For this week’s Energy and Capital , I look at the moves the big money is making into hard assets, and predict tough times ahead for the dollar and U.S. equities.

Investing in Hard Assets

Why Buffett’s Railroad Buy is Brilliant

By Chris Nelder
Friday, November 27th, 2009

One key to being a successful investor is knowing where the big money is going.

And this year, that money has been going into hard assets.

Of particular interest are the in-the-ground oil and gas assets that China has targeted, and farmland.

For legendary investors like Jim Rogers and Julian Robertson, the reason is simple. The unprecedented expansion of the money supply that enabled “bailout nation” eventually must result in the destruction of the dollar. Inflation is now the Fed’s only way out of the mess it’s in, because we’re certainly not going to grow our way out of it.

In my view, this anti-dollar sentiment has largely driven the commodity trade this year, because the fundamental case for commodity demand has been much harder to make.

Over the last three months, however, I have noted a shift in focus from general commodities to hard assets. While most commodities and energy equities have been flat or slightly positive, gold (NYSE: GDX) and silver (NYSE: SLV) have staged an impressive rally.

Warren Buffett’s decision to buy up Burlington Northern (NYSE: BNI) for $34 billion earlier this month is a sterling example. Buying a railroad is the very definition of going long — very long — on hard assets. Indeed, in May 2008 I called it the longest safe bet you can make. Those who thought he overpaid for it at $100 a share when it had been trading around $80 simply didn’t understand the rationale.

One must grasp the implications of peak oil, the long decline of fossil fuels, the slow process of substituting renewables, and the long-term effects of quantitative easing to see that buying rail during a depression is very, very smart.

History will show that even at $100 a share, Buffett got those assets on the cheap. It was a typically shrewd move, in part because there so few opportunities to invest in real assets that are not directly (and negatively) correlated with oil prices and credit growth.

Profits are Un-American

As my readers are well aware, there are more risk factors at work than the dollar. In fact, the dollar could remain flat, or even strengthen a bit, and hard assets would continue to appreciate.

The risk list is a long one. I covered the ones related to peak oil in August, including the problems of sustaining energy and food supply, the likely failure of the air travel industry, and the ineffectiveness of carbon pricing.

But there are others, which are more related to the long-term outlook for the U.S. economy. There is a good case to be made that it will go down hard in a currency panic after the money-printing games are over, sending gold skyrocketing.

Martin Armstrong, former Chairman of Princeton Economics International, recently speculated that gold could explode starting in October-November 2010, eventually reaching $5,000 an ounce in 2016 — not in reaction to inflation, but due to a general loss of confidence in the U.S. Government.

That aside, I do see a dicey situation for the U.S. next year. The unemployment rate will stay stubbornly above 10%. State tax revenues will stay down. Neither the real estate bubble nor the financial bubble can be reflated without utterly destroying the dollar, and there isn’t another growth story waiting in the wings. It’s probably going to be a long, hard slog.

For all the good intentions of investments into energy and climate change mitigation, those areas actually constitute a fairly small part of the federal stimulus program. As such, they will prove to have all the impact of a pea-shooter on an economy that spent the last 30 years sending its manufacturing capacity — that is, the portion of GDP related to creating real value— overseas.

America is quickly learning that a purely service economy is simply not sustainable. And the final pillar that the dollar stands on — its role as the world’s reserve currency, and the primary oil trading currency — is slowly eroding. Whether you argue it on the basis of money supply or fundamental value, the dollar is going to remain weak and under attack.

The smart money is responding by seeking hard assets that are either not denominated in dollars, or not correlated to them. Resource-rich countries like Brazil, Australia, and Norway have been the beneficiaries.

While U.S. equities spent the last 12 months clawing their way back to 2005 levels, look what happened to some of Brazil’s resource plays over the same time period: Petrobras (NYSE:PBR), up 138%; the iShares MSCI Brazil Index ETF (NYSE: EWZ), up 121%; and the Market Vectors Brazil Small-Cap ETF (NYSE: BRF), up 218%. That performance isn’t just about the upcoming World Cup and Olympics Games; it’s based in the fundamental appreciation of Brazil’s natural resources, and how the revenues they bring in are driving its rapidly developing economy.

If the U.S. economy remains stagnant or worse, as I think it will, the developing world will more than make up for the lost demand for minerals and fossil fuels. And if the U.S. economy recovers (at least before oil’s decline pulls the rug out from under it) it will only add more demand pressure, driving commodity prices higher.

Looking farther into the future, one must consider what will happen when capital tries to exit government bonds. This week’s $44 billion auction of two-year debt drew a yield of 0.802%, the lowest ever according to Bloomberg. A mere 1% slide in the dollar would be enough to put those investments underwater. After bonds and overvalued equities, I submit that hard assets are where capital must go to find yield.

Compared to a potentially loss-making $44 billion in 2-year debt, Buffett’s $34 billion buy of an entire railroad looks downright brilliant. Once the rest of the big capital world realizes that, they will find even fewer opportunities to follow suit, creating intense demand.

Bargain Hunting

Aside from a select few foreign equities, MLPs and ETFs, it’s hard for an American retail investor to play hard assets. Buying resources in the ground, or entire railroads, is strictly a game for big money with long investing horizons.

It’s not impossible though. The trick is to identify the companies with substantial reserves in the ground and little debt who have seen their stocks whacked mainly because they couldn’t raise the capital to continue drilling and mining during a credit market lockup, not because they didn’t have a profitable business.

As demand picks up, those companies will either be acquired by deeper domestic pockets, or sucked into China’s blood funnel. Either way, those resources will be developed… and whoever owns them will reap the profits.

This is where investors must get out their pencils and examine the financial statements carefully. It’s possible to buy barrels of oil in the ground for under $5, and natural gas for under $1. But you have to know what you’re looking for. You have to know how to distinguish possible from proven reserves, and know your netbacks (the profits obtained after production costs are subtracted).

Choosing carefully according to those criteria can mean the difference between struggling to trade a volatile and often senseless market (and making more money for your broker than you do for yourself), and kicking back for years just watching your investments grow.

This year has been like an eye in the storm of “peak everything,” offering an incredible opportunity to buy natural resources at low and relatively stable prices, mainly thanks to the excesses of the financial sector.

So let there be no mistake about where commodity prices are going next: all signs point higher. Take your positions and buckle up now, because the wild ride is about to resume.

Until next time,

Chris

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