Some analysts say a slight decline in Chinese demand may help commodities in the long-run


Oct 04 - 10, 2004





Throughout the first half of this year, investors in commodities fretted about China. They worried that its economy was in for a hard landing, as construction, property values and equities all seemed to be overheating.

Such a landing could be disastrous for commodities companies, which have profited from some of the strongest global demand for resources in decades. Much of that demand has been driven by China, which now accounts for 30 percent of world coal consumption and 40 percent of steel consumption.

So far, however, the fears have generally not been borne out. Loan growth in China slowed by 7 percent from August 2003 to August 2004, and while inflation has remained strong, it has been below forecasts. China's consumer price index rose by an annualized rate of slightly more than 5 percent in August. Many analysts now say that China's economy will grow 9 percent this year.

As a result, said Phil Flynn, senior market analyst at Alaron Trading, a futures and options brokerage in Chicago, commodities and shares of mining companies around the world, which have posted sizable gains over the last two years, are still a solid long-term bet. "We're in an era of tremendous opportunity for commodities, and it's going to be one of the biggest sectors not for one year, but for 5, 10 years," Mr. Flynn said.

Moreover, commodity companies do not have to deal with the same headaches as manufacturing or service businesses supplying China. After all, commodities like coal are tough to pirate, and their producers do not need to worry about winning over Chinese consumers to a brand name.

What's more, said Thomas K. McKissick, managing director at TCW Asset Management and lead manager of TCW's Galileo Large Cap Value fund, commodity prices have been so low for so long that even recent demand has not bolstered supply enough. "You were in a 20-year bear market for commodities," which reduced capacity, he said, noting that China still had little of its own manufacturing and transportation infrastructure in place.

Some analysts say a slight decline in Chinese demand may help commodities in the longrun. According to Merrill Lynch's recent report on metals, "Some slowing in Chinese demand is good for the metals market, because high prices always lead to too much supply being brought on the market."



Indeed, though the London Metal Exchange index, a predictor of commodity demand, fell nearly 15 percent in April and early May on fears of Chinese cooling, it has largely recovered. Michael Bradshaw, a senior analyst covering basic materials at Pioneer Investments, said he believed copper was in the shortest supply of all commodities, because there were no easy substitutes for it in industrial processes. China's copper imports were up 20 percent in August, versus the same month in 2003.

Accordingly, Mr. Bradshaw favors Phelps Dodge, a mining company with significant copper assets. Phelps Dodge posted second-quarter earnings of $2.30 a share.

He also likes the Rio Tinto Group, a diversified miner with bases in Australia and Britain. Rio Tinto, whose American depository receipts trade on the New York Stock Exchange, sells its iron, coal and other products directly into China, Mr. Bradshaw said. (Roughly 70 percent of China's energy is derived from coal.) The company posted record profits for the first half of 2004.

By comparison, the mining giant Freeport-McMoRan Copper and Gold, based in New Orleans — which Mr. Bradshaw also favors, though less than Rio Tinto — sells onto the open market, rather than directly to Chinese companies, and thus benefits less from China's growth.

Aluminum has also remained strong, and several metals market analysts predict that worldwide demand will climb 8 percent this year. Mr. McKissick said the aluminum giant Alcoa "is one of our favorites."

"They manage capital well and they benefit from demand in China," he added.

Rather than focus on companies, some investors may put money directly into commodities. But Mr. Flynn of Alaron cautioned that this could be risky, especially for people who are not willing to track the commodities daily. "Futures and commodities are highly leveraged and very volatile," he said. "Go in with your eyes open."

Individual investors interested in exposure to commodities can invest in a fund based on a commodities index.

Dan McNeela, senior natural resources analyst at Morningstar Inc., prefers the Pimco Advisors' CommodityRealReturn Strategy fund to its main competitor, the Oppenheimer Real Asset fund.

"Pimco has a more diversified basket of commodities," he said. "Oppenheimer's fund is skewed much more heavily toward energy commodities; this increases the level of volatility for investors and makes oil prices dominate the fund."

The Pimco fund is up more than 30 percent in the past year. Still, he cautioned, commodity funds are more volatile than natural resources funds, which invest in shares of mining and energy companies and thus have less direct exposure to volatile raw-materials prices. Mr. Flynn says commodities should be no more than 10 percent of an average investor's portfolio.

The commodity sector, after all, can have risks other than volatility. Mr. McNeela says he has "geopolitical concerns, worries about commodity supply disruptions" from terrorist attacks and other causes.

And several large mining companies, like Freeport-McMoRan, have major operations in countries with high potential for political instability, like Indonesia, where nine people were killed and more than 180 injured in a terrorist attack this month. Still, Mr. Bradshaw said, Freeport has been operating in Indonesia for 30 years and understands the local environment.



—Courtesy New York Times