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With oil off more than 20% from its July peak, and the Reuters-CRB Continuous Commodity Index down 19% from its June high, traders are betting that commodities have entered a bear cycle with much further to fall. But it is much more likely that commodities will enjoy another “bounce,” with many of them revisiting record levels before a true downturn sets in.

Smart investors will take advantage of this bounce.

In the long run, commodities prices are likely to deflate. Even for oil, new supplies exist and are economic at prices well below those currently prevailing. For agricultural and other “soft” commodities, it’s mostly a matter of planting new land and waiting for the crop.

However, rapid international growth for several years can cause demand to run ahead of supply, and this causes prices to “spike.” Once this has happened, a sustained period of below-par growth is necessary in order for commodity supply to catch up with newfound demand.

The most important factor regulating international demand is the overall level of interest rates in terms of inflation. If “real” interest rates – netting out the rate of inflation – are high as in the 1980s, demand growth is sluggish (because the cost of capital to make new investments is high) and so commodity prices are generally low. Conversely, low real interest rates and surging inflation, such as occurred in 1973, can cause the prices of all commodities to spike upwards.

While there are signs of global demand slowing, it is nowhere near stalling. The International Monetary Fund [IMF] expects world gross domestic product [GDP] growth of 4.1% in 2008 and 3.9% in 2009. Those rates compare with growth rates of 5% or just over in 2006 and 2007. However, they are still sufficient to put considerable pressure on commodity supplies, which are already stretched by current demand.

To reduce commodity demand, and produce a real drop in prices, global interest rates would have to rise sharply. Currently, short-term interest rates are negative in real terms (below the local rate of inflation) in the United States, the European Union and Japan, and only just positive in the United Kingdom.

They are also sharply negative in India and many emerging markets and likely to become so in China, where official inflation has been suppressed pre-Olympics. With negative real interest rates prevailing almost everywhere, the global trend must be one of firm demand and accelerating inflation.

Eventually, the United States, which tends to lead the international community in interest rate matters, will be forced by accelerating inflation to increase sharply its short term interest rates – the 2% Federal Funds rate is now more than 3% below consumer price inflation [CPI] and more than 5% below producer price inflation [PPI]. When that happens, other countries will follow and the commodities boom will deflate.

However, it won’t happen just yet because of the housing crisis. U.S. Federal Reserve Chairman Ben S. Bernanke wants to see home prices come to some kind of equilibrium before raising interest rates, otherwise he could produce an uncontrollable fall in house prices, causing more or less the whole U.S. home-mortgage market to default.

Since interest rates are likely to remain low for several months at least, commodity prices are likely to “bounce,” rather than remaining in a bear market. Speculative capital, of which there is still plenty, will then rush back into commodities, pushing prices up still further.

Of the various commodities, agricultural commodities are the least likely to bounce substantially, because the supply cycle is relatively short and high prices are already causing new planting. Shipping rates are also fairly unlikely to soar, as new building has been undertaken at a frantic pace in the past few years and capacity is now coming on stream.

On the other hand, metals and energy, for which finding new sources is a lengthier process, are more likely to bounce, particularly if geopolitical uncertainty continues to increase in the aftermath of the Georgia invasion.

The most upwardly mobile commodities are likely to be those whose movements are directly related to inflation – gold and silver. Gold, in particular, is one of very few commodities whose price is currently within a few percent of that last September, when Bernanke & Co. began cutting interest rates. 

While the equivalent in real terms of 1980’s $850 peak in the gold price may be unattainable – that would require gold to reach $2,300 – a $1,500 price for gold certainly seems possible.

I would recommend consideration of StreetTracks Gold shares (NYSEARCA:GLD) as the most efficient way of getting a pure gold play. As an alternative, you might consider a silver investment – the metal is currently at less than 15% of its 1980 high equivalent to $130 per ounce – the iShares Silver Trust ETF (NYSEARCA:SLV) seems the best way to play silver directly.

You may do even better in gold mining shares. The recent declines in the gold price have caused a huge amount of air to whoosh out of gold share prices, to the extent that they now represent pretty good value.

  • Barrick Gold Corp. (NYSE:ABX) is a Canadian company, with mostly North American production, plus some in South America and Africa, and copper and zinc add-ons. With a market capitalization of $29 billion, this firm has plenty of liquidity. It has a trailing Price/Earnings (P/E) ratio (on last 12 months earnings) of 15, and a forward P/E (on next 12 months) of 13. The stock is reasonably valued and has little political risk.
  • Newmont Mining Corp. (NYSE:NEM) is a U.S. company, operating in the United States, Australia, Peru, Indonesia, Ghana, Canada, Bolivia, New Zealand and Mexico. It also has low political risk, but with a $19 billion market capitalization, trailing P/E of 25 and forward P/E of 14, Barrick still looks like a better value.
  • Yamana Gold Inc. (NYSE:AUY) is a Canadian company with mining in Brazil, Argentina, Chile, Honduras and Nicaragua.  It has a market capitalization of $7 billion and a trailing P/E of 33, but a forward P/E of only 10. There’s medium political risk, but the firm expects to double production to 2.2 million ounces per year by 2012, primarily in Brazil and Argentina.
  • Gold Fields Ltd. (NYSE:GFI) is a South African company with mining operations in South Africa, Ghana, Australia and Venezuela (of which they recently sold control to a local company). With a market capitalization of $5.7 billion, trailing P/E of 11 and forward P/E of 10, this firm is an upper-medium political risk, depending on what you think of South Africa. However, its shares have fallen a lot and are now cheap.

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Source: 6 Golden Investments for a Commodities Bounce