Falling Commodity Prices

Falling Commodity Prices: The "Other" Commodities
by Eric J. Fry
The Rude Awakening
Wall Street, New York
February 15, 2006

Eric Fry examines Falling Commodity Prices and points out that some are more overvalued than others.

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[Joel's Note: In today's Rude Awakening your commodity
savvy editor, Eric Fry, takes a closer look at some of the
intricacies involved in trading this particular, and
peculiar, market successfully. Of course, everyone has his
or her own opinion on how to master this beast. If you care
to share yours, please write to me here at
aussiejoel@the-rude-awakening.com

Just remember, in doing so you run the risk of joining our
growing list of "guest columnists" in the Monday Mailbag.
And now, Mr. Fry...

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The "Other" Commodities
By Eric J. Fry

"Rogers, Wien See U.S. Commodity Producers' Shares as
Overvalued," a Bloomberg News headline declared. "Jim
Rogers and Byron Wien are still bullish on commodities
after their biggest weekly decline in 15 years," the news
story explained, "Yet they view the shares of U.S. raw-
material producers as overvalued."

Your New York editor would not rush to disagree with either
Rogers or Wien, but he would add one important
qualification:

Some commodity shares are more overvalued (or less
undervalued) than others. That's because the supply/demand
factors influencing the price of crude oil, for example,
are not identical to those influencing the price of
soybeans.

Falling Commodity Prices: Buy Stuff, Not Stocks

Jim Rogers, the hugely successful former hedge fund
manager, is a full-time fan of physical commodities, but
only a part-time fan of resource stocks. In fact, he
created his own commodity index in the late 1990s (along
with a fund that mirrors the index). So when he says,
"Don't buy the stocks. Buy the stuff itself," he is both
offering honest investment insight AND "talking his book."

But that doesn't mean we should not heed his advice. Rogers
correctly notes that "costs are going through the roof" for
many commodity producers, thereby reducing the profits they
would be earning from the soaring prices of their products.
As faithful Rude readers may recall, we anticipated and
examined this phenomenon in the column of September 16,
2005 entitled, "What's an Ouroboros?"

"For more than four years," we noted, "most natural
resource companies have been enjoying brisk demand for
their products...and rising prices. Unfortunately, rising
commodity prices are causing production costs to increase
sharply for the commodity companies themselves, thereby
eating into their profits. We should not be surprised,
therefore, if profit growth at many resource companies
begins to slow down, or grinds to a halt completely."

As anticipated, steel makers, copper minors, gold miners,
fertilizer producers, chemical companies and many other
types of commodity-based companies are all suffering from a
toxic combination of high energy prices and mounting labor
costs. Therefore, profit growth at many resource companies
is, in fact, grinding to a halt. Based on Wall Street's
consensus forecast, the profits at basic materials
companies in the S&P 500 will fall 8% in the first quarter
of 2006, compared to a 9% increase for the rest of the S&P
500 companies.

Phelps Dodge, DuPont and Alcoa number among the many
resource companies that have reported disappointing
earnings due to rising costs. The "cost of goods sold" at
Phelps Dodge, the world's biggest publicly traded copper
producer jumped $1 billion last, as energy costs jumped
more than 23%. Alcoa suffered a similar fate, which lead to
a surprising drop in first-quarter profits. "Entering
2005," CEO Alain Belda explained, "we anticipated
significant pressures from rising input, energy costs and
other cost inflation, but actual increases were even
higher."

The cost side of the profit and loss statement, however, is
not what worries us most. It is the revenue side. The
prospect of falling commodity prices poses a much more
serious threat to profitability than the prospect of rising
production costs, especially if the most buoyant commodity
markets, like crude oil and platinum, deserve their recent
savage declines. If, as many seasoned commodity traders
believe, "artificial demand" has been boosting the prices
of many commodities, then the current washout in the
commodity sector may signal something more serious than a
mere "correction."

Falling Commodity Prices: A Prophecy

"Billions of dollars of long-only index-fund money is
pouring into these markets," observed commodity-trader,
Richard Morrow, in the February 3rd edition of the Rude
Awakening, "And that's throwing the traditional fundamental
influences all out of whack. These markets are just too
small to handle an influx of money this large...I can tell
you this; if the money-flow into these markets stops,
there's going to be some great opportunities on the short
side."

Immediately after Morrow's Delphic warning, the commodity
markets tanked. Likewise, the stocks of most commodity-
producing companies. But maybe the high-flying resource
stocks deserved their whuppin'. Certainly, they had enjoyed
a spectacular run over the last few years – a run that may
have become a bit too spectacular over the last few weeks.

Even though the Goldman Sachs Commodity Index (GSCI) topped
out last September, for example, the ETF of resource stocks
(NYSE: IGE) that mirrors the weightings of the GSCI
continued soaring into late January. In other words,
resource stocks continued climbing, even though the prices
of the underlying resources did not. The ferocious 11% drop
in the price of IGE so far this month, therefore, is not
entirely unwarranted.

But before panicking in the face of these wicked declines,
we should take a peak inside the commodity indices to see
what's up and what's down. For example, the energy complex
has been dropping sharply, while the grains have barely
budged. In the month of February alone, crude oil has
fallen 14%, while unleaded gasoline has tumbled 20%. But
the prices of corn, wheat and soybeans have registered very
slight declines. And many of the agriculture-based stocks
have actually GAINED ground. Corn Products International
(NYSE: CPO), Archer-Daniels (NYSE: ADM) and Agrium
(NYSE:AGU), to name three such companies, have all advanced
in February...and for the year-to-date.

This divergence between the energy complex and the grains
may contain the kernel of an opportunity: sell what's been
frothy to buy what's less frothy. The ag. Sector, which has
been about as frothy as a week-old glass of champagne,
suggests itself as one possibility.

As the nearby chart illustrates, ag. commodities have been
conspicuous laggards throughout the resource bull market of
the last few years. Perhaps their day will soon arrive. We
based this conjecture on no greater wisdom or authority
than the mere idea that markets tend to be mean-reverting.
Thus, as the chart also suggests, energy prices are rolling
over at the same time that ag. prices are turning up. Hence
a possible mean-reversion has already begun. The fact that
the agricultural sector has been trailing far behind the
energy sector does not automatically imply that the energy
sector is a "sell" or that agricultural sector is a buy,
but it does raise that possibility.

So rather than "sell the stocks and buy the stuff," as
Rogers suggests, maybe it would be better to sell some of
the stocks and some of the stuff, and buy OTHER stocks and
OTHER stuff...like the stocks of agriculture-based
companies.

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And the Markets...

	Wednesday	Tuesday	This week	Year-to-Date
DOW	11,059	11,028	140	3.2%
S&P	1,280	1,276	13	2.5%
NASDAQ	2,276	2,262	15	3.2%
10-year Treasury	4.60	4.61	1.00	20.00
30-year Treasury	4.58	4.59	3.00	4.00
Russell 2000	725	720	8	7.7%
Gold	$540.45	$547.35	-$10.35	4.5%
Silver	$9.21	$9.33	-$0.16	4.4%
CRB	320.75	325.05	-10.85	-3.3%
WTI NYMEX CRUDE	$57.97	$59.41	-$3.87	-5.0%
Yen (YEN/USD)	JPY 117.87	JPY 117.43	0.05	0.0%
Dollar (USD/EUR)	$1.1888	$1.1916	13	-0.4%
Dollar (USD/GBP)	$1.7407	$1.7364	34	-1.2%