Sunday, May 31, 2009

The Great China Commodity Carry Trade

In a volatile market, rather than trying to get ahead of the daily movements, successful investors spend their effort on figure out the big picture of long term fundamentals. Many people often draw the wrong conclusion when their views are too narrow: They look at only the demand side and forget the story on the supply side, or they fail to see the effect of government interventions or speculative forces.

Recently, in researching the market trend of currencies, commodities and shipping, I made one stunning discovery! The discovery is so shocking it completely changed my views, yet almost no one else discussed in any public literature. My discovery, if proven correct, could mean gigantic investment opportunity for those who get it first!

Where is US dollar Going

A dollar bear means a commodities bull. The 2009 US federal budget deficit will be $1.75 TRILLION or even more! It's utter insanity! Any budget bill can be decreed into law, regardless of the deficit. But no one can decree new economic laws. Where do we get the $1.75T? It will be printed out of thin air, as no one, not even China, can lend this much money to us, unless we lend our money printing machine to China first. History has proven repeatedly that mass printing of fiat money always leads to currency debasement and hyperinflation!

My shocking discovery is that we HAVE already lent our money printer to China!!!

I am dreadful of the worst case scenario for America. Current gigantic deficit spending is not the worst part. The worst part is that capitals may escape from American soil for better overseas opportunities, taking away jobs and tax revenues, reducing us to the only option: print more money and debase the dollar further, a nightmare scenario for America.

US dollar bear leads to commodities bull. The people and nations will hoard physical goods to preserve wealth, hence generate demands higher than the immediate needs and higher than available supplies. China is on a big natural resources shopping spree around the world lately, in order to divest its huge foreign currency reserves.

Both events are occurring as people have noticed: Capitals are escaping American soil; and China is on a global shopping spree of raw materials. But people who do notice these two things explain it as simply market behavior driven by speculative forces, they fail to see a more direct, conscious and deliberate reason behind what's going on, because no one noticed one quiet fact!

People watch the US Dollar index daily, but are they watching the Chinese Yuan? Investors trade trillion dollars between the USD, Euro and Japanese Yen daily. But there is not much trading between USD and Chinese Yuan. That is because for the past one year, trading between USD and CNY is equivalent to exchange one dollar into four quarters, nothing is gained or lost.

The Chinese government has locked the exchange rate at a constant Y6.832 = US$1.00, for over a year now. WHY? Insightful investors Jim Rogers, Peter Schiff, Marc Faber all predicted US dollar collapse and the appreciation of Chinese Yuan, and advised people to sell the dollar and buy the Yuan. Many people listened. They sold their houses and furniture in the USA, sold all their US assets. They brought boat loads of US dollars to China, exchange into Yuan, and sit on their piles of Yuan, betting on the Yuan appreciation over US dollar to collect some profits.

And they collected some dust instead. Making money should never be easy. Straight line thinking is never how great investors make their money. Why would China allow foreign speculators to profit on its currency while it suffers loss?

As the flood of US dollars flows in, China merely cranks up its own money printing press to print more RMB Yuan to exchange for the US dollars. It then uses some of the dollars to buy US Treasury bonds and prop up the value of the dollar, maintaining a constant USD/Yuan exchange rate. But China's real goal is not to support the dollar in long term, but to buy time to allow it to divest the huge dollar assets it is holding, in exchange of physical assets: natural resources, raw commodities, foreign mining companies and other physical assets. It costs China nothing to print more Yuans to buy more US dollars and then use the dollars to buy up the whole world!!!

Thanks to currency speculators, we have lent our money printing machine to China. This opportunity allowed China to launch the greatest Commodity Carry Trade (CCT) in history! It is an absolutely ingenious move: US government has no choice but keep printing more dollars; Speculators betting a dollar collapse flee the US market and bring the dollars to China; the drainage of market capital from the US market forces the US government to print even more dollars and drives more investors away from the US and into China; China then print more of its own currency at virtually no cost, swap for the dollars, and then holding the dollars at hands, they go around the world to buy up everything, and go to the USA to buy up everything. At the end when China is done, they will let the US dollar collapse, mean while, the Chinese Yuan, due to strong backing of all the physical assets China hoarded, will hold up its value.

On the concept of China's Commodity Carry Trade (CCT), credit must be given to Andrew Snyder, whose article on the CCT is an interesting read. I smiled big when I read his pitch on a certain metal and a certain US mining company as the next big target of China's CCT. I knew he was talking about palladium, my favorite metal, and Stillwater Mining (SWC), my most favorite mining stock. There is also North American Palladium (PAL) for palladium play. I am not sure whether palladium is China's next big strategic purchase. But even without China's CCT purchases, palladium is extremely bullish. Thanks to recent break through in cold fusion, palladium could be the investment opportunity of a lifetime!

Shipping and China's Strategic Investments

If China is buying commodities for strategic stockpiling, it will boost demand in the dry bulk shipping sector. I correctly called the bottom of the Baltic Dry Index on Dec. 5, 2008. Shares of dry bulk shippers are up tremendously from the early December, 08 bottom, and from the early March, 09 double bottom. I was betting on a reasonable recovery of shipping, but I never dreamed that the BDI could reach 4291 merely 6 months after it bottomed at 666! Today shipping stocks are still very cheap, as analysts are not convinced the global economy is in recovery. But isn't it now an open secret that China is spending out its US dollar holdings in exchange for natural resources and raw materials it can buy and hoard at current low prices. When China purchases for strategic hoarding, current industry demand is not even relevant.

There is but one small cloud in the shipping sector. Drewry report calls current dry bulk sector recovery temporary, as they see a big number of new order ships joining the fleet in the next few years. How credible is Drewry's bearish call based on their new ship order prediction?

Drewry called that BDI "seems to have reached the bottom", six months after the fact. That doesn't give them much credibility predicting something six months after the fact. I actually called the bottom spot on. In 2003, Drewry also made a similar bearish call on dry bulk shipping, based on their prediction of excessive number of new ships. We now know that shipping saw an unprecedented boom period in the next 5 years, peaking in August, 2008. If the new ships Drewry predicted since 2003 are still on paper in 2009, they may stay on paper for 6 more years. Most new order ships may never be built, due to reasons I discussed before.

One of the criteria I use to pick the best shipping stocks to invest, by looking at the ratio of shipping capacities of their fleets versus current market capital, as the shipping tonnage is ultimately what earns revenue. I will leave the detailed discussion till next time. My favorites are EXM, EGLE, DRYS, TBSI and GNK, in that order.

On Precious Metals

Gold will continue to be a laggard in precious metals. The world is never in shortage of gold. Gold is just money, or just cash. Recently some gold bugs made a lot of noise of China revealing that it doubled its gold reserve in the past 5 years. But it must be pointed out that China's foreign currency reserve increased more than 10 fold during the time, so gold is now actually a smaller percentage of China's total currency reserve.

Silver is a better story than gold. If fiat currencies fail, silver is the only monetary metal that is cheap enough to be used as bartering currency. The Chinese consider gold as a luxury but silver as money and storage of wealth. In Ancient China the gold/silver price ratio was 2:1. As Chinese investors turn their attention towards precious metals, silver will be their most favorite metal.

But the best precious metal story is in platinum and more so in palladium. The bullish palladium news from Norilsk Nickel (NILSY.PK) in Russia keeps getting better. Norilsk had announced the production result of Q1, 2009. The Q1 palladium production had fallen to only 557K ounces in the Russian division. Annualized it's 2.23 million ounces per year, compare with a normal year's 3.1 million ounces. I predicted Norilsk's 2009 palladium production would be only 2 million ounces, because they are producing the ores rich in nickel content and poor in palladium. The Q1 result had confirmed my prediction.

The current low palladium price provides no economic incentive to recycle auto catalytic converters. So as the palladium recycling grinds to a halt, it removes another one million ounces of global supply. The drop of recycling is confirmed in Stillwater Mining (SWC)'s Q1 report.

Palladium has huge future potential due to recent renewed interest in Cold Fusion, especially after CBS 60 Minutes aired a special report on Cold Fusion on April 19, 2009.

Other Commodities To Consider

Crude oil price has now surges back to $68 per barrel due to the weakness in US dollar. Some predict oil could surge to $200 in the near future. Comparatively, natural gas price still far lags behind. This creates a great buying opportunity, as natural gas is still cheap to buy, when most other commodities have rallied from recent bottom. Even Dr. Doom Marc Faber called natural gas the most under-valued commodity recently.

Two reasons to buy natural gas here. First, current price is far below the marginal production cost. In the US, the conventional natural gas fields are depleting rapidly. Natural gas production was boosted in the past two years only because of new technology and higher natural gas price made it economical to develop the so called shale gas. But as the price falls below $10-$13 per thousand cubic feet (TCF), shale gas is no longer profitable so producers must cut back.

Second, from the energy point of view, 5.3 TCF of natural gas contains the same amount of energy as one barrel of oil, so $4 per TCF is equivalent to $21 per barrel oil. When crude oil price is already at $68, the low price in natural gas is unsustainable as industry energy consumers will try to use more natural gas and less oil.

How to play natural gas? Buy the United States Natural Gas fund (UNG) is the best way. Stocks of natural gas producers would go up with the commodity. But judged from past experience, price of the natural gas itself could jump up faster and more furious than stocks of producers. Some producer stocks to consider: CHK, SWN, COG, MCF and WMB.

Full Disclosure: The Author is heavily invested in palladium producers SWC and PAL. I am also heavily long shipping stocks EXM, DRYS, EGLE, TBSI and GNK. I also own UNG.