Cashing in on Commodities: Gold May Glitter, But Heavy Metals Shine

By Jason Simpkins
Associate Editor

Editor's Note: This is the seventh installment of a new Money Morning series highlighting investment opportunities in the global bull market for commodities.

When it comes to the worldwide metals market, gold may get all of the attention but other, more durable, metals such as steel and iron have proved to be much more profitable. For instance, the price of gold is actually down 2% from mid-January, but steel prices are 50% higher.

Hot-rolled steel, the industry benchmark, has jumped from $600 per metric ton in January to about $1,000 per metric to today. And in the United States, steel for July delivery has doubled to $1,200 a metric ton.

Steel stocks tracked by the Market Vectors Steel (SLX) exchange-traded fund (ETF) are up more than 50% in the past year and 22% this year-to-date. That's substantially better than the Market Vectors Gold Miners (GDX) ETF, which is up only 13% in the past 12 months, and is actually down more than 3.5% year-to-date.

Without question, steel's practicality gives it a decided edge. Demand for steel has risen exponentially as such emerging countries as China and India create the infrastructure that ultimately will house, transport and service the largest and wealthiest populations on the planet.

Some analysts are beginning to worry that as economic conditions in the world's most developed countries weaken, so too will the demand for steel. But according to the Organization for Economic Cooperation and Development (OECD), emerging markets are ready to pick up the slack.

"Global steel demand growth continues to be led by emerging economies to meet the requirements of expanding industrial sectors and infrastructure growth," Risaburo Nezu, chairman of the OECD steel committee, told Forbes. "Demand in many mature economies has slowed in line with weaker economic activity."

The OECD's steel committee consists of industry and government officials from countries that together account for 81% of the world's steel exports.

And according to Nezu, steel use continues to grow most rapidly in the so-called "BRIC" economies of Brazil, Russia, India, and China. In 2007, steel use rose:

18.6% in Brazil
13.5% in Russia
11.3% in India
13% in China

All told, those four countries found uses for 521 metric tons of steel, with China accounting for 78% of that total. Demand in Africa and the Middle East has surged, as well.

For one key Middle East nation - Saudi Arabia, the world's largest oil producer and exporter - oil prices above $130 per barrel have resulted in a veritable "golden age." Now the Saudi kingdom is putting some of its awesome wealth to use by embarking upon a $460 billion construction program. According to the National Commercial Bank (NCB) Saudi Arabia has formally announced 576 separate projects, 70% of which are already well advanced.

"These investments are inspired by the Kingdom's ambitious strategy to tackle the country's most chronic social and economic challenges; rising unemployment and the need to create more than five million new jobs by the year 2020, declining living standards and overall wealth of the population, and the unbalanced regional economic development," the NCB told Emirates Business.

In fact, as Emirates Business reported, Saudi Arabia has opted to curb steel exports to its Gulf neighbors after soaring demand resulted in shortages that left the nation unable to complete its own slate of massive building projects.

Facing a similar plight, India also has been forced to curb steel exports, as domestic demand continues to outstrip the country's production. While demand is expected to grow by 12% a year, the production is growing at only half that rate. Consequently, India was forced to issue export taxes on its own domestic steel industry. The government has levied a 15% tax on the export of hot rolled coils, a 10% tax on the export of cold rolled steel, and a 5% tax on galvanized steel, The Economic Times reported.

As demand soars and supplies tighten throughout the developing world, analysts are beginning to take note and are bumping up their predictions for where steel prices are headed in the years to come.

Goldman Sachs Group Inc. (GS) has already boosted its projected price for steel to $936 a ton for this year, and expects the price will hit $1,000 a ton in 2009. Compare that to fourth-quarter steel prices, which averaged just over $530 a ton, and it's plain to see that steelmakers are in prime position for record profits.

Here are a few companies to consider:

United States Steel Corp. (X): U.S. Steel is spearheading a revival in the domestic steel industry. About 30 U.S.-based steel mills were shut down between 2001 and 2003 as a strong dollar and cheap foreign labor squeezed the American steel industry. But industry-wide consolidation has reduced production costs and a weak dollar has made U.S.-made steel more appealing to hungry foreign markets.

U.S. Steel shares are up about 46% year-to-date, and are up more than 1,025% from their 2003 levels. Analysts at Deutsche Bank Securities (ADR: DB) just reiterated their "Buy" rating on the stock, while raising their target price from $165 to $220 a share.

Posco (ADR: PKX): Posco is Korea's largest steel company, and its shares are trading at 12 times estimated 2008 earnings. It also features a dividend yield of 1.9%. Posco has a large export operation to China, making it a key participant in China's explosive growth.

Although it's the world's third-largest steelmaker, it's the most efficient in terms of output per man-hour. Posco suffers from the rising prices of raw materials; in its case iron ore business, for instance, it was recently socked with a 65% price increase.

Even so, as we've previously reported to you, let's not forget that when Berkshire Hathaway Inc. (BRK.A, BRK.B) Chairman Warren Buffett made his first investment foray into Korea last year, he took a 4% position in Posco - making it one of 20 Korean companies that he invested in. Posco is a well-run company that will become even more attractive should the commodities bubble deflate.

The Companies Fueling Asia's Steelmaking Industry

Steel is in high demand, but it can't be manufactured without iron ore, its key ingredient. For that reason, the price of iron ore has risen sharply in lockstep with steel, soaring 50% since January. Rising steel demand - especially in China - has been the key catalyst behind the price jump and now iron ore producers are looking to take advantage.

The world's largest iron ore producer, Brazil's Vale (ADR: RIO), has already cashed in, boosting prices by 65% to 71%.

However, Rio Tinto PLC (ADR: RTP) and BHP Billiton Ltd. (ADR: BHP) think they can do better. Both Rio and rival BHP are currently in negotiations with China's steelmakers, and are believed to be pushing for an 85% increase in 2008-2009 benchmark iron ore prices.

That's because the two Aussie juggernauts believe their proximity to Asian markets entitles them to a freight premium. Freight accounts for 30% of the landed cost of Australian iron ore in China, but close to 50% of the price of Brazilian iron ore. The Australian miners want some of the difference to go into their corporate coffers.

China - which is the world's largest steel producer and its largest steel consumer -imported 383 million metric tons of iron ore in 2007, an increase of 56.8 million tons, or 17.4%, from the previous year, according to the China Iron and Steel Association.

At some point, China and other emerging countries in the East are going to have to succumb to the demands of BHP and Rio by paying a premium for their proximity.

Both Chinese steelmakers, headed by Baosteel Group Corp., and the miners expect to have a deal done by June 30.
"This has never really ever happened before," James Wilson of DJ Carmichael & Co. in Perth, Australia, told Reuters. "But the prices also have never been this high before, and the Aussies have never before demanded this much."

Merrill Lynch & Co. Inc. (MER) recently boosted its long-term iron-ore-price forecasts by 30% on the back of tightening market conditions. So both Rio Tinto and BHP stand to profit handsomely as the middlemen for Asia-Pacific iron-ore demand.

Not to be outdone by Australia, Brazil recently announced a $27 billion plan to double its iron ore production, Australia's Herald Sun newspaper reported. Paulo Camillo Penna, president of the Brazilian mining institute, said investment would be driven from 350 million metric tons to 650 million metric tons over the next four years. By comparison Australia's projected production of 489 million metric tons in 2012-2013.

This should bode well for Vale, the world's leading iron ore producer.

Durable, Lightweight, and Profitable

Aluminum, like iron ore, is a very useful metal - and not just for beer and soda cans. With its very light weight and low density, aluminum is often the first choice for long-distance power lines. And buildings made with aluminum are virtually maintenance free, due to the aluminum's resistance to corrosion.

The metal also is ideal for the transport industry, which is actually moving away from heavier steel. At a time when fuel efficiency has been pushed into the spotlight by soaring gas prices and growing apprehension over global climate change, aluminum is poised to make a big difference in the transportation sector - particularly the automotive industry.

On May 30, in fact, the U.S. Environmental Protection Agency (EPA) repealed an obscure clean water regulation that restricted the use of aluminum in automobiles. The restriction was driving up the cost of aluminum car parts by forcing manufacturers to use expensive clean-up systems, Forbes Magazine reported. In effect, the May 30 amendment has made aluminum car parts into a cheaper alternative, and that will accelerate industry plans to replace the large amounts of steel currently being used.

Aluminum could reduce the weight of cars substantially, as it weighs roughly half as much as steel does. With every 10% reduction in weight, fuel consumption declines by 6% to 8%, Forbes reported.

The aluminum industry claims that every pound of aluminum used in a car reduces carbon-dioxide emissions by 20 pounds over a hundred miles.

"Fifteen million aluminum-intensive vehicles containing 250 pounds of aluminum would: save 3.5 billion gallons of gasoline [and] reduce CO2 emissions by 37.5 million tons," according to a lobbying document.

Aluminum figures to be a key component in increasing fuel efficiency in everything from automobiles to airplanes. But as demand spirals, supply concerns escalate in kind. Despite the consensus bet that aluminum prices would fall in 2008, they have climbed, soaring 25% since January - mostly due to rising production costs and dwindling supplies.

Goldman Sachs, UBS AG (ADR: UBS), Lehman Bros. Holdings Inc. (LEH), and Citigroup Inc. (C) each have raised their price forecasts for aluminum. Most recently Deutsche Bank raised its forecasts from this year through 2012 by 8%-13% as oil hit a string of record highs over $100 a barrel.

Energy accounts for 40% of the cost of aluminum smelting, compared to 30% last year, Barclays Capital (ADR: BCS) reported. And demand for aluminum is rising 6% annually.

Six new smelters will need to be built each year to keep up with demand, Gayle Berry, an analyst with Barclays told Bloomberg.

Alcoa Inc. (AA) is the world's largest aluminum company, and according to The Wall Street Journal, its prospects look good because of improving fundamentals in the aluminum market and the company's takeover appeal.

John Hill, a mining analyst at Citigroup, thinks that aluminum prices, now around $1.30 a pound, could hit $2 in 2009, the newspaper reported. As a result, Alcoa's earnings could rise to nearly $5 a share in 2009, from an estimated $3 this year.

Alcoa's shares are currently trading at nearly $40 each, up nearly 10% on the year. The shares feature a dividend yield of more than 1.7%.

[Editor's Note: Money Morning's "Cashing in on Commodities" series last covered gold. Next up: Are high commodity prices fueling global takeovers? What are the top profit plays investors should consider?]

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