Gold and oil have slumped but strong demand is keeping most commodities chugging along

JEFF BUCKSTEIN

Commodities markets have been on a hot streak the past few years, one many experts feel has a long-term foundation in a strong global economy despite signs that a speculative push may have temporarily overheated some items.

"If you go back to 2001, we've seen a pretty strong run in commodities," says John Johnston, Toronto-based chief strategist for the Harbour Group, an asset management group with RBC Dominion Securities Inc.

But "the situation went parabolic, particularly in the latter part of 2005 and first half of 2006 in many of these markets," providing "a strong sense there was some speculative froth in there," amid warning signs a correction would follow, Mr. Johnston adds.

Indeed, a correction has affected certain commodities, some by a large amount. Gold, once above $700 an ounce, is now about $600; oil is well off its peak of $78 a barrel and now closer to $60; and natural gas has dropped from $15 per million British thermal units to about $7 per million BTUs (all figures U.S. dollars).

But Mr. Johnston and many other experts view this as a short-term phenomenon that won't stand in the way of a commodities juggernaut in the long haul.

There are two basic schools of thought about what is fuelling the commodity boom. One is that this is part of a secular trend (long term, generally regarded as being greater than 10 years) that will continue into the foreseeable future. The other view is that this is cyclical, along the lines of a business cycle that may last several more years, and that once the commodity boom is over people will revert to more normal ways of investing.

What is causing this surge in commodities? Two major factors top the list: a strong global economy, coupled with a short supply of key items.

"In many ways you can say that the current global environment is very much like the 1950s, when western Europe and Japan were emerging after having to rebuild in the aftermath of the Second World War. Now we have a whole new series of buyers coming along in the marketplace. We've had the best run in the global economy since the early 1970s," Mr. Johnston notes.

Base metals, such as nickel, copper, aluminum and zinc, have done particularly well and are coveted by China and other countries with rapidly modernizing economies.

Nickel, for example, recently attained record highs and is still hovering at a strong $15 a pound, backed by a strong demand around the globe for stainless steel, most notably in the United States, Europe, China and Japan, says Patricia Mohr, vice-president, economics and commodity markets specialist at the Bank of Nova Scotia in Toronto.

Another key factor in the current high price of nickel is that supplies in warehouses around the world are at "critically low" levels, she adds.

"Most of the strength in base metals is not speculative at all. It reflects very tight global supply and demand conditions," notes Ms. Mohr, who forecasts that the average price of nickel will be $11.15 a pound in 2007, up from $10.62 in 2006 and $6.68 in 2005. "I think on balance most of the base metals are going to remain very profitable right through next year."

Another hot commodity produced in Canada is zinc, which reached record highs of $1.81 a pound in May. "Anything over $1 [a pound] is extremely lucrative for most zinc producers," Ms. Mohr notes.

Copper is also performing well, she says, and "will probably remain quite high for at least the balance of this year," fuelled by concerns about strikes at several key mines in Chile which could further tighten the supply.

Uranium, used in nuclear reactors around the world, is another in-demand commodity, with a spot price of around $55 a pound, up significantly from last year, says Ms. Mohr, noting that Canada is the largest producer of this mineral.

"The operating costs for a nuclear reactor are quite low in terms of fuel costs, so there's a great deal of interest," Ms. Mohr says.

"There are probably going to be 168 nuclear reactors built around the world between now and 2020, and utilities are starting to contract term supplies for new reactors coming on stream in the next four to five years. So the price has moved up tremendously, and I think it has further to climb."

Ms. Mohr notes how two commodities that appeared to be driving the surge a year ago -- oil and gas -- are still strong but have tailed off since hurricanes in the southern United States helped push prices to "spectacular record highs." But the "geo-political risk premium in oil has narrowed in recent months" and U.S. inventories of crude oil and petroleum products have built up to comfortable levels, she says, forecasting a price of just above $60 a barrel on average for 2007.

Natural gas, meanwhile, "plummeted during the late summer" to about $4.10 per million BTUs, but has since bounced back to about $7, with room to rebound further, she says. Gas storage in the United States is "more than ample right now, so we're not expecting a surge.

Ms. Mohr thinks that crude oil and natural gas have had their correction, and that those commodities should strengthen over the next few months as Canada moves into the winter heating season for 2007.

Another strong area is agricultural commodities. "We've seen a very, very good market, particularly in the last year and a half or two years," says Will Hill, senior vice-president of the Winnipeg Commodity Exchange, which deals exclusively in agricultural products. The 119-year-old exchange trades between about 10,000 and 12,000 contracts a day, worth some $16-billion (Canadian) annually.

Mr. Hill attributes the healthy market, which has seen the Winnipeg exchange's trading volume increase 35 per cent for the fiscal year that ended Sept. 30, to three major factors. The first is that commodities in general have attracted so much interest, this has had a positive spillover effect on agricultural items, even when the strongest performers come from other sectors.

A second factor is that there is a huge interest in canola -- one of the major products for the Winnipeg exchange -- both on the food side because it's a healthy oil, and on the bio-diesel side as an alternative fuel.

Third, the Winnipeg exchange moved to an electronic trading platform in 2004, increasing volume, Mr. Hill explains.

Experts note that the performance of commodities in general has prompted many money managers to view them as an alternative asset class, capable of balancing a portfolio heavily weighted with traditional instruments such as equities and bonds.

In fact, institutional hedge fund managers have shown interest in commodities precisely because they tend to move in opposite directions to instruments such as stocks and bonds.

Moreover, although commodities still attract their share of speculators and hedgers, many of today's investors take a more strategic stance toward having a commodities exposure in their portfolio.

"I think commodities should sometimes be part of a long-term portfolio -- just not in extraordinary proportions," says Mark Chow, a senior fund analyst with the Canadian office of Morningstar Research Inc. in Toronto. "Small amounts added to an overall portfolio can give you a much more efficient portfolio."