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Will
the rally last?
What
makes the commodity sector performance tick?
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The shares of many of the world’s biggest producers
of minerals and metals have outstripped the majority
of their blue-chip peers in the past 12 months. For
long-term investors in commodity stocks, the rally will
feel long overdue. We believe the upturn will last and
have identified several factors that should drive commodity
sector performance for years to come.
Structural change
Years of poor returns have forced commodity suppliers
to strip out wasteful practices and drive cost savings.
Many of the problems that have besieged the sector stemmed
from the commodities boom of the 1970s, when US economic
policy sent commodity prices soaring, triggering massive
investment in production capacity and the establishment
of a host of marginal producers.
The lean times since the 1980s put an end to investment
in new production, reducing overcapacity and forcing
the closure or sale of the marginal producers whose
reckless pricing policies had exaggerated the effects
of demand fluctuations.
The companies that are left now are big, highly geared,
efficient and have a global reach. In other words, they
are the sort of companies suited to an industry with
high capital expenditure and low marginal costs of production.
The
inflation effect
We are already seeing the weaker dollar feeding back
into price rises across the commodity spectrum.
An
OPEC conference in December 2003, for example, noted
“with some concern, the decline in the purchasing
power of the barrel as a result of current US dollar
weakness vis-à-vis other major currencies.”
On the back of this “concern” the price
of oil, in US dollars, has risen to record highs of
$40 a barrel recently.
Steel
makers, meanwhile, have increased their prices by an
average
of 20 per cent for 2004 in response to an increase in
the cost of their
raw materials.
All of this will eventually feed into inflation. Crucially
for investors looking for a trend that will drive outperformance
in the commodity sector, that has not yet happened.
There
seems little doubt, however, that increased inflation
is on its way. This is further good news for the commodities
sector. Once it begins
to manifest itself in standard gauges such as Consumer
Price Indices
(CPI), investors will increasingly turn to commodity
stocks as a way to hedge their portfolios against inflation.
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