Be ready for the commodity comeback

By Jim Jubak

We're building the foundation for the next boom in commodity prices -- and commodity stocks.

I can't give you any guarantee that commodity prices won't tumble further in the short term. In fact, I think that's very likely to happen as the U.S. economy slips into recession (possibly along with the economies of Japan and the European Union).

But right now commodity stocks are factoring in huge declines in demand and tumbling commodity prices over the long term that just aren't going to occur. A patient investor who can put up with the pain of the next six, nine or 12 months can now buy a very reasonably priced option on the shares of the strongest commodity producers for the next leg up in commodity prices. I peg the beginning of the next boom at late 2009 or early 2010.

As an investor in commodity stocks, right now you're licking your wounds and wondering whether the next rally will be time to finally get out.

The sell-off has been brutal. As of Oct. 14, the shares of mining giant BHP Billiton (BHP, news, msgs) were down 55% from their May 16 high. ExxonMobil (XOM, news, msgs) was down 21% over the same period.

Shares of smaller commodity producers have also been hit, some even harder. Molybdenum producer Thompson Creek Metals (TC, news, msgs) was down 73% from its May high as of Oct. 14, and oil and gas producer Devon Energy (DVN, news, msgs) was off 39%.

The last thing you want to hear is that it's time to think about jumping back in.

The commodity bull's in the details

But the economic laws of supply and demand don't care if we're reluctant to revisit a stock market sector that has delivered so much pain. And as hard as it may be to believe right now, it looks like the current meltdown in global financial markets isn't going to have much effect on the trends that made commodity stocks big winners until mid-2008.

Growing demand from the rising economies (and the increasingly wealthy consumers) of China, India, Brazil and the Middle East is still going to drive up the long-term price of everything from oil to zinc. In fact, the current global financial crisis could make the commodity boom that much stronger when it does return.

How could that be?

The economies of the developed world are indeed slowing, and the high prices of commodities, especially of oil, have indeed reduced demand. But the reduction in demand isn't nearly as big as you'd believe if you read just the headlines. These days, you have to read not just the headline and the first paragraph but also the rest of the story, called "the jump," buried inside the newspaper. Take the case of oil demand and the headlines.

Here's the headline from the Oct. 11 Los Angeles Times: "Oil prices slip on market woes." Read just to the end of the columns printed on the front page of the business section and you'll come away with this: The International Energy Agency, or IEA, the paper reports, cut its demand forecast for 2008 to 86.5 million barrels a day, down 240,000 barrels.

What you won't discover unless you follow the story to the bottom of Page C3 is that the reduced projection is still 0.5% higher than oil demand in 2007. The world is near recession, and drivers are cutting back on gasoline use because of high prices, yet global oil demand is still going to increase in 2008, according to the agency's projections.

For 2009, the IEA also cut its demand projections -- to 87.2 million barrels a day. Unless my math has completely deserted me, that's more than the agency projects for 2008 demand. In other words, in the midst of what looks like a serious recession in the developed world, demand for oil is projected to keep growing.

Why? Because while demand may be falling in the world's developed economies, it is still soaring in the developing world. "We have yet to see unambiguous evidence of a sharp slowdown from China, while Middle Eastern demand remains robust," the IEA said.

Rolling back the barrels

So much for the demand side. If demand isn't falling as rapidly as investors might have expected, does the supply side have a surprise or two up its sleeve?

You bet. The global capital crisis has dried up capital for smaller oil companies and even for major oil producing countries such as Russia. Federal revenue from Russia's natural-resource-based economy is projected to grow by just 1.8% next year, the Russian government projects. That's down from projected 13.8% growth in 2008.

That's bad news for an oil industry that needs lots of investment capital -- $1 trillion by some industry estimates -- to stop the decline in Russia's oil production that began in the first quarter of 2008. Mexico, Iran, Nigeria, Venezuela and other oil producers are in much the same boat. Without increased investment, oil production will decline. But with prices way down from highs of about $147 a barrel, those governments have more-urgent places to spend the oil industry revenue.

Falling oil prices are also leading private-sector oil companies to cut back on investment in new production. Goldman Sachs (GS, news, msgs) calculates that $50 a barrel is the oil industry's cash cost. Below that level, oil companies with above-average production costs will seriously consider shutting wells, because pumping oil is a money-losing proposition.

Continued: The shortages grow

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