Commodities benefit from timely growth

Serious Money: Leading the charge in the most recent stock market rally have been mining stocks. BHP Billiton is a prominent member of that group and was first tipped by Serious Money two years ago (first rule of stock tipping: repeatedly remind people of your successes and let them remind you of the failures), writes Chris Johns

Billiton mines coal, iron ore, gold, titanium, nickel and copper. It also has interests in oil production and refining. Anyone with a nodding acquaintance with that list of commodities will not be surprised - given how much prices of these basic materials have risen - to learn that Billiton has risen by 116 per cent since April 2003.

The obvious ancillary bet has been on oil stocks. The arguments surrounding commodity prices have applied with equal force to oil prices, but it may come as something of a surprise to see how poor the relative performance of oil stocks over the recent past has been. The emphasis here is on the term relative: BP, for instance, has risen by 40 per cent over the past two years - still a healthy rise but nowhere near as stellar as its commodity cousins. Moreover, the greater proportion of that rise occurred in the five-month period of May to September last year.

The drivers of the underlying assets of these businesses are clear: BHP and BP own lots of stuff that is currently in short supply. It has become a cliché to point to the rise of China as the key reason for higher oil and commodity prices. China has, it is true, been growing rapidly and is a voracious consumer of basic materials. But other factors have been at work, particularly recently: the US economy, still the world's largest by a mile, has continued to bound along. And the world's second-largest economy has suddenly started to grow again after being missing in action for the last decade and a half. Don't underestimate the significance of a Japanese economic resurgence.

Even Europe looks like it might be joining the party. Synchronised global economic expansion is coming as a bit of a surprise to many market participants. Indeed, a significant number of people have never experienced one. So, what happens next? Is it still right to be long commodity stocks? Will oil stocks continue their sideways moves?

Some experts think we are at the start of a commodity "super cycle".

The idea here is that Chinese growth, along with other rapidly industrialising nations like Brazil and India, means that demand for commodities will far outstrip supply. One or two lurid forecasts have even suggested that we could, within a decade or two, simply run out of things like copper. Most analysts are, however, sceptical. The history of this industry reveals a hugely pro-cyclical pattern of capital investment: just when demand for commodities starts to weaken, supply starts to pick up a result of the digging of far too many holes in the ground.

New capacity typically comes on stream when demand starts to fade, thereby producing hugely exaggerated downswings in commodity prices and the share prices of the associated companies.

To argue that "this time is different" is always a dangerous game to play. A good rule of thumb for investors is to regard such arguments as a guaranteed way of losing money. To invest in commodities right now is to believe that the future is, indeed, going to be quite unlike the past.

On the demand side, the bet is clear: global growth continues on its merry way. Regular readers will not be surprised to learn that I have a lot of sympathy with this view. It seems that the only thing that stands in the way of robust expansion for at least the next couple of years is the behaviour of the world's central banks. Provided they don't make a mistake and put rates up by too much, the bet has to be that the global economy will continue to reflate.

That, on the face of it, looks to be good news for commodity producers. But some interesting nuances could be contained within that robust overall story. In particular, there are noises coming out of China that suggest the story is about to change.

The authorities seem to have recognised that a big rebalancing is required such that there is far more consumption and much less capital investment (the reverse of what is needed in the US). Less investment in China could spook the commodity markets as this has been where much of the demand story has been sourced. Markets might also be concerned that the Chinese government may not be able to pull this trick off painlessly: we might just see a slowdown rather than a rebalancing.

Then there is geology. I'm no expert, but it must be likely that the current level of commodity prices induces one or two producers to sink a few mines. The companies themselves seem to have learned some of the lessons of the past and are more capital disciplined than before. But the temptation to produce more must be very strong. Incidentally, it is worry over the need to spend lots more money on exploration that has, in part, held back the share prices of oil companies.

I'm also tempted to make a simple market-related argument based on the observation that few asset classes go up for long without some form of correction. Commodities have had an amazing run and could be due for a correction, if only because that's the way markets typically behave.

Commodities are not for the risk-averse investor. And the risks of a correction must be growing. I think the time has come to take some money off the table. My (virtual) bet on BHP is cut in half and I will implement a "trailing stop", which means that if the price falls by 15 per cent from here I will sell the remaining position.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.