Trend: The supply of some commodities, like copper, has not been meeting demand, resulting in price increases and big profits for suppliers - and investors.
MSN Money columnist Jim Jubak provides some guidelines for investing in commodities.
Jim Jubak's 3 principles for commodity investing:
1. Find a commodity that is in a multiyear boom.
Or, rephrased, find one that is currently behaving like copper and not like natural gas. I don't mean the obvious profits you'd see this year as copper climbs to a record high, while natural gas mopes along the bottom. I want you to think about the longer-term benefit of investing in a commodity that's riding the boom end of a cycle. If you buy and hold, you may suffer a painful 15% loss in a few days, but as long as the commodity cycle that underlies your commodity stock is in a long-term uptrend, this kind of volatility is survivable.
Buying in during a long-term boom cycle can save you from the worst effects of truly terrible timing. Seeing a stock drop from $61.65 to $9.03 in six months is the kind of excruciating loss that can devastate a portfolio if you then sell at the bottom. But Freeport McMoRan didn't just fall from $61.65 to $9.03 in six months; it rebounded to $29.48 by June 2009, then hit $43.66 by January 2010 on its way to $56.76 at the Feb. 4, 2011, close. You could have had the terrible bad luck to buy at the $61.65 top in June 2008, but if you held on, two and a half years later, you'd be looking at a loss of less than 10%.
I'm not recommending this as an investment strategy, mind you. Spending 30 months to get back to within 10% of the money you started with is still a loss -- of money and time. But it's not the worst thing that can happen to a commodity, or an investor.
2. Understand what's driving the commodity cycle.
Let's go back to our friends copper and natural gas. We've already established that, given a choice, you'd much rather own the copper cycle than the natural gas cycle -- at least right now. What's the difference between the two cycles at the moment? Sure, one is up and other is down, but there's more to the difference than that.
The U.S. natural gas industry is currently in the midst of a huge expansion of supply from unconventional sources. The rest of the global industry is following that same path, using technologies pioneered in the United States. The world is, therefore, looking at a big increase in natural gas supply that's likely to run for years. That doesn't necessarily mean that the price of natural gas is headed down, but it does mean that any price increase is dependent solely on an increase in demand -- in this case, an increase in demand large enough to outpace the increase in supply.
Contrast that with copper. It's not that copper miners aren't trying to increase supply; it's that they're having a hard time doing it. For example, in the Jan. 20 guidance for 2011 that went along with the release of its 2010 financial report, Freeport McMoRan said that 2011 copper and gold sales would be slightly below earlier forecasts because of a drop in the grade of ores being mined at its Grasberg mine.
This problem -- lower-quality ores that require a mining company to move more earth to get the same amount of copper -- isn't limited to Freeport McMoRan. Companies across the copper-mining industry face the same conditions. Rio Tinto (RIO, news), for example, recently announced that it had mined 16% less copper in 2010 than in 2009. Copper, unlike natural gas, has both rising demand and constrained supply working in its favor.
3. Make sure you can really tell where supply is heading.
If you want to own the coppers of the commodity world and not the natural gases, then you should value -- really value -- supply transparency.
Oil, I'd argue, has very low supply transparency. For instance, we have no more than educated guesses about the condition of the big oil reserves in Saudi Arabia. How badly, if at all, have they been damaged by production techniques over the last decade or so? We know very little about how hard it will be to increase production from the oil fields of Iraq, or how much more damage Venezuela will do to its oil industry, or what kind of environmental restrictions Canada will impose on its oil sands industry.
Contrast that with copper, where the big uncertainties are geopolitical and the possible deviations from consensus outcomes in unstable countries like the Democratic Republic of the Congo would reduce supply, rather than expand it. I'd put iron ore, coal and potash fertilizer in the transparency-of-supply group, along with copper. I'd put oil, natural gas and aluminum in the less-transparent supply group.
What to buy now
My three basic tenets translate now into a rough hierarchy of commodities, and a few stocks to consider at each level.
At the top of the heap I'd put copper. It's hard to increase supply, demand is increasing with global growth, and supply is relatively transparent. My three favorite stocks in this commodity are Freeport McMoRan Copper & Gold (for more on Freeport McMoRan see this Top Stocks post), Thompson Creek Metals (for more on Thompson Creek and its transformation from a molybdenum miner to a molybdenum and copper miner see this post) and Southern Copper (SCCO, news).
Next I'd put iron ore. Iron doesn't have quite the same supply problems as copper, but India has been reporting what seem to be significant (perhaps only temporary) supply disruptions. Meanwhile, global demand for iron is growing even faster than it is for copper. My favorite stock in this industry is Vale. It gets the nod over BHP Billiton in my book because it has more concentration in iron than its Australian rival does.
I've got a positive rating on both coal and potash fertilizer, but they sit a step below copper and iron on my list because they don't have the supply problems of copper or even iron ore. It looks like the world has plenty of coal in accessible deposits to meet soaring demand. In potash, Potash of Saskatchewan (POT, news) still has idle capacity that it can bring into production when demand and price justify it.
In these two sectors, I'd favor the Australian coal producers BHP Billiton, MacArthur Coal (MACDY, news), and Whitehaven Coal (WHITF, news), because of their proximity to the big coal markets of India and China (for more on Australia's coal miners and the recent floods there, see this post). In the potash sector, I think the most interesting pick is Vale, which is making a big, government-favored push into the fertilizer market in Brazil.
Two risks to keep in mind
Investors face two big bumps with commodity stocks in these sectors. The first is the fear, likely to send the market into repeated swoons in the first half of 2011, that growth will slow in China. (I've suggested cutting back exposure to copper stocks for the first few months of 2011 for investors who want to reduce their exposure to a China slowdown. So far that sector retreat has failed to materialize.)
The second risk, and I think this is a factor for 2012 or so, is the amount of new mining capacity set to come on line from 2013 to 2015 in just about every mining sector. The fear is that this new capacity could send prices down. But I think the reality is that, at least for my two top-rated commodities, copper and iron, the addition to supply won't be enough to keep up with demand.
The global supply deficit in copper will reach 822,000 metric tons in 2011, according to Barclays Capital. That's a lot of supply to make up even when the copper industry is projecting a record amount of capital investment in 2011.