Farmers in Iowa and other regions across the U.S. are deciding if they plan to replant after recent flooding wiped-out entire crops. Not unexpected, prices for the soft agricultural commodities reacted to the news of the flooding with higher prices as traders began worrying about whether supply would be anywhere close to current demand levels. Fortunately, many farmers now take out crop insurance, allowing them to recover at least some of their initial investment (covering up to around 85% of average recent production). Since the floods of 1993, the number of acres of USDA-insured land has more than doubled. This leaves many farmers with a dilemma - take the insurance, or replant. If farmers take the insurance, supply will be down and prices are sure to stay high into the fall, and could potentially go higher. If farmers decide to replant, the potential exists for getting closer to a normal supply-demand balance, and preventing further prices increases.

As reported at the WSJ, the high price of soybeans, currently near $16.23 a bushel for July contracts (see additional WSJ story), is turning out to be too tempting for some farmers. As corn prices rose last year, many farmers switched from planting soybeans to planting corn. Even with the corn crop damage, recent USDA reports showed that farmers had planted 87.3 million acres of corn, compared to the original forecast of 86.0 million. The extra 1.3 million acres of supply caused the price of corn to sell off some this week. Of course, this also means that less soybeans had been planted. A farmers strike in Argentina, a major global supplier, has also put upward pressure on soybean prices. Ironically, the current high prices may actually be the catalysts needed to cause some farmers to forgo crop insurance and take the risk of replanting. For some farmers, even if the soybean yields are below 50% of normal levels, and soybean prices approach $10 a bushel, they can still make enough profit that it is worth taking the risk. But there are risk. In addition to the risk of new weather issues, crops planted this late are also at risk of being damaged from an early frost. Furthermore, corn planted after June 25th, and soybeans after July 10th, receive less coverage from insurers.

So what is an investor to do? Outside of investing directly in soybeans, where the risk of weather and other factors affecting supply and prices levels will still be volatile and somewhat unpredictable, another potential area for investment could be the fertilizer companies. Given the late planting, and issues with land and weather, farmers will no doubt be looking for ways to increase yields. This should help companies such as Potash (POT), Agrium (ARU), and Mosaic (MOS), each of which continues to have the ability to raise fertilizer prices. In addition to fertilizer, farmers will also need to purchase new seed. Companies that could benefit include Monsanto (MON), Dupont (DD), and Syngenta (SYT). If farmers are enticed by the high prices to replant soybeans, each of these companies should benefit. Furthermore, returns from this new round of planting will not be as sensitive to commodity price if there were to be any future crop damaging issues, such as additional harsh weather. Profits from the sale of fertilizer and seed will for the most part have already been made. One caveat to this would be any special offers given by companies working to help farmers replant. The CEO of Monsanto mentioned recently on CNBC that his company will not be charging full price for seed that is replanted as a result of flood damage. This is certainly a nice corporate gesture in a time of loss for farmers, and a time of higher food prices for all.

As reported a few days ago at the Financial Times, the Federal Reserve is reviewing whether or not to consider changing or loosen existing restrictions for non-bank holding companies, allowing them to take larger stakes in the banks without getting regulators involved. Some private equity firms have been interested in taking larger stakes, and providing the banks with much needed capital, but have stayed away due to existing limitations. Currently, companies that are not holding companies are prevented from owning more than 25% of a bank, and even less if they hold a board seat. Holders of large positions are also required to make what are called "source of strength" commitments, in essence agreeing to put up additional funds if necessary. While private equity funds are willing to take initial positions, many are reluctant to keep funding a decreasing asset.

The review by the Fed is in response to the need from banks to raise additional capital. Sovereign wealth funds provided some initial capital, but many have been shying away from U.S. financial companies, even at their current cheaper levels. To date banks have raised as much as $400 billion, but may need closer to $1,300 billion. To close the gap, the Fed may be forced to loosen restrictions in order to provide new ways to get the necessary capital to the struggling financial companies. The fact that the Fed is even considering such actions gives you an idea of how worried they are that another failure could develop. Even today there is an article in Vanity Fair discussing how rumor may have been the main contributer for initiating the run on Bear Stearns. The last thing the Fed, or the U.S. economy needs right now is for worries of capital concerns to cause another financial company to go under. Given the recent price action in LEH, C, JPM, MER, MS, and GS, the market certainly seems to be hinting at this possibility. Given that the Fed has its hands tied with regard to interest rates, unconventional approaches, such as making it easier for private equity to invest, or continuing to work through the discount window, may be its only current options.

The Guardian is reporting that foreign sovereign wealth funds are increasing investment in London hedge funds, in particular funds of funds. The capital increase is coming at a good time for the hedge funds as the credit crunch has decreased debt funding. The magazine Hedge Fund Manager Week is reporting that sovereign wealth funds are on average looking to increase alternative investment allocations from 1% to 10% of total portfolio assets.

Are you interested in wind energy, but don't have billions to invest like T. Boone Pickens? Are you afraid that you are going to pick the next pets.com, and not ebay.com? Don't fear. IndexUniverse.com is reporting that the PowerShares Nasdaq OMX Clean Edge Global Wind Energy Index (ticker: PWND - prospectus) is expected to begin trading next week. It is actually not the first wind ETF. A few weeks ago, the First Trust ISE Global Wind Energy Index Fund (ticker: FAN - prospectus) hit the market. The PWND ETF will begin with 31 companies in its portfolio. The FAN ETF currently has 67 companies. Both have a high level of global diversification, which makes sense, given that I am not sure how they could even find 31 companies in the U.S., let along 67, with a significant exposure to wind energy. As a result of reaching out to global players, PWND is able to list that 90% of its companies are pure-plays. FAN has about 66% pure-plays. What is a pure-play? As defined, most of the business in the company must comes directly from wind energy - or specifically, the company must either produce 1,000 megawatts of energy, or generate $1 billion a year from wind-related power. Non-pure-plays include companies such as General Electric and Siemens, each which have significant interest in wind energy, but for which wind is still a relatively small profit center when compared to other business operations.

In addition to capitalization requirements and weighting rules, the funds also differ in the way they pick their companies. PWND uses a quantitative-based system, while FAN uses more fundamental analysis. Since the methodologies used by each are different, both are expected to deliver similar, albeit different returns. Given that wind energy has been growing at almost 30% per year globally, and crude oil and natural gas are continuing to trade at high levels, wind energy should continue to generate interest and electricity as countries going green begin using less coal to fuel their power plants. Nonetheless, if tax breaks expire, and crude oil and natural gas come back to "normal" levels, interest in wind energy could fall back a little, adding some potential volatility to returns.

Given the global nature of the funds, and that the industry is just beginning to gain exposure, many of the pure-play wind companies are not well-known. For the FAN ETF, major holdings greater than 5% include Vestas Wind Systems, Repower Systems, Gamesa Corp Tecnologica SA, and Hansen Transmission International NV. Given that the PWND ETF follows the Nasdaq OMX Clean Edge Global Wind Energy Index, major components can be found here. The top five holdings greater than 1% include Zoltek Companies (ZOLT), American Superconductor Corporation (AMSC), KHD Humboldt Wedag International, General Electric (GE), and FPL Group, Inc. (FPL). Other U.S. listed companies in the FAN include AES Corp. (AES) and Xcel Energy (XEL).

Recently there was an interesting, albeit somewhat disturbing article at Platts discussing something many of us don't want to admit that we know is coming - higher electricity prices. I know, electricity prices are already high for many of you, along with just about everything else. I am not talking about those high prices, I am talking about the really high ones that are just around the corner. The ones that will result from higher commodity prices, which only seem to keep going higher. The ones that will continue to result from the lack of a coherent energy policy. The ones that result from environmental legislation, which if not carefully considered (no matter how good intentions), may have the ability along with higher commodity prices to bring the power system to its knees. The ones that unlike higher gasoline prices, which are high but still can be paid to purchase the commodity, may not even give us the opportunity to pay higher prices to receive services during a blackout. Yes, those are the ones I am talking about.

According to the Energy Information Administration (EIA), 49.0% of electricity is generated from coal, 20.0% from natural gas, 19.4% from nuclear, 7% from hydro, 1.6% from petroleum, with the remaining 3.1% from other sources, part of which are alternative energy sources not listed (solar, wind, etc.). Approximately 9.5% of electricity generation is currently from renewable sources. If Congress has its way, this number will increase as restrictions on carbon emissions get enacted. While everyone would like to see lower carbon emissions and a cleaner environment, such legislation will have consequences, many of which will be unintended (ethanol anyone?). Hopefully some of these consequences will be considered as we move forward as a country toward developing some type of energy policy, because while we all know about the high cost of gasoline, and the impact that burning this fuel has on our environment, we are also beginning to feel the effects of ethanol mandates, which even with their good intentions are producing unintended consequences of higher food and commodity costs. Unfortunately, electricity prices are the next form of energy that is likely to feel the effects of high commodity prices, regulation, and legislation in a way that is similar to the current impact of high crude oil prices.

Edison Electric Institute expects U.S. consumption to grow by 30% by 2030. Currently, the average U.S. household uses 21% more electricity than it did in 1978, and household consumption is expected to grow by 11% more over the next 20 years as home computer and air conditioning usage continues to rise. To support expected increased usage, infrastructure will also need to be improved, but it too is not keeping up. Desire and action are not enough. Even if we begin today to upgrade the power system infrastructure, it will not come cheap. Infrastructure costs are also going up as both copper and steel prices have been on the rise, affecting towers, transmission lines, and transformer cost. Yet demand will not wait as we hope for lower commodity costs in the future. The North American Electric Reliability Corporation expects peak demand to increase by 18% over the next 10 years, while committed resources are expected to only increase by 8.5%. Not only are services in doubt, but reliability is in jeopardy.

But it potentially gets worse. Congress and both of the presidential candidates are taking about instituting some form of cap-and-trade of carbon emissions (see a previous post for some of the lessons learned from cap-and-trade). The Regional Greenhouse Gas Initiative program begins next year in ten eastern states that already have cap-and-trade rules in place, although some business and governments are already getting nervous and beginning are proposing to place ceilings on the RGGI imposed allowance costs - on the order of a $2/allowance cap (Correction: The Business & Industry Association is pushing to get the caps included, but they are not yet in place as originally written). Without ceilings, some estimate the RGGI would add up to $120 million per year to electricity rates.

Congress is also considering the Lieberman-Warner Climate Security Act of 2007 for regulating greenhouse gas emissions through market-based solutions. While market-based solutions sound better than regulation to some, the Energy Information Administration is expecting the legislation to add between $30-325 per year per household by 2020 if enacted into law, with costs growing over time. The EIA forecast GDP losses from $444-1,308 billion over the 2009 to 2030 time period.

Fortunately, the U.S. has an abundance of coal, but increases in environmental regulations will prevent it from rising above its current 49% generation use levels, and this number is likely to decrease as companies continue to stop building coal-fired generation, and instead switch to cleaner burning fuels. Even if coal were to be used, coal prices are also going up - doubling over the last year as demand from China and across the globe increases. Alternatives sources such as wind power are increasing, but it is still insignificant, hydro has been decreasing, and nuclear power, even if approved and scaled to the level needed (a big "if") is at least 10 years away from receiving the necessary approvals, components, and build-time necessary to get it on-line. The cost to build and fuel nuclear plants is also not getting any cheaper.

That leaves natural gas, which has been reaching new highs over the last year and does not look to pull back anytime soon. Given that natural gas powered generation sets the marginal prices of electricity in much of the U.S., and that natural gas prices are increasing, it does not take much deductive logic to know that is going to happen to electric power prices. As carbon constraints are imposed, natural gas-fired generation, which is often used for peak generation, will now increasingly be used for normal capacity generation. Yet, as mentioned in a recent post, domestic LNG stockpiles are falling as shipments of LNG to the U.S. are instead going to Spain and Japan given the willingness of these countries to pay higher prices. Furthermore, if you consider that crude oil has at times traded with a 6-8 multiple to natural gas (see post), and you expect crude oil prices to either rise or not correct much from their current levels, then natural gas is likely to continue to rise from its current price.

And of course, all of this says nothing of the expected increase in hybrids and electric cars, or other green vehicles expected to run on hydrogen (which requires electricity to separate the hydrogen), or even run on natural gas itself. Each will facilitate an increase in natural gas and electricity prices. So in short, if you though that the inconvenience of not being able to take your normal Sunday drive or extra trip to Grandma's house was painful, you may experience even greater stress on your wallet as electricity prices begin responding to current commodity prices. When consumers have to cut back on air conditioning, reduce lighting, realize that their hybrids are not quite as economical as they thought, suffer planned brownouts, or even worse, an unplanned blackout, then Congress will begin to see the you know what hit the fan - assuming of course that there is any affordable electricity around to actually power the fan.

IndexUniverse.com is reporting about a new global index fund offered from Vanguard, called the Vanguard Total World Stock Index Fund. The new fund tracks the FTSE All-World Index, which currently weights the U.S. at 41% and the rest of the world at 59%. The index includes both developed and emerging markets, covering approximately 2,900 large and mid-cap stocks from 47 different countries. Talk about diversification. Investor, institutional, and ETF shares are offered. The fund trades under the symbol VT on the NYSE Arca exchange.

Not to be outdone, Northern Trust has registered, but not yet offered, an ETF to be called the Dow Jones Wilshire Global Total Market Index Fund. What a mouthful. The index will cover 58 countries and more than 12,800 companies. Can you say transaction costs? At least one broker will be happy.

As recently discussed in a post at Bull Bear Trader, the exchanges were beginning to join up with the operators of the various dark pools of liquidity. Now both the Financial Times and the WSJ are reporting a new union between the London Stock Exchange (LSE) and Lehman Brothers. Per the agreement, the LSE will offer trading of European companies that don't currently list on its exchange, matching buyers and sellers across more than ten European countries. The new service will be based on the Lehman Brothers dark pool trading environment. The multilateral trading platform, called Baikal, is expected to combine algorithmic trading functionality with dark pool liquidity. The venture with Lehman is hoped to allow the LSE to gain exposure into dark pools trading, and get back exchange volume that has been moving to other platforms and environments. According to the Tabb Group, dark pools currently account for about 10% of daily U.S. trading volume.

The recent trends toward dark pools and specialized trading has caused the exchanges to lose out to new electronic trading platforms that are aimed specifically at servicing computer-driven algorithmic traders. Such algorithmic traders are increasing responsible for driving trading volume and providing liquidity. Such threats are causing the margins in the public order books to come under increased pressure. Electronic-based algorithmic trading is also cited for the increase levels of volume and short-term price spikes that are seen in a number of equities and commodities. Unlike in the past, it is not that unusual anymore to see crude oil spike up or down $3-4 in less than an hour as a flood of buying or selling pressure hits the market from electronic orders.

The move to decimalization, with price spreads down to the penny, is also making it difficult for some specialists to create a market that is both profitable and also offers the level of liquidity that is required at each price point. Some market operators are even arguing for going back to larger spreads, such as a nickel, in order to increase the number of shares offered at each price and keep the exchanges in business, but it is doubtful the regulators will allow this. As more market participants use dark pools, the exchanges will look to move more trading volume to this environment due to the cost advantages over the public order books. As a result, the price transparency, increased liquidity, and smaller spreads that decimalization was ironically hoped to provide retail traders is likely to be compromised.

There is an interesting article in Barron's this week regarding catastrophe bonds. Basically, catastrophe bonds are similar to normal bonds in that you invest a principal in return for periodic coupons. Once the bond matures, you receive your principal back - hopefully. The hopefully part is where these bonds are slightly different. Yes, with all bonds you have the risk of losing your principal, but for cat bonds it is less about credit risk, and more, obviously, about catastrophic risk. In most cases this is a binary proposition. If there is no event, you get all your money back. If there is an event, you do not get anything back. In return you get a nice coupon to compensate for the risk you are taking. After Hurricane Katrina, one cat bond tranche was offered by Swiss Re with an annual coupon of near 40%. In fact, cat bonds have returned over 33% from 2005 to this May, ahead of the 19.1% offered by the Lehman High Yield Corporate Bond Index over the same time frame. A additional benefit of cat bonds, beyond the high yields, is that their returns are often uncorrelated with the returns of other equity or fixed income investments, providing another vehicle for diversification.

Cat bonds were designed as a way for insurance companies to remain solvent if an event they insured does occurs. Insurance companies could simply buy reinsurance, passing the risk on to another insurance company, but there is the worry of too much correlation to the event. As an alternative, they could sponsor a cat bond. In short, the company would create a special purpose entity (yes, I know what you are thinking) that would issue the cat bonds with the help of an investment bank. Investors would then buy the bonds and receive a coupon with a defined spread over Libor. This spread can be as little as 0.5% to 20% or more depending on the event and the likelihood of its occurrence. Recent catastrophic events also have an impact on defining the spread. You can get a little more background on cat bonds here and here.

Since cat bonds often involve the creation of a special purpose vehicle, some investors are a little worried that some reinsurance companies are moving beyond their specialties. They are also concerned that by moving the risk off balance sheet, companies are preventing investors and the market from knowing the real exposure each company is taking. Cat bonds do allow reinsurance companies to survive and be less exposed if a major event does occur. Therefore, companies are less exposed by taking out insurance themselves, but off-balance sheet items are more difficult to value and risks are less transparent. The effects on market participants, such as Munich Re, Swiss Re, Liberty Mutual, Allianz, and Hannover Re, among others, is difficult to tell. On the other hand, the benefits to the investment banks underwriting the bonds, such as Barclays Capital, Deutsche Bank, Lehman Brothers, Goldman Sachs, and Swiss Re Capital Markets, among others, is a little easier to see and quantify, along with the potential returns for institutional investors, who at this point are the only ones currently receiving cat bond distributions.

As mentioned in the Barron's article, to date only one cat bond has been triggered, implying a low probability of catastrophic events occurring, or at least the ones that are being underwritten. Then again, the last two years have seen a lower level of terrorist events and major hurricanes. In fact, the last two hurricane seasons, which have been forecast to be strong, have fortunately been milder than expected. This year is once again forecast to have an active hurricane season. Hopefully the forecast will be wrong again, and cat bond investors will get a return of principal, and the people on the coasts and around the globe will be spared from another major event.

I wrote in a recent post how Barclays was getting into the physical trading of crude oil. Now IndexUniverse.com is reporting that Barclays is launching a new iPath Exchange Traded Note (ETN) targeting carbon emissions - the iPath Global Carbon ETN (ticker GRN). As cap-and-trade becomes more prevalent, it is expected that ETN funds tracking carbon emissions will become more popular. Some estimates have the global carbon market being worth more than $50 billion a year. Talk about making money out of thin air.

For the uninitiated, Investopedia (here and here) and Wikipedia give an overview of ETNs. In short, ETNs were first introduced by Barclays in mid-2006 and represents a type of senior, unsecured, unsubordinated debt security that is similar to other forms of debt (since it has a maturity date), but is different in that ETN returns are based on the performance of some other primitive (be it a stock, index, carbon emissions, or anything else). Unlike normal bonds, no periodic coupon payment are made, and your principal is not protected. On the other hand, they can be traded on exchanges and shorted, similar to ETFs. Since they are like bonds, the value of the ETN is affected by the credit rating of the issuer, and is therefore impacted by credit rating changes. This may explain why more ETNs have not been issued in the current environment.

Why use them instead of ETFs? There are a number of advantages (see Wikipedia for an overview), but basically they offer flexibility and tax advantages (see iPath for additional overview of ETN characteristics). Since there is no interest payments and dividend distributions, neither incurs a tax. Capital gains also only occur when the investor buys or sells the ETN - not when gains and losses are taken by the fund, as with a mutual fund, or when securities must be sold due to composition changes in an index, as with ETFs. ETNs are essentially treated as a prepaid contact (like a forward contract), allowing the difference between the sale and purchase to be treated as a capital gain, deferring the tax payment. ETNs also have no tracking error, unlike ETFs which have to buy the underlying assets or futures, thereby producing an inevitable, albeit usually small, tracking error. ETNs do not hold the underlying asset, but simply promise the match the index. This is another area where credit risk potential creeps-in. In a sense, you are trading tracking error risk for credit risk. ETNs also offer the flexibility to gain exposure in areas that are difficult for ETFs to replicate (such as carbon emissions), and allow for the deployment of strategies, such as momentum investing.

Of course, not everything is rosy (see the April USA Today article). In addition to credit risk issues, ETNs also have the disadvantage of being illiquid at times, although as they become more popular, it is hoped that this will be less of a problem for individual investors. Redemption issues do exist for institutional investors. There is also a worry that current tax benefits will be removed/modified by the IRS, which is still considering tax treatment of ETNs (see update) and likes to say "show me the money." There is the potential that the IRS will tax profits as interest, and not capital gains (which long-term are currently only 15%). Single currency ETNs have already been ruled on, and are now being taxed at ordinary income tax rates. Finally, as with all products that offer a specific investment strategy, there are risks with each strategy. Yet, for ETNs this gets magnified since there are now more options available, and as a result, more potential risks for those choosing strategies without understanding the goals, risks, and fit to their current investment portfolio. After all, not everyone wants to worry about whether sub-prime credit problems are going to affect their carbon missions ETN investment, or whether crude oil being in contango is good for their commodity spread ETN.

Note: When researching about ETNs to see if there was any new information to include for this post, I did run across the following on the Investopedia site: "While the benefit of active management is arguable, there is no disputing the value that financial engineering has brought to the financial markets since deregulation took hold in the early 1970s. Financial engineering has made our markets more liquid and more efficient. The advent of ETN is no different. However, as with any new product, there are unanswered questions." Given all the negative connotation around the term financial engineering, this is refreshing. Then again, this article may not have been updated for a while. Nonetheless, every now and then you have to take what you can get.

The Financial Times is reporting that Barclays Capital is planning to enter the shipping business. The bank is attempting to increase its commodities exposure by hiring ships on long-term charter to move oil, gasoline, and diesel. As opposed to gaining exposure by taking derivative positions, Barclays hopes to cash in on the prices involved in hiring ships, which have been up more than 50% in the last six months. The move also allows them to support their new venture into the physical trading of oil. Physical trading allows for a more predictable price since you are not at the mercy of the spot market prices.

Of interest is how moving the physical commodity adds a new level of risk to banks hiring a fleet of ships on a long-term basis - the risk of an oil spill. For this reason, some companies go slowly with physical trading, transporting what are called "non-persistent" oils, such as gasoline, which dissipate in the water quickly. Given all the credit problems that banks are already dealing with, it is hard to image any would want to even consider adding additional exposure in this way. In fact, even though such a move is not unprecedented for banks, this may tell us more about the weakened ability of banks to generate revenues using traditional means, such as investment banking and making loans. It also makes you wonder whether the shipping industry has reached a short-term top, and whether some commodities themselves may be nearing a peak. Maybe speculation is beginning to reach a little too far.

The WSJ is reporting that Hong Kong is planning a new exchange that will trade fuel oil contracts. The new exchange, to be called the Hong Kong Mercantile Exchange - HKMEx, is expected to open as early as Q1 of 2009 and will sell U.S. dollar denominated contracts for delivery of fuel oil to China. If successful, China is expected to expand into other commodities it uses, such as soybeans and iron ore. All this is in an attempt to turn Hong Kong into an Asia-Pacific financial hub. China has tried similar exchanges unsuccessfully in the past, but conditions have changed. More money and capital is now flowing into the east, in particular investment in energy, metals, and soft commodities. The exchange will also give U.S. traders another outlet for both in- and after-market hours trading. Given all the consolidation that is occurring in the industry, it will be interesting to see if the HKMEx can maintain the necessary volumes to stay afloat, and if successful, whether or not it will eventually become an acquirer, the one being acquired, or stay independent. But then again, lets not get ahead of ourselves.

Reuters is reporting that Microsoft and Yahoo! are talking again. Apparently sources from each company have confirmed the talks. The report also mentions that: "The information we have is thin, but what one source is saying [is] that Microsoft is talking a price lower than the $33 they were offering when the talks disintegrated in May." Maybe the thought of going below $20 a share, which seems to be a real possibility given the recent price action of their stock, not to mention the current market environment, has Yahoo! reconsidering their agreement with Google. Of course, Yahoo! does have an escape clause - but that would require them to merge with someone. If it is Microsoft, escape is free. If not, it will cost another company $250 million more to acquire Yahoo!, paid directly to Google. Maybe "Microhoo" is not dead yet. The incentives are certainly there. I imagine Carl Icahn is also actively banging the drum behind the scenes, still hoping to bring home a return for all his billionaire friends that lined up behind him, at least those that have not already added to the recent selling pressure.

Update: CNBC is reporting that there are no new talks. Of interest is that the initial version of the Reuters article mentioned "unidentified sources," or something similar, but after reports were not confirmed by CNBC, they print that the source was the TechCrunch blog. Interesting. The TechCrunch blog also responds: "What we’ve heard is that the two sides are in current discussions over a complete buyout, not necessarily that there’s a deal in place or even that Microsoft has made any kind of firm offer. Another source at Microsoft reiterates to us that they’re a buyer at the right price, but isn’t saying what that price is."

Dark pools of liquidity are back in the news again. See a previous WSJ article, along with two recent posts (here and here) for more background. As reported in a recent Financial Times article, the stock exchanges themselves may now be willing to throw in the towel, and begin looking for ways to work with the dark pools. The reason is obvious. Dark pools currently represent about 12% of all U.S. stock trading, and the exchanges are looking for ways to get this volume back. There is also the implicit admission that dark pools are not a passing fad, given that many of the exchanges are also developing their own dark pool trading environments. In addition to the threat of individual dark pools, of which there are now approximately 40 such pools, the exchanges are also worried that some or all of the individual dark pools currently in existence will get together and form their own exchange. Nothing focuses the business mind like the potential of a new, stronger competitor.

As I have written before, it does not surprise me that such pool of liquidity are developing as more hedge funds (which are also growing in numbers) look for greater trade protection. No one wants to have others front-run you while you are entering or exiting a large position. On the other hand, it is still amazing to me that more traders, investors, regulators, and members of Congress are not more concerned about such pools, or discussing what impact they may be having on price discovery. Not that I welcome such intervention by Congress, but I suspect that after the housing mess, credit concerns, and the reason for high crude oil prices (i.e., speculators) are off Washington's hearing list, dark pools may begin to see a little more light. How this story ends - unfortunately - is probably not that difficult to predict.

As reported in a Bloomberg article, wheat output in Australia is expected to be 19.5 million metric tons for this year's harvest, compared to an original forecast of 23.7 million metric tons. Dry conditions, including the driest May on record, are being given as the reason for cuts in the estimates. Australia is the third largest exporter of wheat. Many farmers converted acreage to wheat as the price increased over the last year (before correcting). Wheat futures were up slightly in morning trading.

Rio Tinto has completed successful negotiations with Baosteel to hike iron ore prices. Baosteel represents Chinese steel mills. The price increases averaged 85% and were argued in part due to increased freight premiums that are necessary to reflect rising transportation costs driven by higher oil prices. China imported 383 million tons of iron ore in 2007, up 17.4 percent from 2006. Analysts are looking for another 1.5 years or so of additional price increases. A CNBC International video discusses the recent price hikes and their effects on the industry. Given that iron ore is cheaper to ship from Australia as compared to Brazil (from Vale), and market prices are continuing to rise, Baosteel really had no other choice.

Given increased transportation costs, it is unclear exactly how much this price increase may add value to Rio Tinto, although a Agence France-Presse article states, "The deal was "very significant" as iron ore is one of the three main drivers of Rio Tinto's earnings, along with copper and aluminum, a Rio Tinto spokesman said." Nonetheless, even if the deal did not directly affect the bottom line, it should at least give Rio some leverage against BHP Billiton's takeover attempt of the company and may force them to up their offer. Rio is a bigger producer of iron ore than BHP, and the recent negotiations illustrate Rio's ability to drive the market price of iron ore. As of now, companies set the price of iron ore in individual negotiations, although the exchanges are looking at offering iron ore contracts in an over the counter (OTC) swaps market, or even a futures market. BHP has already expressed interest in such markets given that it will allow them more ability to take advantage of higher spot prices on a daily basis, without needing to lock into long-term contracts, or renegotiate as prices move significantly.

While individual investors cannot yet invest directly in iron ore futures, they can purchase a few companies that mine and sell iron ore, such as Rio Tinto (RTP), BHP Billiton (BHP), and Vale (RIO), and can also invest in those companies that are demanding the iron ore - the steel makers, such as POSCO (PKX), ArcelorMittal (MT), U.S. Steel (X), and Nucor (NUE). While there is still concern of a global slowdown, demand for steel and the materials that are used for its production, as least in China, are still strong.

As reported at the WSJ and elsewhere, Saudi Arabia promised at this weekend's oil summit to increase production slightly by 200,000 barrels a day for the rest of the year, if needed. The announcement was expected. On a more long-term basis, Saudi Arabia has also promised to increase its overall output capability to as high as 15 million barrels a day by 2018. The Saudi's currently have an overall capacity 11.4 million barrels a day. This is just a long-term promise, and not a fix for current supply-demand issues, but does indicate that the Saudi's may have spare capacity. Recently, some have worried that the Saudi's were not raising production simply because they could not do so. The recent promises indicates they can, but of course, this extra supply may be difficult to pump and may only be economical at current high prices. The extra oil pumped will no doubt also be made up largely of heavier crude, and not the light sweet crude the world is demanding. Experts also think the 15 million figure is high, and that the Saudi's would be able to reach 12 million barrels a day, at best. Given that crude oil prices were up in Monday morning trading, it is easy to suspect that the markets were also not impressed with news out of Jeddah.

Interestingly, by telling the world what it wanted to hear, the Saudi's may have also put themselves up for more criticism. Indicating that they could increase production sends the signal that they have been holding back, and that supply-demand issues are potentially at the heart of the problem, and not just speculators and the dollar as often stated by OPEC.

As for the near-term impact of the summit, and its associated promises, it looks as though it has not changed the outlook for many analysts. In the Bloomberg clip below, Victor Shum, from Purvin & Gertz, elaborates on supply and demand issues and predicts that demand destruction will increase as we move towards the end of the year. He is also expecting more price spikes in the next few months until falling back to an average value in the $120s as high prices finally cause more extensive reductions in demand.

Nice article at seekingalpha.com from Roger Nusbaum regarding whether or not it is time to buy financials. Roger says no, and makes the case why not. I agree. Wait for confirmation of a reversal, both technically and fundamentally. Of particular worry now are the regional banks, many which have some of the same issues as the bigger banks, and may be the next group to take a hit (and currently are for some). Many regionals are moving into municipal bonds (see post here). Hopefully, they will not fall into the same capitalization problems.

As reported in the cover story this week, Barron's outlines the argument that we may be seeing a near-term top in the crude oil markets, and in fact, this may be a sign of a bursting bubble. To setup the argument, Barron's discusses the impact of supply and demand, along with the effects of institutional investments in commodity-linked indexes. For a quick overview, Barron's provides a nice one page overview of oil supply and demand, along with a chart showing the linkage of the price of crude oil as compared to the rise of the Nasdaq Composite in the late 1990s. While Barron's does present the various points for crude oil prices increasing and decreasing (discussed more below), it refers in both the article and video linked below to the "eerily similar" linkage between crude oil prices and the Nasdaq Composite, and how this implies a correction is possible. While a correction is possible, and may be setting-up as we speak, I am not sure it will be happening simply because the price pattern looks like a previous non-commodity bubble, technical analysis notwithstanding. Even Barron's straddles the fence somewhat by stating that prices could increase to $200 a barrel in the next decade, but could fall to $100 a barrel by year end - not exactly your typical deflating bubble, but more like a short-term pull back or correction.

So what exactly are the pro and con arguments regarding the bubble bursting? As to demand, it is mentioned how while the U.S. per-capita oil consumption is 25 barrels annually, both China and India are small in comparison, with China consuming only two barrels per person per year, with India consuming less than one barrel per person per year. Given that China and India have 1.3 and 1.1 billion citizens, respectively, there is an expectation that oil demand will increase in each of these countries as more of their citizens look to enjoy the fruits of the world, such as air conditioning, automobiles, refrigeration, and computers.

It is further speculated that China has been hoarding diesel fuel ahead of the Olympics in order to produce electricity without coal generation - which has been polluting the country, in particular Beijing where the Olympics are being held. China will likely go back to the cheaper coal once the games are over, thereby reducing diesel demand. China has also recently raised prices on gasoline by 18% (see previous post), a move that is expected to place further pressure on demand, although as described in the post, some feel this may just allow pent-up demand to be satisfied as profitability will return for refiners who have been hurt by higher crude oil costs, but have not been able to pass prices on to customers. This has essentially reduced the gasoline supply in China as refiners shut down or scale back operations. Better margins will now increase supply for consumers demanding gasoline, even at higher prices.

It is also mentioned in the article how Saudi Arabia has pledged to boost production by 200,000 barrels a day, from 9.5 million barrels a day to 9.7 million barrels a day, in order to take pressure off prices (see previous post). The potential for supply-oriented news out of this weekend's summit for oil producers and consumers may also generate additional production increase promises. Unfortunately, much of this oil is sour, and not the light sweet crude currently demanded by the markets, and also subsequently responsible for driving up prices. Whether the Saudi's even have the ability to increase production in their aging fields is also a concern regarding any promised production increases.

As for global oil consumption, it is down in total for the OECD nations (which account for more than half of all global oil demand). Demand itself is currently running about 86 million barrels a day and is expected to be relatively flat as nations cut back on consumption, in particular, automobile miles traveled. Yet, oil demand continues to grow in the developing world, and it will be difficult for even developed countries to reverse their trends quickly. As stated by Byron Wien, the chief investment strategist at Pequot Capital Management, "The world isn't finding oil fast enough to replace the 3% to 4% that gets pumped every year." With oil being controlled by governments that have an interest in maximizing revenues, it is unlikely they will have any near-term interest in boosting current production until the signs of demand destruction become more evident. With supply projections even less, at around 85 million barrels a day, with excess demand currently being made up from inventories, lower demand may result in break-even levels at best.

Some analysts are also speculating (hoping) that the U.S. Federal Reserve will begin raising interest rates later this year, which while helping to fight inflation in general, would also help boost the dollar, thereby reducing the cost of dollar dominated crude oil. Given the upcoming presidential election, and the history/attempts of the Fed to stay neutral during the second half of election years, it is unlikely they will do anything until the elections are over in November. The same could also be said for opening up the Strategic Petroleum Reserve. It is unlikely that the president will begin flooding the market this year in an attempt to increase supply and lower prices, although the government recently did stop purchasing oil for the reserve. If the president would begin selling, it would no doubt appear political, even if welcomed. Ironically, opening up the SPR might end up being a good trade if the country was able to sell oil at current prices when it was bought on average at much cheaper prices. Of course, what prices would be paid in the future to replace the oil is unknown. In addition to the SPR, the lifting of off-shore and protected land oil drilling bans could also have some impact. While it is often argued that the impact would be longer-term, as much as 10 years out, lifting of the bans would certainly send a signal that the U.S. is finally getting serious about the problem and is willing to consider all alternatives, not to mention putting political partisanship behind it. Of course, I would not hold my breath on that one, but if prices continue to rise, expect to see pubic support for lifting the bans begin to shift as the U.S. approaches the next election.

Of course, no article on crude oil prices is worth it salt without discussing speculation and investment. While speculation is not discussed in great detail in the article, the increase in commodity index investing is. Investments by endowments, pension funds, and institutional investors has totaled $260 billion as of March, up from just $13 billion in 2003, with $55 billion flowing into commodity investments in Q1 of this year. Calpers alone is listed as increasing its commodity exposure from $500 million to $7 billion. Yet, isn't this to be expected? Good managers should be expected to deploy capital to the areas they feel will see that greatest potential. While the risk are present, fund managers are under increasing pressure to generate abnormal returns. Right now, commodities and energy plays represent some of the best opportunities, but the party may be coming to an end as Congress and regulators are considering limiting fund investment in commodities, along with placing larger margin requirements on speculators. Yet to be seen is whether the higher margin cost, or increase cost of carry will force index funds and speculators to open up stored reserves - speculated in some cases to be in cargo ships off the coasts of various countries. Nonetheless, it will change the dynamic. Whether it changes to price trend is yet to be determined.

Like Barron's, a short-term correction would not surprise me. Nor would a retest to the $100-110 range. Breaking $100 would probably signal or long-term correction, and a possible bursting of the bubble, but even Barron's is not projecting the prices to fall this low. In fact, it has actually done a pretty good job of outlining both the bull and bear arguments, while also tempering how much it expects the prices to fall even if the correction it is predicting is severe enough to be bubble bursting. In the end, Barron's itself may have placed the best crude oil hedge yet.

As reported at Reuters, hedge funds have been raising capital and are looking for ways to deploy it in the current market. Possible outlets include distressed debt and higher quality mortgage debt. Funds also hope to take advantage of lower stock prices as forced selling of equities is expected to intensify as the summer progresses. Famed hedge fund manager John Paulson, who made a correct (and profitable) bet on sub-prime last year, predicts more gains from distressed debt as he expects to see an additional $10 trillion opportunity develop over the next 6-24 months.

Changes in focus are already showing benefits. The Credit Suisse / Tremont index rose 2% in May, as long/short equity, event-driven, and emerging market funds outperformed. High volatility and widening credit spreads are also creating opportunities for convertible arbitrage funds. Of interest is that quants funds are also optimistic, with the optimism not necessarily due to the current market opportunities, but due more to less competition from other quant funds. Last year forced credit selling created unpredictable moves (both directional and magnitude) that ended up shaking out a number of less-capitalized funds that were unable to adapt quickly enough to changing market conditions. Whether the rest of 2008 is any more predictable is yet to be seen.

A number of hedge funds are hiring talent from Wall Street as investment banks cut back on salaries and bonuses. As reported at Bloomberg, many traders, bankers, and analysts are giving up the once preferred bonuses and prestige of investment banks for the potential to cash in with hedge funds as the security once offered by investment banks decreases. As investment banks perform less underwriting and reduce leverage by selling assets, less money is being generated by Wall Street, translating to less bonuses come year end. Pay packages are expected to fall by 20% or more this year alone. Private equity is also benefiting from the dissatisfaction as they too are scooping up investment banking talent. Given the recent closures of small hedge funds, which in many cases are either shutting down entirely or simply being absorbed into larger funds, it looks as though the deck chairs of Wall Street will continue to shift over the summer as the market looks to right itself after the recent credit problems and current commodity and inflation issues.