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Economic: Shifting Left
New York: May 29, 2006
By John R. Stephenson

"Latin America doesn't matter.people don't give a damn about Latin America."

--Richard Nixon

But lately people do care. Perhaps it's the focus on commodities, or maybe it's just the colorful rantings of Venezuela's Hugo Chavez. But for whatever reason, the world's focus is increasingly on Latin America and its struggle to make their societies fairer for their citizens. The battle, which seems to be swinging increasingly to the left of the political spectrum, found its roots in the regional economic stagnation of 1998-2002. When the economy falters, incumbent politicians are likely to feel the anger of disenfranchised voters. Increasingly, voters in Latin America seem to be focusing on authoritarian populists who have been rallying against the evils of the west and free trade in general.

Venezuela, Bolivia and now Ecuador are moving sharply to the left and increasing not only their rhetoric, but also their actions in the war against the West. On May 15th, the government of Alfredo Palacio took the drastic step of taking over the Ecuadorian oilfields being run by Occidental Petroleum, an American oil & gas company. While the nationalization of these oilfields is a blow to shareholders of Occidental, it sends an ominous message to many of the commodity-oriented companies that are increasingly reliant on Latin America and other hot spots of the world for future production.

Never mind that Occidental Petroleum was responsible for producing one fifth of Ecuador's total energy output (100,000 barrels/day) or that the company had invested over $1 billion since 1999 in developing these oilfields. In the war of words that is raging, what sells is that the West is responsible for the hardship of their people.

The problem is, of course, much more complicated than that and is really structural in nature. Latin America has one of the highest levels of poverty in the world (approximately 40 percent of the population is poor) and ranks just ahead of Africa in terms of income distribution. Not only that, but entrepreneurship is severely stifled by burdensome regulation (only Africa and the Middle East are more expensive places to start a business) and weak enforceability of contracts. But for the masses, the West more often than not makes a convenient excuse.

This presents a unique problem for commodity producers who entered into a country that at one time appeared to be relatively riskless. When elections occur and a left wing candidate assumes control and re-writes the rules, the balance of risk shifts quickly and overnight for commodity-oriented companies active in the region.

In general, this is bad news for much of the commodity complex which is reliant on the Middle East, Latin America, Russia and Nigeria for much of its resource base. The result of all of this hype and the fast moves into and out of the market by momentum players is that the equities of commodity producers as well as the futures have been whipsawed of late. So is it time to get out?

Not for our money. While gold, copper, zinc and aluminum have all seen big moves lately, the fundamentals (supply and demand) remain favorable and most of the stocks of these commodity producers are significantly cheaper than they were six months ago.

While nationalizations like the one in Ecuador can spook the market, the bigger factor driving valuations in the commodity sector of late has been an explosion of liquidity (excess cash) chasing after a relatively small market. This has been driven by record low interest rates, mainly from Japan, that allowed huge financial players to borrow abroad at extremely low interest rates (the carry trade) and invest in longer dated assets that were higher yielding (often risky assets such as emerging markets, small cap stocks, commodities etc.).

But with interest rates on an upward march in the U.S., Europe and Japan, the excess liquidity gig is up which is causing large hedge funds and others to unwind their positions and in the process, sending commodity prices tumbling. While all of this unwinding of positions in the marketplace creates tremendous uncertainty (and volatility) in the market, it is a short-term phenomenon. When it will end is anyone's guess. But it will end.

Already the commodities themselves have recovered from their lows, but interestingly, the commodity stocks remain depressed. While there are cyclical reasons for this, the bottom-line is that commodity stocks with minimal exposure to unstable parts of the world look like investment bargains rather than beggars.


This valuation conundrum is more pronounced within the oil complex where only 6% of the world's oil reserves are in countries deemed to be politically secure. Companies such as Exxon, Conocco Phillips and other large multi-nationals trade at a valuation discount to many of the oil sands based producers such as Suncor. While times may remain choppy, countries such as Canada, Australia and New Zealand and the commodity producers should be investment winners in the months and years ahead.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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