Sunday, September 20, 2009

Commodity bull phase II

Commodity bull markets tend to last anywhere from 15-25 years. It takes a long time to find and bring into production a giant oil field, copper mine, gold mine, etc.

First price has to rise long enough and far enough for resource companies to be willing to expand. Understandably, after a 20 year bear market, companies are going to be reluctant to spend a lot of their precious profits on exploration and expansion. They've struggled to remain profitable for two decades. If the past 20 years is any indication those profits can evaporate quickly.

During the first phase of the commodity bull energy and base metals led the charge, driven by emerging market demand for oil and a world wide economic expansion. Nothing sucks up copper faster than a global expansion.

But sure enough the very thing that resource companies feared came to pass. The credit bubble burst and spiking energy prices poisoned the global economy. Almost overnight demand for everything dried up.

Now I'm not saying energy and base metals won't rise during the second phase of the commodity bull. They surely will. They may even make new highs. But they aren't going to be the leaders during this phase. The fundamentals don't support these sectors anymore. I suspect the world is going to cycle in and out of recession/depression for at least another decade, maybe two.

In their futile attempt to combat the ongoing economic malaise governments are going to turn to the printing press. Unfortunately this is just going to feed the cancer growing in the world.

In the attempt to avoid the 30's style deflationary collapse the world is going to buy into a hyperinflationary collapse. Neither scenario is the cure for a credit bubble collapse and maybe in 80 years when we go thru this again we will have learned our lesson and realize that the only real cure is to let the free market run it's course. That won't stop the pain but it will drastically shorten the recovery period.

As we enter the second phase of the commodity bull our job as investors is to determine where the fundamentals are strongest. The second phase of a commodity bull is almost never led by the same sectors that outperformed during the first phase. With an ongoing global recession the fundamentals just don't support energy or base metals anymore. Certainly they will rise, but it will not be from a supply and demand imbalance. These sectors will rally but it will be driven purely by monetary expansion. That is not the fundamental basis for a large sustained move higher.

During this phase of the commodity bull we need to look at the sectors that stand to benefit from the new fundamentals. Expansionary monetary policy = precious metals.

During the first phase precious metal prices rose but not nearly as much as energy and base metals. As a matter of fact spiking energy prices were a huge drain on miners profit margins. That coupled with the fact that bullion prices in percentage terms didn't rally all that much meant that exploration and infrastructure expansion in the mining sector never expanded much during the first phase of the commodity bull.

Now as the fundamentals turn in favor of precious metals we not only have monetary policy supporting higher prices but we have a supply problem developing at the same time demand starts to surge.

Now throw in the fact that in inflation adjusted terms gold is just about the cheapest commodity there is and we have the makings of a huge move higher as the second phase of the commodity bull gets underway.