Making money from the commodities super cycle

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Making money from the commodities super cycle

• Jim Jubak
• MSN Money
• Moneycentral.com
• jjubak_at_microsoft.com
• 17 May 2006

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The commodities boom isnt over.its merely
resting

• Gold, copper, zinc, aluminum, silver, nickel,
  platinum at historic highs. Copper up 90.
  Platinum 25 above last peak. Oil back near 3Q
  2005 highs.
• Volatile markets. Last time platinum peaked, it
  fell 50 in a month. Wouldnt you take profits
  here?
• Fundamentals demand continues to outstrip
  supply. Forecast world oil demand will climb 2
  in 2006 with world oil production scheduled to
  grow by 1 to 2. Refinery shortage to persist
  through 2010.
• Supply deficits in 2005 in aluminum, zinc,
  platinum, and copper. Forecasts show supply
  deficits in 2006 in copper, nickel, and zinc.
  Supply deficits in copper, zinc, and nickel
  projected to continue into 2007 with aluminum
  moving into deficit that year.

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Some on Wall Street calling this a commodities
super cycle

• Commodities are notoriously cyclical industries
  that swing from boom to bust and back again as
  suppliers over-invest in production when prices
  are high, causing massive over-supply 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.
• But not this time, the super cycle argument goes,
  because the last crash in commodities prices was
  so severe, commodities producers under-invested
  in new production and infrastructure for 15
  years. Now 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, of trained engineers and other
  skilled workers.
• Plus shortage of big easily extracted new
  supplies and global and local politics that make
  investment in many countries riskier and that
  slow development once a commodities producer has
  decided to develop a new deposit, and the result
  is that commodity producers can't over-invest in
  new capacity even if they're inclined to do so.
• Super cycles have three investment stages

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Super cycle investing Stage 1 Buy the lag in
estimates

• In Stage 1 Wall Street earnings estimates and
  stock prices lag increases in the prices of
  commodities themselves.
• True in 2004 and 2005 as oil climbed from 25 to
  40 to 50 to 60 to 70. At each step Wall
  Street targets based on lagging estimates of
  commodity price. Calculating target for BP based
  on 25 oil when oil was at 45 and headed higher.
• Now true of metals commodities. For example, Bear
  Stearns price target for Phelps Dodge (PD) based
  on copper at 2.75 pound for 2006 (copper July
  2006 future 3.63) and for 2.40 in 2007 (copper
  future for July 2007 3.12). Bear Stearns
  calculates that stocks recent 90 price reflects
  copper price of 1.98 to 2.08 a pound.
• And Newmont Mining (NEM). Good old conservative
  Standard Poor's has a December 2006 target of
  65 (stock at 54 now), based on an average gold
  price in 2006 of 570 an ounce. Gold at 682 an
  ounce on May 15. Bear Stearns target price of 82
  on forecast of 580 an ounce in 2006 and 625 in
  2007.
• My forecast Stage 1 to run for metals
  commodities stocks into 2007
• Caveat Watch out for production hedges.

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Stage 2 Wall Street catches up with price but
not length of cycle

• Most energy commodity stocks nowfinallyin this
  stage. Big question isnt oil price. Many stocks
  now discount 55 oil or even higher for 2006.
• Big question for valuations here oil prices in
  2007 and 2008many on Wall Street setting targets
  based on 40 to 45 oil for 2007-2008.
• Problem for investors the longer you go out, the
  harder it is to project short-term prices. High
  oil prices will cut demand but no one knows how
  much.
• Energy stock sector with most visibility is oil
  services where many drillers and drilling
  equipment producers are fully booked at rising
  prices through 2007 but where stock prices dont
  reflect big continued earnings growth beyond
  2006.
• Stocks Grant Prideco (GRP), Dril-Quip (DRQ),
  Noble (NE), Transocean (RIG)
• Caveat New supply of rigs starts to swell in
  2008.
• Usual sub-sector dynamics in natural gas where
  many targets and stock prices are based on prices
  above current commodity prices. Sector faces
  reset in late 2006.
• Unusual sub-sector dynamics in coal where the
  electrical industry may be in a rush to build
  before anyone can impose tougher pollution or CO2
  rules.

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Stage 3 Net commodity profits replace gross
commodity prices

• Higher production costs eat into bottom line
  profits. Many oil and natural gas companies
  reporting 15 increase in costs for 2006 over
  2005.
• Higher production costs (and the difficulties of
  finding and expanding new supplythe very things
  that lead to the commodities super cycle to begin
  with) result in individual companies missing
  production and exploration targets. So, for
  example, Royal Dutch Shell cuts its targets for
  reserve replacement. Encana cuts capital budget
  and reduces ramp of news production.
• Combination results in a de-coupling of commodity
  and commodity stock prices as investors begin to
  see that higher commodity prices can produce
  puzzlingly disappointing earnings stories at
  commodity producers.
• Some energy commodity producer stocks have
  already entered this stage but process is just
  beginning. Id expect more and more
  disappointments in this sector in the second
  half of the year.
• Caveat Another strong hurricane season that
  disrupts supply or another geopolitical scare
  that quickly spikes oil and/or natural gas prices
  would delay the arrival of this stage.