6 Commodity Investment Lessons

Copper has been confounding the experts for more than a year. Last September, I wrote, "The rise in the price of copper, from the November 2001 low of $0.60 a pound to Thursday's $0.83 close, has exceeded most experts' predictions. With many industry executives and Wall Street analysts now looking for $0.85 in 2004, the foundation of companies built on copper mining should be strong."

Fast-forward a year, and copper has just hit a 15-year high while it trades close to $1.45 a pound. The analysts didn't see the big surge. Copper stocks must have soared, right?

Lesson No. 1: Getting the price direction is important, but don't bet the farm on one stock. While strike-prone Southern Peru Copper (NYSE: PCU  ) has risen 106% over the last 52 weeks and U.S.-based Phelps Dodge (NYSE: PD  ) has jumped 63%, Freeport-McMoRan (NYSE: FCX  ) is up a measly 8%.

Lesson No. 2: Most mines do not produce just one metal. Freeport's Grasberg mine is the world's second-largest copper deposit and the world's largest gold deposit. Since the end of 2001, Freeport's stock has more than quadrupled because of gold's big run-up in price. Copper was the icing on the cake that, so far, has not caused the stock to surge.

Lesson No. 3: This is a high-risk business. In 2003, the Grasberg mine experienced two slides that temporarily limited production. When you own one big mine, as Freeport does, you have all your eggs in one big basket. There is also $2.2 billion in total debt (it is very expensive to open a big mine).

Lesson No. 4: Big moves in a commodity's price -- such as the 75% increase in copper over the last year -- will not automatically produce an equally big move in the stock. When commodity prices are low, the stocks trade at inflated prices to earnings. Investors anticipate what might happen. When prices are hitting multiyear highs, the stocks trade at deflated prices because investors worry that new capacity will depress prices.

Lesson No. 5: Investing in commodities can drive you nuts. Recently, the press has been talking about low copper inventories. Tight supply has driven prices strongly higher. Today, though, copper is down 9% (and the stocks are down almost as much) on worries that new supplies in mid-2005 will drive down prices.

One last lesson: Commodities are a cyclical business. Yes, in good times (like now), the companies trade at a steep discount to the market -- even the giant broader-based enterprises like BHP Billiton (NYSE: BHP  ) and Rio Tinto (NYSE: RTP  ) .

But realize that copper's gigantic move produced fourfold gains in net income at Southern Peru -- but only (only?) a 106% stock price increase. Investors have seen the boom-to-bust cycle many times before and will be very slow to bid up prices. For now, the longs are hoping that copper (like oil) will stay high for much longer than expected and enrich their holding.

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Fool contributor W.D. Crotty does not own stock in any of the companies mentioned.


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