Gold and Energy Advisor: Gold, Oil & Energy Markets Investment Research
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Gold and Energy Advisor's Real Wealth

Real Wealth #129  11/29/2007

Market Updates, and Two Energy Companies Ripe for an Arab Buy-Out!

Big things are happening in the markets. As always, the investors who see the trends ahead of time will make the most money!

America's Largest Bank: Forced to Beg for Cash from Arab World

As I wrote in Real Wealth #128, even the biggest US financial institutions are falling into the growing sinkhole in the credit markets.

The latest news is that Citigroup, the largest bank in the country, has been having capital problems. To save itself, the bank has now accepted $7.5 billion in cash from the Abu Dhabi government. The Arabs received a 4.9 percent stake in convertible stock, along with a very handsome 11 percent annual interest rate on their money.

Why did Citigroup have to beg from the Arabs? Couldn't it find local investors to bail it out? Obviously not.

This is a very troubling transaction. Eleven percent is a huge interest rate—it's equivalent to a JUNK BOND rate.

It's also not much lower than the average credit-card rate of 13 percent or so. From a lender's perspective, credit cards are among the riskiest loans to make. Why was Citigroup forced to pay an interest rate that high?

You would think that the largest bank in our nation would be a better credit risk than the average credit-card holder. (In the US, total non-mortgage consumer debt has soared to $2.46 trillion. One in six families is close to default, paying only the minimum balances on their credit cards every month.)

Compare Citigroup's bailout to the similar $2 billion rescue of Countrywide, who is only paying 7.25 percent on its loan—almost four full points less. Apparently, Citigroup is a far worse credit risk than Countrywide, even though Countrywide is one of the primary instigators of the subprime catastrophe (and is still teetering on financial ruin).

What's really going on at Citigroup? What problems are they covering up? And what effect will these problems have on the broader market once they're revealed?

Tsunami Warning: Another $108 Billion Loss Coming

Despite the staggering losses incurred by financial firms recently, there are many more ahead.

The subprime meltdown continues on Wall Street. Goldman Sachs just predicted another $108 billion in writedowns from CDOs (collateralized debt obligations).

Meanwhile, rumors are flying about a looming disaster among Wall Street's hedge funds. Many hedge funds have three-month notice periods: when an investor leaves the fund, he has to wait that long to get his money back.

Well, what was happening three months ago, back in August? The markets were collapsing, and investors were dumping their portfolios as fast as they could.

However, fund managers couldn't redeem all their investors' holdings. There was already a massive sell-off across the markets, as funds raised cash to meet short-term obligations. Many funds were forced to delay the redemptions as long as they could, hoping the markets would recover.

The markets did recover slightly, but then fell again. (Both the Dow and the S&P have plunged 10 percent from their highs in October.) Nevertheless, the clock has run out. The redemptions are coming due this month.

Now Wall Street insiders are scared of another huge wave of hedge fund selling. These funds were largely responsible for the late-summer bloodbath we saw in the markets. Are we in for another round this month?

Time will tell.

Corporate Debt Markets Have Almost Completely Seized Up—
Here's Why That's Bad

Consumer debt is usually not a good idea for the borrower. Business debt, however, can be useful.

For example, savvy managers can use the capital to expand capacity, or boost sales and marketing efforts. The higher income then pays off the debt, generates bigger returns for shareholders, and enables the firm to supply the marketplace better. Ultimately, the entire economy can benefit.

That's why it's so worrying that business debt markets have been pulled down along with the mortgage markets. One way to measure the health of the debt market is to compare the spread between high-yield business debt and Treasury bonds. Between June and November, this spread doubled, going from 2.6 to 5.2 percent.

The yield on these corporate bonds has leaped up to 9.33 percent. This means traders are wary of increasing default risk. And new bond issuances in November have sputtered down to only $22 billion. Last year at this time, it was $72 billion.

On its own, this would be bad enough. Without available credit, many businesses won't be able to expand, or (worse) meet short-term cash-flow crunches. This problem alone would probably tip us into a recession.

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But there's a bigger problem looming. Since 2003, about 42 percent of high-yield corporate debt has been rated B- or lower. In the first six months of 2007, that number was even higher (almost 50 percent).

Some $160 billion of those loans are coming due next year. With the credit markets frozen, businesses won't be able to refinance this debt.

Unless things improve in a hurry, we're facing a wave of corporate defaults early next year. This would be similar to the ongoing subprime defaults—except it would be bigger, with even worse effects on our economy.

"It's a deepening of the crisis: it really is."

Those are the words of a UBS Securities strategist, quoted in the Wall Street Journal. All the problems I described above are just symptoms of a financial rot spreading through the markets. Here are some others:

  • Fannie Mae and Freddie Mac, the US government-sponsored mortgage companies, have announced staggering losses. Fannie announced a wipeout of $1.4 billion for last quarter, and has already had to get $500 million in additional funding. Freddie followed with a $2 billion loss of its own, causing its share price to collapse by 29 percent in just one day.
  • The three-month LIBOR rate (the London intrabank loan rate) has climbed to more than a half-point higher than the Fed's target rate for intrabank loans. Banks are reluctant to lend even to each other, fearing defaults.
  • Bank capital ratios are falling sharply. (These are the cash cushions banks are required to maintain, to cover unexpected losses.) For example, Swiss Bank UBS saw its ratio drop by 14 percent in just the third quarter alone. This is not a healthy sign for our banking system. If this trend doesn't turn around, banks will be forced to sell off their non-core assets, and clamp down on lending standards even further.
  • The European covered-bond market, a vital source of funding for the mortgage market, was temporarily suspended last week because of falling prices.
No wonder that the Federal Reserve is intervening in the markets again. (The Fed is offering billions in "repo" loans, with six-week terms: that's triple the normal period.) The European Central Bank and the Bank of Canada have been injecting funds too.

In many ways, the markets look worse now than they did before the Fed's two rate cuts. No wonder gold is surging so strongly!

The Coming Wave of Arab Buyouts

Thanks to our slowing economy, falling stock market, and plummeting US$ valuation, some US businesses are investment bargains for foreign buyers. The $7.5 billion Abu Dhabi government investment into Citigroup is just the beginning of a broad trend.

I'm watching several companies that I think have a good chance of being bought by one of the massive Arab government investment funds. Two of these companies are HALLIBURTON CO (NYSE:HAL) and SUNCOR ENERGY INC (NYSE:SU).

Heck, HAL has already announced plans to move its headquarters from Houston to Dubai this year. Sure, investors are peeved about the weakness in the pumping business. But that slowdown doesn't offset the amazing growth taking place in its international businesses. What better owner of HAL than an oil rich country?

HAL is underpriced—it's even rallying today a bit. I recommend either writing the HAL Dec 2007 37.5000 put (HALXT.X) today, or buying shares. My target is $55 a share if there's a takeover.

Given the animus and mistrust of HAL, it's not likely an Arab takeover would be discouraged by Washington. If the Dems take the White House and the Senate in 2009, Halliburton's share holders will look back on a buy out with relief.

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As for Suncor Energy, don't think its $50 billion market cap makes a takeover/buyout impossible. The Arabs are sitting on trillions of dollars, and this integrated energy company in Canada is a bargain. It operates through four segments: Oil Sands, Natural Gas, Energy Marketing and Refining, and Refining and Marketing.

The Oil Sands segment recovers bitumen, primarily through oil sands mining and in-situ development, and upgrades it into refinery feedstock, diesel fuel, and by-products. Suncor is one of the best plays for the oil sands. With oil at $75-$150 a barrel ahead in the next few years, SU is the intelligent way for an Arab state to step in and secure incredibly large and viable oil reserves.

Buy Suncor by either writing the SU Dec 2007 95.0000 put (OPR:SUXS.X), or buy on a dip to $94 a share.

These take-over recommendations will not be included in the formal model portfolio. However, I will update the recommendations until the companies are bought, or my sell recommendation is initiated.

Please see risk disclosure link below.