Commodity Prices: To Infinity and Beyond

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Have we seen the end of cheap commodities? Are we in for global inflation -- even hyperinflation? The debate is raging from Wall Street to Main Street, from the White House to houses just like yours.

The accepted wisdom states that as incomes rise in emerging markets like China and India, consumers in those countries will want more and more of the stuff Americans take for granted. But the stuff we take for granted is in limited supply. China and India are each home to more than 1 billion people -- more than three times the U.S. population.

Currently, about 49% of Chinese citizens live in cities, up from 36% in 2000. Yet China's urbanization has a long way to go. Research group McKinsey Global Institute estimates that 66% of the country, or nearly 1 billion Chinese, will live in cities by 2025.

This means they'll need more oil to fuel billions of new cars; billions of tons of iron ore and copper to build new apartment buildings, commercial buildings, and subways; and much, much more food, produced on less land and with less water. Where will it all come from? And will it come in time?

When Malthus met Grantham
Thomas Malthus famously wrote back in the late 1700s that population is limited by how much food we can produce. He also lived at a time when the world population was around 1 billion. Since then, the world has seen a net 6 billion new mouths arrive. At the same time, arable land has declined as cities gobble up real estate and water supplies get diverted, depleted, and polluted.

Renowned value investor Jeremy Grantham argues in his first-quarter letter to investors that the only reason Malthus has been wrong to date is because he didn't foresee the dramatic impact that cheap fossil fuels would have on our ability to grow more food per given measure of space.

However, Grantham continues, the age of cheap oil is coming to an end. With it, so will the world of deflationary commodity prices we've become accustomed to over the past century or so.

How to get in on this
If this is the case, a world of $100 oil will seem like paradise, and investors should be loading their portfolio with energy-related stocks. I'm not just talking about Big Oil names like ExxonMobil, Chevron, and BP, but also the service companies that support them. And the smart money will be looking at the so-called unconventional players: oil sands, deep sea drilling, liquid natural gas (LNG), and shale gas.

This means companies like CGG Veritas (NYSE: CGV  ) , one of the leaders in deep-sea seismic mapping; Chicago Bridge & Iron (NYSE: CBI  ) , an engineering/construction firm with experience building LNG plants; and SeaDrill (NYSE: SDRL  ) , owner of a 60-strong fleet of offshore drilling vessels.

You could also play this trend by noting where China will get its resources from: places like Canada, Australia, Brazil, and Africa. The big, obvious names here are Rio Tinto, BHP Billiton, and Vale. A less obvious play is Brookfield Infrastructure Partners (NYSE: BIP  ) , which owns one of the world's largest coal ports in northwest Australia -- a convenient location for supplying Chinese markets -- and high-quality timberland in Canada and the U.S.

You could also play the agriculture angle along with famous trader George Soros. Adecoagro (NYSE: AGRO  ) , of which Soros' investment vehicle owns about 25%, owns sugar plantations and farmland in Brazil, Argentina, and Uruguay.

Hold on, not so fast
While Grantham is bullish on commodities (or pessimistic on inflation) going forward, his value instincts tell him that now, when commodity prices are bubbling, is not the time to jump in. He's waiting for a pullback before he goes all in. And he thinks that pullback will come from a slowdown in China.

He agrees with the logic that demand from the massive emerging economies of China and India is pushing us to the limits of our resource supply. Therefore, he says, if markets feel China's economy, which has grown an average of 10% per year since 1978, is going to slow down, we'll see a serious sell-off in commodities. That will be the time to pounce!

Yet another way to profit 
If you aren't comfortable with trying to guess where commodity prices are headed -- and I'm in the same boat there -- you can still set up your portfolio to benefit from the urbanization of China's population. The Motley Fool Global Gains team is heading to China in a few weeks to find the best ways to invest alongside the rising Chinese consumer. If you'd like to get their notes from the road and see what they find, click here to sign up for their dispatches.

Nate Weisshaar doesn't own any of the stocks mentioned above. The Motley Fool owns shares of Brookfield Infrastructure Partners and CGG Veritas. Motley Fool newsletter services have recommended buying shares of Brookfield Infrastructure Partners.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a doomsday bunker and a disclosure policy.

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