Commodity Prices: Four Favorite Ways to Profit from Rebound

If you're like me, you've been invested in mining companies or oil producers the last couple of months because you expected a return to the strong commodity prices of early 2011.

But if that's the case, like me, you're hurting. Commodity prices are well below the high levels we saw in early May - in fact, they've dropped more than the rest of the market.

The temptation to sell out before things get worse is very strong.

But don't do it.

The preconditions for strong commodity prices are still in place. And at present levels, a number of commodity and energy-producing shares are stone-cold bargains.

Let me tell you why.

Don't Be Fooled by the Price Declines

Against a backdrop of strong commodity prices, these companies had an excellent 2010.

I'm sure you were surprised to see that these same companies didn't do all that well in the first few months of the New Year - even though oil, gold, silver and copper prices were climbing and rare earth prices were going through the roof. The market seems to have believed that these strong commodity prices were actually peak commodity prices - and that producers wouldn't get much benefit from those peaks because they would receive the high revenue for only a short period.

Then when commodities prices dropped from their peaks - oil by about 20%, silver by about 35%, but gold by only 8%, even at the bottom - share prices of commodity producers fell even more. The investor sentiment was very clear: commodity producers hadn't benefited all that much from peak prices, and now that prices were likely headed down, producers were looking at a stretch in which they would be much less profitable.

But here's what I want you to know: This bearish theory on commodity producers becomes flawed if, in fact, we have not yet seen the peaks that commodities will actually achieve. If that's the case, the benefit to producers from high prices would become much greater, as we would expect the prices to rise further and the high-price period to last longer.

And I would argue that this is precisely where we are today.

Monetary authorities around the world are still pursuing loose policies with very low interest rates. Chinese Premier Wen Jiabao recently declared that China had conquered inflation. However, since inflation is currently running at 5.5%, while the People's Bank of China deposit rate is only 3%, giving a minus 2.5% real return to depositors, one can only assume that he has been channeling US Federal Reserve Chairman Ben S. Bernanke.

A Recipe for Strong Commodity Prices

All around the world, only the tiniest steps have been taken against inflation, yet inflation itself is rising quite rapidly, far more rapidly than interest rates are being increased. In the US economy, consumer-price inflation in the last 12 months was 3.6% and producer price inflation 7.2%, yet interest rates are still zero. Not only is monetary policy extremely loose, it is getting looser, with US Treasury bond yields declining in the last few weeks and the Federal Funds target rate of 0.00% to 0.25% falling further and further behind the inflation rate.

Since real interest rates worldwide are negative, hedge funds and other investors are actually being paid to invest in commodities. And those commodities can be expected to track inflation in the long run, with some upward pressure due to rising demand in high-population emerging markets. Thus with both fundamental and funds flow factors supporting commodity prices, they will inevitably end their current pause and rise further - which means it's a virtual certainty that we'll see strong commodity prices once again.

And don't worry about getting nicked by this "bubble," either: You will have plenty of warning before that bubble bursts.

At the earliest, this bubble in commodities prices will burst only when the first decisive steps are taken to raise interest rates - particularly here in the US market.

That's not likely to happen yet. In fact, at last week's press conference, Fed Chairman Bernanke defined the "extended period" for which rates would be held at zero as "at least" two to three meetings of the policymaking Federal Open Market Committee (FOMC). In other words, we won't see even the smallest rate increase before October. And we actually probably won't see one before December.

That would not make me buy shares in general, because Bernanke's policies are damaging the US economy and keeping unemployment higher than it needs to be. Nor would they make me buy bonds - rising inflation and huge deficits seem certain to cause cracks to appear in the bond market at some point soon.

But commodities remain an excellent bet. And given that strong commodity prices are coming, commodity-producing companies (which have been knocked down further than commodity prices themselves) seem an even better one.

Actions to Take: You don't have to be a tealeaf reader to see that strong commodity prices are fait accompli. The evidence is all there - it's just that most investors are choosing to ignore it.

Don't make that same mistake.

In fact, to help you, here are some of my favorite plays in the gold, silver, iron-ore and oil commodities sectors:

Yamana Gold (NYSE: AUY): Yamana is my favorite gold miner, and with good reason. The Toronto-based gold producer earned 20 cents a share in the first quarter; its forward Price/Earnings (P/E) ratio on 2012 earnings is an estimated 10.5 - not at all overly aggressive rating for a miner that is steadily increasing production and pays a dividend.

Silvercorp Metals Inc. (NYSE: SVM): While Yamana is my favorite gold producer, Silvercorp is my favorite silver player. The Vancouver-based player's mines are concentrated in China, and its silver-extraction costs are actually a negative $6 per ounce (yes, you read that right) because of profitable sales of byproducts. The company's stock closed Monday at $8.72 a share - down 47% from its 52-week high of $16.32. Silvercorp is a classic case of a mine whose share price has been knocked back by almost half and is now a bargain, with a forward P/E of 12. Chinese investors are currently major purchasers of silver, and I think both the metal itself and Silvercorp shares are undervalued.

Cliffs Resources (NYSE: CLF): With its substantial operations in Australia, the gateway to the long-term growth we see for China, coal-and-iron-ore producer Cliffs Resources is a company I like very much. The Cleveland-based firm has grown its earnings very rapidly in recent years, and its shares are currently 15% off their highs at a forward P/E of only 5.9.

Suncor Energy (NYSE: SU): With its major holdings in Canada's Athabasca tar sands, the Calgary-based Suncor is a terrific play on oil prices. That's especially true because the tar sands are already highly profitable - and become an outright bonanza when oil prices traverse the $100-a-barrel barrier (crude for August delivery closed at $92.89 a barrel yesterday (Tuesday), after posting its biggest gain in six weeks). Suncor shares are trading at 14 times trailing earnings and 10 times forward earnings, and offers a modest dividend yield, meaning the stock is currently very reasonably priced.

Martin Hutchinson is a Money Morning contributing editor and a former merchant banker and market historian.

About the Author
Martin Hutchinson

Martin Hutchinson is global investment strategist for Money Morning and a former merchant banker and market historian

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