Why Commodities Still Make Sense

From 2001 until last May, investing in commodities was pretty much a one-way bet. Oil prices soared. Copper, nickel and aluminum prices hit record highs. Even venerable gold awoke from its long slumber. Then the market plunged. Suddenly, investors began to focus on rising interest rates, slower economic growth and an unusual lull in geopolitical tensions. Hedge funds and other sources of hot money headed for the exits, aggressively selling commodity futures contracts, commodity-related exchange-traded funds and natural-resources stocks. By the end of September, the Dow Jones-AIG Commodity index, which tracks a basket of 19 items, had fallen 13% from its May high.

Is the bull market in commodities over? Not likely. The downturn appears to be merely a necessary correction in an extended cycle that could run into the next decade. China and other populous developing nations have a voracious, and growing, appetite for energy as well as industrial and precious metals. "People of the emerging world want to live a more luxurious life," says Fred Sturm, manager of Ivy Global Natural Resources. Industrialization, urbanization, rapid growth in vehicles in use, and infrastructure construction -- all key trends in the developing world -- stoke that ravenous appetite.

That's the demand picture. The supply side is one of diminished oil fields and depleted gold and copper mines laboring to keep up with demand. The costs of exploration and production are escalating, and many of the most-commodity-rich nations are unstable and suppliers of questionable reliability.

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Even if prices don't budge, many resource stocks are selling at prices that are attractive relative to the prices of the underlying commodities. Kurt Wulff, an independent oil analyst, says prices of petroleum stocks reflect $45 a barrel for crude oil, although oil traded for about $60 in mid October. He says $60 oil is "very profitable stuff" for these companies. Copper giant Phelps Dodge sells at just seven times the cash per share on its balance sheet and generates huge free cash flow (what's left after necessary capital expenditures), says Standard & Poor's analyst Leo Larkin.

It's a fact of life that unstable political regimes have been endowed with custody over most of the world's energy reserves. France's Total (symbol TOT) has been adept at hatching petroleum deals in such garden spots as Iran, Yemen, Angola and Nigeria. "Total built its business on its ability to produce in these areas of turmoil," says SP oil analyst Tina Vital.

Vital thinks Total can boost oil-and-gas output 4% a year through 2010, a high figure by big-oil standards. The quality of Total's management is comparable to ExxonMobil's, but you get a different geographic mix of assets at a cheaper price. Total's American depositary receipts traded at $66 in mid October, or nine times estimated 2006 earnings of $7.32 per ADR and a bit more than nine times estimated '07 profits of $6.96. Vital, who predicts that oil prices will return to the low $70s by early 2007, thinks Total could hit $82 within a year. The stock yields 3.1%.

The beauty of oil-field-service companies is that they can sell to anyone, including the dominant state-controlled oil companies. Schlumberger (SLB) is king of the industry. "It's better positioned worldwide than any of the other service companies," says Charles Ober, who manages T. Rowe Price New Era. Schlumberger has cutting-edge technology for finding oil and gas reservoirs and maximizing recovery of the hydrocarbons. At $59, the stock is 20% off its May peak and sells for just 16 times '07 earnings estimates of $3.67 per share, a reasonable price for this high-quality company.

If you want a pro to pick your diversified portfolio of natural-resources stocks, consider Ober's fund. New Era (symbol PRNEX, 800-638-5660) holds Schlumberger and Total among its biggest positions, as well as mining giants BHP Billiton and Rio Tinto. The annual expense ratio is a modest 0.68%, and New Era returned 20% annualized over the past five years to October 2.

Gregg Fisher, president of Gerstein Fisher, a New York financial adviser, thinks investors should allocate 5% to 10% of assets to commodities. Commodities alone are more volatile than stocks or bonds, but a diversified portfolio containing all three asset classes will generate a higher return with less risk than a portfolio holding just stocks and bonds.

Fisher steers clients away from commodity stocks and toward exchange-traded and mutual funds that strive to replicate the performance of a commodities index. He reasons that holding shares in natural-resources companies does not reduce portfolio risk because these stocks tend to follow stock-market performance. One of his favorite ETFs is the recently launched iShares GSCI Commodity-Indexed Trust (GSG), which follows the Goldman Sachs Commodity index.