Jul 24 2008 12:06PM

The arguments continue on both sides of the commodity outlook.

Many of the commodity prices continue to hover stubbornly at or near all-time record highs, in spite of the growing chorus proclaiming that the U.S is either in, or is on the brink of, a recession. The concern over the U.S. economy leads many analysts to conclude that commodity prices will soon come down. For that reason, many investors are reluctant to invest in commodity companies.

A recent cover story in Barron’s, a leading financial journal, vividly demonstrates the thinking that predominates in much of the developed world. The article is entitled “Bye, Bubble? The Price of Oil May Be Peaking” and includes the sub-heading “Here’s where you want to be when the bubble bursts.”

The Barron’s article compares the oil price to the Nasdaq high-tech bubble and quotes a Lehman Brothers economist: “the oil markets have been cyclical for 140 years. Why should that have stopped?”

I’m not for a moment suggesting that I believe the oil price will continue to go higher. In fact, it will most likely correct from the current level, which has been affected by speculators. The best way to see the oil market may be to look at the action in the copper market over the past couple of years. Clearly, speculators pushed up the copper price too far, too fast. After a couple of spikes and pullbacks, the market has stabilized at a level that is only pennies from the highest level ever.

Of course, there are speculators in the commodities markets. However, the author of the Barron’s article seems to have forgotten that every contract in the commodities market has two parties. In the short term, longs can dominate over shorts and push the price higher. In the longer term, fundamentals of supply and demand determine the prices.

The Barron’s article does acknowledge the fundamentals in the oil market. It notes that U.S. oil consumption, on a per capita basis, is 25 barrels a year. In Japan, the figure is 14. The Chinese use only 2 barrels per person per year, 8% of the U.S. consumption level. The figure for India is 0.8, 3% of the U.S. level.

There is no way that China and India and the rest of the developing world will ever come anywhere near to the U.S. level of oil consumption – there simply isn’t enough oil in the world. But, they will continue to increase their oil consumption as more and more citizens in the developing world become wealthy consumers.

Even with the oil price well above $100 for some time now, oil production has barely increased. The focus for many people turns to OPEC and the lingering belief that OPEC nations keep their oil spigots only partly open.

The reality is that fully two thirds of world oil production comes from outside of OPEC. The private sector oil companies would do anything they could to sell more oil at $130 a barrel. They are producing all that they are capable of producing.

Buried deep below the “bubble bursting” Barron’s headline is the acknowledgement that the world isn’t finding oil fast enough to replace the oil that gets pumped every year. Further into the article, another expert is quoted as saying that the commodity bubble “isn’t going to burst. It’s going to continue to expand.” He cites the fact that major oil fields are running dry.

The only arguments put forth in support of the bubble bursting headline are the parallel to the tech bubble and the 140 years of cycles, ignoring the world-changing events now unfolding that have no historic precedent.

Yet, in spite of the bullish evidence put forth, many people looking at the Barron’s article will come away with the headline message: “when the bubble bursts”. Few will take the time to read the article in detail and understand the real message, which is: the oil market may be over-bought at this moment and it may correct, but in the long term it will remain at high levels.

That kind of thinking is rampant throughout the commodities market. There is a mind-set that says that profits in commodity companies are determined by rising commodity prices. For many companies, that may be the case. The real investment opportunity comes in recognizing that there is a serious shortage of supply. The best way to play commodities is to look at the companies that are positioned to fill the supply gap.

A talk that I gave at the World Resource Investment Conference in Vancouver  in June expands on these ideas. It is available on the website at www.resourceopportunities.com

If you would like to receive free market commentary from Lawrence Roulston’s Resource Opportunities Newsletter, simply CLICK HERE to add yourself to the list.

Lawrence Roulston

*****

For only $265 US per year, you can be the first to read Lawrence Roulston’s market commentaries and Subscriber-Only company commentaries and alerts. CLICK HERE for more information