Mine the white-hot metals

By Jim Jubak

The commodity rally in metals is back. In fact, the metals sector has been on fire for three months.

You've missed the easiest gains, I'm afraid. And the risks are higher than they were in January. But, while it's too late -- and too risky -- to jump into the rally in copper stocks, it's not too late to pick up good gains in nickel producers. And zinc stocks could yield the biggest gains of all.

I think you can dodge the risk and pick up solid profits for the rest of 2007 -- if you pick the right mining stocks. In this column I'll give you three, and I'll add one of those stocks to Jubak's Picks.

Southern Copper (PCU, news, msgs) is up 54% from its Jan. 8, 2007, low through the market close on April 11. Freeport-McMoRan Copper & Gold (FCX, news, msgs), up 39%. Companhia Vale do Rio Doce (RIO, news, msgs), up 49%. BHP Billiton (BHP, news, msgs), up 37%.

Yes, shares of metals miners over the past three months have been hotter than a smelter on an August day. And, no, I haven't owned much in the sector, with the exception of BHP Billiton and Anglo American (AAUK, news, msgs), up 23% from its Jan. 5 low.

I admit it: Distracted by worries about a potential slowdown in the U.S. economy, the meltdown in markets for mortgages to the least creditworthy borrowers and the ups and downs of oil prices, I missed a huge rally in copper, nickel, aluminum, zinc, tin and lead.

So what's an investor to do?

Too far, too fast?

Start with a top-down view of the financial markets to decide how much of the rally is over. And finish with a bottom-up view of individual metals and mining companies to see what stocks still have the potential to surprise Wall Street.

Top down first: The easy money in this rally is gone. It doesn't hang around long these days.

In the current market, momentum players may start a rally, but speculative money isn't ever very far behind. The billions managed by hedge funds and the expanded proprietary trading desks of big investment firms pretty much guarantee that any rally will quickly attract a flood of hot money looking for the latest trend. Under these circumstances, rallies quickly run to excess.

The big move in the price of copper, the commodity, and copper stocks in the recent rally is a good example. Yes, there are signs that the Chinese have sold off the copper inventory that temporarily depressed copper prices around the middle of 2006. And yes, Desjardins Securities predicts that global copper demand will grow by 5.1% in 2007, up from growth of 3.6% in 2006. So copper prices should be climbing, and copper stocks should be rallying.

But a gain of 5% in one day on April 10? And a gain of 48% from early February to early April? Too far, too fast. It's not just that benchmark copper prices hit a seven-month high of $7,710 a metric ton on the London Metal Exchange on April 10. It's that hedge funds, according to the Financial Times, have started to talk about copper prices breaking the record $8,790 a metric ton set in May 2006.

(A metric ton is 205 pounds heavier than the 2,000-pound short ton measurement used in the United States.)

When the speculative money starts counting its future chickens before they've hatched, you know the easy money has long ago been picked up off the floor.

A question of supply and demand

That doesn't mean that copper and copper-mining stocks can't go higher. A flood of hot money can be followed by another flood of hot money that washes stock prices still higher. But the more that hot money drives up the prices of stocks in a sector, the greater the risk that a change in sentiment will trigger a big outflow of hot money, sending stock prices in the sector plunging.

That's especially a danger for copper and copper-mining stocks now, because we know that even a whiff of bad news from the U.S. housing industry, a big customer for copper, can set the hot money fleeing. And there's no way we've put all the bad news from the housing market behind us.

But a look at the reasons for the big move in copper points investors toward other metals and mining stocks that offer a better combination of risk and reward right now. It's quite simple, really: Demand is growing faster than supply. And demand looks to stay ahead of supply well into 2008, at least.

According to Desjardins Securities, copper supply will run behind copper demand to the tune of a 50,000-metric-ton deficit in 2007 and 55,000 metric tons in 2008. Where does the market get the copper to make up the deficit? From existing inventories. But as inventories get drawn down, the price of copper goes up. As of the end of March 2007, the three big copper markets, in London, New York and Shanghai, showed inventories of about 270,000 metric tons. Desjardins projects an average price for copper of $3 a pound in 2007 and 2008. (On April 12, 2007, copper closed at $3.58 on the London Metal Exchange.)

Investors can find the same supply-demand imbalance in nickel, where, again according to Desjardins Securities, the market went into deficit in 2006 and will stay in deficit in 2007 (by 16,000 metric tons) and 2008 (by 20,000 metric tons). That's a huge deficit considering that Desjardins put nickel inventory at just 5,418 metric tons as of March 30, 2007. (Inventory figures aren't very exact. Higher prices tend to reveal that there's more inventory than expected in unexpected places.) Desjardins estimates that this supply/demand squeeze will push nickel prices up to an average of $16 a pound in 2007 from an average of $10 a pound in 2006. For 2008, the price will also average $16 a pound, Desjardins projects, while CIBC World Markets sees the price falling to $13 in 2008 from $16 in 2007. Recently Deutsche Bank raised its nickel forecast to $17.59 for 2007 and $15.44 for 2008.

Continued: A safety net for nickel prices

 1 | 2 | 3 | next >