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The sky’s the limit. The sky is falling. In the short term pretty that much describes the behavior of commodity stocks.

And it’s all too easy to get caught up on the drama of those short-term moves because the possible profits if you can outguess the market are all too tempting. (I know because I get caught up in it myself.)

But for most of us who aren’t blessed with market-beating 20/20 foresight, playing the short-term volatility of commodity stocks isn’t the best way to make money in this sector.

For most of us most of the time, it’s the long-term swings between scarce supply (which sends prices up and up) and scarce demand (which sends prices down and down) that can last for years and years and years that are the best source of profits.

And right now the long-term pattern says we’re an upswing that has at least two more years to run before it sees a significant downside challenge.

Why do I think that? Supply and demand tell me so. I’m going to end this post with my take on the supply/demand picture as I see it for several important industrial commodities. But first, let me try to put the current short-term volatility in some context.

It’s the potential rewards that get our attention in the short term. Iron miner Vale (VALE) was up 42% from the August 2010 low to the January high. One-stock commodities portfolio BHP Billiton (BHP) was up 44% from the August low to the February high. Molybdenum and copper miner Thompson Creek Metals (TC) was up 88% from the August low to its January high.

But the volatility? Who can stand the drops? Look at just one stock, Freeport McMoRan Copper & Gold (FCX).

On January 11, 2011 shares had rallied to $60.90. Two weeks, January 25, later the stock had dropped 12.6% to $53.22.

On November 11, 2010  it traded at $54.01. Six days later, on November 17, at $48.42. That’s a 10.3% drop, a correction, in just six days.

But by November 11 the stock had soared 62% from its August 25, 2010 low at $33.33. That’s 62% in two and a half months.

And just in case this volatility wasn’t enough by itself to make you insane, hovering over all of these moves is the memory of great commodity rally of 2007 when Freeport McMoRan climbed 86% and the great commodity collapse of 2008 when the stock dropped 74% for the year. The volatility in 2008 was even worse than that if you looked at just the last six months of the year. Freeport McMoRan fell from $61.65 on June 13, 208 to $9.03 on December 3 of that year.

But if this kind of short-term volatility is what you’re focused on, you’re paying attention to the wrong time frame.

Look at oil, for example, but not on a scale of weeks or months but of years. In 1980 the average U.S. price of oil was $37.42 a barrel. Eighteen years later in 1998 oil sold for an average $11.91 a barrel. That’s 18 years of solid losses for investors in oil stocks and other shares that depended on the commodity.

But 1998 marked the bottom. By 2004 the average price per barrel was $37.66, the same as it had been in 1980 and oil was on its way to a peak near $150 in 2008.

With oil demand falling because of the world economic crisis, oil fell back to the $30s, where it had been in 1980 and 2004 before beginning a climb back to a current price near $100 as demand recovered with the global economy and the crisis in Egypt drove up fears of a disruption to global supply.

The long-term patterns for many other commodities look similar. Copper on the London Metal Exchange, for example, sold for $2710 a metric ton in 1990, for $3050 a metric ton in 1995, for $1730 a ton in 1998 and then began a slow and steady climb to $1880 a ton in 2003 and to $2950 in 2004. Last week copper hit an all time record price of $9955 a ton.

But we’re not living in an age when all industrial commodities climb inexorably higher. The big counter example is natural gas in the United States. In January 2002 natural gas sold for $2.50 per 1,000 cubic feet. It then moved to $4.43 in 2003 and then to $8.01 in 2006.  But since then the price of natural gas has been in what began as a brief decline (to $7.38 in January 2008), that turned into a rout (to $4.60 in January 2009), that has become a lasting depression. Natural gas traded at $5.14 per thousand cubic feet in January 2010, raising hopes that the economic recovery was about to lift prices permanently, but then natural gas fell, and fell, and fell, until it sold in December 2010 at $3.34.

These patterns take me to three conclusions for building a strategy for investing in commodities.

  1. You really want to find a commodity that behaves like copper is right now and not like natural gas. Forget about the profits in seeing copper climb to a record high while natural gas mopes along the bottom. Those are too obvious to belabor. Instead think about the other benefit of investing in a commodity that’s riding the boom end of a cycle:  Sure, taking a 15% loss in a few days can be painful, but as long as the commodity cycle that underlies your commodity stock is in a long-term uptrend, this kind of volatility is survivable.  A strong boom cycle can even save you from the worst effects of truly terrible timing. Seeing a stock drop from $61.65 to $9.03 in six months is the kind of excruciating loss that can devastate a portfolio if you then sell at the bottom. But Freeport McMoRan not only fell from $61.65 to $9.03 in six months but it also rebounded to $29.48 by June 2009 and to $43.66 by January 2010 and to $56.76 at the close on February 4. As long as you had enough faith in the cycle to hold on, you could have had the terrible bad luck to buy at the $61.65 top in June 2008 and still wound up looking at a loss of less than 10% two and a half years later. I’m not recommending this as an investment strategy mind you. Spending 30 months to get back to within 10% of the money you started with is still a loss—of money and time. But it’s not the worst thing that can happen to a commodity—or any–investor.2
  2. Not all commodities and commodity cycles are the same. Copper isn’t natural gas and given a choice you’d much rather own the copper cycle than the natural gas cycle. At least right now. What’s the difference between the two cycles at the moment? Well one is up and other down but there’s more to the difference than that. Owing natural gas right now gives you the advantage of only one half of the supply/demand duo. Currently the U.S. natural gas industry is in the midst of a huge expansion of supply from unconventional sources. The rest of the global industry is following that same path using the technologies pioneered in the United States. The world is, therefore, looking at a big increase in natural gas supply that’s likely to run for years. That doesn’t necessarily mean that the price of natural gas is headed down but it does mean that any price increase is solely dependent on an increase in demand (and in this case an increase in demand large enough to outpace the increase in supply. Contrast that to copper. It’s not that copper miners aren’t trying to increase supply; it’s that they’re having a hard time doing it. For example, in the January 20 guidance for 2011 that went along with the release of its 2010 financial report, Freeport-McMoRan said that 2011 copper and gold sales would be slightly below earlier forecasts because of a drop in the grade of ores being mined at its Grasberg mine. This problem—lower quality ores that require a mining company to move more earth to get the same amount of copper—isn’t limited to Freeport McMoRan. Companies across the copper mining industry face the same conditions. Rio Tinto (RIO), to take another example, recently announced that it had mined 16% less copper in 2010 than in 2009. The copper boom, then, unlike natural gas has both rising demand and falling (or at least expensive to increase) supply working in its favor.
  3. If you want to own the coppers of the commodity world and not the natural gases, then you should value, I mean really value, supply transparency. Oil, I’d argue has very low supply transparency. For instance, we have no more than educated guesses about the condition of the big oil reserves in Saudi Arabia—How badly, if at all, have they been damaged by production techniques over the last decade or so? We know very little about how hard it will be to increase production from the oil fields of Iraq or how much more damaged Venezuela will do to its oil industry or what kind of environmental restrictions Canada will impose on its oil sands industry. Contrast that to copper, again, where the big uncertainties are geopolitical and the possible deviations from consensus outcomes in unstable countries such as the Democratic Republic of the Congo would reduce rather than expand supply. I’d put iron ore, coal, and potash fertilizer in the transparency of supply group along with copper. I’d put oil, natural gas, and aluminum in the less-transparent supply group.

I think these leaves investors with a rough hierarchy of commodities.

At the top of the heap I’d put copper, where it is proving so hard to increase supply, where demand is increasing with global growth, and where supply is relatively transparent. My three favorite stocks in this commodity are Freeport McMoRan Copper and Gold (for more on Freeport McMoRan see my post ),  Thompson Creek Metals (TC) (for more on Thompson Creek and its transformation from a molybdenum miner to a molybdenum and copper miner see my post ), and Southern Copper (SCCO).

Next I’d put iron ore. Iron doesn’t have quite the same supply problems as copper does but India has been reporting what seem to be significant but perhaps only temporary supply disruptions and global demand for iron is growing even faster than demand for copper. My favorite stock in this industry is Vale (VALE). It gets the nod over BHP Billiton (BHP) in my book because it has more concentration in iron than its Australian rival does.

I’ve got a positive rating on both coal and potash fertilizer but they do belong a step below copper and iron in my book because they don’t have the supply problems of copper or even of iron ore. It looks like the world has plenty of coal in accessible deposits to meet what is soaring demand. In potash swing producer Potash of Saskatchewan (POT) still has idle capacity that it can bring into production when demand and price justify it. In these two sectors I’d favor the Australian coal producers BHP Billiton, Macarthur Coal (MACDY), and Whitehaven Coal (WHITF) because of their proximity to the big coal markets of India and China. (For more on Australian coal miners, and the recent floods, see my post ) In the potash sector I think the most interesting pick is Vale, which is making a big, government-favored push into the fertilizer market in Brazil.

Investors face two big bumps with commodity stocks in these sectors. The first is the fear, likely to send the market into repeated swoons in the first half of 2011, that growth will slow in China. (I’ve suggested cutting back exposure to copper stocks for the first few months of 2011 for investors who want to cut risk to any temporary retreat in the sector. So far that sector retreat has failed to materialize.)

The second, and I think this is a factor for 2012 or so, is the amount of new mining capacity set to come on line in 2013-2015 in just about every mining sector. The fear of this new capacity could send prices down but I think the reality is that in my two top-rated commodities, copper and iron, the addition to supply won’t be enough to keep up with demand.

The global supply deficit in copper will reach 822,000 metric tons in 2011, according to Barclays Capital. That’s a lot of supply to make up even when the copper industry is projecting a record amount of capital investment in 2011.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of BHP Billiton, Freeport McMoRan, Macarthur Coal, Southern Copper, Thompson Creek, Vale, and Whitehaven Coal as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at