If you’re like me, you’ve been invested in mining companies or oil producers the last couple of months because you expected a return to the strong commodity prices of early 2011.
But if that’s the case, like me, you’re hurting. Commodity prices are well below the highs we saw in early May. In fact, they’ve dropped more than the rest of the market.
The temptation to sell out before things get worse is very strong.
But don’t do it…
The conditions for strong commodity prices are still in place. And at present levels, a number of commodity and energy-producing shares are stone-cold bargains.
Let me tell you why…
Don’t Be Fooled by the Price Declines
Against a backdrop of strong commodity prices, these companies had an excellent 2010.
I’m sure you were surprised to see that these same companies didn’t do all that well in the first few months of 2011 – even though oil, gold, silver and copper prices were climbing and rare earth prices were going though the roof.
The market seems to have believed that these strong commodity prices were actually peak commodity prices – and that producers wouldn’t get much benefit from those peaks because they would get the high revenue a short time only.
Then when commodities prices dropped from their peaks – oil by about 20%, silver by about 35% and gold by only 8% – share prices of commodity producers fell even more.
The bear case was clear: Commodity producers hadn’t benefited all that much from peak prices. Now that prices were likely heading down, producers were looking at a less profitable stretch.
But here’s what I want you to know: The bear case becomes flawed if we yet to see the peak in commodities prices. If this turns out to be the case, the benefit to producers from higher prices would become much greater.
And I would argue that this is precisely where we are today.
A Recipe for Strong Commodity Prices
All around the world, only the tiniest steps have been taken against inflation, yet inflation is rising quite rapidly – far more rapidly than interest rates are being increased.
U.S. consumer-price inflation over the last 12 months was 3.6%. And producer price inflation 7.2%. But interest rates are still close to zero.
And since real interest rates negative in most countries around the world, hedge funds and other investors are being paid to invest in commodities.
And don’t worry about commodities getting nicked by a bubble, either. You will have plenty of warning before that bubble bursts.
At the earliest, any bubble in commodities would burst only when the first decisive steps are taken to raise interest rates – particularly here in the U.S.
And that’s not likely to happen anytime soon.
Bottom line: Commodities remain a great bet. And given that strong commodity prices are coming, commodity-producing companies, which have been knocked down further than commodity prices themselves, are an even better one.
Here are some of my favorite plays in the gold, silver, iron-ore and oil commodities sectors:
- Yamana Gold (NYSE:AUY): Yamana is my favorite gold miner. It earned 20 cents a share in the first quarter. And its P/E ratio on 2012 earnings is an estimated 10.5.
- Silvercorp Metals Inc. (NYSE:SVM): Silvercorp is my favorite silver player. The Vancouver-based company’s mines are concentrated in China. And its silver-extraction costs are actually a negative $6 an ounce due to profitable sales of byproducts. Silvercorp’s share price has been knocked back by almost a half. It is now a bargain on a forward P/E of 12.
- Cliffs Resources (NYSE:CLF): With big operations in Australia, a gateway to China, coal and iron ore producer Cliffs Resources is a company I like very much. The Cleveland-based outfit has grown its earnings very rapidly in recent years. Its shares are about 15% off their highs and trading on a forward P/E of just 5.9.
- Suncor Energy (NYSE:SU): With major holdings in Canada’s Athabasca tar sands, the Calgary-based Suncor is a terrific play on higher oil prices. The tar sands are already highly profitable. And they will become an outright bonanza when oil prices cross the $100-a-barrel mark. Suncor is trading at 14 times trailing earnings and 10 times forward earnings.