Buy and Hold

Every commodities boom in history has eventually ended due to a combination of permanent demand destruction via conservation, the switch to alternatives, and extensive development of new supplies. Not one of those factors is in evidence today. In fact, the recent precipitous drop in raw materials prices has likely postponed their appearance, very likely by several years.

Low prices discourage the kind of massive development of new reserves necessary to meet the long-range demands of the developing world. And absent high prices, there’s little incentive for the kind of conservation or the turn to alternatives that permanently destroy demand–the set of factors that combined to end the last great commodity bull market in the 1970s.

As long as investors are consumed with worry about the state of the global economy, commodity-producer stocks will be hard-pressed to mount a sustained rally. But this is an excellent time to lock down the sector’s best names at prices not seen since early in the decade.

Prices could well go lower; many investors are giving up on the market entirely, even with prices at deep value levels. But this is far from the first time we’ve seen this kind of action in the commodity markets. In the bull market ’70s, for example, enormous selloffs induced many to throw in the towel. Such downturns were, however, followed by staggering rebounds once the economy again showed signs of life.

Another interesting feature of this cycle is that for many vital resources, the dip in global demand is already being matched by lower production. For example, for the first time ever global steel producers have basically cut their output in unison. That’s a function of being a far more efficient industry than in the past. Meanwhile, resource nationalism and labor unrest are challenging supplies for other raw materials.

There are a few things we should keep in mind for the road ahead.

First, the world’s infrastructure (from transportation to machine availability) wasn’t–and still isn’t–ready to supply the materials needed to support global economic growth. And that’s the case even if this growth isn’t as strong as in prior years. In fact, unless the US and Europe completely collapse, the current demand slowdown won’t be enough for the supply bottlenecks to go away.

Second, the current US dollar (USD) rally should be viewed as nothing more than a short-term counter move to the long-term downtrend. The reasons for the USDs strength are more technical and political in nature than fundamental.

The liquidation of investment positions around the world, and the demand for USDs in order to buy Treasuries are the two main reasons why the dollar remains strong. Furthermore, there’s been support for Treasuries from central banks around the world because nobody’s in position to sustain a USD collapse. The fragility of the global financial system is such that the USD’s real value automatically becomes a secondary issue.

This is why the dollar will continue, for now, to perform much better against emerging market currencies, until investors and monetary authorities around the world get a better idea of what the outcome of the current crisis will look like. This should start happening sometime toward the middle of 2009.

The dollar outcome is very important for commodities, especially oil, which usually leads the rest of the commodity universe. Oil peaked around the same time the USD bottomed, in mid-July. Expect commodity-related stocks to benefit substantially once the dollar reverses course, at which time the stocks trading at the most attractive valuations should perform best.

It’s extremely unlikely that the Chinese economy will fall off a cliff. The government recently affirmed the continuation of its infrastructure and urbanization plans. That’s a call on natural resources the scale of which is without precedent.

Chinese authorities have traditionally stepped in to support the economy during difficult times through fixed-asset investment (FAI) increases. Their target has been to keep overall FAI growth at around 25 percent for the past eight years; before 2000, the goal was 15 percent.

During the Asian financial crisis, state spending rose by 72 percent in 1998 and 55 percent in 1999. The state pulled back dramatically in 2000 and let the private sector carry on. By 2003, the state’s FAI contribution was negative 15 percent.

Infrastructure-related companies will benefit from China’s FAI actions. That’s a solid call on global resources that won’t falter, even if US growth goes negative this year and next. Investment is further aided by the minor problems China’s banking system will have to face as a result of the global credit crisis, a stark contrast with Europe and the US.

Of course, even Chinese economic growth will weaken once the global recession really turns nasty. But an 8 percent growth rate (which I think is achievable) in an economic environment such as this shouldn’t be ignored.

That said, the point to understand is that the long-term China investment story is based on the fact that the country’ leadership is moving steadily toward economic integration with the global financial system. It’s also laying a foundation for strong domestic economic growth.

The Stock

Brazil-based iron ore giant Vale (NYSE: RIO) offers long-term value at current levels.

As the essential ingredient of steel, it’s no surprise that iron ore has been impacted by the weakness in steel production. Here the magnitude of the Chinese slowdown will play a big role in the final outcome. China currently absorbs 45 percent of global demand for iron (760 metric tons for 2008) and also represents 75 percent of global demand growth, which is still quite strong given the global turmoil.

Vale is cutting production by 30 million tons per year in order to “adapt our supply to global demand, avoiding unnecessary and costly inventory building.” Rio Tinto (NYSE: RTP) has also said it will be cutting iron production by 20 million tons because of the fourth quarter demand drop from China.

Another reason for the weakness in the iron ore price is the collapse in freight rates. The rate for Capesize ships–the largest dry bulkers, which carry iron ore, coal and grains–is now USD35.60 per ton from Brazil to China. The rate is USD11.50 per ton for runs from Australia to China and USD20 per ton for the India-to-China route.

Apart from the economic slowdown, the difficulty in obtaining letters of credit (a standard process in chartering a ship) is further explanation for the collapse in the shipping rates. Rates will gradually perk up once credit woes subside. 

Source: Bloomberg

Given that investors remain negative on steel and its materials, Vale stock may lack a strong near-term catalyst. Nevertheless, it should be a prime beneficiary of any relief rally because of its low current valuation.

Longer term, Vale offers the highest quality iron ore in the market. And the Chinese will eventually use more of it as they increase the quality of their products.

The current price weakness is driving high-cost producers either on the sidelines or out of the game all together, thus allowing the major producers to control new production growth.

This development fits well with our position that investing first in bigger, more diversified companies is the right approach in the resource sector right now. Investors are still trying to limit risk and therefore aren’t chasing small, commodity-leveraged, low-volume companies, as was the norm a year ago.

Source: Vale


Vale reported good third quarter earnings numbers, and although iron ore is its main product, copper, nickel and lower production costs allowed for USD6.25 billion in earnings before interest, taxes, depreciation and amortization. Vale is more diversified than most investors appreciate, as the chart below demonstrates, and will be able to navigate the current turmoil.

We view this as a good time to allocate funds into Vale, in order to get exposure to the eventual increase in production in Chinese steel. Vale, a new addition to the New World 3.0 Portfolio, is a buy up to USD15.

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