The Energy Report: You are famous for taking the long view of the political economy, Don. What does the machinery of history tell us about the likely future of the Western world as measured against the newly industrializing economies, including China, India and Brazil?
Don Coxe: For the first 17 centuries of the so-called Christian Era, China and India together generated about 40–50% of global gross domestic product (GDP), due to the sheer size of their populations. But when they did not participate in the Industrial Revolution, the relatively small number of people living in Europe and North America were able to take over 70% of global GDP. The East stagnated.
"Of the new wealth being created in the world, more than half of it is being created by China and India."
Then, in 1978, a momentous event changed the world—Deng Xiaoping was invited by the British Labor Party to visit Great Britain. Labor was facing an election against Margaret Thatcher, whom they regarded as the devil incarnate. The party wanted to show Deng how awful things were for the British working class. However, he was astounded at how well the working class lived. When he returned to China, Deng changed the slogan on the Mao posters from "to work is glorious" to "to be rich is glorious." It was the most important editorial alteration in the history of the world. Then, he put politics to work liberating the entrepreneurial spirit of the Chinese people.
Twelve years later, in India, the Congress Party brought a Sikh into the Cabinet, Manmohan Singh. The fall of the Berlin Wall and the collapse of the Soviet Union had been a shock to the Left in India; people could see that China was moving forward; a charismatic leader was needed to change things. Manmohan Singh became, in his own modest way, the Deng Xiaoping of India. He didn't have Deng's absolute power; he was just one cabinet minister. But the results were amazing: India quickly climbed from a rate of growth of about 4% to 6%, then to 7%, and then to 8%. The magic of GDP compounding worked, just like how compound interest grows.
Remarkably, China returned double-digit rates for 10 straight years—a feat never seen before. Of the new wealth being created in the world, more than half of it is being created by China and India. Indonesia, Vietnam, Malaysia and Brazil have started growing their GDPs at much faster rates, too. In a mere 15 years, economic and political power has shifted dramatically toward the East.
TER: How has this shift impacted the global demand for natural resources?
"The only way to grow from being a primitive economy to being an advanced economy is by consuming natural resources."
DC: The only way to grow from being a primitive economy to being an advanced economy is by consuming natural resources. At the beginning of the last century, the most important corporation in North America was J. P. Morgan's U.S. Steel Corp. replacing Britain. The U.S. became the major industrial power of the world by riding the success of its domestic steel industry. Now China uses 50% of the world's steel. Industrialization requires energy as well as metals, of course. This is why China has gone from being the 20th largest consumer of oil in the world to being the second biggest with breathtaking speed. Fortunately, we've found new oil resources. Otherwise, the Chinese would be driving oil prices to levels that would bankrupt us.
TER: Are the pricing mechanisms for energy commodities controlled by the East?
DC: China does not produce much of its own energy commodities. India produces a lot of coal, but not gasoline. Growing Asian demand for energy resources has disrupted global market patterns. Oil is at $97 per barrel (/bbl). If China were still where it was at 10 years ago, oil would be at $50/bbl.
TER: How do the needs of the new middle classes in these emerging economies affect investment opportunities for Western investors?
DC: In this century, about 400 million people worldwide have already transferred from subsistence to high-protein diets. There has been a huge increase in the price of basic grains, which are converted into meat and milk and eggs. It takes seven units of vegetable protein to produce a unit of beef, six for milk, five for pork and three for poultry. As people added these items to their diets and their physiologies changed, they absolutely had to keep on ingesting high protein quotients. They couldn't go back to a few slices of bread a day. This has created a gigantic bull market in agriculture. For example, at the beginning of the millennium, corn was at $2/bushel, and now it's $8.35/bushel. Soybeans were $4.90/bushel, and are now at $17.25/bushel. The agricultural sector of the U.S. economy has enjoyed sustained economic growth based on strong prices for four years. Shares in agricultural firms that produce fertilizers, farm machinery and genetically modified seeds are terrific investments.
TER: What is the effect of the current drought in the Southwest?
DC: There is drought somewhere in the world every year. The bad luck this year is it came in the most important grain-producing section of the world. But if the drought had been over the North Atlantic, we wouldn't have noticed it. Due partially to drought, the prices of grains have climbed to record highs. But one of the things that got put into the Farm Bill five years ago was crop insurance. There is now going to be a gigantic claim against this insurance, because farmers are allowed to recoup 85% of what their average production per acre was for the last three years at the price of corn, soybeans or wheat today. This means that farmers whose crops are hit hard by drought don't have to work very hard, and their income is 85% of those who have perfect weather. Not bad.
TER: How do biofuels affect agricultural investments?
"When the U.S. and Europe crashed, China, India and Indonesia did not; they continued to consume commodities. That's what I call a commodity super cycle."
DC: The biofuel industry is an example of where greed and good intentions combined to create a monster. Back in the 1990s, when there were corn surpluses, we got the bright idea to produce corn liquor to add to gasoline. The idea was to create "green" jobs and renewable energy rather than relying upon coal, oil and natural gas. This wasn't a problem when corn prices were reasonable. But then the ethanol beasts succeeded in having the alternative fuel mandates increased. They actually got a law passed through Congress that mandates putting 15% ethanol in every gallon of gas next year. God help us if the government actually imposes that mandate, because I don't know where we'll find the corn.
But bad as we may be, the Europeans are almost as bad. They add palm oil to diesel fuel. They're ripping down the jungles of Southeast Asia and the demand for palm oil has skyrocketed its price. Palm oil has been calculated to be the single most important protein source for poor people in the big cities of Southeast Asia. It's their biggest source of protein, because they cook with it. When palm oil is sent to Europe to replace hydrocarbons, local palm oil prices skyrocket.
Three years ago, the nations of Southeast Asia, including Indonesia, sent an emergency letter to the European Union (E.U.), demanding that it stop the palm oil mandates. The E.U. knows how to handle things like this—they set up a committee. That committee has not yet reported. The result is that the prices of all of these vegetable oils—palm, soybean, canola—have skyrocketed. The chairman of Nestle was asked what we need to do to get food prices down to sustainable levels. He said it's quite simple. Stop subsidizing ethanol. That's it. Bang.
I analyze global food issues for the G8 meetings. I've been pointing out the problems with biofuel year after year, but nothing happens about it because the ethanol and palm oil lobbies are so powerful. I personally regard this as an outrage.
TER: What exactly is a commodity "super cycle"?
DC: The global economy has been through a crash and a recession, but commodity consumption overall is higher than it was before. Why? When the U.S. went into recession in 2008, Europe went down the tubes. But China, India and Indonesia did not; they continued to consume commodities. That's what I call a commodity super cycle: It transcends the ordinary economic cycle. In past recessions, the worst economic assets were commodities—their prices plummeted. That has changed. For example, during our boom periods, about 40% of the metal consumed is manufactured from scrap left over from economic downturns. When the new economies, particularly China, were formed, they didn't have previous industrial cycles, so they had no reserves of scrap. Therefore, they've been buying virgin metal and our scrap. The metal component has been dramatically higher in this super cycle than it's been for 150 years.
TER: How have natural resource commodities fared in general since the tech meltdown at the turn of the millennium?
"We are witnessing a great transfer of political and economic power."
DC: The tech crash in 2000 was the greatest idiocy in the history of financial humankind. There was a 150 multiple on NASDAQ and very few barriers to entry in the tech business. The crash was inevitable. This meant that the emerging economies were able to get our technology cheap. They caught up with us in a hurry. Without the crash, it would have taken China and India two generations to acquire the technical knowledge and the factories to compete with us. Plus, by Moore's Law, the cost of information technology fell by 50% every 18 months. And in many cases, they just stole our patents. The tech crash was great news from the standpoint of China and India—it meant that perfect competition was operating in technology. They were able to set up their own factories, obtain foreign subcontracts and get in on the global commodity game because they had lower operating costs.
The NASDAQ stocks recovered a bit, but then came the idiotic real estate crash. That crash was based more on fraud and on government policy than on Moore's law. When governments mandated that banks had to make a certain percentage of their loans to poor people, Wall Street said, we'll take these loans off your books, because we have these marvelous new collateralized debt obligations. With alchemy, we can buy sub-prime mortgages and mix them in with good mortgages and—magically—get a triple-A rating.
That was the second time that technology was involved in creating a crash. Technology was involved the first time in the stocks of companies doing neat, new things. The second time, technology created the mathematical formulas to produce financial products. It's the equivalent of mixing sewer water with tap water and claiming that because there was more tap water than sewer water in the glass, it was safe to drink.
TER: How have the ups and downs in the residential real estate market affected natural resource commodity stocks?
DC: Much wealth has been destroyed. This wealth could have gone into the stock market and personal savings and individual retirement accounts. It was just wiped out in the 2008 crash. Consequently, the multiples on perfectly good commodity stocks are now much lower than they should be, considering their quality.
TER: Do you have any thoughts on why junior energy and metal mining stocks have been at relative lows over the last three quarters?
"A much bigger percentage of new resources are being successfully developed by China."
DC: Part of the problem is political. Extremely rich, tax-exempt organizations staffed with lawyers attack mining companies when they try to open new mines or drill for oil. A whole sector of the economy has been taken outside the tax system. It used to be if you were trying to prevent an oil company from drilling, you had to take your own risk and get landowners together to wage the fight. Now the fights are being waged by rapacious lawyers hired by extremely rich non profit organizations set up, ironically, from the estates of capitalists who actually created wealth.
Blocking the Keystone Pipeline was a shocking political development. Elitists from Hollywood posing as environmentalist experts demonstrated in Washington and spent a night in jail, for which they were treated as national heroes. This creates a political risk climate for the resource industry. It's tough to get capital for small companies when somebody out there is going to be coming after you, politically.
TER: How do politics affect international competition for natural resources?
DC: The oil companies and mining companies are not allowed by law to bribe local dictators; the Chinese are free to do that. They can also destroy the landscape, which we are not allowed to do in this country. We have tied the hands of our corporations working abroad. Meanwhile, the Chinese are developing mineral resources in some pretty toxic parts of the world. There are 800,000 Chinese living abroad, going to universities, learning and working. They are moving into countries, particularly in Africa, where there is no chance that a listed U.S. company could ever make a legitimate deal.
We are witnessing a great transfer of political and economic power. A much bigger percentage of the new resources at the margin are being successfully developed by China, because its firms do not have to worry about tort lawyers suing them, or their own government prosecuting them.
TER: Are the Chinese coming into North America as well?
DC: Yes. They are currently buying Nexen Inc. (NXY:TSX; NXY:NYSE) in Canada. From the standpoint of Canada, China is actually a friendlier country than the U.S. is—with Obama blocking the Keystone Pipeline. And the environmentalist groups in the U.S., the ones that are big funders of Obama, are determined to not only stop new pipelines, but also to shut down the oil sands, which they regard as a big source of carbon dioxide. If your next-door neighbor is trying to stop you from developing your own property, you will find friends wherever you can.
TER: The Canadian tar sands and the black shales are worthwhile prospects, as are the discoveries in North Dakota. Let's talk about the economic benefits of investing in those spaces.
"Canadian companies would be wise to make deals with China."
DC: It is stunning that North Dakota is producing more oil than Alaska! The companies doing this are a boon to the U.S. economy, although they've had opposition all the way. But I do believe that the good guys are going to win in most cases, because most of the voters want to see progress. They want to see lower gas prices. They want to see gas replace coal. I think that the enviro-left is going to lose in the long run. Therefore, the junior explorers ought to be successful.
But in the case of the Canadian companies, they may be wise to make deals with China, rather than with American firms, at least for the next four years.
TER: Who are these tax-exempt enviro-groups that you're talking about?
DC: The Sierra Club. The Natural Resources Defense Council. There is a long list of organizations that are staffed by really smart, dedicated people. You can't say exactly that they are rapacious, but they have a view. Of course, it really amuses me that they will fly in corporate jets of their own to meetings, while trying to snuff out the excessive carbon footprint that the rest of us have. There is a certain amount of phoniness about them. But there is no question that they are a real barrier to development. However, as long as we have 8–9% unemployment, they're going to have trouble convincing the average man or woman on the street that what they're doing is in his or her interest.
TER: We talked about the downsides of regulating the energy and mining industries. Are there upsides to regulation? I know that you have written that BP Plc (BP:NYSE; BP:LSE) should have been more closely monitored.
DC: I never would have invested in BP. When John Browne took over, he made himself the darling of the Left by talking about how BP was going "beyond oil." But when you looked at its work practices, they were shoddy. It was pretty embarrassing when the company that was supposedly the most enviro-friendly created the biggest mess of all. But it is possible for a well run company to safely drill in deep sea depths. BP probably needed more rigorous enforcement of existing regulation. The company had a refinery fire in Texas and people were injured. The government report denounced BP for multiple safety violations. It had a terrible track record in operating its Trans-Alaska pipeline, where it had multiple leaks.
TER: Are there energy stocks that are more appropriate for institutional pension funds than for retail investors?
DC: Energy-related commodity stocks should be in all portfolios. People should invest in the companies, rather than in the commodities themselves. That's socially better, because sequestering hundreds of billions of dollars' worth of commodities adds to global inflation. Individuals should to talk to an adviser who knows their personal affairs. But for a large organization or a person with a few million dollars to invest in natural resource commodities, we recommend about one-third of the portfolio should be in agricultural stocks, because they have the best risk-reward ratio. About 30% should be in gold stocks. The rest should be in oil and gas stocks. We don't recommend more than 8% in base metals. Because the Chinese are taking over these properties, we do not think there is long-term growth in the base metals.
TER: You're scheduled to talk about navigating the politicized economy at the upcoming Casey seminar. Can you give us a preview of your presentation?
"Energy-related commodity stocks should be in all portfolios."
DC: Today's investment risks are different from the risks of past eras, because the old rules applied when governments did not so voraciously inquire into your personal affairs. And tax rates were not as high. Governments were not so concerned about dictating operating rules for industrial enterprises. We are now competing against emerging economies that do not have to face that kind of governmental problem. Therefore, those economies are going to be more successful than us.
When building up a portfolio, one should not assume that the U.S. is the safest country on earth to invest in. It may be once again, but the evidence is that Washington is aggregating more and more power unto itself. It might not matter who wins the White House as this pattern continues. And we're now competing against China, which has all those people. It has a huge amount of internal cohesion, and it is determined to become as rich as, or richer, than we are. My basic rule is do not invest in companies that produce what China produces, or is likely to produce. Rather, invest in companies that produce what China needs to buy.
TER: That's good advice. Thanks for speaking with us today.
DC: My pleasure. I encourage your readers to attend the "Navigating the Politicized Economy" summit. I'll be delving into these topics in greater detail. If you can't make it, you can order the audio collection, which will include my presentation as well as a lot of valuable information from the conference's 28 expert presenters. It's cheaper if you preorder; you'll save $100.
Donald Coxe has more than 39 years of institutional investment experience in Canada and the U.S. He is Strategy Advisor to BMO Financial Group with $500 billion under management. From his office in Chicago, Don heads up the Global Commodity Strategy investment management team—a collaboration of Coxe Advisors and Harris Investments—to create and market commodity-oriented solutions for investors. He is advisor to the Coxe Commodity Strategy Fund, the Coxe Global Agribusiness Income Fund and the Virtus Global Commodity Stock Fund. Coxe has consistently been named a top portfolio strategist by Brendan Wood International; in 2011, he was awarded a lifetime achievement award and was ranked number one in the 2007, 2008 and 2009 surveys.
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1) Peter Byrne of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Don Coxe: I personally, and/or my family, and/or the Funds I advise through Coxe Advisors LLP do not own shares in the following companies mentioned in this interview: BP and Nexen. I personally, and/or my family are not paid by the following companies mentioned in this interview: BP and Nexen. I was not paid by Streetwise Reports for participating in this story.