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The Commodity Supercycle: Why It's Time to Choose Consumables Over Reusables


The sectors that deserve bullishness are those focused on commodities that are consumed, like energy and agriculture, specifically fertilizer.

Much has been said and many charts have been plotted to prove that the commodity "supercycle" has run its course. The days of $1,800 gold, $150 oil, and $18 soybeans have passed. But before we write this group off, we should first understand that placing them all under the umbrella of "commodities" limits our ability to analyze this wide range of products and resources.

To borrow a phrase from Raymond Carver's 1981 collection, what we talk about when we talk about commodities as part of our grand investment theses needs to be defined. In addition to his phraseology, we can also learn from Carver's philosophy; he was by no means a sentimentalist: Don't get married to a concept. Deal in the reality of supply, demand, and capacity.

The Sectors

The Commodity Research Bureau's commodity-tracking index (CRB) is the oldest and still the basic benchmark for commodity indices in the world. There are currently 19 components ranging from the obvious (like oil) to the obscure (like tallow and rosin). It slices and dices the sectors, but after its tenth makeover (the revision in 2005), we are left with four major groups: energy, agriculture, precious metals, and base metals, whose weightings better reflect the importance of energy and agriculture, now representing 39% and 41% respectively.

Across these groups there are a variety of input/output economic forces that have led to a wide diversion in price performance. And the price of the underlying commodities has a wide and variable impact on the profitability, and therefore the share price, of the companies that produce, sell, or use these materials.

Consumable Vs. Recyclable

I like to break these products into two main categories: those that are consumable and those that are recyclable. For example, commodities such as copper and iron not only have a fairly predictable and expandable production capability, but can also be recycled.

The chart below shows the price comparison of copper and oil as measured by their respective ETFs.

As you can see, both crumbled in late 2009 as the financial crisis took its toll and as global growth contracted. But within months, oil started to outperform by a wide margin. And this came despite China's continual production and hoarding of copper (among other metals, such as steel) in its attempt to maintain massive infrastructure spending and growth. China soon became the world's largest producer and supposed consumer, reaching nearly 40% of worldwide supply of the industrial metals -- a completely disproportionate amount relative to the actual demand. China's reluctance to shutter plants resulted in ghost cities but failed to prop up prices as lower-cost recycled material found its way back onto the global marketplace. Copper and iron prices coud remain under pressure for years to come. This does not bode well for firms such as Freeport-McMoRan (NYSE:FCX) or AK Steel (NYSE:AKS)

Oil, on the other hand, quickly rebounded and has held steady, albeit below peak prices, even as demand has remained muted. The reason is that oil is a consumable, and all the talk of the shale revolution aside, is becoming increasingly harder to find and produce. In fact, the shale and fracking revolution might be coming to end before it even had chance to fully be exploited.

Currently, due to a lack of infrastructure and a means to refine, distribute, and consume the product, an increasing amount of gas is being burned at the tip, flared, than used. At the moment, nearly all the new basins have wells that are burning gas; the number of flaring permits has more than doubled to 630 in 2012 from 303 in 2010. It is estimated that some 30% of the gas produced in North Dakota is being burned off wells waiting to get connected to pipelines.

It's well known (pun intended) that the most productive period of any drill site is early in the lifecycle. Depletion rates run between 40-70% year-over-year, and it will take more and more continuous drilling to maintain current production levels. Drillers have focused on the sites with the greatest potential and will now move down the curve to less promising locations as time passes.

There's no doubt shale and fracking are adding significant supply but when all is said and done, this might be a single generation play. We may soon be back to talk of peak oil/gas and the steady march of higher energy prices. So let's not raise the victory flag on a permanent state of energy independence quite yet.

The companies best positioned to benefit from energy growth should be those providing the equipment for exploration, such SeaDrill (NYSE:SDRL) and Transocean (NYSE:RIG).

Feed Me

The other area that I have a long-term bullish outlook on is the agricultural sector. I'm not talking about buying soybean or corn futures, which can be accommodated through exchange traded funds such as Teucrium Soybean Fund (NYSEARCA:SOYB) or Teucrium Corn Fund (NYSEARCA:CORN), but rather the fertilizer companies. While price of the underlying crops can vary widely year to year depending on the season's production, the long term demand to boost yields, shorten growing cycles, and make crops more resistant to fungus or disease remains on a steady rise.

Though there seems to have been a pause in recent years, the growth of the middle class among emerging markets such as China, India, and Eastern Europe is inevitable. Along with the trend toward urbanization comes the desire for a diet higher in protein. With corn and soybeans the main feed for cattle, pork and chicken companies such as Potash (NYSE:POT), Mosaic (NYSE:MOS) and CF Industries (NYSE:CF) stand to benefit.

The map of how corn (maize) yields have been stagnating across Asia and Latin America shows the need to boost production.

The three names above, along with Agruim (NYSE:AGU) and Intrepid Potash (NYSE:IPI), all took a hit in early August, tumbling some 25% each on news that Russian-based OAO Uralkali -- the world's largest potash producer at nearly 20% of global production -- was breaking off its partnership with Belaruskali, citing a violation of their export agreement. Together they accounted for 43% of global exports. This seems to be a gambit for Uralkali to grab share, particularly of exports to China, and has lead to concerns that a pricing war would soon be underway. But there seems to have been some fence mending in recent weeks.

In either case, low-cost producers such as Potash stand to benefit not only from scale, but also from the opportunity to further consolidate the industry.

A recent move by BHP Billiton (NYSE:BHP) seems to sum up the story of direction and bifurcation of commodities. BHP, one of the largest miners of copper and iron, has been shedding some of those assets in Australia. It is planning on investing $2.9 billion to develop a potash mining facility in Saskatchewan, Canada. It expects be able to mine the Jansen project for the next 50 years, and views it as a way to profit from the rising global demand for food.

When it comes to commodities, think consumable, not reusable.

Twitter: @steve13smith

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