Sunday 20 June 2010

Investment Note: 06/05/2010 - Oil and China By Gareth Milliams

Oil
The massive oil spill off the coast of Louisiana will not directly affect the short term oil price. It is only a single rig and individually will have a limited impact. However, seasonal increases in productivity, the summer driving season and a possible ban on offshore drilling could push crude prices higher as demand increases.

The most immediate danger is that the 30-mile oil slick starts to disrupt tanker traffic in the Gulf of Mexico, slowing shipment of imported crude oil to two refineries in Mississippi and Alabama. Shipments of crude could be slowed on the Mississippi River between New Orleans and Baton Rouge, home to 11% of the US’s crude oil refineries.

Downside for oil is limited due to this correlation of circumstances. However, the underlying dynamic is that demand is rising, due to increases in US industrial growth. If true then this is fundamental growth and $100 per barrel becomes a stronger possibility.

I recommend consideration of the ETF USO.

China

Although it is unfashionable to say and goes against conventional wisdom, I believe that there is a possibility that China is a massive bubble of diminishing viscosity.

China has been implementing the largest economic stimulus in history as a percentage of GDP (14%). This is because China has no social safety net and construction is the easiest way to keep people employed during a global recession.

Fact: According to Credit Suisse, the average mass market home in Beijing costs 12 years of annual household income. The nearest equivalent is 7.5 years in New Zealand.

60% of China’s GDP is construction. There's currently 30 billion square feet of Chinese real estate in the works, which would work out to a 5x5x5 cubicle for every man, woman, and child in the country. Beijing alone has more empty commercial real estate than all of the property that exists (occupied or unoccupied) in Manhattan.

Their stimulus is underwritten by the government but what is the quality of those loans? Has China created a sub-prime credit class within its own business community? The problem is, is that as with bank profits, whilst speculators and construction companies are making massive profits (from government hand outs), it is impossible to see the real picture.

Therefore the two questions to be asked are:

1. Can China deflate the bubble by growing into its property development?

Entire ghost towns are appearing all over China. These will decay and fall to ruin. But as they disintegrate, the debts on the books of China’s banks will grow creating a potentially massive credit crunch.

2. Has China overdone its stimulus package by handing out too much money too early?

You can only stop financial stimuli when the recovery is a reality. If the capital flow is cut off too early then the problems that they were originally trying to avoid may manifest themselves.

Part of the problem is that China has a centralised government. Centralised governments with absolute power have absolutist mindsets. There is little room for flexibility. Conversely, in a democratic free market, financial power is fragmented between corporations of various sizes trading and vying within a legislative framework. There is intervention from government but only so as to maintain order.

The Chinese government may be able to plan its own economy but it cannot control events beyond its own borders. China is an export economy. The stimulus package is very dependent upon the countries that import Chinese goods actually doing so. Should there be a double dip, China could face its own crisis.

The crisis that we face will be a crash in industrial commodity prices and shipping. Commodity currencies such as the Aussie dollar that are dependent upon business with China will fall dramatically.

I recommend China as a component of a savings plan portfolio. No matter how far it falls it will jump back twice as high. But the profit will be made via the volatility.

Have a profitable week

Gareth

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