Under the Southern Cross, with Charlie Aitken

I am trying work out how much of the current spot oil price is driven by fundamental oil supply/demand dynamics, and how much by speculation. I suspect that at current West Texas Intermediate (WTI) oil prices, there's at least $10 of "speculative premium" in the spot price, with hedge funds and commodity trading advisors playing a large role in the speed of the rise of oil prices.

The point I think is most important, and it is reinforced by the International Energy Agency (IEA) increasing supply immediately after Hurricane Katrina and the US Government releasing crude from the "full" (700 million barrel) strategic petroleum reserve, is that we aren't dealing with a supply problem in crude oil. Crude oil markets are finely balanced; the real supply/demand imbalance is in refining capacity.

As I wrote on Friday, the tail has been wagging the dog, with rising refined product futures prices dragging up physical oil prices. I think this relationship is in the process of breaking down a notch, as the world works out that we aren't physically short of oil, we are short of refining capacity.

I think global refining margins will remain in uncharted territory, while physical spot crude prices will retreat as some of speculative heat comes out of the pricing. This appeared to start on Friday night, with WTI oil down to $67.23 a barrel, while Singapore refiner margins rose to $19.50 a barrel.

Strategically, I suggest taking the top off selected oil "producers" and rotating to refiners and beneficiaries of lower physical oil prices. My key recommendation is a trading rotation from "energy" to "metals", and you can see that lower oil prices saw prices on the London Metal Exchange (LME) advance sharply.

Draw-downs of inventory saw copper prices rise by 1.7 percent to $1.79 a pound, and nickel by 1 percent to $7 a pound, while zinc prices (63.5¢ a pound) responded to stories of 12 barges carrying zinc going missing on the Mississippi River, potentially leading to "force majeure" being declared by local zinc refineries. Soft commodities also advanced sharply, as the main US export ports for softs remain closed. The New Orleans grain port facility, which remains closed, represents the hub for 60% of the US corn, wheat and soybean exports.

I believe we are in the cusp of a very substantial spike in commodity prices, apart from oil, and the real money will be made over the next three to six months in metals and agricultural commodities.

Remember, the northern hemisphere summer holiday period is ending, and manufacturing starts ramping up. LME inventories remain critically low, and you can see the influential hedge funds are going to move from energy markets to metal and softs markets.

I also believe the underwhelming rescue and recovery response of the US Government to the hurricane will lead to an overwhelming "economic" response. They will throw money (liquidity) at the problem, and that will include the United States Federal Reserve setting interest rates below where they naturally would have been.

We have already seen US GDP growth forecast downgrades by investment banks on the back of the hurricane's disruption, and that clearly puts pressure on the Fed to sit on its hands for the next six months.

Considering the Fed has responded to every financial crisis in the past by providing "liquidity", I believe there is a good chance that chairman Alan Greenspan could step back from the current tightening program. The Fed Funds Rate is currently 3.5 percent, the next Fed Open Market Committee meeting is due on September 20. The bond market is already anticipating an early end to interest rates rises with 10-year yields back at 4 percent. The economic fallout is not expected to be big; the three most-affected states of Louisiana, Alabama, and Mississippi account for only 3 percent of US GDP, and although there have been minor downward revisions to third-quarter GDP projections, if the past is any guide, the economic disruption could be offset by rebuilding activity.

THE TELSTRA REALITY CHECK

The furore over the reality check the "Three Amigos" have dealt the Telstra share price reached fever pitch yesterday, and it was hard to find a politician who didn't have something derogatory to say about the situation. Never before have we seen such widespread uninformed comment.

There's plenty of emotion in this debate, as there is when the value of a 51% public asset falls by $10 billion in a month. Yet it could be that all we are really seeing is a dose of reality being priced into Telstra stock.

With no offence intended to past Telstra management teams and boards, they were politically appointed "yes men", who attempted to manage the conflicts between being in effect a public/ Government partnership, and being regulated by your largest shareholder. Previous management, and previous boards, knew who their master was.

Here we are today with a new chairman and a new outsider management team who don't seem to care about the past; they care about the future. And, basically, the truth hurts.

There's no doubt that the comment "I wouldn't recommended it to my mother" was irresponsible at best, but almost everything Telstra management have said is based on factual developments within the telecommunications sector, and within Telstra itself. For too long we have been presented a "sugar-coated" view of Telstra prospects; the majority shareholder wants to go back to the days of "sugar-coating" to off-load its holding, but that is just not going to happen.

The reality check is a good long-term event for Telstra shareholders, and although no shareholder is pleased with the share price fall, in the longer term it will be the catalyst for regulatory change.

There should be no doubt Telstra operates under a harsh regulatory environment, and you can see that view just looking at very simplistic industry versus Telstra performance. The telecommunications sector is forecast to grow at a rate 1% above GDP, so for 2005-06 that should see underlying sector growth of 5%. Telstra, after the profit downgrades, expects to experience falling revenue, falling margins, and earnings dropping as much as 10% at the EBIT level.

They're not just standing still; they're going backwards in a market that is growing overall. That shows you that either the company has been poorly run, or that regulation is too "draconian", or both.

I have spoken to large Telstra shareholders, who represent about 500 million shares. Even though they have taken a heavy hit on their shareholdings, they believe the "Three Amigos" are playing the right strategy card, albeit a card we have rarely seen played in Australia.

The biggest mistake the "Three Amigos" made was in believing that institutional investors would join the battle with them, and until this point we have heard a deathly silence from large institutional Telstra shareholders.

THE CALVARY IS COMING

I believe that's about to change, and you are going to see some of these large Telstra shareholders start publicly backing the management strategy, which might change the course of the debate. Most agree that to unlock value in Telstra shares you need an easing in regulation, even a slight easing, and you are about to see institutional shareholders take the Telstra side of the battle publicly.

This is going to be intriguing: the large institutional shareholders in a company that is 49 percent publicly owned going head-to-head with the 51 percent shareholder and regulator. If the trading market figures out that the largest institutional holders are backing the management, the pressure will come off the stock a little.

Many people have pointed to the record volumes changing hands in Telstra, suggesting they show an institutional exodus, but I'm not so sure that's right. My reading of the turnover is that about 80 percent of the Telstra turnover has been brokers trading as principal, and the other 20 percent has been a combination of hedge funds short-selling and some quant-based selling of the consensus downgrades.

I think the brokers are having a huge influence on the volume and the share price, all trying to make up for fees going missing as the likelihood of T3 happening fades. The biggest short-sellers are not hedge funds: it's the broking community as principal, all backing their universally bearish analysts. The rumoured "hedge fund shorting attack", is actually a broker shorting attack, but I just wonder who these shorters are going to buy the stock back from?

The vast bulk of Australian institutions are underweight Telstra, the mums and dads aren't going to exit a stock yielding 12 percent fully franked on a 13-month view; international investors are underweight or nude the stock, quant funds are underweight, and hedge funds are short. Brokers are short, and the only supply of scale potentially large enough to fill these shorts is T3 itself, and it simply won't occur at these levels.

The 13-month yield of Telstra is a minimum 12 percent fully franked, or 17 percent grossed up, which is three times the unfranked long-bond yield of 5.10 percent. That in itself will underpin the share price. Why would you buy an unfranked government bond, when you can buy three times the tax-effective income stream in a quasi-government bond called Telstra.

The final missing pieces in the Telstra story arrived today, with an ASIC enquiry and ratings agency downgrades, and if I have learnt nothing else over the past 15 years, it is that ratings agency downgrades and ASIC enquiries usually coincide with the absolute low of the share price.

If you're able to asset allocate within an equity portfolio you should be buying Telstra today as a high-yield corporate bond, with the hope of small capital gains through time. Buy the crescendo in noise, and before institutional shareholders start taking Telstra management's side. Just because we haven't seen a gunfight like this in Australia before doesn't mean we can't make money out of it.

MANAGEMENT QUALITY

This has been a key driver of the Australian equity market's re-rating to a global price/earnings levels over the past five years, and I think we are all still guilty of underestimating the level of management skill in this country. Compare what you see here to some of the dribblers you see interviewed who are running large US companies, and then realise the p/e rating of our management may still be too low in a global context.

You could also include macro-economic managers in that context. We believe the consistent expansion of the Australian economy over the past 14 years can but partly attributed to political stability, and policy stability. You could argue the responsible and balanced macro-economic growth strategy set by the Treasurer and Reserve Bank governor has filtered down to company-specific management over the past five years in particular to the point where political and corporate Australia, with the exception of Telstra, pretty much sing from the same economic song sheet.

Expansionary macro-economic policy has set a "pro-growth" standard that corporate Australia has followed. Due to the quality and depth of Australian management, the earnings growth derived from consistent macro-economic expansion has been exponential.

But it seems analysts still don't get this whole management quality and entrepreneurial company culture theme.

Coles Myer chief executive John Fletcher criticised the "guidance counsellors" this week for their narrow focus. "I've given up trying to talk to analysts about the importance of ideas, culture, and standards,” he said, “because most of them are young and they've never run anything, so they have no experience about what it's like to be in business, and therefore they just don't understand it."

So, the CEO of a top 10 company thinks analysts "just don't understand it", yet the market still puts most of its time into consensus forecasting. Sounds like a big arbitrage opportunity, and the more companies that move away from physical guidance giving, the more opportunities will present themselves for genuine investors.

Fletcher's comments about "ideas", "culture", and "standards" are absolutely correct. I reported in this note a week ago about a Rural Press (RUP) results presentation I attended where there wasn't a single question on "strategy", just endless "modelling-based" questions about tax rates and IFRS changes. It was truly pathetic. Forty "analysts" had access to the CEO and CFO of a top 100 company, and not one of them asked a question about strategy.

My conversations with company directors continue to point to a broader move away from physical profit guidance giving. Many commentators are interpreting this development as meaning that companies are less confident of the future, yet I would say that is completely the wrong interpretation.

Companies are sick of holding analysts’ hands, and the only thing they are "fearful" of is class action litigation if their profit guidance proved inaccurate. There will be examples of high-quality stocks whose share prices fall after moving away from physical earnings guidance, and that will provide tremendous medium-term opportunities. Do not interpret a move away from profit guidance to mean the future is less clear.

THE RURAL RECOVERY CONTINUES

The winter rainfall chart above shows you that just about all of rural productive Australia received average or above-average winter rainfall, and it's no surprise on that basis that ABARE upgraded all winter crop forecasts this week. This is a positive for ground transport, agricultural finance, and fertiliser stocks.

ABARE has responded to very good winter rainfalls by substantially increasing production forecasts for the 2005-06 Australian wheat crop, up to 19.7 million tons, well above a June projection of 16 million. If the latest forecast is achieved, wheat production would only be marginally down from last year's 20.4 million ton crop. Substantial official upgrades to forecasts for cotton and barley have resulted in ABARE forecasting total production for winter crops this year of 31.1 million tons, down only marginally from last year’s 31.7 million tons.

However, a breakdown of the figures highlight the same regional rebalancing for soft commodities as is occurring in the mining and infrastructure regional spending. West Australian wheat production this year is expected to be 9.2 million tons, up 20 percent with Queensland steady on last year, while NSW is expected to fall a massive 25 percent.

Clearly, the above-average winter rainfall has lifted rural confidence, which will result in increased spending on machinery and fertilisers as the recovery gains momentum. The latest Rabobank rural survey figures show the proportion of farmers planning to increase investment on their properties over the next 12 months rose to 33 percent, the highest level in almost four years. The ABARE figures confirm the rural recovery but also highlight the regional rebalancing occurring, reinforcing our overweight call on companies leveraged to the WA and Queensland state economies.