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Finding ways to gain from the commodity boom Add to ...

The theme

The way to make money in a gold rush is to sell the picks and shovels, goes the old saying. A more certain reward comes from keeping the miners supplied with tools, accommodation, food, transportation and other necessities.

There aren't any Klondike gold rushes these days but we do seem to have a global commodity boom brewing again. That suggests modern-day purveyors of picks and shovels are likely to be found among the companies supplying miners, drillers and farmers.

The rationale

Emerging countries, notably China, are industrializing and raising their living standards. That process is resulting in greater demand for natural resources. Another factor boosting commodity prices is limited reserves for several commodities, along with past underinvestment in exploration and development.

There was a hiatus during the recession but the boom now appears to be regaining momentum. Scotiabank economist Patricia Mohr notes in the Scotiabank Commodity Price Index report: "In 2010, commodity prices should continue to move higher alongside: 1) ongoing strength in China's economy, 2) some re-stocking across the G7 countries, and 3) continued interest by investors in commodities as an 'asset class.'"

In short, commodity producers will need more picks and shovels as 2010 progresses.

Mining-equipment companies

Two mining-equipment companies worth considering are Joy Global Inc. and Bucyrus International Inc. , according to Jim Letourneau, editor of The Big Picture newsletter (www.jimletourneau.com). The two companies "are seeing orders pick up."

Both have significant exposure to coal, Ms. Mohr's top pick for best-performing commodity in 2010. She reports that steel production in Japan began a recovery in the third quarter of 2009, triggering a 21-per-cent jump in coal imports. Meanwhile, China's steel output reached a record high in 2009.

Mr. Letourneau also suggested Finning International Inc. , a dealer of Caterpillar equipment in Western Canada, the United Kingdom and South America. Caterpillar equipment is widely used in the mining and forestry industries.

Oil-service companies

Ms. Mohr's second choice for best-performing commodity in 2010 is crude oil. Vehicle sales in China overtook sales in the United States during 2009; India saw a 34-per-cent surge in vehicle sales.

For the oil-services sector, Mr. Letourneau believes drilling-service companies Energold Drilling Corp. and Major Drilling Group International Inc. "are solid places to start." Other oil-service firms include: Ensign Energy Services Inc. , ShawCor Ltd. and Trican Well Service Ltd. .

Suppliers to agricultural producers

Ms. Mohr's third choice for best-performing commodity group in 2010 is potash and nitrogen fertilizers. In China, inventories are coming down and prices are starting to rise. Brazil is expected to plant more sugar cane in response to record prices.

Potash Corp. of Saskatchewan Inc. is a key supplier of potash (a vital ingredient in fertilizer). There were recently some signs of a pick-up in business: "Potash Corp.'s Lanigan mine will be re-started in early January, sooner than planned," states Ms. Mohr.

Spotlight on Potash Corp.

Potash Corp. is the world's largest producer of potash, supplying about 20 per cent of the global market. It is also a major producer of nitrogen (another ingredient in fertilizer) and phosphates (used to make herbicides).

The recession has knocked potash prices down from $1,000 (U.S.) per ton in 2008 to $350 per ton, the price negotiated in December by China with Russian producers (all figures in U.S. dollars).

Due to weak market conditions, Potash Corp. sales registered $1.1-billion in the quarter ending Sept. 30, 2009, down considerably from $3.1-billion in the same quarter the year before. Net income was $248.8-million compared to $1.2-billion.

Canpotex Ltd., the North American marketing consortium of which Potash Corp. is a member, is currently negotiating with China to set prices for the next round of purchase agreements. Judging from recent price gains in the shares of potash suppliers, investors seem to be betting Canpotex will get a price as good as - if not better than - what Russian producers obtained.

If so, this could mark the bottom of the downward spiral. But if lesser terms are agreed upon, it may cause a sell-off in potash stocks. As well, some analysts could express concerns about Potash Corp.'s balance sheet, which shows total debt of $4-billion (and a debt-to-capital ratio of nearly 33 per cent).

Yet, Potash Corp.'s third-quarter profit margins were 25 per cent, so price declines would have to go quite deep to produce red ink. Cash flow from operations was $355.8-million over the nine months to Sept. 30.

Also, senior executives at potash companies say a turning point is close at hand in the market. They note that prices for many agricultural crops, such as corn, soybeans and palm oil, have recently gone up substantially, which makes farmers more inclined to spend on fertilizer and other products.

Beyond the near-term uncertainty, the outlook for potash and other fertilizers remains favourable, according to Ms. Mohr. Reasons include:

with higher oil prices making biofuels more economical, plantings of sugar cane, palm oil and corn crops will likely increase;

as the credit crunch eases, it will become easier for farmers to borrow and expand;

global population growth of 70- to 80-million people per year increases demand for food while reducing arable land.

The risks

The commodity boom could taper off at times. Lakshman Achuthan, managing director of the Economic Cycle Research Institute, for example, warns that the 2010s will experience lower trend growth and more frequent recessions thanks to the challenges of withdrawing the massive stimulus unleashed during the financial crisis and deep recession.

The commodity boom could even taper off for good. Emerging countries could push economic growth to bubble levels and subsequently suffer a prolonged hangover like Japan has experienced. Or, the supply of commodities could surprise on the upside as new technologies make extraction easier and higher prices bring marginal and new properties into production.

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