Two Ways to Cash in on the Commodity Craze

By Martin Hutchinson
Contributing Editor

When Brazilian iron ore producer Vale (RIO) [formerly Companhia Vale do Rio Doce] induced its Asian steelmaking customers to agree to a 67% price increase for the iron ore it supplies, it demonstrated a key challenge companies face in today’s inflationary markets: It’s nearly impossible to control the cost of the raw materials that form the basis of their products.

One of the biggest players to get nicked by this price hike was South Korea’s leading steelmaker, the Seoul-based Posco (PKX). On Friday, Posco, the world’s fourth-largest steel producer, turned around and said the increase in iron-ore costs would force it to boost steel prices – though it had yet to decide by how much. Iron ore is the key raw material in the steelmaking process.

“With raw material prices soaring, wouldn't it be necessary for us to raise steel prices?”  Lee Ku-Taek told journalists after Posco’s annual shareholders meeting. “We will have to consult with our clients on how much we will raise the prices.”

[Posco is also embroiled in negotiations for coal, and many analysts are predicting that so-called “coking coal” – also key to the steelmaking process – will double in price as a result of the contract talks with coal-mining companies that are now under way. For our just-published investment research report, “Why Coal - the World’s Forgotten Fossil Fuel - is About to Double in Price,” please click here. The report, part of our ongoing “Outlook 2008,” investment-opportunity series, is free of charge].

The Lowdown on Commodity Prices

Back in the 1990s, it was a different story. Posco was the most efficient steel producer in the world, and was therefore expected to dominate price setting in the steel market, because its costs were lower than everybody else’s. The fact that Korea has no significant resources of iron ore, steel’s key ingredient, didn’t matter: Iron ore was a commodity, and was readily available on the international market. If iron ore prices rose 10%, steel prices could be expected to rise by the appropriate fraction of 10% [depending on what fraction of steel’s input costs iron ore constituted], because everybody was paying the same cost.

That is no longer the case. Commodity prices have been rising sharply for half a decade, and rapid growth in demand from the world as a whole – but particularly from India and China – have made supplies much tighter. The best example of this is crude oil, which is especially sensitive because of its strategic importance and the political instability of many key suppliers. The same is true with other commodities, such as iron ore, even though Brazil is a politically stable country and its supplies of iron ore are plentiful. 

The problem even extends to so-called “soft commodities:” Wheat prices are up 80% this year because of a poor Australian winter wheat harvest, while the corn-price increases caused by the economically absurd U.S ethanol subsidy program actually caused riots in the streets of Mexico City after the price of tortillas soared. Cotton could be next.

Posco vs. Vale

The vulnerability of companies without their own source of raw materials has shown in their recent stock prices.

  • Posco shares are down more than 30% from their October 2007 peak, as it became clear the company’s production efficiency and strong sales are both vulnerable to price increases in raw materials.
  • But Vale’s shares have soared more than 80% over the last 12 months; its own costs from digging out and processing iron ore have changed very little, while its sales have soared due to higher prices charged.

Vale is still trading at less than 16 times earnings [12 times projected earnings], but earnings can be expected to increase sharply with the new price increase it has negotiated.

One caveat: This can’t last forever. The sharp increases in natural resources prices have been caused by the policy of excessively easy money followed by the U.S. Federal Reserve since 1995. That monetary policy has produced surplus liquidity all over the world, and now it’s poised to cause inflation to spike through the mechanism of commodity-price increases. The interest-rate cuts enacted by Fed Chief Ben S. Bernanke since August – which have taken the benchmark Federal Funds Rate from, 5.25% to 3.0% – have made the worldwide inflationary effect much worse, however much they have helped Wall Street and the subprime mortgage market. Thus, U.S. import prices were up 1.4% in January, constituting an annual rate of increase of almost 17%.

At some point within the next few months, you can expect that these rapid commodity price increases will start to be reflected in U.S. inflation and in consumer price inflation elsewhere. When that happens, Bernanke in particular and other central bank heads in general will have to raise interest rates, in order to start fighting inflation. That will cause a decline in commodity prices, as growth slows and expansion projects become more expensive.

The result: Posco will start to see its environment become more friendly, while Vale’s environment becomes significantly less friendly.

The timing of this reversal depends not just on higher inflation appearing, but on central banks reluctantly deciding they have to do something about it. That may well happen by the end of this year, but seems more likely to play out sometime in 2009, as price declines in the bond market force Bernanke’s hand, while a new president can blame any resulting hardship on his or her predecessor, President George W. Bush.

Meanwhile, companies that are rich in natural resources may be in for another exciting ride.

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