The Brightest Stars in the Commodities Boom, Part I

by: Mark Anthony

Thursday saw the market's kneejerk reaction of oil dropping of $4 a barrel, in response to China's announcement of gasoline and diesel price boost of 16%. Most traders perceived higher price will suppress Chinese demand on oil. They know nothing about what's going on in China.

After the price boost, gasoline still costs only US$3 a gallon, far cheaper than prices in the US and Europe. It will not supress demand at all; consider that only wealthest 3% of households in China own a vehicle. The Chinese transportation fuel market is in severe short supply. Refineries are unwilling to increase production because the crude prices are high, while the refinery product must be sold at government controled low prices, well below cost. The government hopes the price boost will encourage refineries to INCREASE fuel supply to ease the shortage. It actually will boost oil demand. Consider buying the U.S. Oil Fund ETF (NYSEARCA:USO) for a quick rebounce once the market realize they got it totally wrong!

Commodity guru Jim Rogers is my hero not only because he correctly predicted the commodity boom as early as 1999, but because the way he does market research and due diligence study is very inspiring to me. His millenium adventure around the world, which I recommend everyone to read in his bestselling books, was not a safari, but a real adventure with real danger to his life. I do not think I can be as brave. I wish I knew him and read his books earlier.

Commodity investments provided some of the most spectacular returns in recent years. Look at the fabulous chart below. Don't you wish you had bought some rhodium in early 2004? Me? I wish I had studied about CD-RW and bought tellurium in 2004 for $10. I want to talk about rhodium in more details in a later article since this is a very interesting case study on how to find commodity superstars, before they shine.

Jim said the commodity boom is far from over, which I agree. Although the current commodity bull cycle started in 2000, many of the raw materials did not start the earnest rally until pretty recently. Copper did not take off until late 2003/2004. Food grains and fertilizers did not take off until early 2007. As for coal, it doesn't make much movement until early 2008 when it all of a sudden rallied spectacularly, running from $45 a ton to well over $160 per ton in a few short months, surprising every one including me. I had the vision to load up heavily the coal mining stock James River Coal (JRCC) at $4 last year, but did not have the foresight to see that it could reach almost $60 today, in just a few short months.

JRCC gained 15 fold in 10 months, or more than 12.5 fold in exactly 7 months. How often do you see such an incredible rally? How you wish you have grabbed that opportunity. I did catch it at the start, but did not hold it through the whole course. I remember on Nov. 19, 2007 I was watching JRCC and I really wanted to buy it back but I had no dry powder. I knew I was giving up an opportunity but never knew how big an opportunity I had given up. I wish had paid closer attention to the coal market, and discovered this article last year.

Of course, JRCC is not the only coal stock that see spectacular rallies lately. There are a dozen others, PCX, BTU, ACI, CNX, FCL, FDG, MEE, and ANR all gained tremendously.

How do you discover such bullish commodity players, before they take off, and how can you hold on to them for the whole course? And even more importantly, how do you decide your exit strategy? Three words: due diligence research. If you know the market fundamentals and supply/demand trends, you can spot a bullish commodity player before it takes off, and you will have the conviction to hold through the highs and lows to rip full profit potential, and you will also know when it becomes over-valued and it is time to move on.

Coal's recent rally far exceeded my original expectation. I believed coal was bullish but I thought it's a long term play, at least 2 or 3 years out in the future. It is worth going back and re-example my original assessment of the coal market, and see if I missed anything.

As I discussed before, for any commodity play you need to examine the supply/demand relationship to see how bullish it is. You concentrate on several things:

  • Is the natural source of the raw material scarce or abundant?
  • What's the supply/demand numbers? How bad is the shortage?
  • How price elastic is the supply? How high does the price need to go to boost supply, and how soon will it happen?
  • How price elastic is the demand? Can demand be reduced or replaced if the cost is too high? How high does the price need to go to cause that to happen?

I looked at all four criteria for coal and could not find a very solid bullish case. Global coal reserve is still abundant, worth a few hundred years of production. The global coal supply and demand figures in 2007 were 3135.6MT and 3177.5MT respectively. The shortage was 41.9MT, about 1.3% of annual demand - a very small percentage of shortage worth about 5 days of global consumption. Coal is mostly used as fuel in power stations, which often stock up to 3 or 4 weeks' worth of coal. That should be plenty of buffering to absorb 1% or 2% of shortage in any given year. From the price elasticity point of view, the high coal price can not last long. China's coal production in 2007 was up 7% year-over-year. Recent news indicate that due to higher prices, the largest coal producer in China is boosting coal production at an annual pace of 13.3% or more. The global coal shortage may end soon right when every one is talking about higher coal prices.

So why did coal price double or triple in just a few months? I guess several reasons.

  1. The global coal market is huge. But most coal supplies are already tied up in multi-year long-term supply contracts netween producers and power stations. So the amount of coal available on the spot market is pretty limited, and so is very sensitive to any temporary supply disruptions.
  2. Mid to long term, both the coal supply and demand are quite price elastic. But in very short term, both supply and demand could be completely price inelastic. If a power station is running low on coal reserve and faces the danger of shutting down electricity, it pays any price to ensure uninterrupted electricity supply. Mean while disruption at Australia's Newcastle Port forces many dry bulk ships, up to 30 at a time, waiting for weeks to be loaded with export coal. Can't load faster no matter what price you pay.
  3. A few global events caused short-term supply shortage. Those include the disruption in Australia's NewCastle Port, a major coal export port. By the end of last year, the Chinese government launched a crackdown which shut down a whole batch of small-scale private coal mines operated under unsafe conditions, removing a significant portion of the production. As the coal shortage becomes evident, the government is now urging those small coal mines to resume production as soon as possible, when safety has improved.
  4. It can not be ruled out that international hedge funds may be speculating on the coal market and bid up the price on the futures market.

Currently most coal mining stocks are priced so high that their prices are being justified on the basis that coal price will continue to climb, and will stay high for the foreseeable future. If you look at the history of coal prices there have been periods of quick booms and bursts. JRCC itself emerged from a bankruptcy just a few years ago, and it is still heavily in debt today. So my advice to all the folks holding coal stocks is to sell now and move to something else. I am not calling a top, few people can recognize a top right when it occurs. I am definitely not calling for shorting coals. In all likelihood, the coal fever may well continue for some time and make new highs, but the big crowd has arrived. When big crowds arrive it is often time to move on to something else. There is always a bigger opportunity some where else where the big crowds have not gathered yet.

The biggest crowds in commodity investment probably concentrate on oil, coal, alternative energy, and gold. The gold crowd is too crowded. Today you can not visit an investment site or even tune to a radio or TV station without hearing someone pitching gold. The most famous gold bug operates a free web site which I read daily. I appreciate the education on fiat currency, the credit crisis and the need of individuals to protect themselves from inflation. But why should gold be pitched as the only good hedge against inflation, and no mentioning of other precious metals, like platinum, palladium, even rhodium? I don't buy gold! You have nothing to gain in gold, in real term, comparing with other physical commodity investments. The only way you can make profit from gold is when you sell it to another gold investor, who just like you, hopes to be able to sell gold for yet higher price to the next gold investor in the line. Pretty much sounds like the bigger fool theory? The world has accumulated 320,000 tons of gold. There is never a shortage of gold.

Relatively, the palladium investment crowd is far smaller and far quiet. Lots of gold bugs and silver bugs on the internet. But I have yet to find a palladium bug. Even the respected metals analysts don't understand the palladium market. Year after year they made bearish predictions based on the notion that Russian stockpile palladium flooded the market, each year they were proven wrong as palladium moved up and they scratch their heads wondering why they were wrong. Does it really stretch the mind to understand that Russian stockpile HAS to run out one day, and that will result in an industrial shortage, sending the metal price flying? Look at the sudden boom of investment interest since late 2003. Someone must have had a Eureka Moment at that time and has been quietly loading up on this unprecedent investment opportunity ever since, driving the price up.

And now,  the Russians themselves admitted they are running out of palladium stockpile. Is there any wonder that palladium price surged 12% in one week since then? People are getting it and jumping on the wagon but unfortunately even a highly respected and award winning metals analyst, Rhona O'Donnell, didn't get it at all! She believed there was still some palladium stockpile somewhere "available to the market."

Hello! Whoever hoarded palladium since 2003 is NOT doing it for a global charity. It's for making money! If the price is not right, it is NOT "available" to any one at all. On such notion of "large stockpile available," then shouldn't someone argue then that gold price should fall just because there are huge stockpiles in the world? No one ever made such a ridiculous argument. Whoever hoarded palladium waited exactly for such a Russian checkmate moment, and now the checkmate Time in palladium is coming rapidly. The data contained in the Rhona O'Donnell article confirms that without Russian stockpile palladium, the market is in a pretty big gap of supply shortage. Do you notice that the palladium lease market may be halted?

Could palladium be the next rhodium? It could be possible. At least it's a way much better physical metal investment than gold. So you can never go wrong buying some palladium coins or metal bars. Of course, buying the stocks of the only two primary palladium producers in the world, Stillwater Mining (NYSE:SWC) and North American Palladium (NYSEMKT:PAL), may provide higher leveraged investment gains.

PGM metals are unique - unlike gold, whose largest demand is investment demand, which is unpredictable and can not be counted on. PGM metals are critical to many important industrial applications whose demand can not be suppressed even at very high price levels. But at the same time, the physical metals can also be hoarded away by investors, increasing the physical demand and adding to the shortage, driving up price. The global PGM market is so narrow and so tight that minimal investment demand can send the price to very high levels.

That is quite different from other commodity investments. I buy SWC and PAL stocks, but I also buy physical palladium metal bars. All your folks who buy coal or oil stocks, do you also stack up a ton of black coal or a couple hundred barrels of crude oil in your backyard? If I visit the Goldman Sachs (NYSE:GS) office, do I expect to find a truckload of coal just delivered? No, there can never be any real physical demand from speculative investors, not even in the futures market. All trades are done on paper and when the contract is about to expire they roll it to the next month. No delivery is ever taken so there is no physical investment demand in coal, oil, food grain etc.

I think I would rather invest in something that can be physically held in my hands. But maybe I will just buy enough USO to hedge the gasoline price I pay at the pump, and U.S. Natural Gas Fund (NYSEARCA:UNG) to hedge my monthly natural gas bill. I finally read an interesting speech by Kevin Crisp which explains why PGM metals are critically important to the industries.

Disclosure: The author is heavily invested in SWC and PAL.