The Rude Awakening
Wall Street, New York
Friday, October 13, 2006

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• Your insight to the nuclear threat from the world's
  most uranium-rich nation,
  
  
• Trading places – an Aussie for a Yank,
  
  
• Cultural clashes, collusion and conflicts, French
  views on Australian water issues and much more...

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Eric Fry, on location in the O.C., reports.

Last week, as faithful Rude readers will recall, we
presented a few insights from Dan Denning, editor of the
Australian Daily Reckoning.

As an American ex-patriot living in Australia, Dan is the
mirror-image of the Rude Awakening's own Joel Bowman: an
Aussie ex-pat living here in America. But that's not the
only reason we feel a certain esprit de corps with our
colleague Down Under. We just happen to like him and we are
always intrigued by what he has to say.

In the column below, Dan's musings roam effortlessly from
French protesters who condemn Australian water policies, to
Korean dictators who wear drab jump suits, to American
hedge fund managers who always fail to expect the
unexpected

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Water, Nukes and Catastrophe
By Dan Denning

"We are encouraging ze government to stop cutting down ze
forests in ze catchments and help save ze valuable water of
Australia. We need your help. Zees campaigns cost money,
but only $7 dollars per week. Will you sign up monsieur?"

It took us a moment to realize that we were being educated
on Australian water issues by a young Frenchman on Acland
Street during our lunch hour yesterday. But as far as we
could figure, he had a point. We don't know much about
logging policy. But it does make sense to us that logging
trees in water catchments decreases the amount of ground
water stored up from rainfall. Exposed soil erodes more
quickly and rainwater runs off into rivers and out to the
sea.

But we should be honest and say we didn't have all the
facts, nor did we listen long enough to get them. We were
merely surprised that the issue of water preservation had
made it down to Acland Street to join us for lunch. Water
issues are becoming as prevalent as water itself is
becoming scarce. "Victoria's two biggest inland cities,
Ballarat and Bendigo, are on the brink of major water
crises after record low rainfalls over the past decade,"
reports last week's Australian. Water storage levels are at
13% in Bendigo and 26% in Ballarat, and spring has hardly
sprung. 

Is there really a local water crisis? A global water
crisis? I turn the tap on at home, out comes the water. You
can find the stuff on the shelves in any corner store. It
falls from the sky for free. How can there really be a
water crisis?

Fair questions. But we would note that entire civilizations
in North America (the Anasazi, for instance) disappeared
for lack of water. Canals, pipelines, and irrigation have
since made it possible for human beings to dwell and
prosper in places that would otherwise be uninhabitable.
Lush, green golf courses now blanket the very same
landscapes of the American Southwest that failed to sustain
the Anasazi. Score it as a victory for innovation,
ingenuity, and human adaptability.

We are putting the finishing touches on our own in-house
examination of water, from an investment perspective. But
we'll give you a sneak peek at our conclusions. The water
crisis will not be "solved" by conservation, although that
will help. It will be "solved" by investment in massive
infrastructure projects, from canals and pipelines to
desalination.

Whether the water-focused Australian companies we are
monitoring will become part of Australia's water solution,
we can't say. But they are already part of some of the most
ambitious projects of this century in locations all around
the globe. Stay tuned

Yankee Go Home!

Russia has barred foreign oil companies from participating
in the development of the mammoth Shtokman gas field in the
Arctic. At least that is what Alexei Miller, chairman of
Russian gas monopoly Gazprom, said yesterday. Gazprom has
decided it will develop the Arctic field, 550km from
Murmansk, by itself . "This field will be developed without
offering foreign companies the right to its reserves,"
Miller said. "Gazprom will be the 100 percent owner."

Whether the Russian's have the know-how to execute the
project is another question. We recall a former U.S. air-
force pilot and Boeing Executive once telling us that the
Russians can do more with less than any people on the
Earth. We wouldn't put it past them. But the real
significance of the announcement is that by excluding U.S.
oil companies Chevron and ConocoPhillips, Russia has
decided to export future production from the giant field to
Europe. Clearly, U.S. oil companies no longer get "first
dibs" on all of the world's new oil and gas discoveries.

The Shtokman project also highlights two important trends.
First, finding and developing conventional hydrocarbons
like natural gas and oil is becoming much more difficult
and expensive. You might be able to find lots of gas in the
Arctic, but developing it is going to cost you. Second,
energy producers are scrambling to replace their reserves
and to keep global production steady at current levels.

Global oil production appears to have hit a plateau at 85
million barrels per day. This confirms the peak oil theory
that the production of the world's easily recoverable
hydrocarbons has, in fact, peaked. So what comes next?

That depends on how long the plateau is. We can chug along
at this rate for awhile. Peak oil skeptics will take this
relatively placid plateau as evidence that there is no oil
problem. Prices will fall. Urgency will vanish. And then,
one fine day, depletion will begin to hit the world's
largest producing oil fields. You know, the oil fields that
account for the bulk of the world's daily oil production.

At the risk of repeating ourselves, we continue to believe
that the energy bull market is still in its infancy. The
future will favor investors who buy into weakness in the
oil and gas sectors.

Strategic Genius or Fashion Victim?

Is Kim Jong Il mad as a hatter or mad as a meat axe? The
question interests us here at the Old Hat Factory, where
the legacy of mercury-induced insanity seems to have
produced a tolerance for eccentric behavior. It doesn't
matter if Kim Jong Il is insane, delusional, or a shrewd
tyrant who chooses to dress in drab jump suits.

What does matter is that the world's nuclear club may be
adding a new and unwelcome member. Geopolitics is not our
beat in this space. But money is. Does North Korea's bomb
have investment consequences?

So far, the markets have taken the bomb in stride. This
tepid response implies one of two possibilities: Either the
market has no idea how to price the risk of a new,
unpredictable nuclear power, and therefore needs more
information, or, risk is so thoroughly hedgeable in this
derivatives-empowered era that even the birth of a new-era
of nuclear proliferation does not pose a threat to global
capital flows.

Our take? The devil is in the details. It is not the
obvious big fall in an index that signals financial
catastrophe. That would merely be a symptom. Catastrophe
usually arrives in baby steps. For example, Bloomberg
reports, "The risk of owning South Korean bonds surged. The
price of credit-default swaps based on $10 million of South
Korea's dollar denominated debt rose to $26,000 per year
from $24,100 Sept. 6, according to data compiled by
Bloomberg. It was the biggest increase in 16 months."

These kinds of marginal changes in bond, currency, and
derivative markets are exactly the type of thing that hedge
fund managers never plan on. Their models relegate
geopolitical events to the realm of "exogenous" events and
assign them low statistical probabilities. This makes the
models incredibly vulnerable when they come into contact
with real life, like a sea kayaker who comes into contact
with a typhoon that wasn't in the forecast.

A sudden shift in capital flows, a rush out of South Korean
bonds or the yen and into some other asset class or
currency is the kind of thing which sets about a cascade of
other changes in the inter-connected world of derivatives.

But wait. Is it fair to hold fund managers accountable for
events which they could not possibly predict? Of course
not! But life is not fair. Models which fail to take into
consideration human behavior are bad models. Though it is
hard to program human behavior into a model, failing to do
so can be financially disastrous.

As Eric Beinhocker writes in The Origin of Wealth, "Real
human beings have real behavioral regularities." One of
those regularities is that entire nations go stark raving
mad from time to time. The history of the 20th century is
filled with examples. The world is full of hatters, and all
of them are going mad.

It would be nice to have a tidy mathematic model that
accounts for the periodic irrationality of financial
markets. But quantifying irrational behavior is notoriously
difficult. From a financial perspective the moral is
simple: do not underestimate the unanticipated financial
consequences of a geopolitical event that triggers a fiasco
in the derivatives markets.

Pricing risk is not the same kind of science as splitting
the atom. Inexactitude in one is nearly as explosive as
precision in the other.

[Eric's note: Erratic, unpredictable markets terrify most
investorsBut not short-sellers like Jeff Clark. He accepts
the stock market's inevitable volatility as "profit
opportunities." Jeff is a very successful professional
investor, who also happens to be an excellent short-seller.
His knack for identifying fundamentally flawed stocks – and
for choosing opportune moments to bet against them – has
won him an avid following of very satisfied subscribers.

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[Joel's Note: As this issue goes to "print" some 130
bushfires rage across the Great Southern Land of Australia.
Aside from the devastating effects on local residents, the
Aussie cattle and wheat markets have copped a battering
too. In one of the world's richest resource nations, it
pays to be in the know when environmental forces like this
strike. Whether it be their mammoth coal industry, their
oft-controversial uranium deposits or raging infernos,
there is always news from the frontline that could be
effecting your investments.

If you are a curious Aussie, or merely enjoy the commentary
from our mates down at the Australian Daily Reckoning, you
can check out their unique brand of witty musings right
here:

http://www.portphillippublishing.com.au/freeservices.html

Team Rude will return tomorrow for your regular weekend
installment but, until then, have a gander at our Aussie
mates and enjoy the final trading day of this record
breaking week.

Cheers,

jOEL

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