When commodities rally on the crest of widespread bullish outlooks, observers appear quick to decry a crowded trade that leaves the space vulnerable to one if its notoriously nasty corrections. We are right in the midst of one of those volatile pullbacks even as we speak.
But Fools are reminded that the pendulum swings both ways, and that the mass exodus of investment capital from the commodities sector over the latter portion of 2011 is just as likely to overextend to the downside beyond any rational reflection of the resilient long-term bull market trend. Whether it's retail investors gripped with an understandable fear of Eurogeddon, or indiscriminate liquidations by a vast galaxy of underperforming hedge funds, a number of factors have combined this year to render the previously sizzling commodity space once of the loneliest corners of the equity market today.
Let's start with a visual aid to convey the extent of the commodity carnage during 2011.
BHP Billiton Stock Chart by YCharts
Staring at greater-than-30% declines year-to-date in sector-ETFs like the pair depicted in the chart, one might expect to find companies within the sector desperately ducking for cover against a horrific implosion in commodity demand. But quite to the contrary, the commodity market gurus at Joy Global (NYSE: JOY ) confirmed this week that the long-term demand outlook for bulk commodities such as copper and coal remains resiliently bullish, even in the context of a relative slowing of China's manic growth trajectory. Mining companies, furthermore, are moving forward with major capital expenditures for 2012 because they "expect today's sluggish demand to return to strong growth well before the lead time to bring new mine production on line."
A soft landing for copper and coal demand
Within the company's fiscal fourth-quarter earnings release, Joy Global explains: "The global mining industry currently operates with little available excess capacity. Although down from earlier peaks, current spot prices for coal, copper and iron ore are up by 50 to 75 percent over the past two years and provide sufficient returns to justify continued mine expansion by all but the highest cost producers." The equipment supplier continues to anticipate a "soft landing" for China and points out that China intends to spend $840 billion on "investments in power generation and the electricity grid" over a period of five years. The company expects ongoing copper supply deficits to support prices above $3.50 per pound and forecasts "significant long-term opportunity to the upside." Accordingly, I interpret a 33% drop year to date for the First Trust ISE Global Copper Index Fund (NYSE: CU ) as an invitation to increase long exposure to quality copper producers. The recent $3.4 billion acquisition of QuadraFNX Mining by European copper producer KGHM further supports this bullish view, and I view Quadra rival HudBay Minerals (NYSE: HBM ) as a particularly attractive copper stock. Also, despite fervent opposition to the miner's New Prosperity project in British Columbia, Taseko Mines (AMEX: TGB ) continues to stand apart as a noteworthy bargain for copper.
Shifting to coal, Joy Global reports that India is likely to miss its coal-production target for 2011 by at least 100 million tons (out of 660 million tons targeted) and that Australia is anticipating another destructive rainy season that could substantially impair output. But as with copper, the big story for coal remains the bullish long-term outlook that Peabody Energy (NYSE: BTU ) touted as a global supercycle not so long ago. While it is wholly appropriate to dial back expectations somewhat from prior demand projections, the implied global softening is certainly insufficient to erase a story of that magnitude in its entirety. Here again, major consolidation activity highlights the resilient strength anticipated by the major miners of coal, particularly with respect to metallurgical coal. Peabody pounced on Australia's Macarthur Coal earlier this year with a hugely transformative deal, Arch Coal (NYSE: ACI ) snatched up International Coal, and rivals Xstrata and AngloAmerican have been seen consolidating their property holdings within the coveted Peace River Coal Field in British Columbia. Without reservation, I characterize the recent breakdown in coal-mining stocks as entirely overdone, and I expect the coming year to yield a convincing recovery for Peabody Energy, Alpha Natural Resources (NYSE: ANR ) , and others.
Even as Joy Global concedes that "slowing global growth is tempering the demand for mined commodities" and cautions investors that growth in demand for mining machinery is likely to moderate in 2012, Fools are encouraged to consider carefully how much of that emerging outlook may already be priced into commodity stocks -- and then some! Because I perceive a disconnect between the near-term dynamics that appear to have trampled the sentiment of commodity investors, and a resilient long-term outlook for baseline global commodity demand that I consider entirely reliable under numerous macroeconomic scenarios, I view this noteworthy sell-off as an opportunity to increase exposure to quality producers of copper and coal at prices that I consider extremely attractive. Please bookmark this link to track my ongoing coverage of this forlorn commodity sector, and keep track of specific companies using the following links.