How To Profit From The Commodity Surge

It is an uncertain time in the global economy, and the price of commodities are unexpectedly surging in the middle of the recession. While the short-term effects are …

It is an uncertain time in the global economy, and the price of commodities are unexpectedly surging in the middle of the recession. While the short-term effects are likely to be detrimental to economic recovery, there are several ways to capitalize on this spike. The following article from Money Morning explains how you can profit from the surge in commodity prices.

Commodities prices are surging.

World white sugar prices reached record levels on Aug. 10, largely because of booming demand in India where the government has lifted a ban on imports. Oil prices continue to hover around $70 a barrel, and gold is in the mid-$900 range. Meanwhile the CRB Continuous Commodity Price Index has surged to a level 30% above its March low.

Finally, copper, supposedly a barometer of the global economy, went above $6,000 per metric ton – up more than 96% this year.

And while prices for most commodities are still well below last year’s peaks, the price spike is more dangerous than it looks.

Normally, commodities prices zoom at the top of a global inflationary boom, as in 1973, 1980, or last summer. This time, the surge is happening at the bottom of a recession. If it continues, the commodities price resurgence could cut off global recovery before it really gets going.

Commodities prices usually take off at the top of a normal business cycle, as inflation is accelerating. The price rise then causes commodity consumers to feel poorer. This reduces demand and brings on a recession. Then, new production capacity comes on stream after demand has fallen back, causing prices to remain depressed for several years.

That’s what happened in 1973, with the first Organization of Petroleum Exporting Countries (OPEC) oil price rise, and again in 1980, with the second. After 1980, we didn’t see a real commodities price surge until the middle 2000s. That’s because the tech revolution caused consumer demand to move to things like computer chips that used fewer raw materials than traditional products.

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Last summer, we had a similar price peak. Given the depth of the current recession, you’d expect commodities prices to stay low for several years, as new production capacity comes on stream. But that hasn’t happened. Instead, prices have rebounded sharply.

There are three possible reasons for this year’s surge.

First, it could be the result of very low interest rates and loose monetary policy. In that case, it will soon lead to a rise in general inflation.

It could also be due to the worldwide fiscal stimulus – in the United States, China, the United Kingdom, India and most other economies. Much of the stimulus – particularly in China – consists of infrastructure spending. Infrastructure development requires lots of steel, copper, cement and other commodities. If that’s the case, the resulting budget deficits are likely to cause bond market problems. That would restrict the supply of funding for capital investment and other private sector needs.

Finally, the surge in commodities prices could be due to continued rapid growth in India and China. The 2.4 billion citizens of those countries, as they get richer, are demanding more goods that require a lot of commodities to produce, like automobiles.

Thus, when India and China grow faster than the rich West, we can expect commodities demand to surge more than global gross domestic product (GDP). If this is the cause, rapid commodities demand will lead to a rise in general inflation and spot commodities prices that will accompany shortages and price spikes. That would have a deflationary effect on output.

We saw this effect in 2008’s third quarter, when real U.S. GDP dropped 2.7%. That drop must have been the effect of $147 oil in July, since the financial crisis did not hit home until the very end of that quarter.

It’s impossible to tell which of these three is really causing the current commodities price surge. We can, however, be sure that it will choke off global recovery if it carries on much longer.

That’s a miserable possibility, especially if it means we also get inflation and higher interest rates. However, as investors we can make some money from the commodities surge.

Here are some ideas:

Powershares DB Base Metals Fund (NYSE: DBB): This exchange-traded fund (ETF) tracks the Deutsche Bank AG (DB) base metals index, allowing you to invest directly in the price movements of non-precious metals. With a market capitalization of $308 million, it is reasonably liquid. Plus, a lot of money has been flowing into it recently.

Vale S.A. (NYSE ADR:VALE): Vale is the world’s largest iron ore producer and a key supplier to China’s exuberant infrastructure growth. Historical P/E of less than 10; will benefit hugely from price run-ups in steel.

iShares Silver Trust (NYSE: SLV): This ETF Invests directly in silver bullion, which has been left behind somewhat in its relationship to gold’s price rise and can be expected to move up as gold does, possibly by a much greater percentage.

Market vectors Gold Miners (NYSE: GDX): Gold miners benefit disproportionately from a rise in the gold price because their production costs are fixed. They are thus a more leveraged way to play it than the metal itself, particularly as surging speculative demand can increase mining companies’ price-to-earnings (P/E) ratios.

This article has been republished from Money Morning. You can also view this article at Money Morning, a mortgage and real estate news site.

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