How Complex Securities, Wall Street Protectionism And Myopic Regulation Caused A Near-Meltdown Of The U.S. Banking System Part 1

There’s no time to beat around the bush. Let’s flush out the three credit-crisis catalysts that have remained hidden for too long, thanks to Wall Street protectionism and myopic regulation. Those catalysts - which brought us to the brink of a financial meltdown - are structured collateralized debt obligations, credit default swaps, and the horrific offspring of the two - credit default swaps on structured collateralized debt obligations.

An asset-backed security (ABS) is a type of tradable debt security that’s derived from a pool of underlying assets. We could be talking about a pool of mortgages, of automobile leases, or loans made to various borrowers. We’re using the example of residential mortgages, though the example is exactly the same for commercial mortgages, automobile leases or bank loans. Here’s how it works.

Anatomy of Mortgage Loan
A mortgage company makes home loans in your county, as does your local bank branch. Then an investment bank comes along and buys the mortgages from the mortgage company and from the bank. It only wants to buy the mortgages made to prime borrowers who are paying 6% interest on their mortgages. Once it acquires those loans, the investment bank securitizes the mortgages, meaning it pools them into a tradable package it can sell to investors.

This particular pool is known as a “closed pool,” meaning no more mortgages will be added, though some may leave the pool if the underlying borrowers pay back their mortgages early because they sold their homes, or refinanced them, or if underlying mortgages are in default and the “servicer” allows them to be removed from the pool. The only income coming into the closed pool results from the monthly interest and principal payments being made by the homeowners.

In our example - because all the mortgage loans were made to so-called “prime” borrowers with strong credit - you might have an investment grade (A+) security that pays 6%, because all the mortgage holders are paying 6% and the payments are being passed through to the investors. That’s it. There are very good, though not exact, methodologies to value this particular security, primarily because it is uniform in that all the mortgage payers are prime borrowers who all are paying 6%.

Asset-backed-securities become infinitely more complicated when they are sliced and diced into structured collateralized instruments. They generally fit into two main categories:

Collateralized debt obligations (CDOs), which include all manner of residential and commercial mortgage-backed securities.
And collateralized loan obligations (CLOs), which are pooled bank and investment-bank loan portfolios.

CDOs and CLOs are created from “closed-pool,” asset-backed securities. They are collateralized by the underlying assets - hence the prefix - but they are also “structured.”In our example above, our asset-backed mortgage security was rated A+ and pays the investor who buys it 6%. If I want to create higher-yielding securities that I think I will be able to sell a lot more of, I will pool mortgages from subprime borrowers.

Because subprime borrowers are, by definition, higher-risk borrowers, the mortgage companies and banks charge them higher rates of interest to offset the greater risk that they represent. If I pool these mortgages, their ratings would be “junk” - or close to it - which will be a problem as I try and sell these securities to investors all around the world.

That’s where the magic of financial engineering, better known as structuring, comes into play. I can divide up the closed pool of subprime mortgages and structure the pool into layers, or tranches. What I’ll do is divide up the pool into multiple tranches, or slices. I’ll structure the cash flow payments from all the mortgages so that if the 1st or 2nd tranches run into trouble, I’ll take cash flow payments from the lower tranches to keep up with all the payments to the holders of the 1st and 2nd tranches.

For someone trying to peddle these asset-backed securities, this is a stroke of genius. In our example, since I’m now pretty much guaranteeing that the 1st and 2nd tranche security holders are going to get paid, maybe I can get the Big Three debt-rating companies - Standard & Poor’s, Moody’s Investors Service (MCO) and Fitch Ratings Inc. - to give my 1st and 2nd tranche CDOs’ investment grade ratings. Maybe I can even buy insurance from a monoline insurer like AMBAC Financial Group Inc. (ABK) or MBIA Inc. (MBIA), and get my top tranches a coveted “AAA” rating. Wow, I could sure sell a lot of this high-yielding stuff with an investment grade rating!
That’s just what happened. And they did sell a lot - a whole lot.

Those Troubling Tranches
As I said in Part II of this investigative series, CDOs - on an individual basis - are difficult to value. Indeed, “legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. (CRAY) supercomputer 48 hours to calculate.

The problem starts here. There are so many of these tranched securities out in the marketplace - and on the balance sheets of banks, investment banks, insurance companies, hedge funds and all manner of other unsuspecting investment entities worldwide - that when subprime borrowers began to default, it wasn’t long before the lower-tier tranches ran out of money to pay the so-called 1st- and 2nd-tier “AAA”-rated securities. The problem escalated quickly and almost all of these securities were downgraded. That’s not a surprise. Nor is it the whole story, for it leaves a key question unanswered.

What happened to the lowest-level tranches?
Those tranches were “ugly” to begin with because I started by pooling subprime mortgages (the high-risk borrowers). Then I made them “toxic” by “stripping out” their cash flow to support other tranches. This toxic waste was so bad, no one would ever rate it and only greedy hedge funds or crazy speculators would buy it for its high yield. Or, maybe, I think so much of my creation that I’ll keep this piece for myself, or maybe I’ll have to because no investor will ever buy it.

This kind of stuff is out there. There’s a lot of it. And only an act of God will bring these securities back from the depths where they now reside.

With their collateralized premise and structured nature, CDOs are very difficult to value - especially since no one trusts anyone else’s “internal valuation model.” Since everyone is afraid of these securities because no one really knows what they’re actually worth, no one wants to buy them.However, when an institution - such as a Merrill Lynch & Co. Inc. (MER) - gets desperate enough to sell a portfolio of these securities at 22 cents on the dollar, then everyone else who has to “mark-to-market” their assets now has to value similar securities of their own at 22 cents on the dollar. That causes massive write-downs at banks, investment banks, insurance companies, and other financial institutions. And these companies write down assets and watch their losses escalate, they are forced to raise additional capital to meet regulatory requirements.

CDS - Controlled Dangerous (Financial) Substances
It’s a vicious cycle - one that’s eroding our faith in our banks, and worse, banks’ faith in other banks. As a result, banks have ceased lending to each other out of the fear that the next round of write-downs and losses may imperil some of the trading partner banks that they used to lend billions of dollars to every night.

Not anymore.

It would be bad enough if that were the only problem facing the securities market. On top of these overly engineered structured securities I’ve just discussed, we also have credit default swaps with an estimated notional value of $62 trillion out in the marketplace. A credit default swap (CDS) is a financial derivative that’s akin to an insurance policy that a debt holder can use to hedge against the default by a debtor corporation, or a sovereign entity. But a CDS can also be used to speculate.

In Part II of our investigation, which ran Monday, I explained how problematic credit default swap pricing is and how the indexes against which the value of these swaps are determined are tradable themselves as speculative instruments and how the whole complex is driving the financial system into an abyss. That’s essentially what led to the collapse of the otherwise healthy insurance giant, American International Group Inc. (AIG).

Unfortunately, I don’t see the U.S. Treasury Department’s much-needed rescue plan being effective without actually addressing the problems facing both the CDO and the CDS markets. The Treasury Department’s initiative will create more problems than they attempt to solve and will eventually saddle taxpayers with so much debt that they risk sinking the dollar, and worse, the U.S. government’s investment grade rating. That would be calamitous.

Tomorrow (Thursday), in an addendum to this piece, I will outline a proposal that I’m calling the Money Morning Plan because it potentially heralds a new dawn in the credit crisis, addressing the problems from the bottom up, and not from the top down. Although this plan is straightforward and elegant in its simplicity, we still opted to present it as a separate story in order to provide you with the focus, the detail and the explanations we feel this strategy merits.
If the Treasury Department wants to immediately triage the gushing wounds that are bleeding our banks and financial system dry of readily available credit by purchasing and warehousing illiquid assets with taxpayer money, it won’t be long before the U.S. financial system begins to hemorrhage somewhere else.

The free market caused these problems under the noses of undistinguished regulators.
The free market - with the oversight of good governance practices mandated by effective regulators, who should not be empowered to kill entrepreneurial capitalism - will once again rise to the occasion and prove America’s robustness and indefatigable spirit.

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How credit default swap works Part 2

At this point, it makes sense to explain just what a credit default swap, or CDS, is. They were the key reason for the demise of AIG (AIG), and for the fear that if they were not bailed out that the whole ball of wax would come unglued. Essentially it is an insurance policy, but an unregulated one (the State of N.Y. just recently said that it would start to regulate part of the market — can you say closing the barn door?).

If you buy a bond from, say, General Motors (GM), you are lending them money for a set interest rate for a specified length of time. You face two sets of risks in doing so. The first is that they go bankrupt and don’t pay you back. The second is that interest rates rise and the bond falls in value (think of bond prices and interest rates as being on opposite sides of a see-saw).

With a CDS, you could go out and find someone who will insure against the default risk. For a given premium, the seller of the CDS will pay off on the GM bond if GM goes belly up. Now, if it was from a real insurance company, the insurance company would be regulated and would have to hold enough money in reserve to pay you off in case GM actually did go belly up. This is just like how a Life Insurance company has to have enough cash on had to pay off on your policy in case you die.

However, since this is an unregulated market, someone can sell you a CDS and blow the money in Las Vegas. In that case, if GM did go belly up, you would just plain be out of luck.

In the case of life insurance, there are strict limits on who can take out a policy on you. You can take out a policy on your own life, and on close family members. In some circumstances you can take out a policy on your business partner, but beyond that there are not many people you can take out a policy on. You have to have what is called an insurable interest; you can’t just wander the halls of the hospital looking for people who are unlikely to make it and take out life insurance policies on them.

This is not true for the CDS market. You are perfectly free to take out a “life insurance policy” on GM, GE (GE) or any other firm that issues a bond, and you do not have to be holding the bond. You can even take out a “life insurance policy” on the synthetic garbage the Wall Street has been pumping out.

This ability to buy insurance on things that you have no insurable interest in transformed this market into a huge casino. It is totally unregulated, and even the new steps by the New York State Insurance Commissioner, Eric Dinnallo, only covers the least egregious part of the market, where people actually have an insurable interest (i.e. hold the underlying bond). Regulation of this market was specifically prohibited under the Commodity Futures Modernization Act of 2001. That provision was slipped into the bill in the dead of night by our old friend Senator Phil Gramm of Texas — now Vice Chairman of UBS (UBS).

People use this market to bet on the credit worthiness of companies, and often hedge funds will hold both long and short positions on the same underlying credit.

For example (NOTE: figures are made up here, not a reflection of the actual creditworthiness of GE), the hedge fund might make a bet that it is worthwhile to get $200,000 up front and be on the hook for $10 million if GE defaults sometime in the next five years. Then after a few months, GE raises a bunch of capital which significantly strengthens its balance sheet and lowers the risk of default, so it can make a bet with someone else who would now be willing to take just $100,000 to bet that GE will not go belly up within then next five years. The hedge fund could have a perfectly matched book, so in theory they were totally indifferent if GE survives or not.
However, suppose that the person who they made the bet with goes bankrupt themselves and can’t pay up. That hedge fund might then have a hard time paying its counter party. This is where the fear of “cascading cross defaults” comes in.

All this is to say that the CDS market has seen more growth than practically any market in the history of mankind. It is currently at over $62 TRILLION, up from under $1 Trillion a decade ago. It would not take a very big percentage of that market to fail to leave a very big mark on the world financial system. When the dust settles from all the current mess, bringing this market under control has to be high on the agenda.

I would suggest that the contracts be standardized and that they be traded on an exchange, where the exchange itself acts as the counter-party for each trade (this is how the commodity exchanges work). It might also make sense to require that any party buying a CDS have an insurable interest in the underlying bond (i.e. that they are using it to hedge, not speculate).

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US Investment bank summary

16 Sept 2008

Lehman Brothers (LEH)… gone!

Bear Stearns… gone!

AIG (AIG)… fighting for its life!

Freddie Mac (FRE) and Fannie Mae (FNM)… bailed out!

Washington Mutual (WM)… grave being dug!

Wachovia (WB)… could be next!

UBS (UBS)… nearly gone!

Morgan Stanley (MS) running for the hills!

Goldman Sachs (GS)… run for the hills!

Money Market

When a money market mutual fund's net asset value (NAV) drops below $1 per share. Money market funds aren't federally insured like bank deposits; therefore, fund assets have an implied promise to preserve capital at all costs and preserve the $1 floor on share prices. These funds are regulated by the Securities and Exchange Commission and Rule 2a-7 restricts what they can invest in based on credit quality and maturities with the hope of ensuring principal stability.

Breaking the buck is an extremely rare event that money market fund managers always want to avoid, but it can occur if the underlying fund investments (which are generally assumed to be completely safe) significantly drop in value. This can happen if the underlying investments suffer large losses, such as defaults or strong moves in interest rates. Several funds reached or approached this critical point (from an investor faith standpoint) during the credit crisis that occurred as a result of a drop in mortgage-related assets beginning in 2007.

the Reserve Primary Fund, a money market mutual fund whose assets have fallen 65 percent in recent weeks, fell below $1 a share in net asset value due to losses on debt issued to Lehman Brothers.

It's the oldest money market funds in the United States. Money market funds aren't supposed to lose money, Primary Fund from Reserve on Tuesday 16 Sept 2008, saw its holdings fall below its total deposits, a condition known as "breaking the buck" that hasn't happened to a money market fund since 1994, Money market funds are supposed to be conservatively invested and almost as safe as cash.

Credit market

17 Sept 2008, the four-week T-bill yielded just 0.245 per cent and the three-month bill 0.06 per cent, the lowest levels since 1954. Dramatic declines in US T-bill yields underline the level of risk aversion in global financial markets, as traders around the world move their funds into risk-free US government debt

A closely watched measure of global borrowing costs made its biggest jump in nine years Wednesday 17 Sept 2008 and another lending risk gauge rose to a level not seen since Black Monday in October of 1987, as banks grew increasingly wary to lend to each other and sell-shocked investors sought refuge in safe-haven short-term Treasury bills.

The London Interbank Offered Rate, known as the Libor, measures the interest rate at which banks are willing to lend to each other overnight or for longer periods. The Libor rise is simply the result of continued concern over the health of the banking system. Banks are demanding higher rates to lend to each other.

TED - The price difference between three-month futures contracts for U.S. Treasuries and three-month contracts for Eurodollars having identical expiration months. The Ted spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the rate associated with the Eurodollar futures is thought to reflect the credit ratings of corporate borrowers. As the Ted spread increases, default risk is considered to be increasing, and investors will have a preference for safe investments. As the spread decreases, the default risk is considered to be decreasing.

The TED spread is the difference between what the Treasury pays to borrow for three months and the amount banks charge each other for loans, measured by the spread between the interest rate on a three-month U.S. Treasury bill and the three-month Libor rate.

17 Sept 2008, three-month Libor in U.S. dollars jumped 19 basis points to 3.0625% the biggest jump since September 1999. The London Interbank Offered Rate, known as the Libor, measures the interest rate at which banks are willing to lend to each other overnight or for longer periods. The Libor rise is simply the result of continued concern over the health of the banking system.

According to some estimates, loans and derivative contracts totaling roughly $150 trillion more than $20,000 for every person on Earth are indexed or tied to Libor in some way. As a result, big changes in the Libor rate have major global implications for the cost of borrowing.

The so-called TED spread widened to 302 basis points Wednesday 17 Sept 2008, that's a few ticks higher than it was on the day of the Oct. 20, 1987 stock market collapse, when it rose as high as 300 basis points. Prior to the crisis, normal is below 25 basis points for the TED spread.

CDS are a common type of derivative contract that pay out in the event of default When the difference, or spread, between rates on these contracts and rates on U.S. Treasury bonds increases, that suggests investors are willing to pay more to protect against defaults.

Gold futures jumped $70 an ounce Wednesday 17 Sept 2008, the biggest daily gain in dollar terms in more than two decades. That represents gold's biggest one-day jump in dollar terms since at least 1980, the earliest year historical data were available on the Comex. Gold futures started trading in the U.S. in 1974.

Notes for the bear market

In the last seven bear markets, the Standard & Poor's 500 Index tumbled an average of 33%, according to S&P.

The never-ending tug-of-war between risk and reward always disrupts investors when anxiety and uncertainty get the upper hand.

The fundamentals will come back into play when market panic is gone, and that's when you want to do some buying base on fundamentals.

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Tips on FOREX trading

There are a few things your Forex broker doesn’t want you to know. Or I should say there are a few things your “dealing desk” Forex broker hopes you don’t find out.

I say “dealing desk broker” because honestly, only dealing desk brokers care how market savvy you are. Regular non-dealing desk brokers couldn’t care less. They don’t care how (or if) you make money on your trades. They get their standard fee spread either way.

But dealing-desk brokers…well, that’s a whole other story.

A “dealing desk” brokerage firm actually has traders sitting at a desk, who make their living betting against their clients’ trades. In other words, they follow a trading model that ensures they win when you lose.

And vice versa. When you’re congratulating yourself over that last winning trade, your dealing desk broker is sitting on a loss.

Why is this profitable for a brokerage house? It’s because most Forex traders are novices. These beginners try to trade on their own, so they often rack up the losses. This gives “dealing desk brokers” a natural advantage.

Of course, it’s not difficult to give yourself the advantage. In fact, it’s pretty easy. But you have to know a few “Forex secrets” that your FX dealing desk broker definitely won’t tell you. In fact, he’s betting you don’t know these tricks.

So let’s shake things up a bit and take a look at the top three secrets your broker doesn’t want you to know.

Secret #1: It’s All About the Fundamentals

Firstly, you need to trade on the side of the fundamentals and never against it. So pay attention to what central bankers are saying about their economies. This is important. They may not always give you all the facts, but you can usually get at least an idea what they will do next from their statements.

Central bankers will give you their thoughts on their respective economies. And if they don’t tell you outright, you can tell by their actions. For example, when central bankers raise rates, it means they’re fighting inflation. That’s usually a good sign for the country’s currency. However, if inflation is shrinking or if the central bank is in “rate cut” mode, then it’s bad for the currency.

If the economy is growing (according to its GDP numbers), then that’s another plus for a country and its currency. On the other hand, a falling GDP either means a country is slowing or the economy is shrinking rather than expanding. Either way, that’s a bad thing for the country’s currency.

So to find the perfect currency pair to trade, you need to play “matchmaker.” Match up the best-looking country with high inflation and rising interest rates with the ugliest country with the worst fundamentals (lower inflation and slashed interest rates). Once you have your “best-of” and “worst-of” currencies, simply trade the good country vs. the bad country.

For example, let’s say you decided the U.S. dollar was the “ugliest” currency in the world because the U.S. is slowing and the Fed just cut rates. You also decided that the euro was the best-looking currency. In this instance, you would buy the EUR/USD pair.

Your dealing desk broker doesn’t want you to trade with the proper fundamental direction. They’d prefer you “trade against the trend” of the economic fundamentals. These greedy brokers want to you to “pick tops” and “pick bottoms” (and ultimately fail) because you’re fighting the trend. You do that, and your dealing-desk Forex broker wins.

Secret #2: Trade Less Than Your Broker Wants You To

The second secret is how much leverage to use. Trust me: Your dealing-desk broker would love you to pour on the leverage (a.k.a. trade more “lots” per trade).

Why? The bigger the lot size that you use, the more money you have to pay them in fees in the short-term (because you pay the spread as your fee, and higher leverage means a greater the number of lots which means more spreads for them). On the other hand, if you use a smaller lot size, and use less leverage per trade, then you pay your broker fewer spreads, at least in the short-term.

So if you use a ton of “lots” and trade very, very frequently, then you’re actually helping out your broker (not necessarily yourself). Your dealing desk broker will love you because your over-trading is “good for business.” You’re also making a ton of money – only for your broker, not yourself. That’s why they’ll always encourage active trading.

However, you’ll build up your trading account over the long-term if you trade a lower number of lots in proportion to your account size. Also, if you trade less frequently and hold trades longer, you’ll help yourself and your trading account rather than your broker.

Secret #3: Buy and Hold and Rake in “Daily” Interest!

The last secret is you should always trade “with” the carry interest when possible. Carry interest involves buying a currency from a “higher interest” country that is outperforming a currency from a lower interest country. You’ll give yourself an advantage if you invest in the higher interest currency, and then hold it for a while to pick up the daily interest.

By the way, make sure you compare interest rates between potential brokers. In theory, they should all pay you the same interest. However, in practice many brokers won’t pay as much interest as they should. Interest adds up, so check this out before you open up your account.

Tip: It’s best to go with a “no-dealing desk” broker that pays out favorable “rollover interest” (aka carry interest).

Now, here’s the word of caution with these “carry trades.” (Remember carry trades? They involve borrowing a low-yielding currency and using those funds to invest in a higher-yielding currency.)

Just because you’re invested in a “high interest” currency, does not mean that currency will stay on top forever. Eventually the higher interest country will start to slump. That country’s central bank will start cutting rates. If you see rate cuts coming, don’t bother buying a currency just because it pays higher interest.

ONLY take the longer term carry trades when the higher interest country (compared to the lower interest country) is expanding more favorably. You’re looking for a high-yielding country that has higher inflation than the lower interest country. Then, in those times, you have a fundamental support for these trades.

Case in point, many traders like to buy GBP/JPY because it pays out good “daily interest.” However, right now, the U.K. economy is crumbling and headed for a recession. This means the Bank of England will soon have to cut rates.

In times like that, you don’t want to buy that pair. Instead, wait for the fundamentals to turn around and the central banker starts to report a more favorable outlook. Once that happens, then you can resume “carry trading” for a longer term position.

The Golden Rules of Trading Forex

To recap: Buy ONLY the country in the pair that has the more favorable fundamentals and make sure you pair that strong country with a poor country with eroding fundamentals. This gives you the edge over the house which is the market maker or what many refer to as “brokers”.

Then even when trading in the right fundamental direction, make sure to limit your leverage. I prefer mini-lots. If you’re trading mini-lots, I suggest using US$5,000 or more in your account (per 1-2 mini lots traded).

This means you’ll be able to trade with a well-funded account for quite some time. Also, your dealing desk broker will hate you because you don’t trade as often.

Then finally, when the fundamentals are working in your favor, buy the higher yielding currency against the lower yielding currency. Hold onto that pair with a low leveraged position and collect the “daily interest.”

Again, this will frustrate your broker, but it gives you one more way to become profitable on the trade. It also gives you the edge and takes the advantage away from the “house,” (aka your brokerage firm).

Even if you ultimately choose a no-dealing desk broker, still follow these same rules because it will help you be successful on your trades in the long run.

So keep in mind these “secrets” that I’ve learned from all of my years of “being on the inside.” This way, you’ll have the natural advantage – instead of your broker.

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Future Price of Oil

Want to know what the price of a barrel of oil will be in eight years? Exactly $119.50 a barrel.

There’s no shortage of pundits predicting where oil prices are heading. And every day seems to bring new reasons to change the forecast – a resurgent dollar, Americans curtailing their driving habits, oil supply reports… The list goes on.

But the guys who really know the future of oil prices are those sitting right in the driver’s seat – oil producers.

Every day, they make bets about the direction of petrol prices on the futures market. And right now, they’re telling you – in no uncertain terms – oil’s got a floor price of $100 a barrel for years to come.

“Oil-flation” is here to stay".

The Future Price of Oil – And Why You don’t Need a Crystal Ball

Crude oil is the world’s most actively traded commodity. Every day, oil producers trade futures contracts on the New York Mercantile Exchange (NYMEX) to hedge against price swings.

At the end of the day, they – along with speculators who bring liquidity to the market – determine the price of oil, which is simply a reflection of the market’s attempt to balance supply and demand.

So, that prediction of $119.50 a barrel? That’s a recent closing price on NYMEX for the December 2016 contract.

Fact is, NYMEX has over 1,000,000 active futures contracts or “open interest” on crude oil for the next eight years and not one trades below $112 a barrel.

That means the guys in the business – the ones who make their living producing and selling oil – are predicting oil will be priced over $112 a barrel for most of the next decade.

Why are they predicting the continuation of triple digit oil prices?

Plain and simple, the markets are telling us future demand for oil will outstrip supplies.

Demand for Oil Keeps Growing

Although demand is highest in the developed world, exploding economies like China and India are quickly becoming large oil consumers.

The United States is still the world’s largest consumer of petroleum and our thirst for oil is growing rapidly. Between 1995 and 2005, U.S. consumption grew from 17.7 million barrels per day (bpd) to 20.7 million bpd – a 17% increase.

In the same time frame, China’s consumption vaulted from 3.4 million bpd to 7 million bpd – a 106% increase. And that number’s rising, as China surpassed 8 million bpd for the first time in June.

Meanwhile, India’s oil imports are expected to more than triple from 2005 levels by 2020, rising to 5 million bpd.

All totaled, Asia accounts for 60% of the world’s new oil demand.

Putting a worldwide number on it, the International Energy Association recently increased its 2009 oil demand forecast to 87.8 million barrels a day.

On top of that, The U.S. Energy Information Administration projects world consumption of oil to increase to 98.3 million bpd in 2015 and 118 million bpd in 2030. That’s a 35% increase by 2030.

Oil Production Dropping?

By now, you’ve probably heard of the Peak Oil theory – that worldwide oil production has peaked and is now dropping. Consider:

1) The U.S. Energy Information Administration Energy contends that world production leveled out in 2004, and reached a peak in the third quarter of 2006.

2) Oil tycoon T. Boone Pickens recently told Congress, “I believe you have peaked out at 85 million bpd globally.”

3) And at a recent industry conference, the chief executive officer of Total SA (TOT: 64.21 -0.96 -1.47%), the French oil major, said the industry would be lucky to produce 95 million bpd by 2020.

But whether you believe Peak Oil is true or not, at least nine of the largest 21 oil fields on the planet are in decline.

In 2006, a Saudi Aramco spokesman admitted that its mature fields are declining 8% per year. It’s now clear that Ghawar, the largest oil field in the world, has peaked.

The second largest, the Burgan field in Kuwait, started down in 2005. And Mexico announced that its giant Cantarell Field entered depletion in 2006.

Reserves Don’t Equal Production

Then there’s the matter of oil reserves, a moving target if there ever was one.

Oil reserves are classified three ways:

1) Proven; it reserves have at least 90% to 95% certainty of entering production.

2) probable; it reserves have 50% probability.

3) possible; it reserves have a 5% to 10% chance.

A 2007 report by the Energy Watch Group pegged total world proven plus probable reserves at between 850 and 1,250 billion barrels. That’s 30 to 40 years of supply if demand holds steady – which it won’t.

But as Sadad I. Al Husseini, a former VP of Aramco, said in October 2007, “Reserves are confused and inflated. Many of the so-called reserves are in fact speculative. They’re not delineated, they’re not accessible, they’re not available for production.”

By Al-Husseini’s estimate, 300 billion of the world’s proven reserves should be re-categorized as speculative.

On top of that, about 70 oil-producing nations don’t reduce their reserves to account for yearly production. As noted investor Jim Rogers says, “Despite consistently pumping 8 million bpd for over two decades, Saudi Arabia has repeatedly stated their reserves are at 267 billion barrels.”

Organization of Petroleum Exporting Countries (OPEC) member nations even have economic incentives to exaggerate their reserves, as the OPEC quota system allows greater output for countries with bigger reserves.

The reality is this: it’s highly likely we have a lot less than 1,200 billion barrels to burn in the next 30 to 40 years.

And increasing demand could have us running on fumes in an even shorter span.

New Production — a Pipe Dream?

Even though we continue to hear about new oil discoveries, new oil reserves will be harder to find and extract.

Take Kazakhstan, for instance. Its oil fields are slated to be the third largest in the world. The heralded Kashagan field should produce 1.5 million bpd at its peak. But technical problems continue to plague the project.

In 2005, production was scheduled to start in 2009. A year ago that was moved to 2011 and now it’s been pushed back to 2013. And the projected cost has risen to a whopping $50 billion.

Canada’s oil sands are another example. Production could reach 5 million bpd by 2030 in a “crash program,” but the oil contains contaminants such as sulfur and carbon that are difficult to extract and leave highly toxic tailings.

Frankly, the most easy-to-extract oil has been found. Price increases have led to exploration where high technology is required and where it is much more expensive to extract the oil.

We are replacing OPEC oil that costs $3 per barrel to produce with deep-water and other nonconventional sources at $60 per barrel and up.

And that’s why the markets are predicting triple digit oil prices are here to stay.


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Contrarian View in Perspective

A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company’s risks, and understates its prospects for returning to profitability.

Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don’t pan out. Avoiding investments in over-hyped investments reduces the risk of such drops.

Professionals vs. Non-professionals

“Whenever you find yourself on the side of the majority, it’s time to pause and reflect.” - Mark Twain

What is the “Crowd”? They are the group of not-so-smart institutions, individual investors, traders, speculators, and other players in any market that form a collective opinion that is expressed in the terms of a degree of optimism or pessimism. We will call them the non-professionals.

The professionals are the “smart money”. These are the very few that are aware of crowd behavior and are able to adjust their strategies (long and short) to profit from extreme sentiment. Please note that professional does not mean institution by definition. Most institutions are part of the crowd. The media’s definition of “professional” is not always correct so be aware of the difference.

The key point to make is that when non-professionals display an excessive amount of optimism or pessimism, the professionals enter into the market and drive prices in the opposite position. Any truly non-professional, one-sided opinion or expectation of a market will be unable to anticipate a movement created by the professionals in the opposite direction that is anticipated by the group of non-professionals. This is contrarian investing, going against the masses that believe in only one direction of a market and taking advantage of their unanimous opinion by crushing them on the other side.

How does this work? Some might argue that if everyone’s buying and extremely positive, then why would the market crash? The answer: as more and more investors buy, the market will be almost fully invested. The last ones buying are the ones that bought into the market when the professionals were selling and will be stuck because of this overhead limit. After everyone’s bought, there won’t be anyone left to sustain the buying. Therefore, a fearful panic ensues and the masses start to sell, often times much later than they should have done.

A Recent History of Crowd Behavior: NASDAQ

“You don’t get harmony when everybody sings the same note”. - Doug Floyd

* 12/17/2001 (Brokerage House Strategy) - “2002 - Bring It On: Double-digit earnings growth and benign inflation environment will fuel a 20% gain in the S&P 500 to 1375 by year-end. (Note: the S&P 500 returned -22% at the end of 2002!!!)

* 12/31/2001 (Barron’s) - “The Case of the ‘Super-V’, three stimulating economic factors may come together for 2002″ (Note: There has never been a “V” bottom for bear markets that declined 18 months or longer)

* 1/2/2002 (NY Times) - “The Outlook for Stocks, for investors, 2002 should be better than 2001″ (Note: Still optimistic sentiment holding out in the market)

* 1/2/2002 (WSJ) - “After Two Years of Suffering, Investors Hope for a Rebound” (Note: feelings of depression and hopelessness)

* 12/31/2001 (BusinessWeek) - “Q&A: Still a True Believer in Dow 36,000″. In 2002, the Dow lost another 16.67% and the NASDAQ lost an additional 31.53%. The famous harbinger of this theory is James Glassman. He is 61 and will probably not be able to see his own theory work.

Even towards the bottom, everyone was still optimistic. A bottom cannot form when there is still a divide in sentiment. As the crowd was buying and hoping for a quick rebound, the professionals were still shorting the market the whole way down. The smart money bought toward the end of 2002 when the crowd was bleeding into hopelessness. A technical clue is when the current low is higher than the previous low.

A Perfect Example of a Professional: J. Paul Getty (1892 - 1976)

Billionaire Sir J. Paul Getty said it best in the first chapter of his book How to Be Rich, entitled “How I Made My First Billion”:

“In business, as in politics, it is never easy to go against the beliefs and attitudes held by the majority. The businessman who moves counter to the tide of prevailing opinion must expect to be obstructed, derided and damned. So it was with me when, in the depths of the U.S. economic slump of the 1930s, I resolved to make large-scale purchases and build a self-contained oil business. My friends and acquaintances - to say nothing of my competitors - felt my buying spree would prove to be a fatal mistake.”

In 1962, he was buying when the following headlines were printed in the media:

* “Black Monday Panic on Wall Street”
* “Investors Lose Billions As Market Breaks”
* “Nation Fears New 1929 Debacle”

Shortly afterwards, he mentioned: “I’d be foolish not to buy. Most seasoned investors (Professionals!!!) are doubtless doing much of the same thing. They’re snapping up the fine stock bargains available as a result of the emotionally inspired selling wave.”

He was completely right.

Contrarian Strategies

“The fastest way to succeed is to look as if you’re playing by somebody else’s rules, while quietly playing by your own.” - Michael Konda

* Buy when media headlines read the absolute worst and there is no sentiment divide among investors. Once sentiment becomes entirely pessimistic, buy. Also look out for a bottoming of new capital in flows into stocks. Historically, the good time to buy was when capital in flows were between 10 -15%.

* Sell when everyone is overly bullish and capital in flows into common stock & mutual funds reach a high. (In 1960 the market declined 18%, in 1962 -29%, in 1966 -27%, and in 1968 -37%, while stock ownership levels were between 32- 34%, the highest ever. In 1999-2000, stock ownership levels were at 31-33%, at all time-high)

* Don’t fight the trend. If the primary trend is down, go short. If the primary trend is up, go long. Why fight the long-term direction of the market? Stop trying to be a hero.

* Watch financial networks and read newspapers and magazines to get an idea of where sentiment levels are. Magazine covers are my favorite.

Conclusion

“Follow the path of the unsafe, independent thinker. Expose your ideas to the dangers of controversy. Speak your mind and fear less the label of ‘crackpot’ than the stigma of conformity. And on issues that seem important to you, stand up and be counted at any cost.” - Thomas Watson

It’s safe to say that following the real professionals is the way to go. In order to do that, you have to know how they play. There are three points that need to be stressed:

1) there is tremendous pressure and influence to join the crowd and gain easy acceptance,

2) the crowd is wrong in the majority of times,

3) under duress, psychologically, our emotions and objectivity can become distorted and cause us to rationalize (a dominant coping mechanism) or deny (a dominant defensive mechanism) even the basic realities of truth.

Investors will be able to join the crowd when appropriate, but remain flexible to leave the crowd at times when the market warns us. I encourage each investor to respect the nature of human weakness and to become a free-spirited independent thinker.

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F.E.A.R is "False Event Appearing Real"

"BRAVERY is essential in all things, for while the aspirant allows the negative accumulation of fear to discolour his outlook, he cannot ever truly aspire to Freedom.

"Freedom from fear can be brought into active manifestation within all men providing they have knowledge. Knowledge of the right kind dispels fear, whether the manifestation of this fear be petty or more potent.

"It is not necessary for man upon Terra to fear man upon Terra, for if you obey the Unchangeable Laws, indeed by your obedience do you burn fear in the bright light of dawning Enlightenment.

"Man upon Terra today is beset by strange fears which imprison his actions, his very outlook; which imprison his mind—aye, even his psychic abilities.

"Fear is a weapon being now used by the darkest forces to cause you to become their ignorant pawns.

"Break away from this fear by delving deep within yourself and discovering the great dormant Powers which are latent there.

"Break away from this tight bondage by so Enlightening your­selves that this weapon may be rendered useless.

"Study fear for what it is. Study it coldly without emotion. You will discover that it is but a state of mind which you have formulated for yourselves.

"This state of mind is the result of Karma, environment and present outlook.

"Karma—you can, at this very moment, make for yourself a Kar­mic pattern which, when manifested, will not bring vague fear as a result.

"You can rise above environment, for it is a changing thing, it is not real.

"Knowledge gained by adherence to the Unchangeable Laws can bring to you that stage of Enlightenment which dispels fear. A state of mind can be changed at once for good or for evil. It is just as easy to have a state of mind unclouded by fear as it is to allow it to be warped by this intrusion.

"Have this outlook upon Life. Act in this way and fear becomes non-existent.

"When fear has been transmuted in the fires of applied knowl­edge, tempered by Love, you become Wise. In your Wisdom there is fortitude and BRAVERY.

"The First Freedom—dispel fear. Go forth into BRAVERY and you will know many things, for you will have taken an essential step upon the ladder of Evolution.

"There will come a day when you will be examined in this Light. Prepare for tomorrow's examination now and Mastery will be yours...

"BRAVERY is victory through experience. "Be Brave, not foolish; but Brave through Wisdom—and know The First Freedom.