander, Col. Ralph Kauzlarich, were full of fight, patriotism, and the confidence that only a chosen people can possess. It was, in their view, a just war and they deeply believed that in no time at all they'd use their superior war-making capabilities – supported by the sure knowledge that they held the moral high ground – to clean the bad guys out of Dodge and get the whole mess straightened out pronto.

Reality, however, turned out to be significantly different, starting with the fact that rather than being welcoming, the population was overtly hostile – so much so that almost every time the soldiers drove off the base (which was part of the daily routine), the locals would try to maim and kill them. And they had considerable success at it.

In addition to trying to kill them, the community’s leaders seemed uninterested in the outreach efforts the colonel was instructed to make, including an initiative to rebuild the sewers and fix the power and water delivery systems in the area around his command. Of course, it didn’t help that it was the blunt-force approach used by the U.S. military in capturing Baghdad that destroyed so much of the infrastructure in the first place. Regardless, all attempts at doing “good works” were stalled and disappointed at every turn, with billions of dollars wasted in the process.

As the book progresses, the author juxtaposes President Bush's and General Petraeus' rosy comments about how well the surge is working with the on-the-ground realities. And those realities are presented as raw and graphic as they are – with the tops of soldiers’ heads being taken off by IEDs, or burning to death in Humvees while friends watch helplessly.

So successful was the military and political leadership in convincing Congress and the media that the surge was a winning strategy that, to this day, its acceptance as a fact has become a meme throughout the body politic. Back on the ground in Iraq, however, the daily grinding down of the front-line forces continues apace.

During the period of time covered in The Good Soldiers, the Iraqi insurgent attacks lightened up only slightly – but only because the ruling mullah in the battalion’s area of operation unilaterally called a cease-fire. The resulting dialing-back of attacks on U.S. forces was immediately pounced upon by the military leadership and the Bush administration as proof that the surge was working.

That that wasn’t the case became clear the day the same mullah called off his cease-fire and hell opened up. One minute the area was relatively quiet – the next, the streets were filled with armed gunmen and snipers, and bombs were going off on what seemed like every corner.

One of the more remarkable aspects of the war, an aspect that largely goes unreported, was just how sophisticated the Iraqi opposition became in their attacks against the occupying forces. Not only did their roadside bombs become murderously powerful – so powerful that they could almost evaporate a fully armored Humvee – but the Iraqis began attacking the U.S. bases using everything from mortars to rockets and even homemade missiles.

The lob bomb, for example, was created out of propane tanks, filled with ball bearings and shrapnel, with a triggering device welded to the nose, and a rocket on the rear. In one instance, two large dump trucks drove near the base; after tilting up their backs to drop their loads, they revealed rails which were then used to guide a barrage of lob bombs, resulting in millions of dollars of damage to the American base.

By the end of the battalion’s stay, the soldiers were mentally and, in many cases, physically ruined. One chapter near the end of the book, which recounted Col. Kauzlarich’s visits to some of his wounded soldiers back in the States – soldiers who suffered truly catastrophic injuries – I had to skip after just a couple of pages. It was just too painful to read.

Lessons from The Good Soldiers…

There are a number of important lessons that can be derived from The Good Soldiers, including:

• The on-the-ground commanders and soldiers being sent into places like Iraq and Afghanistan have only the best of intentions. Though their reasons for joining up may vary, as they head off for war, most believe their leaders wouldn’t deploy them unless there was good reason to do so. Thus when it becomes clear to them just how ill-used they have been – that they have lost friends and limbs for no discernable purpose – it creates a deep sense of disillusionment. The odds of another Timothy McVeigh emerging from the crowd of returning vets are very high.
   
• Despite the U.S. government spending tens of millions of dollars a day in Iraq – with the total spent now approaching $1 trillion – the mission has accomplished nothing other than antagonizing the Iraqis whose doors the U.S. troops kick down regularly. When I say “accomplished nothing,” that is actually an overstatement. In fact, other than toppling Saddam, the outcome of the mission has been to create an everlasting antipathy between many Iraqis and the United States, blowing wind into the sails of the most radical elements of Iraqi society. What a mess.
   
• The U.S. occupation has turned into a very effective laboratory for the insurgents. At the beginning of the conflict, the resistance fighters were relatively weak – but as time has gone by, the natural ability of humans to adapt and improvise has led to the development of an array of inexpensive but seriously lethal antipersonnel weaponry. That these technologies are now spreading throughout the region can be seen in the recent death of eight U.S. soldiers in Afghanistan, in a single blast.
   
• Short of staging a scorched-earth form of warfare – turning these cities into parking lots – the U.S. cannot possibly ever win one of these conflicts. There is no fixed enemy that the U.S. can target with its superior weapons. And it’s unrealistic that the military can hunt down all of the opposition by going door to door.
   
• The U.S. political and military leadership is straight out lying to its troops and to the public at large. It is hard to comprehend why, but I dare you to read The Good Soldiers and come away with any other conclusion. Maybe they continue the tragic farce because to cut and run – as we ultimately did in Vietnam – is just too embarrassing. Maybe it’s because they are so effectively lobbied by the war profiteers – may they eventually rot in the hottest corner of hell. Maybe it’s because they are allowed to wage war from a safe distance (no politicians visited the forward operating base where Kauzlarich and his battalion were based during their stay there, and Petraeus only made a single, quick stopover).
  
  Meanwhile, the U.S. continues to bleed billions in these misguided wars, while the soldiers just bleed.

Someone, and probably a lot of people, should be held accountable for this travesty – as in being brought up on serious charges and, if found to have propagated lies resulting in the loss of lives and the wasting of hundreds of billions of dollars, sent to jail for a very, very long time. Or, better still, turned over to the Iraqis to punish. I’m sure they’d figure out something appropriately medieval.

Why This Is Important to Us as Investors

Given the urgency of addressing the U.S. debt and deficits, the bloated U.S. military budget is clearly the most obvious place to start making cuts that will actually matter. Yet Congress made no such cuts when passing the $690 billion budget requested by the Defense Department – doing so last week by an overwhelming margin.

That budget includes another $119 billion to flush down the toilets of Iraq and Afghanistan. Showing that it has learned no lessons, the Obama administration – encouraged no doubt by new friends in the military-industrial complex – has already managed to spend $750 million in the undeclared war on Libya.

There is a way to use this understanding that the bankrupt U.S. and its allies are doing little more than breaking furniture and making enemies in the Middle East to one’s advantage. Simply, unless and until the U.S. politicians muster enough spine to pull out of Iraq and Afghanistan and slash the military budget, the government’s massive budget deficits will continue.

And if the budget deficits continue, then the trend for the U.S. dollar is sharply downward (though I remain convinced we’ll see a rally in the near term, a topic we’ll be tackling in greater detail in the upcoming edition of The Casey Report).

That is not conjecture, but the unavoidable conclusion uncovered by a number of objective analyses done on past sovereign debt crises by folks such as Kenneth Rogoff and Casey’s Chief Economist Bud Conrad.

To those readers who think that cutting the military budget, or pulling out wholesale from the Middle East, will increase threats to the continental United States, we will have to agree to disagree. In my view, destroying our economy to wage war – in the process squandering the huge commercial advantage of providing the world its reserve currency – is far more destabilizing. As is making yet more enemies by continuing to lob bombs and kick in doors here, there, and everywhere.

Unfortunately, the U.S. leadership and, I guess, some significant swath of the voting public who supports that leadership are suffering from some sort of mass psychosis (or maybe it’s paranoia), that actually has them thinking that it is somehow in the country’s interest to continue flinging billions of dollars and the lives of its good soldiers into lost causes overseas.

But don’t take my word on the topic – do yourself a favor and pick up a copy of The Good Soldiers today. As I can’t know where you stand on these wars, I can’t say whether or not reading the book will change your mind. But I can guarantee you that its on-the-ground perspective will enlighten you as to the true and disturbing nature of what’s really going on, and the futility of it all. It is anything but entertaining, but is very well written and very illuminating.

Meanwhile, use the military budget as a proxy for the seriousness (or lack thereof) of the government’s intent to reduce its spending by any significant amount. And, absent any serious cuts in that spending, continue to take measures to protect yourself against wholesale debasement of the currency.

Every month, David Galland and his co-editors – among them Doug Casey – of The Casey Report research and analyze significant events in the U.S. and global economy, as well as in politics and the markets. Their goal is to recognize the trends in the making that will directly or indirectly affect investors… and to provide the best profit opportunities, even in a time of crisis. Learn how you can outpace rampant inflation by crisis-investing like the pros in this free report.

Ed. note: I am a Casey Report subscriber and affiliate.

Energy Investing Outlook for 2010 and Beyond: Geothermal, Natural Gas, Peak Oil, and More!

With oil back up in the $70 range, what's the current energy outlook for the global economy?  And more importantly - how should we invest?  For some insights, we're going to turn it over to our pal David Galland, who's rounded up two of Casey Research's energy experts for an insightful interview...

The Doctor and the Dealman: An Energy Update

By David Galland, Managing Director, Casey’s Energy Report

At first glance, no two individuals could seem more different.

The Doctor, middle-aged and balding, could be the very archetype of the college professor. The Dealman is young with a full head of well-styled hair: more than a few people have compared his looks to Elvis in his prime.

The Doctor is quiet and soft-spoken. The Dealman is outspoken and, under the right circumstances, even outrageous.

On further examination, however, you begin to uncover the similarities that make them one of the energy sector’s most potent teams, starting with the fact that they each possess an intimidating intelligence.

Case in point, while only 23 years old, the Dealman taught advanced mathematics at the university level.

The Doctor, an elected fellow of the Royal Society of Canada, is a PhD professor of petroleum and coal geology at the University of British Columbia and the winner of the coveted Thiessen Award, the highest award presented by the International Committee for Coal and Organic Petrology.

They also both share a passion for the energy sector, though as is typical with this atypical team, they approach the sector from two different perspectives.

The Doctor, one of North America’s leading experts in “unconventional” oil and gas, loves to analyze every aspect of modern-day hydrocarbon exploration and production.

While fully conversant in the technological and geological facets of the global hunt for energy, in his work as the chief investment officer for Casey Research’s Energy division, the Dealman lives to find the next big money-making energy play. Even if it requires working almost around the clock, he is passionate to uncover companies with the magical combination of the right management, the right commodity in the right place and with the right geology. And, most important, the right financial structure at the right price that allows investors to lock in serious upside potential but with very little downside risk.

Individually, the Doctor, Dr. Marc Bustin, and the Dealman, Marin Katusa, are powerful resources when it comes to separating facts from fiction about today’s energy scene and where the real opportunities for investors are to be found. But working as a team, they become a force of nature.

With oil gushing into the Gulf, the global economy under pressure as well as the prices of energy and energy stocks, and with the new American Power Act lurking in the background, John Mauldin called to ask if we could provide an update for readers on the always-important energy sector.

And so, with that goal in mind, I arranged to sit the Doctor and the Dealman down for a chat. The highlights of that chat follow.

Q: Let's start by asking your opinion, Dr. Bustin, on the sinking of the Deepwater Horizon rig off the coast of Louisiana and the impact that could have on oil exploration in the U.S.

Bustin: It’s an environmental ecological disaster, and everything else pales besides that fact. That said, I think what we're looking at is a major shutdown in offshore exploration off North America.

In addition to the Obama administration, the Canadian government has also come out and said that there will be no further offshore exploration until we understand what went wrong and there is something in place to better control a similar incident should it happen.

The impact of the disaster is already being felt in that Obama had only recently announced an expansion of offshore drilling, but that's now dead. Likewise, probably for the rest of my life, offshore Western Canada won't go ahead, so it's a huge impact, and of course this is going to affect the mid-term oil price.

Katusa: It is really important to understand that, for companies with existing drilling permits, the costs are going to be significantly higher… in terms of construction and maintenance costs, labor, permits, battling lawsuits filed by environmental groups and others with an interest in the water – the fishing industry, for example. Then there is a big increase in insurance costs, more taxes, and special clean-up funds.

As a result, when you start looking at the bottom line impact on companies you might want to invest in, when it comes to offshore projects, the netbacks are going to decrease significantly, so your profits are going to decrease significantly. Then there’s the overhang of the potential for another actual disaster and the clean-up costs.

Q: So this is clearly going to be a setback to offshore drilling. What are the implications from a supply perspective? Are you guys believers in the whole Peak Oil thing?

Bustin: Fundamentally, I'm a believer in the concept of Peak Oil. Yet, with the new accessibility to reservoirs made possible by technologies that allow us to drill horizontally and release petrocarbons unconventionally through fracking, I am not sure we have actually seen Peak Oil. Ultimately, however, we are burning through an awful lot of what is undeniably a finite resource.

Katusa: David, the problem with the Peak Oil theory is, it doesn’t take into account the increase of production and supply and the economic value of the reserve using unconventional technologies, which are always improving. Moving forward, we are long-term bulls on the oil price, but we've been consistent in telling our subscribers to stick to the fundamentals – that the companies they should be investing in are those that are able to produce at the lowest costs. Viewed from another angle, if a company in your portfolio needs $150 oil to make a profit, you should be a seller.

Q: What cutoff price do you think investors should be looking at for a company they want to own?

Katusa: In our in-house calculations, we use US$45 per barrel. If a company cannot produce economically and with a solid netback at $45 oil, they are not a low-cost producer and should be avoided.

Q: For the readers who are not familiar with the term, can you define "netback"?

Katusa: Netback is basically the difference between your production costs and what you sell your oil for at the well head. Let's say the spot oil price you are receiving is $75 and your all-in costs are $40, your netback would be $75 minus $40, for a netback of $35.

Q: On the topic of unconventional production, there's clearly a trend towards viewing the oil sands from an environmental standpoint as being a bad thing. Do you anticipate there being additional taxes levied or even a complete ban on the sale of oil from oil sands?

Katusa: The oil sands have too big of a production profile for them to be banned as a source. Already, one out of every six barrels of oil consumed by a U.S. citizen comes from the Canadian oil sands. We’ll almost certainly see increased taxes, however, that assure that oil sands are not going to be our cheap source of oil, though it will continue to be a sure source of oil.

Q: Won't that ratchet overall prices higher?

Bustin: The overarching problem is that the oil sands projects are so capital intensive – we're talking about 60-80 billion dollars already invested, with potentially another 300 billion dollars yet to be invested to maximize the resource. You can't put together projects with a capex of that magnitude unless you have a predictable price of oil.

Katusa: It’s worth noting here that the existing production is profitable at a cost of around $40-$45 per barrel. But of course, that doesn’t take into account any new taxes.
For the time being, taking into account the netbacks being earned by both conventional and unconventional producers – with even the oil sands operators currently operating at margins of close to 100% -- we see the potential for some downward pressure in the price of oil in the short term. Remember, for years and years, the big oil companies were running at 10-15% margins.

Q: Do you think we’ll see a carbon tax – cap-and-trade and all that?

Bustin: Absolutely.

Katusa: Whether you like it or not, it’s coming. While we all know it’s complete nonsense, if there is one certainty in today’s world, it is that the governments are going to tax whatever they can, and most of the people who support the current government in the U.S. believe that a carbon tax is good because they’re taxing the bad polluting companies that have billions of dollars in their banks. So it's coming.

Right now the voluntary market for CO2 is trading around $8-10 per ton, but in Europe, which has a mandatory market, the cost is double that. That's a big cost.

Q: Let's talk a bit about natural gas. From the geological perspective and also as an energy investor. Dr. Bustin, what’s your outlook for natural gas?

Bustin: In North America, we see natural gas lingering around the $5-or $6 range probably for the rest of the year. There really is a lot of natural gas available. Also keeping a lid on prices is that there are a lot of projects on line that aren’t quite economic at current prices. However, as soon as prices start moving up a little, a large amount of gas will become economic and therefore hit the market.

Prices in Europe are starting to decline significantly from a year ago as well, thanks also to increased supplies, so we're pretty soft on natural gas. That doesn’t mean you can't make money in natural gas or by investing in natural gas-producing companies – you can, but you have to be very selective and focus on low-cost producers.

Katusa: Moving forward, there are two things that will be very important to the sector. The first is that, thanks to unconventional technology becoming increasingly streamlined and effective, there are thousands of wells that have been drilled, fracked, but not completed. Those wells can come on stream with between 2-10 BCFs per day and are just sitting there. Think of it as a shadow supply of natural gas in the U.S.

The second thing to keep in mind is that the success that companies have had in exploiting the shales has resulted in massive new deposits.

Finally, it’s important to understand some of what’s going on with the oil-to-gas-equivalent ratio, which has traditionally been around 6:1. Consequently, at current spot prices, many analysts and promoters are saying, "Well, natural gas is cheap relative to the price of oil." Be careful when you hear that.

For instance, a lot of oil companies are purchasing gas companies because lower gas prices have made the companies cheap. The oil companies then look to boost the reserves on their balance sheets by reflecting the gas they acquire as BOEs, or barrels of oil equivalence. They will then actually book it as a barrel of oil to analysts at a ratio that is something like 22:1 today.

Q: What are the implications to us as investors?

Katusa: It all comes down to what a company is actually worth, which will guide you in what you pay for it. If a company says it has a billion barrels of oil equivalent in the ground, it will command a much higher price than if it showed its actual oil reserves and that it also had, say, three TCFs (trillion cubic feet) of gas. A surprising number of companies are doing this, including mid-tiers and majors. Imagine the implication to shareholders if this con is exposed for what it is?

Q: Can these companies actually convert their gas into usable oil?

Katusa: No.

Q: With the oil/gas ratio skewed in favor of gas, what about the market for substituting oil with gas?

Katusa: You have to ask, can we create a market for the natural gas that actually substitutes for oil? Of course, the big one would be having more compressed natural gas stations to encourage car manufacturers to make the switch, and there are a number of companies in North America looking to do just that. The big movers in that initiative are Canadians, but the idea has a lot of potential given the general theme of trying to reduce reliance on oil from foreign sources.

Q: Isn’t an increasing amount of base power generation switchable from oil to gas?

Bustin: With a lot of effort. Of course, the big one is the switch from coal to natural gas. Natural gas is much cleaner burning. In Canada, just a couple of weeks ago, legislation was passed calling for no new coal-fired plants. I think after a period of 15 years, they won't allow the existing coal-fired plants to be refurbished and continue to burn coal. So there's going to be a huge shift towards natural gas-fired electrical generation in North America, because of the carbon issues.

Q: I know you guys like coal, which is kind of counterintuitive, seeing how most people view it as dirty and dangerous. What's driving your outlook on coal – again from a fundamental standpoint and also in terms of finding investment opportunities?

Katusa: Start with the big picture. As much as 75% of China’s electricity generation currently comes from burning coal. That’s not going to change anytime soon. In fact, 2009 was the first year ever that China actually imported coal. Not so long ago, it had been a big exporter. But already half of the coal in the world that is produced is used by China.

On top of that, and this is pretty ironic given the popular view of coal, is that the U.S. is the second largest consumer of coal in the world, after China – with India being a distant third. Everyone is saying coal is dirty, coal is ugly, coal is smelly. It's done. We're going green. Even Obama said so. Yet if you’re careful, it’s where the profit is to be made. In fact, coal has been the biggest winner of all the energy subsectors over the last 12 months.

Q: How do we invest?

Katusa: In terms of investments, we like those related to met coal, versus thermal. As a reference point, there have been contracts signed in China at $105 per ton of thermal coal, but and as high as $500 per ton of met coal.

That’s because on the order of 90% of all steel production is dependent on met coal because of the temperature it produces. In North America, there are serious difficulties bringing on a thermal coal project, starting with environmentalists and government regulators, but also because transportation of the coal is the largest cost of a coal project – and therefore the deciding factor in the economics. Simply, at today’s prices, if you don’t already have a train running almost right up to your new thermal coal mine, it’s almost certainly not going to get off the ground.

So we have decided to stick with met coal for North America. On our North American met coal plays, we have recently recommended two in our alert service. They are doing well, and we expect them to go a lot higher.

Q: You like companies with significant upside as opposed to run-of-the-mill returns. That typically means small-cap companies. Are there smaller coal companies investors can get into, or are these all large companies?

Katusa: The coal companies have huge amounts of cash right now, because they’re kind of like the base metal of the energy sector. They’re boring, but they make a lot of money.

There are ETFs you can use to play the coal sector, but the reason why I like the juniors is the share price can go up ten times, as was the case recently with Western Canadian Coal. Of course, there are big companies with good coal exposure, like Peabody or Nobel or Teck Cominco. They have great assets, but the bang for your buck is not going to be as high as with a small-cap play.

Q: Let’s talk nuclear. There has been a lot of talk about pebble-bed reactors dotting the Chinese landscape, yet here they are scrambling for coal. Whatever happened to the dozens of new nuclear plants that were supposed to be headed for China?

Katusa: Despite popular conceptions, the pebble-bed reactors are actually an old technology, initially developed by the Nazis. The Chinese bought the technology off the Germans.

Pebble-bed reactors were supposed to be the Henry Ford Model T of nuclear reactors. They would actually be built in an assembly line. Imagine it like a LEGO set. As a town grows, you add a module. As the city grows and the energy requirements grow, so does the number of nuclear reactors.

However, the technology is still not ready for prime time. In fact, it's years away. That said, in the not-too-distant future, the demand for power and the need for governments to launch make-work projects will almost certainly kick off a rush to get a piece of the action. Especially in China.

Q: How would you play it as an investor?

Katusa: The best way is through a small-cap uranium company with a substantial economic resource, because these reactors are going to need a lot of feed. The time will come when the spot price of uranium is going to return north of $100 per pound. The last time that happened, a lot of the early investors in the better uranium juniors – most of which are Canadian – made a lot of money.

Q: What's your time line for uranium to push back over $100 per pound?

Katusa: I'd say 3-5 years.

Q: What are the fundamental reasons for this?

Katusa: The HEU Agreement, which involved nuclear warheads being dismantled and the uranium blended down to nuclear fuel has now come to an end and it will be three years before it is renegotiated. The last time it was negotiated, Boris Yeltsin was in power and Russia was on its knees. That's not the situation today. Russia is very powerful and Putin is still running the country behind the scenes. This time around, they’re going to negotiate a much different agreement. And don’t forget that today, unlike back when the last treaty was negotiated, the China factor is huge.

We would expect the Russians to go to the Chinese first before they renegotiate with the Americans. So the Americans are a victim of their own success by depending on the cheap Russian nuclear fuel. That time is coming to an end in three years, and within five to six years you'll see spot prices very high.

With the world increasingly looking to ramp up nuclear energy production – as it very much is – any of the companies with large reserves and the potential for low-cost production are going to be trading at a nice premium to where they are today.

Q: As an investor, where in the energy sector is your biggest focus right now? Where are the big opportunities in the relative near term?

Katusa: Before you can talk about specific opportunities, it’s important to be sure you have the right strategy to bringing those opportunities into your portfolio. These are very fragile markets, and so our strategy has been very conservative for some time now.

For instance, we spend a lot of time identifying great management teams that are personally heavily invested in their own companies – and then wait for them to raise cash through private placements that allow investors to pick up both a share and a warrant on favorable terms. Once the holding period is over, which can be as little as a few months, selling the shares and riding the warrants can be a good move as it gives you most of the upside with none of the downside if the markets tumble.

Likewise, we don’t chase stocks but instead decide what we’re willing to pay for a stock – which in these volatile times might be 20% below where it currently trades – and then wait patiently for it to come to us. That approach doesn’t always work, as sometimes we don’t get filled, but we’re okay with having a greater-than-normal allocation to cash at this point.

Another technique we use is what we call the Casey Cash Box – which involves running regular screens of a universe of small to mid-sized energy companies, looking for prospective companies selling at discounts to cash and other liquid assets. You might say we look to buy dollars for quarters.

Finally, when we get the desired result from our analysis – i.e., we buy good companies cheap and watch them move higher, we don’t hesitate to cash out our initial investments and take a free ride on the balance.

These are dangerous markets, and being cautious while building a diversified portfolio of energy plays makes a lot of sense. At least to us.

Okay, with that foundation, where would I invest today?

For starters, I might try to get ahead of the large sovereign wealth funds. And they are being pressured to invest in green energy. That’s one reason we’re more bullish than ever on green energy plays with the real potential to be economic.

Q: So which of the green energies are potentially economic?

Katusa: Geothermal and run-of-river are two we particularly like just now.

Q: Geothermal is not a new technology. It’s been used in energy production for something like 100 years, right?

Katusa: That’s correct.

Q: So why isn't it in wider use? What percentage of the base load in electricity in the U.S. comes from geothermal?

Katusa: Less than 1%.

Bustin: Economic geothermal projects are found in areas where you have very high heat flow or fluids near the surface. Of all the deep dry rock geothermal projects, where the real energy potential exists, none are actually economic. Currently they’re still in the experimental stage. At some of the more prospective sites in Australia, they ran into some significant problems, so it's still in the science box.

As a consequence, most of the geothermal projects you see are not where the real future is, which is in the deep dry rock geothermal projects, and those are going to take more time and a lot of money to get right.

Q: Aren’t government subsidies that can help the geothermal companies try to reach economic sustainability a big part of the attraction just now? Isn’t that also the case with run-of-river?

Katusa: No question, depending on the jurisdiction a company operates in, the subsidies for green energy projects can be very substantial. So much so that it makes it almost impossible for a company to lose money. Which, of course, all but eliminates the risk to shareholders as the company tries to build something that can last.

As for run-of-river, which involves diverting flow from a strongly running river, using it to turn a turbine, then returning it to the main river, there are actually quite a few opportunities. In fact, our latest look at the sector found over 45 small-cap companies. We recommended two, and one of them gave us a double that allowed us to cash out all of our initial investment, giving subscribers a free ride on the rest.

Overall, the prices on these companies have reached the point where we are holding off on any new recommendations in the sector, but we expect the prices will come back to an attractive level in the not-too-distant future. We’ll be ready when they do.

Q: Dr. Bustin, we’ve heard from the Dealman. Now, speaking from the technical perspective, are there any particular energy sectors now attracting your attention?

Bustin: Well, I'm really concerned about the coal sector. We're so dependent globally on coal. If we start slapping some major carbon taxes on coal, it's going to be catastrophic. I'm not quite sure how it's going to work out, because there is no way China and India and a lot of the developing nations, particularly in Southern Africa, which are so dependent on coal, are going to be able to manage. If they have to face these carbon taxes, I'm not sure where the world economy is going to head, because there's no way we can free ourselves from coal.

Q: I've heard the idea to use taxes to level the playing field between the dirty and the clean sources of base power. So coal would be weighed down, if you will, by added taxes to the point where there is no cost advantage to using it over natural gas. Have you heard the same thing?

Katusa: The beauty of coal is, it's base load. It's cheap and it's easy. The problem with solar is nighttime, and the problem with wind is no wind. And even run-of-river, which we like, fluctuates according to the climate, which is why geothermal is our favorite green energy because of its base load potential.

Taken together, these alternative energy sources are okay as secondary sources to meet excess demand, but they’re not your go-to sources. What most people don’t realize is that much of the power used isn't from people charging their Blackberry or running their computers, or any of that. It’s used by big commercial industries, such as manufacturing and mining, for example.

Q: In the past, Dr. Bustin, you’ve said that is the question is not so much about which energy sources to use, but rather that, in order for the world to maintain even the status quo, the answer will be “All of the above.” In order to avoid the economic devastation of runaway energy costs, we're going to need every single source we can get over the next ten years. Fair statement?

Bustin: Yes, it is. Unfortunately, when we look at our gross national product per capita, it's directly proportional to our energy consumption. And, of course, if you look at multiple billions of people who have very low standards of living and if you want to give them a gross national product per capita comparable to that we enjoy in the developed world, you have to expect global energy consumption is going to continue to skyrocket.

As I’ve tried to indicate, the only way to even come close to meeting that energy demand is with coal. There is just no alternative for the foreseeable future, until we get into bigger reactors or some other interesting usage of nuclear power. Bottom line, we're stuck with fossil fuels, and the fossil fuel that is readily available and most economic is coal.

Q: Are you looking from an investment standpoint at any offshore opportunities to tap into some of that demand for coal coming out of China?

Katusa: We've got one on our radar screen now, but it’s premature to mention it here. I've actually visited the site twice and like the story. It's a great project, the management is heavily invested in it themselves, but we haven’t recommended it yet because we are waiting for a couple of financings to come free trading, which will result in more stock available – and that will create downward pressure. By being patient, investors should be able to get it at a cheaper price. That theme, of being patient, can’t be stressed enough. Especially in markets as volatile as these.

Q. Good advice, and a good place to leave off. Thanks for your time.

----
David Galland is a partner in Casey Research, LLC., an international firm providing research and investment recommendations to individuals in over 150 countries. Prior to joining Casey Research, he was a founding partner and director of a successful mutual fund group (Blanchard Group of Mutual Funds), and well as a founding partner and executive vice-president for EverBank, one of the biggest recent successes in online financial services.

If you’re interested in the staying closely in touch with the ever changing investment opportunities in the energy sector, you’ll find no better team than Marin Katusa and Dr. Marc Bustin as your guides. Just recently they tapped into one of the best-kept secrets in European energy policy – a sure-fire winner. Read more here.

Ed. Note: I am a Casey Research affiliate and subscriber.  I also head up their Sacramento Phyle.

An Everyday Commodity With Record Bearish Sentiment Against It Right Now

While oil has been on a tear during the reflation rally, it's cousin natural gas has not received the same love from traders.  "The Natty", which currently is languishing around $4, couldn't be hated more, writes Steve Sjuggerud for DailyWealth:

Specifically, right now, there are more bets against natural gas by large speculators than there have ever been in history.

The old rule about the large speculators goes something like this... They're "wrong at extremes, and right in between." Right now, we're at the greatest extreme, ever. Chances are, they're wrong.

The thing is, all these bets against natural gas have to be reversed... That means we must see billions of dollars worth of "buy" orders in natural gas futures, because that's the way these traders close out their trades. So the price of natural gas could rise dramatically – and possibly soar – just in the normal course of all these large speculators entering billions of dollars worth of "buy" orders to close out their bets against natural gas.

I love it.

Now think about this... Natural gas has a permanent price "floor." When it gets particularly cheap, energy companies want to substitute natural gas for what they're using – whether it's oil of some kind, or coal, or whatever.

It sure has been a tough past few years for The Natty - hovering around 5-year lows!

Source: Barchart.com

Why is natural gas so hated?  In short, there's too damn much of it available right now.  Commodity prices are amazingly efficient at correcting supply/demand imbalances.

When Natural Gas spiked in 2006, and North America was reportedly running out of it, producers went to work, and figured out how to extract it from new places, like shale.  Supply went way up, and prices collapsed - not bad for a "free" market!

If you're thinking about a speculative position here, the natural gas ETF ticker is UNG.

And if you're looking for a great supply/demand breakdown, here's a great piece of natural gas fundamental analysis by Casey Research's David Galland.

The Common Thread in Nature, Investing - and Life!

Despite what some investing talking heads may say, the financial world is not exempt from natural law.

There's a natural flow to the way the world works - and it absolutely carries over into investing. One common thread is change - things are either improving, or deteriorating, but they are almost never stagnant. Nature, after all, hates a vacuum!

Guest author David Galland expands upon this topic as only David can do. Read on, to learn why the world, as we know it, is (always) wasting away in some way, shape, form...

***

Entropy – Why the World as We Know It Is Dying

By David Galland, Managing Editor, The Casey Report

The concept of entropy is one of the most useful terms for understanding just about everything. While it has its origins in natural law – thermodynamics, specifically – the concept holds true pretty much across all closed systems.

In the simplest of terms, every closed system will ultimately degrade toward a state of maximum entropy.

I’ll use the current political system of the U.S. as a convenient example. When American democracy was first shoved out of the nest by the founding fathers, it was new, fresh, and energetic. It took the world’s breath away at its boldness and unlimited promise, and set the wheels turning on tangible change across much of the world.

Before the ink dried on the Constitution, however, the degradation began. From the beginning, the country’s political operations fell into the hands of a strictly limited number of parties, which quickly coalesced into just two. Since then, they have essentially shared power, with only minor differences in policies between the two. Simply, absent a disruptive external force, the closed political system quickly matured into an institutionalized “sameness” that all but assures no serious challenges – leading, ultimately, to the certainty it will degrade to only a shell of its former self.

It was, perhaps, because of his own understanding of natural law that Thomas Jefferson was heard to remark, “The tree of liberty must be refreshed from time to time with the blood of patriots and tyrants. It is its natural manure.”

That doesn’t mean I am advocating revolution – just pointing out the fact that any closed system, no matter how well constructed, will degrade. To expect the United States of America to avoid this fate is to expect the impossible.

Switching to a corporate example, I used to be a regular buyer of Toyota cars. They were well made, innovative, and suited my changing needs over the years. And I wasn’t alone – in 2007 they became the world’s largest automobile maker, with a global manufacturing and distribution system that made them appear dominant. Behind the scenes, though, entropy was at work.

In 2008, when the time had come to lease a new car, I reflexively headed over to the local dealer fully expecting to drive off with yet another Toyota, just as I had done several times over the previous decade or more. But as I walked around the showroom, it was impossible not to notice that the company had lost its edge. The cars on offer were not only more expensive than the competition, but even the newest models had that “so yesterday” look about them.

Surprising even myself, I walked out and ended up leasing from another company. I remember vividly at the time saying to my wife that we should short Toyota’s stock. Of course we didn’t – but if we had, it would have been a good play, as you can see in the chart of the company’s stock price here. Note that Toyota’s share price peaked in 2007, almost concurrently with it becoming the world’s largest car company.

As I said at the onset, you can see entropy at work in virtually every closed system. Consider the U.S. dollar, which became the world’s de facto reserve currency as a result of Bretton Woods.

What an amazing advantage for the United States – this unique ability to provide the world’s central banks with their primary reserve component! And to have all the world’s commodities dealt in dollars. In short, the dollar became the centerpiece of the global economic system.

It was, of course, damned to entropy, with Nixon’s ending the dollar’s gold backing just being part of the natural progression. And if he hadn’t done it, one of his successors would have – due to some “emergency” or as a “temporary” measure, or some other flimsy political cover.

Regardless, the degradation of the currency gained speed and, systematically, it’s been all downhill since.

You may also want to think about entropy when pondering the Chinese miracle. No question, China is having a heck of a run. As James Quinn writes in his article “Is China’s Recovery a Fraud?” in the February edition of The Casey Report, in 1970 that country’s GDP was just $92 billion. Today it is $4.9 trillion!

“Unstoppable!” cheers the punditry. The Chinese leadership, whose capable hands are very much on the levers of the macro-economy, are cut from special cloth, they add.

In answer to that, Quinn points out that despite China being an export-based economy, purpose-built to supply goods to a U.S. population engaged in a mad rush to spend themselves into debt and default – which is to say, an economy now only a memory – there is currently 30 billion square feet of commercial real estate under construction in China.

I’m not sure if bowling is popular with the Chinese, but with all that spare space, some enterprising individual might want to consider promoting it as the coming thing. Roller rinks? Indoor laser tag centers?

Meanwhile, back in the U.S., we the people are no longer content with a free-market system that embraces periodically burning down the house in order to rebuild stronger and better – a system which has been proven to create wealth, and lots of it. Instead, we are hell bent on adopting the closed economic system of a socialist model where everything and everyone is tightly controlled.

On that point, a recent article in the Wall Street Journal titled “No Exit in Sight for U.S. as Fannie, Freddie Flail” sheds light on the continuing degradation in the free market that used to underpin the nation’s hugely important housing sector…

Fannie and Freddie, for their part, remain at the core of a housing-finance system that inflated a dangerous housing bubble. After prices collapsed, sending shock waves around the world, the federal government put America's housing-finance system on life support. It has yet to decide how that troubled system should be rebuilt.

On Dec. 24, Treasury said there would be no limit to the taxpayer money it was willing to deploy over the next three years to keep the two companies afloat, doing away with the previous limit of $200 billion per company. So far, the government has handed the two companies a total of about $111 billion.

(Full story here.)

Can’t you just smell the entropy? The results are not just predictable, they are evident – just look around.

As investors, it is, I would contend, important to understand the notion of entropy – and to watch for it in your portfolio companies, in your bureaucracies, and, on a more personal level, your relationships and your health. On that last point, the human body is very much a closed system and so, as we all are too painfully aware, will degrade until it ceases to exist.

You can slow the degradation by taking care of yourself. But it’s also worth remembering that it’s a one-way slope, so enjoy yourself while you are fit and able to.

While it’s impossible to halt entropy, what you can do is take action to protect yourself and your assets from its effects. That’s what the editors of The Casey Report do best: recognize and examine emerging trends in the economy and markets, and help investors take advantage of the opportunities that arise from them. And profits are everywhere if you know what to look for – even in the worst economic crises. Click here for more…

Ed. note - I am a Casey Research subscriber, and affiliate, and I highly recommend their stuff.

An Exclusive, Insider View of the Real Estate Market (Hint: It Ain't Pretty)

Is real estate bottoming? Ummmm, I guess it depends what you mean by bottoming...but unless you work for the NAR, probably not!

Here's an exclusive, insider look at the "real estate train wreck" as Casey Research's David Galland sat down with real estate entrepreneur and guru Andy Miller.

This read will make you think twice about "bottom fishing" in real estate just yet!

***

An Insider’s View of the Real Estate Train Wreck

By David Galland, The Casey Report

The first time I spoke with real estate entrepreneur Andy Miller was in late 2007, when I asked him to serve on the faculty of a Casey Research Summit. And there was no one in the nation I wanted more than Andy to address the critical topic of real estate.

My interest in Andy was due to the fact that he has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects – such as shopping centers, apartment communities, office buildings, and warehouses – from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming.

Back in 2007, however, what most intrigued me about Andy was that he had been almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people that think they know what’s going on, and those who actually know – Andy very much belongs in the latter category.

In fact, he initially refused to speak at our event, only agreeing very reluctantly after I had hounded him for several months. The reason for his refusal, I later found out, was that he had spoken at several industry events before the real estate collapse and had been all but booed off the stage for his dire outlook.

The happy ending of this story is that Andy’s speech at our Summit was a rousing success, and he enjoyed it so much that he has now spoken at several, and has kindly agreed to sit for periodic interviews to keep our readers up to date on the latest developments in this critical sector. So far, Andy’s real estate forecasts continue to come true.

As you’ll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation’s biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate.

David Galland

No one has been more right on the housing market in recent years. So, what’s coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well?

MILLER: I don’t think so.

For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the U.S. were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

If it's true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn’t help a homeowner whose property is worth less than the mortgage. So when the supply of government-facilitated loans dries up, it's going to put the home market in a very, very bad place.

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.

The public doesn’t have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It’s huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can't get people to focus on it, and it's very esoteric, it's very hard to understand. But it’s not something the bond market won’t notice. The government can’t keep doing what it has been doing to support mortgage lending without pushing interest rates way up.

Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that's exactly where they’re headed. So anyone who’s comforted by current statistics on single-family homes should look beyond the data and into the dynamics of the market. What they’ll find is very alarming.

On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money.

MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the U.S. Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that they were going to remove all the caps on the agencies.

So what about commercial real estate?

MILLER: When I saw what was happening in the housing market, I liquidated all my multifamily apartments, shopping centers, and office buildings. I liquidated all my loan portfolios, and I'm happy I did.

Then it occurred to me in 2005 and 2006 that the commercial world had to follow suit. Why? Because it's a normal progression. Obviously, when single-family homes decline in value, multifamily apartments decline in value. And when consumers hit the wall with spending and debt, that's going to have an impact on retailers that pay for commercial space.

Furthermore, the financing for retail properties had gotten ludicrous. The conduits were making loans that they advertised as 80% of property value when they originated them, but in reality the loan-to-value ratios were well over 100%. And I say that to you with absolute, categorical certainty, because I was a seller and nobody knew the value of the properties that I was selling better than I did. I had operated some of them for 20 years, so I knew exactly what they were bringing in. I knew what the operating expenses were, and I knew what the cap rates were. And, you know, the underwriting on the loan side and the purchasing side of these assets was completely insane. It was ludicrous. It did not reflect at all what the conduits thought they were doing. They were valuing the properties way too aggressively.

I became very bearish about the commercial business starting in late '05. In fact, I think I was in Argentina with Doug Casey, sitting on a veranda at one of the estancias, and he and I were lamenting what was going on in the real estate business, and I said there was going to be a huge adjustment in the commercial market.

Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash?

MILLER: I think the first thing that changed was that people learned that prices don’t go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don't think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate.

But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in fantasy land for 10 years. And that was the first change – a mental adjustment from Alice in Wonderland to reality.

Today it's clear that commercial properties are not performing and that values have gone down, although I've got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is.

Right now there are an awful lot of banks that do an awful lot of commercial real estate lending, and for about a year now you’ve been telling me that you saw the first and second quarter of 2010 as being particularly risky for commercial real estate. Why this year, and what do you see happening with these loans and the banks holding them?

MILLER: It's an educated guess, and it hasn’t changed. I still think that it's second quarter 2010.

The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there's some alternative in place, it's going to be a very hideous picture for the bond market and the banking system.

The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I’ll give you an example.

In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn’t have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.

That's very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they’ll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that's horribly destructive.

Just to be clear on this, let's say I own an apartment building and I've been making my payments, but I'm having trouble and the value of the property has fallen by half. I go to the bank and say, "Look, I've got a problem," and the bank says, "Okay, let's work something out, and instead of you paying $10,000 a month, you pay us $5,000 a month and we’ll shake hands and smile." Then, even though the property’s value has dropped, as long as we keep smiling and I’m still making payments, then the bank won't have to reserve anything against the risk that I’ll give the building back and it will be worth a whole lot less than the mortgage.

MILLER: I think what you just described is accurate. And it’s exactly a Japanese-style solution. This is what Japan did in '89 and '90 because they didn’t want their banking system to implode, so they made it easier for their banks to sit on bad assets without owning up to the losses.

And what’s the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it’s not going to sell them.

Why is that bad? Well, the money tied up in the loans the bank is sitting on is idle. It is not being used for anything productive.

Wouldn’t banks know that ultimately the piper must be paid, and so they'd be trying to build cash – trying to build capital to deal with the problem when it comes home to roost?

MILLER: The more intelligent banks are doing exactly that, hoping they can weather the storm by building enough reserves, so when they do ultimately have to take the loss, it's digestible. But in commercial real estate generally, the longer you delay realizing a loss, the more severe it’s going to be. I can tell you that because I'm out there servicing real estate all day long. Not facing the problems, and not writing down the values, and not allowing purchasers to come in and take these assets at discounted prices – all the foot-dragging allows the fundamental problem to get worse.

In the apartment business, people are under water, particularly if they got their loan through a conduit. When maintenance is required, a borrower with a property worth less than the loan is very reluctant to reach into his pocket. If you have a $10 million loan on a property now worth $5 million, you’re clearly not making any cash flow. So what do you do when you need new roofs? Are you going to dig into your pocket and spend $600,000 on roofing? Not likely. Why would you do that?

Or a borrower who is sitting on a suburban office property – he's got two years left on the loan. He knows he has a loan-to-value problem. Well, a new tenant wants to lease from him, but it would cost $30 a square foot to put the tenant in. Is the borrower going to put the tenant in? I don't think so. So the problems get bigger.

Why would the owner bother going through a workout with the bank if he knows he’s so deep underwater he’s below snorkel depth?

MILLER: It's always in your interest to delay an inevitable default. For example, the minute you give the property back to the bank, you trigger a huge taxable gain. All of a sudden the forgiveness of debt on your loan becomes taxable income to you. Another reason is that many of these loans are either full recourse or part recourse. If you're a borrower who’s guaranteed a loan, why would you want to hasten the call on your guarantee? You want to delay as long as possible because there’s always a little hope that values will turn around. So there is no reason to hurry into a default. None.

So that’s from the borrower's standpoint. But wouldn’t the banks want to clear these loans off their balance sheets?

MILLER: No. The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against their capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. Remember, you suffer if the bank succumbs and turns around and liquidates that asset, then you really do have to take a write-down because then your capital is gone.

So here we are, we've got the federal government again, through its agencies and the FDIC, ready to support the commercial real estate market. They’ve taken one step, in allowing banks to use a very loose standard for loss reserves. What else can they do?

MILLER: Well, obviously nobody knows, but I can guess at what’s coming by extrapolating from what the federal government has already done. I believe that the Treasury and the Federal Reserve now see that commercial real estate is a huge problem.

I think they’re going to contrive something to help assist commercial real estate so that it doesn’t hurt the banks that lent on commercial real estate. It’ll resemble what they did with housing.

They created a nearly perfect political formula in dealing with housing, and they are going to follow that formula. The entire U.S. residential mortgage market has in effect been nationalized, but there wasn’t any act of Congress, no screaming and shouting, no headlines in the Wall Street Journal or the New York Times about "Should we nationalize the home loan market in America." No. It happened right under our noses and with no hue and cry. That's a template for what they could do with the commercial loan market.

And how can they do that? By using federal guarantees much in the way they used federal guarantees for the FHA. FHA issues Ginnie Mae securities, which are sold to the public. Those proceeds are used to make the loans.

But it won’t really be a solution. In fact, it will make the problems much more intense.

Don’t these properties have to be allowed to go to their intrinsic value before the market can start working again?

MILLER: Yes. Of course, very few people agree with that, because if you let it all go today, there would be enormous losses and a tremendous amount of pain. We're going to have some really terrible, terrible years ahead of us because letting it all go is the only way to be done with the problem.

Do you think the U.S. will come out of this crisis? I mean, do you think the country, the institutions, the government, or the banking sector are going to look anything like they do today when this thing is over?

MILLER: I know this is going to make you laugh, but I'm actually an optimist about this. I'm not optimistic about the short run, and I'm not optimistic about the severity of the problem, but I'm totally optimistic as it relates to the United States of America.

This is a very resilient place. We have very resilient people. There is nothing like the American spirit. There is nothing like American ingenuity anywhere on Planet Earth, and while I certainly believe that we are headed for a catastrophe and a crisis, I also believe that ultimately we are going to come out better.

Andy Miller is the co-founder of the Miller Frishman Group (www.millerfrishman.com), which includes three companies serving different sectors of the real estate market – from mortgage brokerage and banking, to the building, management, and marketing of commercial real estate across the United States. His firm is currently deeply involved in the distressed real estate business, assisting lenders across the nation with their growing portfolios of non-performing loans.

Real estate crashing, unemployment rising, sky-high government debt – is there any silver lining in all of this? There is, and the editors of The Casey Report are pros in locating it. Analyzing tomorrow’s mega-trends and finding the best opportunities to profit from them is what they do. Learn how these expert trend hunters can help you make money even in the toughest crisis… click here.

Ed. note - I've been a Casey Research subscriber since 2006, and an affiliate since 2008.

Latest Inflation Insights From Casey's David Galland

Many - including me - think that 2010 will be a pivotal year in the inflation/deflation saga. And while I hopped over to the deflationist "dark side" almost a year ago, I try to stay very tuned into the inflation scenario, to continually check my thinking on the subject. It's OK to be wrong...I just want to recognize that as soon as I can, and adjust my outlook accordingly.

David Galland always puts together some thought provoking points, and his piece here is tough to argue with. I'll let you read and absorb, and I'll be back with some thoughts from the deflationist point of view later today in our weekly update column. Enjoy!

***

What the Deflationists Are Missing

by David Galland, Managing Editor, The Casey Report

An interesting article by Ambrose Evans-Pritchard came my way the other day. It’s worth a read, if for no other reason than that he paints an appropriately dark picture of the current state of the U.S. economy. You can read it here.

While I very much share Mr. Evans-Pritchard’s view that the global economy is far from out of the woods, our views diverge in that he sees devastating deflation speeding our way down the tunnel. Casey Research readers of any duration know that we see devastating inflation.

While we could both be right, with deflation first and inflation later, I’m not so convinced.

For starters, there is already a massive inflation operation being run by the Fed, evidenced in a historic spike in the monetary base over the last two years.

And the Obama administration is far from done.

The Democrats’ reinvigorated focus on jobs – the single most important factor in this November’s elections – will soon translate into a flurry of new initiatives designed to put people back to work, most of it funded at taxpayer expense.

To believe in the deflationary case would seem to require believing that Obama and his minions are ready to forgo any further political aspirations by collectively putting their feet up on their desks for the balance of their sole term at the apex of global power.

Given Obama’s meteoric rise to power – evidence that he possesses a certain drive and competence in the game of politics – that seems highly unlikely. And so it seems safe to assume we’ll soon witness a redoubling of his efforts to keep interest rates down… to make it easy and cheap for strapped consumers and businesses to keep borrowing… and to otherwise flood the economy with money.

In a deflation, the value of the money increases – which is actually a pretty desirable thing, if you ask me. Inflation, by contrast, means that pretty much everything you own in the local currency steadily loses value – forcing investors into a perpetual game of catch-up. It’s hard for me to calculate how the government can dramatically increase the money supply and yet have each of the currency units become increasingly more valuable over a sustained period of time.

Arguing against that point, Evans-Pritchard makes the case that the U.S. government is making much the same mistakes that were made in the first part of the Great Depression, i.e., being overly tight with the money. And that the velocity of money is falling.

There are a couple of key differences between now and then, however. First, the Fed didn’t actually know what the money supply was back then. They literally had no monitoring tools in place, mostly because no one thought it was important enough to track. Second, they didn’t have fiat monetary powers. Today, neither of those factors apply.

Everyone knows what the money supply of the U.S. is and watches it keenly. Including our foreign creditors. And so it is not surprising to see the Fed publicly talking about tightening up a bit. But it’s just talk at this point.

With the economy continuing to struggle, the only reasonable assumption that can be made is that the Fed – in cahoots with the entirely politicized Treasury – will keep shoveling money onto the economic embers, and continue to do so until economic activity again flares up.

That will, of course, require increasing the quantity of money that actually makes it into the economy – but that should be child’s play for Team Obama – with direct hiring and spending, continuing to buy mortgages and other loans to suppress interest rates, forgiving the bad debts of banks, or changing accounting rules so that banks can postpone reckoning day. And that’s just for starters, all of it packaged nicely in the name of the public good.

And once the money starts to flow, there will be a pick-up in economic activity, which will beget yet more money moving around. At first, this money will be a palliative for the economic worries, but then comes the inflation – a small trade-off, the politicians will decide, if it buys them enough of a recovery to make it through the November elections and get the president the second term you know he so strongly desires.

There is something else that I think the deflationists are missing, and that has to do with confidence in the currency. If the U.S.’s many creditors come to agree with our point of view – that the dollar is being led to the altar as a sacrificial lamb to political expediency – then they’ll further reduce their purchases of our Treasuries and start trading their dollars for stronger currencies and tangible assets, including precious metals.

At that point, interest rates will have to begin rising to attract new buyers. As you can see in the chart of long-term Treasury bond rates, a significant move off recent lows has already occurred, and rates are looking poised for a breakout to the upside.

Of course, the higher those rates ratchet, the more it will cost the U.S. government to carry its massive debt. While rising rates will continue to drive demand to the short end, suppressing those rates, in time the sheer quantity of paper that will have to be rolled over, and the rising tide of inflation, assures that short-term rates will have to rise too.

At that point, the train begins to leave the track.

As the train wreck approaches, the government is going to have to find creative new ways to fund its social contract with impatient voters. Perhaps, for instance, pegging everyday fines and assessments to the amount of income a person makes. Executed brashly, such policies might even allow the government to charge a person of means, say, $290,000 for a speeding violation.

I know what you’re thinking: C’mon, let’s be realistic – that could never happen. Think again…

Europe slapping rich with massive traffic fines

By FRANK JORDANS

The Associated Press

Sunday, January 10, 2010; 11:30 AM
GENEVA -- European countries are increasingly pegging speeding fines to income as a way to punish wealthy scofflaws who would otherwise ignore tickets.

Advocates say a $290,000 (euro203,180.83) speeding ticket slapped on a millionaire Ferrari driver in Switzerland was a fair and well-deserved example of the trend.

Germany, France, Austria and the Nordic countries also issue punishments based on a person's wealth. In Germany the maximum fine can be as much as $16 million compared to only $1 million in Switzerland. Only Finland regularly hands out similarly hefty fines to speeding drivers, with the current record believed to be a euro170,000 (then about $190,000) ticket in 2004.

The Swiss court appeared to set a world record when it levied the fine in November on a man identified in the Swiss media only as "Roland S." Judges in the eastern canton of St. Gallen described him as a "traffic thug" in their verdict, which only recently came to light.

"As far as we're concerned this is very good," Sabine Jurisch, a road safety campaigner with the Swiss group Road Cross.

Full story here.

Or maybe the government will force you to convert some or all of your IRA or 401(k) into Treasuries, perhaps packaged up in an annuity. You’d be given the choice of making the switch or making a withdrawal and paying all outstanding taxes at that point. This is something that Doug Casey has warned about for several years now.

The seeds of that possibility may be headed for the soil: the following article from BusinessWeek reveals that the Treasury is now looking very hard at the trillions in retirement accounts and trying to figure out new ways to “help” the owners of those accounts.

In my view, what’s important in this little dissertation can be summed up as follows:

1. The current administration and its congressional allies have powerful political motives to soak the economic soil with fresh dollars. The Christmas Eve announcement that the Treasury is removing the $400 billion cap on losses it will cover for Freddie and Fannie is a classic example of how far they are willing to go to keep the money moving.

2. Unlike the Great Depression, the U.S. is now on a fiat money system – which is purpose-built for the current scenario. Open the taps, and if that doesn’t work, open them even wider. Failing to do so would be political suicide, and Obama and his team are just not into the idea of serving a single term.

3. Given the size of foreign holdings of U.S. dollars, the nation is faced with a “rock and a hard place” situation, where a sharp loss in confidence on the part of our creditors would likely lead to a currency crisis that drives the value of the dollar quickly lower, at the same time that it drives interest rates higher.

Something will have to give. We think that something will ultimately be the U.S. dollar, as it’s politically more acceptable to have a failing dollar than a smoking hole where the economy used to be.

Before this thing is over, I would not be surprised to see a new currency regime adopted that introduces exchange controls and a different category of dollar to be issued for the purpose of paying back foreign creditors. Such a dual-track currency system is nothing new but has been used by desperate regimes numerous times throughout history.

Forecasting the future is actually impossible, as there are just too many variables. But that doesn’t mean that we can’t step back and make certain logical assumptions about the policies the politicians are most likely to deploy in their efforts to retain power.

In the case of today’s world, the only politically logical decision will be to keep on spending until that spending itself becomes a pressing problem, at which point the politicians will turn their attention to “solving” the newest in a long list of problems they have created.

At which point they will no doubt find some creative way to blame the inflation on speculators, profiteers, and the free market.

The economy is now so manipulated by politicians, big bankers, and special-interest groups that making sense of the markets has become an almost impossible feat. In the spirit of “making the trend your friend,” no matter how dire it is, the editors of The Casey Report are experts in analyzing budding mega-trends and seizing the profit opportunities hidden in them. Learn to do the same – click here for more information.

Ed. note: I am a Casey affiliate, and have been a subscriber of theirs for over 3 years now. The Casey Report gets my highest recommendation for its excellent analysis.