PROFITING FROM COMMODITIES
With prices at 22-year lows, there are big opportunities for the investor
By Assif Shameen
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Tarnished reputations Gold and oil prices have plunged
THIS IS WHAT WORRIES Peter Chapman. In all the years he has been following the commodities markets, the analyst at brokerage Burdett Buckeridge Young in Sydney could predict when a slump would end. "The cycle never lasts more than three to four years," he says. So, the prices of gold, silver, platinum, copper, iron ore, coal, oil, gas, cotton and wool should recover soon - they have been in a free fall since 1996, even before the Asian Crisis erupted. Or maybe not. "Most Asian countries are down to the barest minimum of inventories in almost all commodities they use," says Chapman. "The danger is that just as Asia starts to pick up, there may be a marked slowdown in Europe and the U.S. In that case, we may see commodities prices stay at their current 22-year lows or fall even further toward the end of the year. It's a scary thought."
At least for countries that depend heavily on commodity exports like Indonesia, Australia and Brunei. For the most part, Asian economies are now so diversified that they would be reasonably cushioned from the shock. Malaysia, for example. "Our economy is 80% dependent on exports of manufactured goods, not oil," said Prime Minister Mahathir Mohamad last week. "If oil prices become too low, we can stop production." As things stand, most Asian economies benefit from cheaper prices, especially big petroleum importers like Japan and South Korea. True, countries such as Thailand, Pakistan and Bangladesh could be earning more if rice, natural rubber, cotton and jute had not fallen from their earlier highs. On balance, though, their lower import bills probably even things out.
That is scant comfort for miners and investors caught in the crunch. "Taking commodities as a bunch, I would say there is a 10%-to-15% downside from current price levels," says Chapman. In late December, the benchmark CRB commodities index fell to its lowest point since 1976. "If you adjust for inflation, some commodities are actually close to their 60-year lows," says Jim Lennon of Macquarie Equities in London. "They haven't been this cheap since the Great Depression." Petroleum and metals are the hardest hit. Soft commodities like wheat have also fallen, but not as far. Edible oils are holding their own - and since they are priced in dollars, farmers and plantation owners enjoy local-currency windfalls because of the steep devaluation of the rupiah, ringgit, peso and other Southeast Asian units. "People still use cooking oil, drink coffee, eat bread and buy clothes, though they may buy slightly lower amounts," says Lennon.
Crude oil was trading at around $11 a barrel last week. A year-and-a-half ago, prices were closer to $20. Some analysts expect a fall to $7, below the production cost of most oil companies. "It's now certain that Iraq will be allowed to pump far more oil," says Andrew Haythorpe, who runs a global commodities fund for U.S.-based Bankers Trust. (The U.N. capped Iraqi production after Saddam Hussein's 1990 invasion of Kuwait.) The additional supply could coincide with lower demand as the severe winter in North America and Europe ends. Others are more optimistic. They concede that prices may fall to $9 as they did in December. But they predict a bounce to $14 to $15 a barrel later in the year. "All you need is one severe winter and some pick-up in demand in Asia," says a Singapore-based analyst, who believes oil prices can rebound to $18.
But Haythorpe thinks the oil glut is just too huge. "You have distressed producers like Indonesia, Malaysia, Venezuela and Mexico that need hard currency and are just not interested in production cuts," he says. "Saudi Arabia's biggest mistake was that it tried to keep oil far too high for too long - at $18-$20 per barrel - and what we see now is a reaction. You can never hold up prices artificially." In Haythorpe's view, falling prices will eventually be good for oil producers. "What low prices for a year or two will do is stop new investment, push out weaklings and disenfranchise marginal players." Indeed, oil behemoths like Mobil, Exxon, British Petroleum and Amoco figured in mergers last year to promote efficiencies.
Base metals are hurting too. Demand for iron ore, copper, nickel and aluminum was down 10% last year in Asia alone. Steel production worldwide got trimmed by the same proportion. "If you look at base metals over the last 30 or 40 years, the big dips have almost always been demand-driven," says Lennon. "As prices fall, there is a de-stocking effect as holders of commodities try to wind down their inventories. That means demand for commodities fall far faster than industrial output and that pushes prices down even faster." You would need strong demand for cars, ships and construction materials for a recovery in steel, an unlikely prospect in Asia and Latin America. And there is no guarantee that the U.S. romance with vehicles, houses, stocks and shopping will continue.
Iron ore may be the most vulnerable. Long-term contracts between producers and steel mills are expiring. "I suspect we might see a 20%-to-25% downside in contract prices for iron-ore shipments this year," says Chapman. Another complication: major iron producer Brazil, which has just floated its currency, the real. The country may increase ore mining in its drive to pile up foreign exchange. Coking coal, used to turn ore into steel, is likely to get hit as well. Lennon is wary of aluminum too. "There is a lot of oversupply," he says of the metal, which goes into airplanes, refrigerators, air conditioners and food-processing equipment. "Too many smelters were built in the early 1990s and until recently. Unless prices come down another 20%, we are probably not going to see substantial improvement in demand." For his part, Haythorpe is bearish on copper because "everyone has gone out and built himself a copper mine."
PRECIOUS METALS HAVE LOST their luster too. "There was a huge de-hoarding in Asia last year, with consumers selling not just $2 billion worth of gold but also tens of millions in silver, diamonds, and other stones," says Lennon. After touching $1,000 per troy ounce in the 1980s, gold slid to the $350 to $380 range in the early 1990s. It rose to $430 at one point in 1996, but was trading at $286 last week. Still, Haythorpe is not selling gold short. "It has some upside, probably late in the year," he says. "Who knows, there might be a 15%-to-20% price increase over the next year or so. Once the cycle turns and inflation becomes a threat in some areas, gold should shoot up. Historically, gold has anticipated inflation and reflation very well. Now, it may be the first cab off the ranks." Haythorpe predicts a range of $330 to $350 for gold this year.
He is also a long-term bull on silver and palladium. "Supply and demand for both are looking good," says the analyst. Influential U.S. investor Warren Buffet bought silver last year (its price has fallen 15% since his purchases). Other Haythorpe favorites include zinc and tin. Lennon is betting on nickel. "There have been a lot of production cuts announced in recent months around the world," says the Macquarie Equities analyst. Asian demand for stainless steel, which is made from nickel, is starting to pick up, especially in Korea and some Southeast Asian countries. "But these are still early signs, and the recovery is being offset by slowing demand elsewhere," cautions Lennon. "What you really need is growth in real consumption."
That is tall order in the current environment. "Consumers just aren't buying," says Lennon. "If car sales are booming the world over and there is a global housing boom, steel and iron prices will go up. But too many people believe things will get cheaper and are holding back [on big-ticket items]. The longer they hold back, the cheaper things become and the more they become convinced that prices will fall further." Don't forget the other key reason - in Asia, and increasingly in Latin America, consumers fearful of losing their jobs are saving rather than spending. They run the danger of actually getting axed as their employers downsize or close the company altogether because no one is buying its products.
But commodities are natural survivors. You need coal to fire up power plants, oil to fuel planes and cars, steel to make houses and ships. The up cycle may come later than usual, but it will come, and because the downturn is so severe, the gains could be substantial. "If I were to stick my neck out, I'd say the downside in commodities over the next year is 20% from these levels," says Lennon. "The upside could be anything from 50% to 100%. On a risk-reward basis, commodities are looking very interesting indeed. True, the next three to six months are probably going to be terrible. But if you have a 12-to-18-month horizon, you will probably make decent returns." When that happens, though, try to remember that the peak in commodities is always followed by a trough.
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