Petrocapita Update

March 2010
Summary

We continue to live in historic financial times and in particular in

the first synchronized, global, fiat money inflation effort. Further
to this we have zero interest rate policies in virtually every major
market and the monetary base of the world’s reserve currency is
up 150 percent in the last 24 months and growing.

In such an environment it can be a challenge to distill actionable

investment themes from the noise and uncertainty in the market
place. This is why the compass by which we steer is value.

Investors must be in the business of buying cash flow

inexpensively in order to generate long-term returns. If I had to
label my approach it would be value investing informed by the
Austrian School of Economics - value driven at the investment
selection level with Austrian analysis at the macro level to provide
insight into trends. Contents
3 “The U.S. government must make
It is of trends that I want to speak more about because we are adjustments in its spending.”
in the midst of some unsustainable trends if history and Austrian 3 “If it were possible to take interest
Economics is a guide. I have written this many times in one form rates into negative territory, I
or another but it bears repeating: would be voting for that.”

There is no way to create capital and the prosperity that flows 3 Why the US Financial Sector is
from it other than through private savings and private production. still not Healthy – More bailouts to
follow?
Sadly this is a message to which our governments, under the 4 How Much Is Too Much?
sway of Keynesian ideology, are unwilling to listen. It is axiomatic 4 Peak Oil
that state spending requires that capital is first taken out of the
hands of the profit making private sector activities via taxes, 5 Emerging Economy Decoupling
borrowing or inflation and then deployed in typically, loss-making Revisited
public sector activities. 6 AIG – oh dear, oh dear, oh dear
6 Ben Bernanke The Second
To quote Jens Parssons from the “Dying of Money: Lessons Coming Of Rudolf von
of the Great German & American Inflations” - “Everyone loves Havenstein?
an early inflation. The effects at the beginning of inflation are all
good. There is steepened money expansion, rising government 7 Austrian Definition of Money
spending, increased government budget deficits, booming stock Supply
markets, and spectacular general prosperity, all in the midst of 8 US Inflation is 10% not 3%

1
Summary (continued)

temporarily stable prices. Everyone benefits, and no-one pays.

That is the early part of the cycle. In the later inflation, on the
other hand, the effects are all bad. The government may steadily
increase the money inflation in order to stave off the latter effects,
but the latter effects patiently wait. In the terminal inflation, there
is faltering prosperity, tightness of money, falling stock markets,
rising taxes, still larger government deficits, and still roaring
money expansion, now accompanied by soaring prices and an
ineffectiveness of all traditional remedies. Everyone pays and no-
one benefits. That is the full cycle of every inflation.”

The Austrians have many useful insights on the economic

consequences of state expansion. Friedrich Hayek, the prominent
Austrian economist, wrote “The Road to Serfdom” and “The Fatal
Conceit” as a warning against an expanding state and intervention
in the free operation of the markets. Despite the almost universal
belief that more government is needed, Hayek’s works should
make us ponder the ultimate damage caused by such actions. It
has been state control over the cost of money (i.e. interest rates)
and the moral hazard created with “too big to fail” that led directly
to the problems we now face. More of the same will not solve our
problems. Hayek once said “I do not think it is an exaggeration
to say history is largely a history of inflation, usually inflations
engineered by governments for the gain of governments.“ You
can bring this quote up to date by adding the financial sector as
the other beneficiary. Give this some thought as you watch the
governments of the world pursue their current fiscal and monetary
policies.

If you haven’t already, please take the time to read these books or
if you find them overly daunting as a starting place then perhaps
consider Frederick Bastiat’s short but seminal work “The Law”. I
am confident that all these books will cast some light on what we
are currently sowing and what we can expect to reap.

On a final note, we continue to believe that with all that is taking

place this is a market where concerns about “return of capital”
should take precedence to concerns about “return on capital”.

2
Petrocapita Update (continued)
“The U.S. government must make
adjustments in its spending.”
In the spirit of delicious irony, Kansas City Federal
Reserve Bank President Thomas Hoenig said recently
“The U.S. government must make adjustments in
its spending and tax programs,” (emphasis mine). “It
is that simple. If pre-emptive corrective action is not
taken regarding the fiscal outlook, then the United
States risks precipitating its own next crisis”. This
coming from the same Fed that increased the base
money supply over 150% in the last 24 months.
Click to read Hoenig’s speech.
“If it were possible to take interest
rates into negative territory, I would be
voting for that.”
San Francisco Federal Reserve President Janet Yellen
has been nominated by Obama to be Vice Chair
of the Fed’s Board of Governors. Yellen, who has
consistently downplayed the dangers of inflation, is
now able to vote on the interest rate-setting Open
Markets Committee. In support of her view that the
Fed’s role is to create full employment, Yellen recently
said, “If it were possible to take interest rates into
negative territory, I would be voting for that.”
Why the US Financial Sector is still not
Healthy – More bailouts to follow?
Residential Mortgage Backed Securities (“RMBS”)
- A recent study estimates that 5 million houses
and condominiums on which mortgages are now
delinquent will go through foreclosure or related
procedures that put them on the market over the
next few years – the majority of the estimated 7.7
million households currently behind on their mortgage
Chart 1: Months of Shadow
Home Supply
Metro Area Number of Months
Phoenix 15
Las Vegas 18
Miami 24
Orlando 27
Stockton, CA 27
U.S. Average: 10 months
Source: John Burns Real Estate Consulting
payments. Based on the average sales rate over the
past decade this “shadow inventory” is enough to last
about 10 months.
When this inventory is released prices will drop even
further and magnify the already large losses on
mortgages and RMBS being suffered by the banking
sector. 
Commercial Mortgage Backed Securities (“CMBS”):
The other large asset sitting on bank balance sheets
is commercial real estate loans. Its clear from the
CMBS market that all is not well in the commercial
real estate lending world.
– At the end of January, a record 10% of CMBS
by balance ($72.3 billion of the $723 billion of
outstanding CMBS loans in the U.S.) were in the
hands of special servicers, up from 9.43% on
Dec. 31, 2009.
3
Petrocapita Update (continued)

– The special-servicing rate is now six times higher

Chart 2: Total US Federal
than the year-end 2008 level of 1.62%.
Spending v Median Income
– The 60-day delinquency rate has increased to
6%. 250 %
$2.79 trillion
+221%
More commercial loans are certain to become non- 200
performing over time, as overleveraged borrowers are In 1970 Total federal spending
Total federal spending
150
unable to refinance at maturity. In addition, the pace was $870 billion, and median
household income was $38,851
of maturing CMBS loans will accelerate over the next 100
$41.355
few years. According to the Congressional Oversight +32%
Panel (COP) recent report on the state of the US 50
Median household income
commercial real estate market:
0
1970 1975 1980 1985 1990 1995 2000 2005
– Between 2010 and 2014, about $1.4 trillion Source: Heritage Foundation based on US Census Bureau and
in commercial real estate loans will reach the OMB, 2008 inflation adjusted dollars
end of their terms. Nearly half are at present –
underwater! – that is, the borrower owes more
than the underlying property is currently worth.
– Commercial property values have fallen more than to default or inflate away its obligations. What is
40 percent since the beginning of 2007. happening to Greece, Ireland, UK and Spain is a
– Increased vacancy rates, which now range microcosm of the decisions that rapidly expanding
from eight percent for multifamily housing to 18 governments the world-over may be faced with in a
percent for office buildings, and falling rents, few years.
which have declined 40 percent for office space
and 33 percent for retail space, have exerted
Peak Oil
a powerful downward pressure on the value of
commercial properties. Chart 3 is drawn from the WEO-2008 report that
shows that “oil from fields currently producing” is
How Much Is Too Much? projected to enter a significant decline in production. 
The production shortfall is made up primarily by
US Federal government spending has grown 7 times “oil fields yet to be developed”, “oil fields yet to be
faster than real (inflation-adjusted) median found”, and “natural gas liquefaction”. However, the
household income over the last 40 years. low rate of oil field discovery since the early 1960’s
begs the question of how this gap will be filled.
Government spending cannot outstrip private sector
income indefinitely unless the government plans

4
Petrocapita Update (continued)

Chart 3: IEA 2030 Oil Forecast Chart 4: Consumer Spending – US vs.

Emerging Economies
mb/d
120 n Emerging Markets’ Consumption n U.S. Consumption

100
35%
80

60

40
25%
20

0
1990 2000 2010 2020 2030
1990 1995 2000 2005 2010
n Natural gas liquids n Crude oil - fields yet to be found
n Non-conventional oil n Crude oil - fields yet to be developed Source: JP Morgan Chase
n Crude oil - additional EOR n Crude oil - currently producing fields

Source: IEA
Chart 5: Global PPP GDP in 2008
Emerging Economy Decoupling Revisited
Other Dev
Russia
Emerging-market consumers recently outspent 3%
India 3%
American consumers for the first time in modern
5% Other EM
history. For example, January auto-sales compared to
26%
a year earlier were up:
China
12%
– 50% in India
– 33% in Malaysia
– 6% in the US Brazil
3%
The source of this domestic strength – high growth
Japan
rates and high domestic savings rates that provide 6%
a large pool of productive capital. The emerging
economies are now larger in total purchasing
Dev Europe
power adjusted GDP terms than the developed 21%
world. Inevitably this will mean that their growth is US
increasingly dependent on trade amongst themselves 21%
rather than with the developed world. Source: Everest Capital

5
Petrocapita Update (continued)

AIG – oh dear, oh dear, oh dear Ben Bernanke The Second Coming Of

Rudolf von Havenstein?
American International Group, Inc. (“AIG”), the
insurer that has absorbed approximately $180bn Dylan Grice of Societe Generale has done a review
in taxpayer funds, recently reported its results for of the Weimar Republic inflation in his latest `Popular
the fourth quarter and full-year 2009. AIG reported Delusions’ note. Prussian central banker Rudolf von
a net loss attributable to common shareholders of Havenstein monetized Germany’s debt during and
$8.9 billion for the fourth quarter of 2009, or $65.51 following the First World War, eventually leading to
per diluted common share, compared to a net loss massive bouts of hyperinflation.
of $61.7 billion or $458.99 per diluted share in the
fourth quarter of 2008. Fourth quarter 2009 adjusted Apparently economic thought at the time held that
net loss was $7.2 billion, compared to an adjusted increasing money supply had nothing to do with the
net loss of $38.5 billion in the fourth quarter of rate of inflation. Instead, Germans were told the high
2008. However, from section 1A, Risk Factors, of rates of inflation were caused by the war reparations
the company’s 10-K filing the narrative takes a turn Germany had to pay. More from the note:
for the worse indeed: “AIG has been significantly
and adversely affected by the market turmoil in late “One might think that the big difference is that today
2008 and early 2009, and, despite the recovery we have a greater expertise. Surely we understand
in the markets in mid and late 2009, is subject to what happens when deficits are financed with printed
significant risks, as discussed below. Many of these
risks are interrelated and occur under similar business
and economic conditions, and the occurrence of Chart 6: Weimar Germany CPI
certain of them may in turn cause the emergence, or
exacerbate the effect, of others. Such a combination 100,000,000,000
could materially increase the severity of the impact 10,000,000,000
16,579,999% inflation
1,000,000,000
on AIG. As a result, should certain of these risks 100,000,000
emerge, AIG may need additional support from 10,000,000
the U.S. government. Without additional support 1,000,000
5,300% inflation
from the U.S. government, in the future there 100,000
60% inflation
could exist substantial doubt about AIG’s ability 10,000
1,000
to continue as a going concern.” (Emphasis mine) 100
10
1
01/21 04/21 07/21 10/21 01/22 04/22 07/22 10/22 01/23 04/23 07/23 10/23

Source: SG Cross Asset Research

6
Petrocapita Update (continued)

money, and that it is only backward and corrupt
states that don’t know any better, like Bolivia and
Zimbabwe? But just a few years ago didn’t we think
that it was only backward and corrupt states that
suffered banking crises too?
And anyway, how could Von Havenstein not have
known that the continued and escalating printing
of money to fund government deficits would
cause inflation? The United States experience of
unrestrained money printing during the Civil War had
been well documented, as had the hyperinflation of
revolutionary France in the late 18th century. Isn’t it
possible that, like today, he was overconfident in his
ability to control his creation and in the economic
theory which told him such control was possible?
Certainly, in an article in the New York Times on
the eve of the First World War, again from Liaquat
Ahamed’s book, there seems to have been evidence
of the general optimism that there would be no
“unlimited issue of paper money and its steady
depreciation … since monetary science is better
understood at the present time than in those days.”
The fact is we do understand the economics of
inflation. Despite what economists everywhere say
about being in “uncharted territory” with QE, we know
that if you keep monetizing deficits eventually you
get inflation, and we know that once you’re on that
path it can be extremely difficult to get off it. But we
knew that then. The real problem is that inflation is an
inherently political variable and that concern over debt
Austrian Definition of Money Supply
The True Money Supply (TMS) was formulated by
Murray Rothbard and represents the amount of
money in the economy that is available for immediate
use in exchange. It has been referred to in the past
as the Austrian Money Supply, the Rothbard Money
Supply and the True Money Supply. The benefits of
TMS over conventional measures calculated by the
Federal Reserve are that it counts only immediately
available money for exchange and does not double
count. In any event the True Money Supply continues
to grow rapidly.
Chart 7: True Money Supply
billions of dollars
6,282
5,282
4,282
3,282
2,282
1,282
282
1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

2009

sustainability and unfunded welfare obligations leaves

us more dependent on politicians than we have been Source: Ludvig von Mises Institute
in many decades.”

7
Petrocapita Update (continued)

US Inflation is 10% not 3%

Chart 8: CPI vs SGS Alternative
Despite the rosy public assertions to the contrary,
Year-to-Year Change %
inflation is not running at subdued levels in the US.
If you calculate the US CPI using the pre-1980s 15
methodology you can see from the Shadowstats CPI-U SGS Alternate CPI
data below that inflation is approaching levels not 10
seen since the 1970s when the US last lost control of
monetary policy.
5

-5
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Source: Shadowstats.com

8
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