Today's big news from the commodity patch is Exxon's $41 billion purchase of natural gas producer, XTO Energy. The announcement drove XTO stock up roughly 15% to $48 a share.

 

While the purchase sounds exciting at first glance, it actually signals a rather negative situation for oil and energy in general...

 

SECOND-RATE ENERGY DEPOSITS SUDDENLY WORTH BUYING

 

While Exxon and other major oil companies have shunned Iraq (where the signatories to any deal is likely to only have numismatic value in the next five years), they have been willing to shell out big bucks for Western African fields.

 

Exxon's purchase of XTO may seem sensible – at first glance – given that the U.S. has an excellent infrastructure and is the safest place in the world to own oil or gas reserves. But when a company is willing to pay top dollar for energy assets what does the big dollar bid say about XTO’s assets?

 

True, at $48 a share, Exxon seems to have paid a significant premium for XTO's stock, at least if you confine yourself to the 1-year chart. Last December, XTO traded at less than $36.

 

On the other hand, if you look back to 2007, when gas prices were roughly the same as now, Exxon appears to have paid very little premium at all for XTO stock. And if you look at XTO's high of around $70 in June 2008, Exxon seems to be snapping up a bargain.

 

Could it be that, despite the advantage of being located in the U.S. - XTO's assets are not valuable enough to fetch a premium from Exxon? Perhaps not. You see, much of XTO's gas reserves are situated in shale deposits. So while they appear extensive, the problem with shale gas is that the cost of extraction may be prohibitive down the road – due to rising prices of water, energy, and other resources. We suspect XTO didn't need its arm twisted to agree to this deal.

 

Exxon seems to be willing these days to pay a king's ransom to make any kind of increase in its reserves, and this is one such deal. The company's problem is that oil and other energy sources are in very tight supply today. Good reserves are getting hard to find. And even the assets that seem plentiful are often plagued with problems. Big oil companies are having to choose between assets in a virtual war zone (Iraq) or assets that may soon be too expensive to develop.

 

As the U.S. economy returns to growth, the problem of finding good oil reserves will worsen. Even if U.S. growth stays subdued, oil will still become scarcer due to Chinese growth, which is likely to be higher than many expect.

 

Speaking of Chinese growth and commodity prices...

 

COMMODITY PRICES SIGNAL A QUICK RECOVERY – AND MAYBE A SHORT ONE

 

One index we pay much attention to is the Raw Industrial Commodities Index published by the Commodities Research Bureau. This index reflects commodity transactions among companies and covers such uncommonly thought of economic inputs as burlap, tallow, etc. Many of these are not sold on commodity exchanges, nor can you trade them on margin. Consequently, they do not invite speculation. The index reflects the prices that manufacturers are willing to pay for raw materials.

 

Historically, the Raw Industrial Index has been a terrific leading indicator of economic growth. And today, its message is very positive. Year-over-year, this index has risen 50%. That's unusually strong. The next highest reading, 37%, occurred in 1987 – when it also signaled a very frothy market. In fact, whenever this index has risen strongly, strong economic growth has occurred in the months after. Such moves have also been accompanied by falling unemployment, and an effort by the Fed to tighten monetary policy (to cool down the overheated economy).

 

Today's high reading, in the context of the current economic weakness, is highly unusual. To us, it suggests that we may see an economic recovery arrive faster than anyone expects. However, that recovery may be short-circuited by inflation brought about by rising commodity prices.

 

Ironically, commodity prices will take over the Fed's traditional role in restraining economic growth. If the recovery comes, the Fed is hardly likely to start raising interest rates or tightening credit to any extent that could be described as “restrictive.” Unemployment is just too high right now. But sky-high commodity prices could very well put the brakes on growth. They would motivate consumers to ease up on spending and cut into profit margins.

 

What makes the situation unusual is that commodity prices have been high despite weak U.S. growth. The reason, once again, is soaring Chinese growth. China is committed to rapidly enlarging its alternative energy infrastructure – a task that will take trillions of dollars. They've already told the world that they plan to spend more money on alternative energy over the next 10 years than the U.S. spent on World War II – and it will take a lot of raw materials.

 

So those who think copper and iron ore prices must be near or at their peak, are deceiving themselves. They are thinking too much like Westerners and need to look at the situation through Eastern eyes.

 

The other big story in today's news comes from Copenhagen, where China has joined forces with Africa to demand Western nations do more to curb atmospheric emissions. China and Africa have never been natural allies – their cultures are too different. But China has a lot of respect for African resources, which it knows it needs to fulfill its long-term plans. It also wants others to take on more of the burden of protecting the climate.

 

We'll talk more about this in your next issue of TCI. For now, our views on the commodity boom remain unchanged. Gold, silver, copper, etc. have a very bright future.

 

The Fed is becoming increasingly irrelevant since it has very little scope to do anything other than stay the course it has already set. It doesn't matter who runs it – whether Dr. Bernanke or anyone else. There's nothing much for any Chairman to do when the bank's on autopilot.

 

In the short-term, the correction in commodities could have a little further to go – but not much. Long-term, the big money will be made in this arena. Hold onto your gold, silver, and our recommended stocks and you should get through this turbulent era in style.