Five Ways to Profit from the New Year Rebound in Commodity Prices

By Martin Hutchinson

Contributing Editor
Money Morning

Between September 2007 and June 2008, oil prices doubled, gold rose 30% and commodities, in general, advanced by a similar percentage.

So why, six months later, when prices have fallen back below last year's levels, does everybody think they won't rise again? The difficulties of extraction haven't gone away, nor have the prospects of increasing consumption in the faster-growing emerging markets such as China. Yes, the prices of commodities are severely affected by marginal moves in supply and demand, but this is ridiculous!

Rest assured, commodities prices will rebound in the New Year. The reasons will soon become quite clear.

The decline in commodities prices since the summer is broad-based. The Reuters Continuous Commodities Index traded recently at 341, down 25% from a year earlier and off about 45% from its June high. At $48 a barrel, oil is trading at less than one-third of its June high. And gold, which appreciated less than other commodities in the spring, is still down 18% from the $1,000-per-ounce level it reached earlier this year.

Conventional wisdom blames the decline in commodity prices squarely on the global recession. Since the rise in demand from emerging markets – particularly the huge consumption bases of China and India – had caused the previous run-up, it seems natural that the absence of that demand growth would cause prices to decline. After all, that happened in 1982, when a deep recession in the United States spread to a number of other countries. Oil prices plunged from $40 a barrel to a mere $10, breaking the back of the Organization of the Petroleum Exporting Countries (OPEC) in the process.

This time around, however, the math doesn't seem to work. For one thing, the world as a whole is by no means locked into recession. We in the rich countries think of our economies as spiraling into a deep decline, but the reality is that we may only be witnessing a secular shift caused by the narrowing of income differentials between rich and poor countries as globalization proceeds.

In countries such as China, India and Brazil – three of the four so-called "BRIC" economies – growth has slowed and many are suffering imbalances in their financial structures, but there is little sign of actual decline in any of them. Indeed, if China's recently announced $590 billion infrastructure investment serves to redirect growth toward domestic consumers, it is possible that the demand for oil and other commodities there may show very little dip at all; it takes a great deal of iron ore and other commodities to produce $100 billion worth of railroads, for example, one of China's stated objectives.

On the supply side, OPEC was full of spare capacity in the 1980s. South Africa and the Soviet Union were still expanding gold production, and the explorations of the 1970s had produced surpluses of many other commodities. But in the past two and a half decades, things have changed.

Oil, for example, remains in short supply. Both deep offshore fields – like those discovered by Petroleo Brasileiro SA, or Petrobras (ADR: PBR), in the Tupi Complex – and the tar sands (like the ones in Canada and Venezuela), are economically unfeasible with oil trading at such a low price. And, if prices remain low, the expansion and exploration of new sources of production will be curtailed even further.

More importantly, though, supply and demand is only one of the reasons commodity prices rise and fall. What really spurred the big price rise in commodities that took place earlier this year was the explosion in the money supply throughout the world.

Money supply, unlike demand, is something that hasn't evaporated with the economic downturn. In fact, it has actually ramped up. Even though money markets have become illiquid, central banks throughout the world are forcing down interest rates and pumping out liquidity by every means they can think of [Indeed, the policymaking arm of the U.S. Federal Reserve meets today (Tuesday), and is expected to cut rates yet again. For a related story, click here].

Meanwhile, governments everywhere (except Germany) are implementing massive "stimulus packages" that will destabilize budgets and insert huge additional demand into the global economy. Since the governments will have to borrow the money to finance those stimulus packages – and the budget deficits that are inevitable in an economic downturn – central banks will be compelled to pump out even more money to accommodate all the increased debt; otherwise, interest rates would go through the roof and finance for the private sector would become unobtainable, hardly the object of this whole costly exercise.

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The future is thus one of rapidly increasing inflation, combined with a healthy recovery in global demand, at least in the emerging markets, as Europe and the United States may suffer deep recessions this time around.

To take advantage of this likely trend, I would recommend a broad portfolio of shares whose prices are closely linked to the prices of major commodities. Among those you might consider:

• Vale (ADR: RIO): As a gigantic Brazilian iron ore producer, Vale will benefit enormously from China's new infrastructure program (Think of all those steel rails!). The stock is currently trading at just over $12 a share with a Price/Earnings ratio (P/E) of about 7.0 and a yield of slightly more than 1.0%.

• Rio Tinto PLC (ADR: RTP): Another huge mining conglomerate, the long-and-bloody attempted takeover of Rio Tinto by BHP-Billiton Ltd. (ADR: BHP) recently fell apart. At $93, Rio Tinto shares have a yield of 5.8% and a prospective P/E of about 3.0. The company is overleveraged, so somewhat dangerous, but you'd be getting paid for the risk.

• Suncor Energy Inc. (SU): The largest pure player in the Canada's Athabasca tar sands, Suncor's marginal cost of production from operating facilities is about $30 per barrel and the cost of opening new facilities is about $60 per barrel. It's currently trading with a P/E of 8.0 but has a yield of less than 1.0%, as it needs all its cash.

• SPDR Gold Trust (GLD)exchange-traded fund (ETF): The largest ETF that invests in gold, GLD has more than 750 tons of the "yellow metal" held in trust.

• Yanzhou Coal Mining Co. (ADR: YZC): China's largest coal miner, Yanzhou has a P/E of 4.0, yields 3.5% and enjoys low costs – not to mention a super-close proximity to the gigantic market that is China.