Making money from the commodities “super cycle”

1. Making money from the commodities “super cycle” Jim Jubak MSN Money Moneycentral.com jjubak@microsoft.com 17 May 2006

2. The commodities boom isn’t over….it’s 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. Wouldn’t 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.

3. 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

4. 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.

5. Stage 2: Wall Street catches up with price but not length of cycle • Most energy commodity stocks now—finally—in this stage. Big question isn’t oil price. Many stocks now discount $55 oil or even higher for 2006. • Big question for valuations here oil prices in 2007 and 2008—many 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 don’t 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.

6. 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 supply—the 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. I’d 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.