Commodity Run Changing, Not Ending

Where once Buying Gold was enough, now broader commodities are set to rise...

The RUN-UP in global commodity prices has been a long one, and it shows no signs of abating, writes Martin Hutchinson, contributing editor to the free daily Money Morning email.

Long-time Money Morning readers will know that we predicted this bull market. Back in October 2007, for instance, we told readers to Buy Gold – back when it was trading at $770 an ounce. Those of you who followed our advice have done quite well.

But now it's time to make a new prediction. Because while the run-up in commodities prices isn't going to end, it is going to change. Commodities are going to break into two distinct groups – traditional inflation hedges, such as gold, and big industrial commodities, such as coal.

Going forward, I believe, the industrial path will be the one that investors will want to travel for maximum profit. Here's the No. 1 way to play what we're calling "the commodities boom of 2011".

Over the last two years, governments around the world have used monetary policy as a tool to prop up their economies after the financial crash. That has pushed up gold and Silver Prices. They are based on speculative demand, and during the current run-up, loose global monetary conditions and the fear of inflation have served as the catalyst for record prices. The increase in the yellow metal has been moderate, albeit steady, while silver has doubled in the last 18 months.

But interest rates are now rising in many countries, as central banks work to head off inflationary pressures. In both Britain and the Eurozone, interest-rate increases look quite close – in Britain, where inflation has already appeared there at the 4-5% level, and in the Eurozone, because the managers of the European Central Bank (ECB) are monetarily quite conservative.

It also looks fairly unlikely that US Federal Reserve chairman Ben Bernanke will succeed in imposing another period of "quantitative easing" – involving large-scale purchases of US Treasury bonds – after the current "QE" program expires in June.

By the fourth quarter, inflation stemming from the world's rising commodity prices may penetrate the notoriously insensitive price reports from the US Bureau of Labor Statistics (BLS). If that happens, Bernanke & Co. may be forced to start increasing interest rates by the end of this year – although the Fed chairman will no doubt do his best to delay and limit the process, as he and predecessor Alan Greenspan did from 2004 – 06.

With monetary policy gradually getting tighter – and trillions of fewer Dollars in liquidity sloshing around the global economy – the upward pressure on gold and silver prices will decrease, although those won't disappear immediately.

At the other end of the commodities spectrum – in food commodities and bulky commodities such as iron ore – the trajectory will be different. With this group of commodities, the primary upward catalyst won't be global monetary policy; it will be the rapid growth in emerging-market economies.

Emerging-market consumers, whose incomes are rapidly growing, are nevertheless poorer than Western consumers and do not have the basic goods that are associated with modern affluence. Hence, those newly minted middle-class consumers are now buying modern apartments, automobiles, kitchen appliances and a host of other items that, unlike electronic gadgetry, require large amounts of such basic materials as iron and steel to manufacture.

Since demand for basic industrial commodities is driven by emerging-market consumers – and not by monetary policy – there is relatively little speculative activity in coal or iron ore. Instead, the demand is industrial in nature.

This is an important distinction for prospective investors. You see, price increases driven by industrial demand are likely to persist longer than those that were speculative in nature, particularly since it's not at all likely that modest interest-rate increases will kill off the growth that we're seeing in emerging-market economies.

We should not, of course, neglect the supply side. For some commodities – most notably oil – a number of new supply sources have arisen over the last five years. For instance, Canadian tar sands now form a more-substantial part of the US oil picture.

And with oil-shale prices currently near $100 per barrel, this is now a viable source of additional supply. Colorado has a big supply. Outside the United States, the Tupi oil fields in Brazil are due to come on-stream in 2012, while Colombian production has been increasing at a rapid rate and is expected to ramp up further in coming years.

Moreover, the speculative zoom that oil prices experienced in the summer of 2008 showed us that – at prices above $100 per barrel – demand becomes quite sensitive to oil prices, partly because very high oil prices tend to deflate non-oil-producing economies. Thus, the upward pressure on oil prices is likely to be moderate.

Conversely, copper is particularly likely to continue rising in price because new sources of supply take a very long time to come on stream, and many mining projects were severely delayed by the 2008-09 global downturn.

In addition, speculative demand by hedge funds and through the exchange-traded-funds (ETF) mechanism is withdrawing physical copper from the market. That's a much more serious problem than it is with Gold Bullion, because the world does not have large stocks of unused copper. Thus, copper – which sits "in the middle" between speculative and industrial commodity – is likely to continue rising in price, until major new sources of supply come on stream in 2014-15.

That brings us to coal, which is shaping up to be the best way to profit from the commodities boom of 2011. Coal is at the far industrial end of the spectrum. In the past, supplies have been plentiful, and speculative demand negligible. Both China and India are heavily dependent on coal for electric power. And both countries have increasingly resorted to imports as demand grows. Furthermore, coal mining has not been particularly profitable in recent years, and developing new coal mines in advanced countries is a permitting nightmare because of the environmentalists.

There is thus much less capital in the coal industry than there is in the oil sector, and much less ability to ramp up production to meet soaring demand. So where does that leave us? I believe that coal mines – not gold mines – will be the key to investor profits in the commodities boom of 2011.

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