The Death of Chinanomics

China's slowdown will be worse than most analysts expect...

IS IT POSSIBLE that the same profession that completely missed the global financial crisis would completely underestimate the severity of China's pull-back? asks Daily Reckoning Australia editor Dan Denning.

Well, past performance is no guarantee of future results. But when it comes to underestimating severe shocks to the economy, economists are as reliable as the sun. You can bet their sunny disposition will be inclined to view 2013 in the best possible light.

The best-case scenario is that the investment boom reaches its climax in the next year. Big spending by the miners and energy companies will support GDP. Then, once the investment pipeline tapers off, increased production of commodities (even at lower prices) will lead to steady growth in national income. Everything will be fine. China's new leaders will spend to the heavens and the iron ore price will rise. Nothing to see here. Move along.

But China itself isn't exactly moving along. The volume of cargo moved by rail fell 9.2% in August, year-over-year, according to data from China's National Bureau of Statistics. The decline in the volume of stuff moving on China's railroads matches the size of the decline in 2008 and 2009.

Back then, China reignited the mining boom by spending nearly $600 billion on 'shovel-ready' infrastructure projects. Will a similar spending boom bail Australia out again? No! The mining boom is dead. The mining boom ended because the Chinese growth model of the last 30-years isn't working anymore.

PIMCO analyst Ramin Touloi says it this way in today's Age: 'Our view for the last year has been that many analysts were underestimating the extent of the impending slowdown in China...policymakers [in China] are grappling with a major change in the economic growth model.'

If, by 'a major change in', he means 'the death of', then he's dead right. Most major economists won't/don't see this coming. They can only perceive the world through the Keynesian senses of debt, GDP growth, government spending, and aggregate demand. They don't understand or believe in sound money (real money).

If you think we're exaggerating, you should have a look at why China-based economist Michael Pettis has gone out on a limb to show why, 'By 2015, hard commodity prices will have collapsed.' Pettis reckons there are four reasons. First, the initial gap between supply and demand at the beginning of the boom has been closed by increased commodity production. Second, the gap was driven by China's 'unbalanced' growth model, now in disrepair. Third, the rebalancing of Chinese growth will be less commodity-intensive. Fourth, Chinese commodity inventories are bulging and more destocking is needed.

It's all persuasive. And absent some economic sleight of hand by the new communists in charge, it seems like a plausible scenario. But economic facts aside, if it's the end of the mining boom, what are you to do with a company like BHP? This is where 2013 could get really interesting for investors.

BHP is not only a hard rock miner. It's an oil and energy company as well. That could pay off in 2013. It may not be enough to compensate for falling iron ore and coal prices. But it's better than having nothing to fall back on (see Rio Tinto).

Bloomberg had an interesting story over the weekend about the US shale industry. The story was actually about Australian-listed companies with shale assets in America. In turns out many of those companies are trading at a discount to their US peers. Bloomberg reports:

'Australian companies exploring for oil and natural gas that's trapped in shale rock in the US and Canada are valued at a median of 11 times their reserves, a 23 percent discount to their counterparts that are listed on stock exchanges in North America, according to data compiled by Bloomberg. The valuation gap driven by Australian investors who are more than 8,000 miles (12,800 kilometres) from the companies' wells in Texas and Oklahoma may lure acquirers, said RBS Morgans Ltd.'

It's true that Aussie companies with US shale assets may be undervalued because Australian investors know less about them, or are unsure how to value them. The US shale gas industry is more mature. And if the companies have an actual reserve number — an idea of how much (and what kind) of gas they could extract at a profit — then the discount really could be Aussie investors not paying attention.

But the bigger story in 2013 is not going to be Aussie companies with US shale assets. It's going to be Aussie companies with Aussie shale assets. For its part, BHP is already turning its focus back to off-shore LNG in Western Australia. BHP made special note of the Tallanganda discovery in the annual report. Tap Oil has a 20% stake in that project, and has previously claimed the field could hold as much as 1.3 trillion cubic feet of gas. BHP didn't confirm that in its report. But it certainly highlighted the project.

All of this is part of the global boom in off-shore and on-shore natural gas production. This article highlights how the gas boom is changing the world's geopolitical picture. Russia is worried that shale gas could lessen its influence over energy consumers in Europe. The shale revolution is certainly shaking things up everywhere.

For Aussie investors, the biggest gains may not come from BHP or Aussie firms with US assets. They may come from Aussie companies developing Aussie shale assets. That's our position anyway. And we're sticking with it.

By the way, did you notice that BHP highlighted its off-shore gas assets in the South China Sea? Hmm. Is it possible the territorial disputes in the South China Sea and the East China Sea aren't about fishing rights or American influence? Are they about oil and gas and which country gets to sell the permits to extract them and collect the royalties from them? Hmm.

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Formerly editor of Strategic Investment with Lord William Rees-Mogg, Dan Denning is an independent investment analyst now based in Melbourne, from where he edits the Australian edition of The Daily Reckoning. He is also author of the best-selling The Bull Hunter (Wiley & Sons).

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