The world experienced a commodities boom until recently, when a very sharp sell-off occurred. But past boom will be nothing compared to the commodities boom that is already in the making..

The following article was from Jim Jubak. We arrived at much the same conclusion for the main energy stocks we’re researching here, InterOil and Chesapeake (the latter is actually in the forefront of cutting supply).

We have already reported on the main themes, but it can’t hurt to state them again.

1. Demand is fundamentally driven by the rapidly growing middle classes bid developing countries like China and India, this is hardly dented by the present crisis, and lower demand in developed economies is temporary
2. Supply is suffering much more than demand in the present downturn, because of the following factors:
3. Falling energy prices and much tigher credit have a big impact on exploration and investment in the very capital intensive energy sector (and the same can be said for much of the mining industry)
4. Energy in particular suffers from too few cheap exploration and drilling opportunities (‘peak oil’), and there were these opportunities are, they are almost invariably under control of regimes who’s first interest is not investment (political ‘peak oil’)

Be ready for the commodity comeback

• Like nearly every other stock, commodity stocks have been dropping. But don’t misinterpret that as lack of demand. Now would be the time to get in. That’s right: Get IN. By Jim Jubak
• We’re building the foundation for the next boom in commodity prices — and commodity stocks.
• I can’t give you any guarantee that commodity prices won’t tumble further in the short term. In fact, I think that’s very likely to happen as the U.S. economy slips into recession (possibly along with the economies of Japan and the European Union).
• But right now commodity stocks are factoring in huge declines in demand and tumbling commodity prices over the long term that just aren’t going to occur. A patient investor who can put up with the pain of the next six, nine or 12 months can now buy a very reasonably priced option on the shares of the strongest commodity producers for the next leg up in commodity prices. I peg the beginning of the next boom at late 2009 or early 2010.
• As an investor in commodity stocks, right now you’re licking your wounds and wondering whether the next rally will be time to finally get out.
• The sell-off has been brutal. As of Oct. 14, the shares of mining giant BHP Billiton (BHP, news, msgs) were down 55% from their May 16 high. ExxonMobil (XOM, news, msgs) was down 21% over the same period.
• Shares of smaller commodity producers have also been hit, some even harder. Molybdenum producer Thompson Creek Metals (TC, news, msgs) was down 73% from its May high as of Oct. 14, and oil and gas producer Devon Energy (DVN, news, msgs) was off 39%.
• The last thing you want to hear is that it’s time to think about jumping back in.
• But the economic laws of supply and demand don’t care if we’re reluctant to revisit a stock market sector that has delivered so much pain. And as hard as it may be to believe right now, it looks like the current meltdown in global financial markets isn’t going to have much effect on the trends that made commodity stocks big winners until mid-2008.
• Growing demand from the rising economies (and the increasingly wealthy consumers) of China, India, Brazil and the Middle East is still going to drive up the long-term price of everything from oil to zinc. In fact, the current global financial crisis could make the commodity boom that much stronger when it does return. [Indeed, that’s what we’ve been arguing for natural gas in relation to InterOil here]
• How could that be?
• The economies of the developed world are indeed slowing, and the high prices of commodities, especially of oil, have indeed reduced demand. But the reduction in demand isn’t nearly as big as you’d believe if you read just the headlines. These days, you have to read not just the headline and the first paragraph but also the rest of the story, called “the jump,” buried inside the newspaper. Take the case of oil demand and the headlines.
• Here’s the headline from the Oct. 11 Los Angeles Times: “Oil prices slip on market woes.” Read just to the end of the columns printed on the front page of the business section and you’ll come away with this: The International Energy Agency, or IEA, the paper reports, cut its demand forecast for 2008 to 86.5 million barrels a day, down 240,000 barrels.
• What you won’t discover unless you follow the story to the bottom of Page C3 is that the reduced projection is still 0.5% higher than oil demand in 2007. The world is near recession, and drivers are cutting back on gasoline use because of high prices, yet global oil demand is still going to increase in 2008, according to the agency’s projections.
• For 2009, the IEA also cut its demand projections — to 87.2 million barrels a day. Unless my math has completely deserted me, that’s more than the agency projects for 2008 demand. In other words, in the midst of what looks like a serious recession in the developed world, demand for oil is projected to keep growing.
• Why? Because while demand may be falling in the world’s developed economies, it is still soaring in the developing world. “We have yet to see unambiguous evidence of a sharp slowdown from China, while Middle Eastern demand remains robust,” the IEA said.
• Rolling back the barrels
• So much for the demand side. If demand isn’t falling as rapidly as investors might have expected, does the supply side have a surprise or two up its sleeve?
• You bet. The global capital crisis has dried up capital for smaller oil companies and even for major oil producing countries such as Russia. Federal revenue from Russia’s natural-resource-based economy is projected to grow by just 1.8% next year, the Russian government projects. That’s down from projected 13.8% growth in 2008. That’s bad news for an oil industry that needs lots of investment capital — $1 trillion by some industry estimates — to stop the decline in Russia’s oil production that began in the first quarter of 2008.
• Mexico, Iran, Nigeria, Venezuela and other oil producers are in much the same boat. Without increased investment, oil production will decline. But with prices way down from highs of about $147 a barrel, those governments have more-urgent places to spend the oil industry revenue.
• Falling oil prices are also leading private-sector oil companies to cut back on investment in new production. Goldman Sachs (GS, news, msgs) calculates that $50 a barrel is the oil industry’s cash cost. Below that level, oil companies with above-average production costs will seriously consider shutting wells, because pumping oil is a money-losing proposition.
• Continued: The shortages grow
• But the key supply-side number is actually much higher — at $70, $80 or even $100 a barrel. That’s what’s called the marginal cost of production, what it costs to get oil out of the most expensive new production projects. The marginal cost right now is about $75 to $80 a barrel, according to Bernstein Research in London. When oil prices fall below the marginal cost of production, oil companies postpone or cancel their most expensive exploration and development projects.
• That’s already happening, and it’s happening fastest in the parts of the globe with the highest costs of production. In Alberta’s oil sands, where operators say they need prices of $85 to $100 a barrel to make an investment pay off, projects are getting pushed back or canceled. BA Energy, for example, is looking at delaying its upgrader, essential equipment for turning the bitumen mined from the sands into oil, for 18 months to three years. Cancellations and delays have led the Canadian Association of Petroleum Producers to cut its forecast for 2020 oil production from Alberta’s oil sands by 11.5%.
• The shortages grow
• That wouldn’t be a big deal, except that before the current financial crisis, the IEA was pointing to mounting evidence of a big oil supply gap in the next five to 10 years as production fell well short of supply. The worry then was that because it takes so long to find and then produce new oil, there simply wasn’t enough current investment in new production to meet demand over the next five years. Delays and cancellations that push off the delivery of supply aren’t going to help fill that gap.
• Thanks to the current crisis, the world is looking at an even bigger demand-supply gap in the near term once the economies of the U.S., Japan and Europe emerge from recession in 2009 or 2010.
• The future supply squeeze that’s being created by the drop in commodity prices and the difficulty of raising capital in the midst of a financial crisis aren’t limited to the oil and natural-gas sectors. It’s actually an even bigger problem for mining companies. This year, through Oct. 14, the prices of copper, lead, nickel and zinc have fallen by 25% to 50%. The prices of all the base metals, except for copper, have fallen to a level that’s below the costs of production for all but the most cost-efficient producers. At current prices for aluminum, about 80% of aluminum smelters are losing money, for example.
• You know what that means, right? Mine closings, delays in production projects, and cuts in exploration and development budgets. So, for example, the Aluminum Corporation of China (ACH, news, msgs) has announced shutdowns of 1.3 million metric tons of production. OZ Minerals (OZMLF, news, msgs) plans to cut zinc production from its Golden Grove mine in Australia by 35%.
• Still-private Russian Copper has shelved plans to build new nickel and zinc plants with annual capacity of 10,000 metric tons of nickel and 300,000 metric tons of zinc. HudBay Minerals (HBMFF, news, msgs) closed its Balmat, N.Y., zinc mine in August. The mine, just restarted in January 2007 when zinc prices were much higher, had been projected to produce 60,000 tons per year. Xstrata (XSRAY, news, msgs) suspended operations at its iron-nickel mine in the Dominican Republic for four months in August. The list goes on and on.
• Plans to suspend production will take care of any temporary short-term surpluses in most metals due to a global economic slowdown. Canceling the development of mines, however, guarantees that when demand rises with a return of global growth, the world will be looking at tight supplies that guarantee a return to booming commodity prices.
• Buying in: If not now, when? So what should you do about this?
• First, recognize that the long-term commodity boom driven by the rise of the world’s developing economies (and the difficulty in increasing supplies of everything from oil to zinc) is intact and that you want to own the next stage in the boom just as you wanted to own the last stage.
• Second, admit that investors face a big timing problem. Stocks in mining and energy companies have plunged with the financial crisis, and fears of a recession aren’t going to do them any favors. Prices will recover from current deeply depressed levels as soon as the market’s general panic subsides, but the big gains will come when the global economy shows signs of picking up speed again. You want to catch that moment in 2009 or 2010. But these stocks could well be dead money in much of 2009.
• Third, decide if you have the patience to be a true value investor. (If you don’t, try to catch this sector when the charts for these stocks show signs of life in 2009. But this sector can move very, very fast, since a relatively modest 10% change in the price of the commodity produces a 17% increase in earnings, according to calculations by Deutsche Bank.)
• These stocks are extremely cheap right now. Deutsche Bank calculates that current share prices for mining companies, for example, reflect on average just 60% of the value of their resources in the ground.
• Fourth, separate the stocks in the mining and energy sectors into two groups by the price risk in their underlying commodities. So, for example, since copper is still trading above the average cost of production, it is relatively risky. The metal has further to fall before its price starts to eliminate mine capacity. Zinc, on the other hand, has already tumbled to levels so low that producers are shutting mines as fast as they can. Oil comes with an intermediate level of risk, I’d argue. We know that the Organization of Petroleum Exporting Countries is going to move to cut production to support oil prices at $80 a barrel. But we don’t know how effective OPEC will be.
• Fifth, and finally, look at how deeply the market has discounted the prospects of any individual company. Take, for example, Thompson Creek Metals, a Jubak’s Pick. The stock of this molybdenum miner had fallen from $24.45 a share May 19 to $6 a share Oct. 14.
• Before the crash in commodity prices, Wall Street was calling for molybdenum prices of $32 a pound in 2008 and $30 in 2009. Nobody’s using that price estimate for molybdenum now. Deutsche Bank, for example, has cut its price estimate for molybdenum to $26 a pound in 2009 and $20 in 2010. The investment bank has also cut the price-to-earnings multiple it uses to calculate a target price for the stock to 9 from 10. And still that results in a target price of $24 a share — a full $18 a share, or 300% above the current market price.
• That’s a valuation based on estimates of the company’s future earnings power, and earnings estimates can be fickle. Fortunately, there are other ways to value companies like Thompson Creek with concrete assets. The company’s book value is $6.49 a share. (Book value accounts for assets based on their original cost minus depreciation and therefore doesn’t consider how the value of a mine might increase with inflation or the price of molybdenum.) Net asset value, as calculated by RBC Capital Markets, is $8.96 a share. Both are above the current market price.
• A deep-value investor tries to buy a business for less than it is worth. I think you can do that for Thompson Creek right now. That, plus the fact that production costs for molybdenum at many of the company’s competitors are climbing due to the increasing scarcity of high grade molybdenum ores, makes this a stock I’d be willing to buy now — or to hold while adding to my position. At this price, I’m willing to wait for the next stage in the commodity boom.