Bet Long Term for Commodity Profits

02/08/2011 10:03 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Short-term volatility can test an investor's mettle. But if you get in during a boom cycle, like copper and iron ore are in today, you can win big. Here's how.

The sky's the limit. The sky is falling. In the short term, that pretty much describes the behavior of commodity stocks.

And it's all too easy to get caught up on the drama of those short-term moves, because the possible profits, if you can outguess the market, are all too tempting. (I know because I get caught up in it myself.)

But for most of us who aren't blessed with market-beating 20/20 foresight, playing the short-term volatility of commodity stocks isn't the best way to make money in this sector.

For most of us most of the time, the long-term swings between scarce supply (sending prices up, up, up) and scarce demand (sending prices down, down, down), which can last for years and years, are the best sources of profits.

And right now, the long-term pattern says we're in an upswing that has at least two more years to run before we see a significant downside challenge.

Why do I think that? Supply and demand tell me so. I'm going to end this post with my take on the supply/demand picture for several important industrial commodities. But first, let me try to put the current short-term volatility in some context.

Why a Short-Term View Is So Appealing

The potential rewards in the short term are what get our attention. Iron miner Vale, (NYSE: VALE) was up 42% from the August 2010 low to the January high. One-stock commodity portfolio BHP Billiton, (NYSE: BHP) was up 44% from the August low to the February high. Molybdenum and copper miner Thompson Creek Metals (NYSE: TC), was up 88% from the August low to its January high.

But the volatility? Who can stand the drops? Look at just one stock, Freeport McMoRan Copper & Gold (NYSE: FCX).

On Jan. 11, shares had rallied to $60.90. Two weeks later, on Jan. 25, the stock had dropped 12.6% to $53.22.

On Nov. 11, 2010, it traded at $54.01. On Nov. 17, it was $48.42. That's a 10.3% drop in just six days.

But by Nov. 11, the stock had soared 62% from its Aug. 25, 2010, low of $33.33.

Just in case this volatility wasn't enough to make you insane, hovering over all of these moves is the memory of the great commodity rally of 2007, when Freeport McMoRan climbed 86%, and the great commodity collapse of 2008, when the stock dropped 74%. And the volatility in 2008 was even more severe than that if you look at just the last six months of the year. Freeport McMoRan fell from $61.65 on June 13, 2008, to $9.03 on Dec. 3.

If this kind of short-term volatility is what you focus on, you're paying attention to the wrong time frame. You need to be investing on a scale of years, not weeks or months.

Look at oil, for example. In 1980, the average US price of oil was $37.42 a barrel. In 1998, oil sold for an average of $11.91 a barrel. That's 18 years of solid losses in oil stocks and other shares that depended on the commodity.

But 1998 marked the bottom. By 2004, the average price per barrel hit $37.66, the same as it had been in 1980, on its way to a peak near $150 in 2008.

With oil demand sagging because of the world economic crisis, oil fell back to the $30s, where it had been in 1980 and 2004. It then began a climb back to a price near $100 a barrel, as demand recovered along with the global economy and the crisis in Egypt drove up fears of a disruption to global supply.

The long-term pattern for many other commodities looks similar. Copper on the London Metal Exchange, for example, sold for $2,710 a metric ton in 1990, $3,050 a metric ton in 1995, and $1,730 a ton in 1998. It then began a slow, steady climb to $1,880 a ton in 2003 and to $2,950 in 2004 before rocketing up to its current price. Last week, copper hit an all-time record price of $9,955 a ton.

But we're not living in an age when all industrial commodities climb inexorably higher. The big counterexample is natural gas. In January 2002, natural gas sold for $2.50 per 1,000 cubic feet in the United States. It then moved up to $4.43 in 2003, and to $8.01 in 2006.

Since then, though, the price of natural gas has been in what began as a slow decline (to $7.38 in January 2008), then turned into a rout (to $4.60 in January 2009), and now has become a lasting depression. Natural gas traded at $5.14 per thousand cubic feet in January 2010, raising hopes that the economic recovery was about to lift prices permanently. But then it fell—and fell and fell—until it hit $3.34 in December 2010.

So what's a commodity investor to do?

NEXT: Profit from These Three Principles

|pagebreak|

Profit from These Three Principles

Here are my core tenets for commodity investing:

1) Find a Commodity That Is in a Multi-Year 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 both 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 the other is down, but there's more to the difference than that.

The US 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 (NYSE: RIO), 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.

NEXT: Commodity Stocks to Buy, Key Risks to Consider

|pagebreak|

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 (NYSE: FCX), Thompson Creek Metals (NYSE: TC), and Southern Copper (NYSE: SCCO).

  • For more on Freeport McMoRan, see this post
  • For more on Thompson Creek and its transformation from a molybdenum miner to a molybdenum and copper miner, see this post

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 (NYSE: 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, (NYSE: POT) 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 (NYSE: BHP), Macarthur Coal, OTC: MACDY), and Whitehaven Coal (OTC: WHITF), 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.

At the time of publication, Jim Jubak did not own shares of any of the companies mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned in this post. The fund did own shares of BHP Billiton, Freeport McMoRan, Macarthur Coal, Southern Copper, Thompson Creek, Vale, and Whitehaven Coal as of the end of December. Find a full list of the stocks in the fund as of the end of December here.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

Related Articles on STOCKS

Keyword Image
The Best Buys in Cybersecurity
12/08/2017 5:00 am EST

After weeks of sifting through hundreds of cybersecurity stocks on the market, I finally narrowed my...