Jubak's Journal5/16/2008 12:01 AM ET
The key to commodity profits

Stop worrying about demand. Look to the supply side to see why copper, iron, oil, natural-gas and fertilizer stocks all have more boom times ahead.


By Jim Jubak

If you want to be a successful investor in commodity stocks, start thinking like a CEO.

Most investors in the sector are still making investment decisions based on the demand side. Will demand in the United States fall? Will demand from China hold up? They calculate their potential risk and profit based on the answers to such questions.

The CEOs at commodity companies are much more focused on the supply side. At this point in the commodity cycle, they know that what's important to their companies is how quickly record prices will bring new capacity into production.

In past commodity cycles, a surge in production has led the market to swing from scarcity to glut, destroying the economics of their companies. They know that's how commodity cycles end -- with a rapid growth in production that sends prices plunging.

A supply-side glut, not a demand-side collapse, is how a commodity boom always comes to an end. These CEOs are watching very carefully for any signs of a glut. Every decision the industry's smartest veteran CEOs are making these days is about the supply side.
Demand can take care of itself
Investors in commodity stocks should follow their lead. It's time to worry about supply and stop obsessing about demand or projections that try to calculate when the boom will end based on the length of past boom-bust cycles.

Demand can take care of itself very well, thank you, without any help from worried investors.

Take a look at the oil market, for example. A slowing U.S. economy hasn't been the disaster investors feared. The Energy Information Agency of the Department of Energy now projects U.S. oil consumption will fall by 330,000 barrels a day in 2008, yet oil has still climbed to $120 a barrel.

Whoops, better make that $125 a barrel.

Growing demand from China, the Middle East, Russia, Brazil and India has more than made up the difference. Chinese demand alone is projected to climb 400,000 barrels a day in 2008.

Outside the United States, strong economic growth, rising incomes, rising consumerism, government subsidies and price controls mean the oil market has so many sources of growing demand and so many consumers who don't care much about prices that the rising global thirst for oil for the next five to 10 years is as close to a certainty as anything ever gets in macroeconomics.

The current global economy and history show that commodity booms turn to busts not when demand collapses -- well, OK, you do get a commodity bust if the global economy goes into depression, as it did in the 1930s -- but when growth in supply overwhelms demand and causes prices to plummet.

So far, the story from the supply side says this commodity boom and the attendant rally in commodity stocks have much longer to run, but no commodity company CEO is taking the current supply-side discipline for granted. And neither should investors.


Case study: Molybdenum
So how do you go about thinking about the supply side? Let me give you an example of a recent decision faced by the CEO of Thompson Creek Metals (TC, news, msgs), a Canadian miner of molybdenum.

What would you do if you were the CEO of Thompson Creek Metals? Your engineers have brought you a preliminary report on developing the new Davidson mine. They tell you the mine is likely to have a 10-year life and produce 4 million pounds of molybdenum a year. Developing the mine, they estimate, will cost about $110 million.

You notice your finance people screwing up their faces. They point out that the costs of developing this mine were estimated at just $60 million in 2005. That's inflation of $50 million in just three years. They calculate that if the current cost projections are correct -- a big if, their faces make clear -- then, after subtracting operating costs, the company will be able to meet its targeted 20% internal rate of return for capital projects if molybdenum prices average $16.13 a pound over the next 10 years.

Done deal, the engineers say. Molybdenum is now selling for $32 a pound. And they get up to leave the room.

Not so fast, the financial team says; market research has found two very different forecasts for molybdenum prices. Forecast No. 1 shows molybdenum prices climbing to $35 in 2008 before beginning a gradual decline to the range of mid-$20s a pound. Forecast No. 2 shows molybdenum falling to $12 a pound by 2011 and then to $9 a pound after 2015.

What do you do as CEO? Go or no go on Davidson?

The real-life CEO of Thompson Creek Metals decided to give the project a green light. As best as I can reconstruct the logic of the situation, here's why: First, the company could get the mine into production very quickly, with production starting in August 2009 and full production in 2010, and second, by using existing infrastructure from nearby Thompson Creek Mines, the mine would cost relatively little.

This is supply-side thinking. If Thompson Creek Metals can get the mine into production quickly, it has a good chance of reaping the maximum benefit from current high molybdenum prices and of minimizing its exposure to declining prices later.

It's a whole lot less critical to Thompson what molybdenum prices are after 2015 if a mine with a 10-year life starts full production in 2010 than if it starts production in 2013. And if the mine can use existing infrastructure, it lowers the cost of the project and minimizes the risk that costs will escalate beyond current projections or that there will be endless delays. You don't get cost overruns and construction delays on infrastructure that already exists.

5 questions for investors
Let me generalize from this example to create five questions for investors to ask in applying supply-side thinking to their buy and sell decisions on commodity stocks:

* What are the lead times for new production? The longer it takes to get a mine, oil field, chemical plant or whatever into production, the less investors have to worry about an immediate surge in supply.

* What's the cost of capital for production projects? Globally, the cost of capital is all over the map these days. Money is theoretically cheap after a string of interest rate cuts by the Federal Reserve, but capital is actually tight for some. Banks aren't lending as freely as they were, and junk bonds are a tougher sell to investors than they were in 2006. On the other hand, with cash-rich commodity-producing countries such as Saudi Arabia focused on building a domestic chemical industry and China looking to lock up natural-resource deposits in Africa and Asia, some projects can raise all the capital they need without worrying about profit targets. All else being equal, investors should avoid industries in which governments are throwing capital at building capacity. Such industries face the greatest danger of a supply glut.

* What are the economics of boosting production? Costs in the oil industry rose by about 15% in 2007. But that figure ignores the number of projects that were canceled because some key raw material -- steel pipe, truck tires, oil-field engineers -- weren't available at any cost. The more uncertainty about costs and the availability of raw materials, the more likely companies are to cancel or postpone new capacity.

* How big are the infrastructure barriers? Ending the chronic shortages of electricity that have plagued Chilean and South African mines in the past year, for example, requires building new power plants. That's not an overnight fix.

* How big are the political barriers? Countries that renegotiate deals, that award and rescind contracts based on political connections (or bribery) or that nationalize the assets of overseas producers make the economics of adding new supply far more uncertain and slow the development of new capacity.



When I answer those questions about the supply-side picture for individual commodities, it leads me to want to own the following sectors and companies at this point in the commodities cycle:

* Metals with infrastructure problems. One of these is copper, which faces power shortages, rolling miners strikes and national governments determined to get more for their copper. Stockpiles are low. Production at disrupted levels looks unable to fill the gap. And sometime the U.S. housing industry will recover and build houses again. My choice here is Freeport McMoRan Copper & Gold (FCX, news, msgs), a Jubak's Pick. A second is iron, which suffers from a decision by the big three producers -- Rio Tinto (RTP, news, msgs), BHP Billiton (BHP, news, msgs) and Vale (RIO, news, msgs) -- to make acquisitions rather than expand production. Look for smaller producers such as Fortescue Metals Group (FSUMF, news, msgs) and Anglo American (AAUK, news, msgs).

* Commodities with big political problems. Expanding oil production, even as oil hovers around $125 a barrel, has turned out to be tough. National oil companies have locked out capital- and skills-rich Western oil companies, and governments have underinvested in new production for political reasons. I'd concentrate on U.S. companies expanding production in the last quarter and year, such as Devon Energy (DVN, news, msgs), Ultra Petroleum (UPL, news, msgs), Murphy Oil (MUR, news, msgs) and Hess (HES, news, msgs). And on international companies expanding production, including Petrobras (PBR, news, msgs), Suncor Energy (SU, news, msgs), EnCana (ECA, news, msgs) and Canadian Natural Resources (CNQ, news, msgs).