3 stocks for the commodities rebound

By Jim Jubak

The sell-off in commodities from gold to copper to oil that started last week is, in my opinion, a needed short-term correction for a market that had run up too far, too fast.

But I don't see any signs that the long-term boom in commodities is over. It looks like it has years to run. The fundamental imbalance between supply and demand for many of these commodities will persist into 2008 as best as I can tell right now.

Which puts investors who agree with my assessment of the long-term upward trend in commodities prices in something of a bind: When have prices -- and in which commodities -- corrected enough so that buying is a smart move?

Right now, it's much easier to answer those questions for the stocks of commodities producers than for the commodities themselves. So I'd advise sticking to the shares of commodity producers until the trends in the commodity markets become clearer. Buying the stocks rather than the commodities is much safer right now, and I've got some ideas in this column for how to make it safer still.

And for those investors willing to go the equity route, I've got a way to get a handle on when buying makes sense for you. I'll end the piece with three commodities stocks for profiting from this correction.

Signs of reaching a top

There's little doubt that the markets for many commodities have been caught up in speculative fever. How could they not? The markets for many of these commodities are just ideal for speculation. They're very small -- on May 12 only about $100 million in copper contracts traded, for example, in comparison to trading volume of about $70 billion that day on the New York Stock Exchange. And they're highly sensitive to news and rumor -- a potential strike at a copper mine in Mexico is a market-moving event. All of which makes it easy for speculators with enough cash to move the market.

And the markets in many of these commodities have been showing classical signs of a top in emotion.

Consider this quote from the CEO of Aditya Birla Minerals, an Indian copper company that just went public in Australia: "Any price (for copper) is justified when you have such demand, low inventories and supply constraints."

Talk about no price being too high, particularly from the CEO of a startup that just started mining copper in December 2005, always makes me nervous. Especially when the commodity in question, copper, hit an all-time high last week. As did the prices for aluminum, zinc, and nickel. Gold, of course, has been setting a new 25-year high just about every day as the metal creeps up on its all-time high.

All of which is by itself enough to explain the recent sell-off. The traders who dominate the commodities markets know they're dealing in volatile markets that have a history of selling off big time after spikes like these markets have seen this year. Copper, for example, even after a three-day sell-off was still up 90% for the year as of May 15.

When I say volatile, I mean volatile to a degree that investors in stocks really don't understand. Platinum, for example, hit a high last week 25% above the peak price during the metal's boom in the 1970s. Platinum traders know, though, that the earlier peak was followed by a crash that dropped the price of the metal 50%. In a month.

Knowing that, wouldn't you take some profits here?

Take the long view

Think that the commodities boom is over in the long term? Not a chance, in my opinion, as long as the economies of China and India keep devouring a bigger chunk of the world's raw materials and as long as the established economies of the United States, Japan and Europe keep chugging along at growth rates between 2% and 4% annually.

Platinum, for example, showed a net supply deficit in 2005 of 70,000 troy ounces. Supply rose by 2.2%, but demand climbed faster, by 4.8%.

And platinum is by no means an isolated case. There were supply deficits in aluminum, zinc and copper in 2005. Forecasts by Desjardins Securities show supply deficits in 2006 continuing for copper and zinc, with nickel moving into deficit in 2006 after showing a slight surplus of supply over demand in 2005. The supply deficits in copper, zinc and nickel are projected to continue into 2007, with aluminum moving into deficit that year.

The result is what some on Wall Street -- Citigroup for example -- call a "commodities supercycle." Commodities are notoriously cyclic industries that swing from boom to bust and back again as suppliers over-invest in production when prices are high, causing massive oversupply that leads to a crash in prices. With prices low, commodity producers cut back on investment and gradually supply falls behind demand, setting the cycle in motion again.

This time, the supercycle argument goes, because the last crash in commodities prices was so severe, commodities producers underinvested in new production and infrastructure over the past 15 years. Now, thanks to the length of that period of underinvestment, there is no quick way to ramp up production -- getting new deposits and reservoirs into production has run up against a shortage of everything from truck tires to drill bits and most importantly, trained engineers and other skilled workers.

Commodities producers also face a shortage of big, easily extracted new supplies, compounded by global and local politics that make investment in many countries riskier and slow development of new deposits. The result is that commodity producers can't over-invest in new capacity even if they're inclined to do so. So growth in China and India push up demand and prices but don't lead to a repetition of the overproduction that has created commodity busts in the past.All of which says part of your portfolio should be in commodities for the long haul but doesn't tell you what price for copper or nickel or zinc is froth and what price is a good entry point for participating in any long-term commodities boom.

Buying the stocks, not the stuff

Here's where I think buying commodities stocks instead of the commodities themselves can help. The fundamentals of even a recent public offering in a hot commodities market aren't nearly as frothy as the price of copper or even, in this case, the CEO's talk about the future price of copper. In its IPO prospectus, Aditya Birla Minerals (AU:ABY, news, msgs), 51% owned by India's Hindalco Industry (HNDNF, news, msgs), forecast earnings based on copper trading at $1.73 a pound on average. That was less than half the $3.90 a pound closing price on May 15 for the July 2006 copper contract on the London Metal Exchange and a $1.60 a pound below the July 2007 price of $3.33. If copper climbs 10 cents a pound, the prospectus goes on, the company's earnings before interest, taxes, depreciation and amortization (EBITDA) would climb by 22%.

Buying your copper in the form of shares of Aditya Birla Minerals gets you a lot less froth, I'd argue, and much better guideposts for what's overvalued, what's not and when to buy. All that adds up to less risk.

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