Thursday, October 27, 2011

It's Time to Buy these 3 Commodities

When it comes to commodities, there are two factors that dictate prices. The first factor is the underlying demand for the commodity, which can exceed or lag relative supply. The second factor is the technical picture, which is in focus for global investment-bank desks, which simply respond to the direction of a price of a commodity while paying little attention to the fundamental forces in place.

Right now, it's the latter factor ruling the markets. Many commodities are being dragged down by technical factors as losing sessions beget more losing sessions. As a result, silver, platinum and copper have all been sucked down, each trading more than one standard deviation below their 50-day moving average. On a technical basis, this "oversold" condition usually is a considered a "buy" signal. Come to think of it, the fundamental picture also means it's also time to buy. Let's take a closer look...




These three metals sold off sharply in recent months on fears that the global economy -- led by a sputtering U.S. economy -- was headed for a slowdown that would crimp demand for these commodities, which have a range of industrial applications. Yet as we've seen in recent weeks, the potential systemic shock that some were anticipating in July and August is now less likely to happen: Recent U.S. economic data have been decent enough to likely deter a recession; Europe is belatedly tackling the Greek debt crisis, and the rest of the world is cooling to a more moderate but still-respectable rate of growth.

This means demand for these commodities is unlikely to slump sharply from current levels, and pricing should rebuild at least part of the way back. This isn't a call for a boom in the commodities sector, but a solid opportunity for a rebound snapback. If that's the case, then what's the best way to play for each metal?

Silver
Mining firm Couer D' Alene (NYSE: CDE) is always a solid play on silver when the metal is in an oversold state. I made a pair of suggested trades on this stock earlier this year. Back in January, I thought it looked undervalued at $22. But in April, I thought the stock had run too far too fast -- up to $35, and suggested profit-taking (or even possibly shorting the stock).

With the stock back at $23, it looks like the light is flashing green again.

This is because industry watchers have set their 2012 price targets for the underlying spot market for silver in 2012, and the outlook is good. A survey of 11 silver analysts by Bloomberg predicts silver will rebound to $42 an ounce in the first quarter of 2012, up from a current $32. The most bearish of the analysts surveyed sees silver falling from its current price around $30 to about $27, so the current price isn't far from that view.

Assume silver stays put at just $30 an ounce in 2012. In that event, UBS' analysts figure Couer D'Alene could offer up a solid dividend in 2012 -- yielding 7% at current prices, which assumes a 50% payout ratio). As I noted back in January, the miner has completed the most exhaustive phase of its capital spending program and will soon be generating robust free cash flow. In a recent note, UBS noted: "On their most recent conference call [Aug. 8], management indicated that the dividend policy is something the board will be evaluating as cash continues to accumulate. Management indicated they believe 'returning capital to shareholders is a 2012 event...'" In a more bullish scenario, the dividend math becomes more striking. Assuming silver rebounds back to $40 in 2012, a 50% payout equates to a 12.5% dividend yield, according to UBS.

Couer D'Alene will release quarterly results on Nov. 7. Pay close attention to management's commentary about potential dividend plans. This could wind up being a nice snapback AND dividend play.

Copper
There are several ways to play a rebound in copper, but miner Freeport McMoran (NYSE: FCX) is the most logical candidate, due to its heft and global exposure. Shares plunged from $55 to $30 late this summer and are now inching their way back to the $40 mark. The fall from those mid-summer highs is largely due to concerns that China, the biggest consumer of copper, was on the cusp of an economic slowdown. Yet on Monday morning, Oct. 24, a key manufacturing index showed that the sector expanded in September for the first time since June.

Analysts at Merrill Lynch predict copper prices will stay in the $3.40 to $3.80 per pound range from now through the end of 2013. (The current spot price is $3.40, down from $4.50 this past July). Based on this range Merrill Lynch's analysts think Freeport-McMoran's stock is quite undervalued. They figure the firm's mining assets are worth roughly $65 a share, and they have an overall price target of $57 a share (which is derived on a blended price-to-net-asset-value, price-to-cash-flow and price-to-earnings basis). That price is where the stock was earlier in the year, and reflects 45% upside from current levels.

Platinum

The recent sharp drop in platinum, from $1,900 an ounce in mid-August to a recent $1,500 is a bit curious. Demand for the metal isn't really dependent on China, but instead is a key metal for the auto industry, which uses platinum in catalytic converters. Scarcity is the real driver here, as it is only mined in South Africa and Russia, and Russia has warned that its output will begin falling. Meanwhile, auto industry production is expected to rise the next few years.
If you're looking for a way to play the sector, then the ETFS Physical Platinum Fund (Nasdaq: PPLT) is now at its lowest level since it was introduced in early 2010.

Risks to Consider: These commodities could fall further if the European debt crisis fails to get resolved and the major world economies are roiled.

Action to Take -->
Commodities go through deep bull and bear cycles. Even within these cycles, you'll spot major moves. The current pullback looks simply to be a re-entry point in a longer-term bull market, especially as it increasingly appears that the U.S. and Chinese economies -- the greatest driver of these commodities -- will not slow to the extent some had feared just a few months ago. Any of the options I mentioned above are suitable for investors to play these snapbacks, but there are other options out there as well.

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