By Neville Bennett

My analysis of historical trends supports a strong outlook and opportunity in many commodities. Prices plunged last year after the bubble. I predicted production would be sharply cut because inventory was huge. Once the inventory-overhang was slashed, there would be a price rise because some producers would lack the funds or credit to resume production.

I am not suggesting another boom: demand is not sufficiently strong to encourage much new investment in increasing capacity in industrial metals, but it is in good precious metal and oil prospects.

The shrinking value of the US dollar, broadly associated with lax monetary and fiscal polices like quantitative easing encourages some investors to use commodities as a store of value. AS US $ values fall, commodities prices compensate.

Recent Miner rally
Four of the 10 blue-chip gainers on the FTSE 100 last week were miners. This followed a strong recommendation by Credit Suisse citing on "on-going recovery" in metals. The ASX200 Resources is 53% up from its November 2008 lows. Obviously purchasing now owes less to value than momentum, although stocks have low price to earning multiples.

Gold has vaulted US$90 this month to US$960 driven by positives, ranging from China's decision to double its bullion reserves, to a floundering US dollar. One dealer, Paulson & Co alone holds 1106 tons, three times the UK's reserves! Gold has beaten the S&P 500 index by 500% this century, and should continue to out-perform.

Back in December, oil was below US$40, and prominent people in the industry predicted US$30. Actually it is trading around U$62: up 85% on three months ago. It is driven by increasing consumption, as well as a supply crunch. Supply has been lowered by OPEC output cuts and a clamp on production. Rigs have declined by 42% since September because credit lines have been cut.

The International Energy Agency says that spending on exploration and production will decline by 20% this year. Moreover, the biggest fields are declining in output. This indicates the possibility of a "vertical supply curve": a dangerous situation which means that a small increase in demand could stimulate much higher prices.

Why Metals Shares Crashed
Many metal producers are at about half the market valuation of early 2008, following a sharp fall in prices after the bubble. Sky-high prices for commodities were not, however, the principal driver of the collapse in demand. That was more a result of market activity, especially a collapse of spot prices on futures markets.

This collapse was a part of the deleveraging of the credit crisis. Debt almost ceased to be available. Distressed sales then dominated, driven by margin calls and the unwinding of complicated strategies, sometimes funded by yen-based "carry-trade". Contracts were sold down, and a gap emerged between price and value.

When the dollar also rose sharply in value in the Northern Hemisphere autumn, there was a perfect storm in working capital. Many companies could not get credit, and were forced to sell stocks, inventory and assets into a falling market in order to get cash to pay back their loans.

Smaller companies have been ferociously compressed in market value. Many Aussie miners fell to 10% of their highest price.

How Metals Reacted

There is now a two-tiered system: the ones that have cash and the desperate without cash. Both had to cut costs immediately, and most also cut capital projects entirely or delayed them. Mines with negative cash flow were closed and many will not re-open. Companies with strong balance sheets have sought acquisitions but sellers have largely held out. Mergers seem easier. China has closed some deals.

There could be a mass extinction of smaller companies. At present only about 150 are listed in London, but Toronto lists 356, and more than 1000 miners on its TSX-Venture board. There are 600 on the ASX. Most are looking for a partner, acquirer or an angel investor. Many will go private to reduce costs.

Ernst and Young* estimates that 14% of AIM miners on the London Exchange have a capitalization of less than their cash holdings, and 29% of those have only less that ₤1 million. Their "burn-rate" is high ( the burn-rate is the speed of spending).

Exploration
Exploration has been sharply reduced, even for gold. This is severe as exploration is the R&D of mining; the source of future cash flows. But acquisition is important where most good ground has already been pegged. Existing mines' output is subject to falling grades. It will take a long time to gear up to meet the demands of a recovered world economy. The future will have severe supply constraints.

Debt finance remains a constraint. Major companies have enthusiastically accessed the bond market. This emphasizes a new model in the industry. No longer is capital raised for one mine. The new model is a large company with equity and bonds providing sufficient capital to finance new mines.
Mining shares have been dumped by the marker. Early in March, the p/e ratio of all miners on the London Exchange was 3;1, the lowest p/e group of all. In contrast, the Life insurers group had a p/e of 30. Even automobiles and Parts had a p/e of 25: !.

Rosy outlook

It is hard to see recessions on production graphs of aluminum, copper and zinc over 40 years. History shows an almost unstoppable growth in the use of these metals, particularly aluminum. Recessions have damaged prices in the past but output keeps expanding . The charts for coal and steel are flatter, but there are no serious dips in output in previous recessions. This view of the past, questions current gloomy forecasts

Markets have over-sold mining shares because production has fallen, exploration has almost ceased, and capital investment in infrastructure has fallen away. But the world population keeps growing, especially in emerging markets. The inventory over-hang will soon go and prices will recover. The large infrastructure spends in many economies will be good for metals