TableofContents

LittleBookBigProfitsSeriesTitlePageCopyrightPageForewordIntroduction

TheNewNormalDollarDowner

DiscoDays?GetReal

ChapterOne-CallingonCommodities

TradingPlacesYeah,But...WaitaMinuteRicochetABulgingMiddleADecadeofDecline

BondBluesTheHouseIsA-Rockin’WhatAmIMissing?

ChapterTwo-Gettin’Goin’

DumbLuckGoAlongtoGetAlongReadytoRockn’Roll?ManagingtheFutureCompanyMan

ChapterThree-Gusher

BigOilToErrIsHumanFromRussiawithLoveHaveWeReachedthe

Peak?HopeSpringsEternalShiftingSandsDeclineThatGreatSucking

SoundSecondComing?

Fill’ErUpNiceWheelsCrackShackSlickOperatorsPetrolProfits

ChapterFour-DrillingforDollars

BeCarefulWhatYouWishForFromImportTerminals

toAirportTerminalsWeatherBetsAPipelineofProfitsMethaneManGasGlutBreakingUpIsHardto

DoDrillingforDollars

ChapterFive-GoingforGold

AwashinDebtStartthePressesAGoldenEraTheGoldenRulesMoneyintheBankBaubles,Bangles,and

BlingBillionDollarBabyMyTwoCentsTheFamilySilverSilverLiningTheSilverScreenPlatinum:TheNewGold

LoveintheFastLaneMetalMeddling?HammerandSickleBlingFling

ChapterSix-DiggingIt

KerplunkHeavyMetalsMetalFatigueOutofAfricaThe800-PoundGorilla

LondonCallingSpringingaLeak?NukeRebootMetalMania

ChapterSeven-BettingtheFarm

FoodFightLandGrabGoingGreen?ThisLittlePiggyWent

toMarketNothingRunsLikea

DeereMoneyinManure?DustBunnyRoundup

ChapterEight-OrderingtheBreakfastSpecial

ReadyforaPerkUp?SugarHigh

FromGrovetoGlassDecadentDelightWhenPigsFlyAPlatefulofProfits

ChapterNine-GaininginGrains

FoodforThoughtSeedsofDoubtYouReapWhatYou

Sow

SweetHomeChicagoChicagoBullsGrainandBearItFoodChainWeatherReportPlowingforProfits

ChapterTen-BulkUp

CheapThrillsFireandBrimstoneGrowthinGirders

EntertheDragonLettheGoodTimesRollGristfortheMillRiskyBusinessSootandSuccessG’DayMateShipsAhoyForgettheFuture

ChapterEleven-CapitalizingonCommodities

MaxedOutBeltTighteningAsianAscensionBuyLow,SellHighBonanza

LittleBookBigProfitsSeries

IntheLittleBookBigProfitsseries, the brightest icons in

the financial world write ontopics that range from tried-and-trueinvestmentstrategiesto tomorrow’s new trends.Each book offers a uniqueperspective on investing,allowing the reader to pickandchoosefromtheverybestininvestmentadvicetoday.

Books in theLittleBookBigProfitsseriesinclude:

The Little Book That Beats

theMarketbyJoelGreenblatt

The Little Book of ValueInvesting by ChristopherBrowne

The Little Book of CommonSense Investing by John C.Bogle

The Little Book ThatMakesYouRichbyLouisNavellier

The Little Book That BuildsWealthbyPatDorsey

The Little Book That SavesYour Assets by David M.Darst

The Little Book of BullMoves in Bear Markets byPeterD.Schiff

The Little Book of MainStreet Money by JonathanClements

The Little Book of SafeMoneybyJasonZweig

The Little Book ofBehavioral Investing byJamesMontier

The Little Book of BigDividends by Charles B.Carlson

The Little Book of InvestingDo’sandDon’tsbyBenSteinandPhilDeMuth

The Little Book of BullMoves, Updated andExpandedbyPeterD.Schiff

The Little Book ofCommodity Investing byJohnStephenson

Copyright©2010byJohnStephenson.Allrightsreserved.

PublishedbyJohnWiley&Sons

Canada,Ltd.

Theviewsexpressedinthisbookare

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Allrightsreserved.Nopartofthisworkcoveredbythecopyrighthereinmaybe

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LibraryandArchivesCanadaCataloguinginPublication

Stephenson,John,1962-

Thelittlebookofcommodityinvesting

/JohnStephenson.ISBN978-0-470-67837-4

1.Commodityfutures.2.Commodityexchanges.3.Finance,Personal.I.

Title.HG6046.S.63’28C2010-901888-5

CW

Foreword

PLANNINGFORTHEENDGAME. “May you live ininteresting times” wassupposedly an ancientChinese curse. Historiansreally only write about the

greatevents,usuallydisastersandwars,asthereisnotmuchofinterest inpeaceful,serenetimes. So, if the period youlive in is interesting, it isprobablynotserene;volatilityand the unknown become apartofthefabricoflife.

Unfortunately, as far asinvesting is concerned, welive invery interesting times.As I write this foreword, wehave just come through the

worst financial crisis andmost serious recession sincethe Great Depression. Itappears that the economiesare recovering in the UnitedStatesandAsia,buttherearerumblings that things mightnot be so good in theEurozone. Many of itseconomies are in recessions,ranging frommild to severe,and the credibility of thesovereign debt of the Club

Medcountriesisindoubt.

Indeed, just as we lurchedfrom one bubble to anotherover the past decade, we arerapidly approaching theburstingofthenextbubble—thatof sovereigndebt.Whileconsumersandbusinessesareretrenching and the world ofprivatedebtisinvolvedintheGreat Deleveraging,governments around theworld are running massive

deficits as they try tostimulate their economies inthe face of unemploymentand slack demand. But thereis a limit to the amount ofmoney they can borrow andto the interest rates theywillbeabletopay,astheturmoilinGreece and the rest of theMediterranean demonstrates.Even Japanwill find there isalimit.

And we are rapidly

approaching that limit. Asinvestors, we must nowcontemplate The End Game.What will the investmentclimate be when thedevelopedworld is forced todeleverage? For somecountries,itwillbedeflation.Forothers,itwillbeinflation.You can count on majorcurrency fluctuations.Recessions will come moreoften andbemorepersistent.

Unemployment will remainuncomfortably high. Interestrates?Expect themtobe lowuntilmarkets loseconfidenceintheabilityofagovernmenttorepayitsdebt.

As Reinhart and Rogoffwrote: “Highly indebtedgovernments, banks, orcorporations can seem to bemerrily rolling along for anextended period,when bang!—confidence collapses,

lendersdisappear,andacrisishits.”

Bangistherightword.Itisthenatureofhumanbeingstoassume that the current trendwill work out, that thingscan’treallybeasbadas theyseem.Comparehowthebondmarkets looked only a yearagowithhowtheylookedjusta few months before WorldWar I. Therewas no sign ofan impending war. Everyone

thought that cooler headswould prevail. In a similarvein, just prior to the recentcredit crisis, bond markets(andindeedallothermarkets)around the world were notsignalingthattheworstcreditcrisisin70yearswasabouttoemerge. And then overnight,so it seemed, the bankingmarkets collapsed. Bang,indeed.

Wecanlookbacknowand

seewherewemademistakesin the current crisis. Weactually believed that thistime was different, that wehad better financialinstruments, smarterregulators, and that we wereso,well,modern.Timesweredifferent. We knew how todeal with leverage.Borrowingagainstyourhomewas a good thing. Housingvalues would always go up,

andsoon.

Now, there are voicestelling us that things areheaded back to normal.Mainstream forecasts forGDP growth this year arequite robust, north of 4percentfortheyear,basedonevidence from pastrecoveries. However, theunderlying fundamentalsof abanking crisis are fardifferent from those of a

business-cycle recession. Ittypically takes years toworkoff excess leverage in abanking crisis, withunemployment often risingforfouryearsrunning.

So, John, this is all veryinteresting, but what does ithave to do with a book oncommodities?Everything.

Wehavejustgonethrougha lost decade for the stock

markets in the United Statesand much of the developedworld. What worked for somany years no longer does,yetmany investorspersistonputtingthebulkoftheirassetsinequities.TheenvironmentIhave described above is onein which equities and indexfunds (which are the mainway investors invest inequities) will struggle,offering nowhere near the

toutedlong-termaverages.

Indeed,ifyouwentbackto1966and invested in20-yearU.S.governmentbonds,yourbond portfolio would haveoutperformed the stockmarketoverthenext43yearsthrough the end of 2009.Stocks for the long run,indeed.

Whatthatsaystomeisthatinvestors should look for

ways to diversify theirportfolios away from thecurrent over-allocation tostocks. And one way to dothat is through commodityinvesting. But simply buyinga fund tied to somecommodity aggregate indexisn’t the answer. And that’swhere this book by JohnStephensonwillbesouseful.

To be a successfulcommodity investor takes

knowledge—as muchknowledge as (or even morethan) it takes to be asuccessful stock investor.While a pound of aluminum,iron, or nickel is the sameanywhere, the price canchange based upon demand.Thepriceofabushelofcornreflects not only the demandfor tortillas, but also thedemand for ethanol. Andeverything is complicated by

theworldeconomy,becauseagrowingAsiawillneedmoreenergy and food, even as thedeveloped world struggles tofindthatsamegrowth.Whichfactors will have moreinfluence?

Once you have made thedecision about pricedirection, there are manyways to invest incommodities. Stephensonhelps you work through the

pitfalls and advantages ofvariousfundsandstyles.

While I think thedeveloped world is in for aMuddle-Through Economy,there are so many ways thatindividual investors canprosper—even in a sidewaysworld. They need only tolook beyond the traditionalportfolioandexplore the restoftheinvestmentcornucopia.Volatilityandnimblenesswill

bringyouopportunity.

Arm yourself with thebasicknowledgethatisinthisbook,thendigdeepandlearnmore. And as my friendDennisGartmansays:

Good Luck and GoodTrading!

JohnMauldin

JohnMauldin (Dallas,TX)is the President of

Millennium WaveInvestments. One of theworld’smostreadinvestmentanalysts, his free weekly e-letter Thoughts from theFrontlineisreadbymorethana million people each weekand is reprintedonnumerousWeb sites. Mauldin is alsoauthor of the bestsellingbooks Bull’s Eye Investing(978-0-471-65543-5)andJustOne Thing (978-0-471-

73873-2).

Introduction

THE NEXT GREAT BULLMARKET HAS ARRIVEDand it’s not in real estate,bonds, or stocks, but incommodities. After thegreatest financial collapse in

more thanagenerationandadecadeofdeclinefortheS&P500stockindex,commoditiesstandalone as theonlygo-tosectorofthemarket.Bestyet,commodities are an indirectplayontheonlyregionoftheworld that is experiencingexplosiveeconomicgrowth—Asia.

Theheavily indebtedWestfaces years of sluggishgrowth and a dismal outlook

for job seekers. But forcommodities the story isdecidedly more upbeat,because commodities are thebasic raw materials ofurbanization andindustrialization. Today,hundreds of millions ofpeople are rising out ofextreme poverty and, for thefirst time in recordedhistory,becoming global consumers,a good news story for

commodities.

TheNewNormal

Consumers in the West hadenjoyed amore than 20-yearbonanza, one where realestatepricessteadilyclimbed,interest rates fell, andemployment prospects weregood.But today, in thewake

of the global financial crisisof 2008-2009, mostconsumersaredeeply indebtand so too are theirgovernments. Governmentsaroundtheworldhavepouredtrillions of dollars intostabilizing their nationaleconomies, yetunemployment rates remainhigh in the West andeconomic growth is tepid.Western economies are in

rehabaftera20-yearrunonadebt-fueledbender.Recoveryis likely to be painful andslowastheseeconomiesshedthe bad habits of racking uptoomuchdebtandsavingtoolittle.

Conversely, Asia’seconomy is rising and theprospectsforcommoditiesarerising along with it. ChinaandIndiawentintotheglobalfinancial crisis of 2008-2009

inmuchbettershapethantheWest.Theseemergingmarketeconomies had much lowerlevelsofnationaldebt,lotsofforeign currency reserves,and consumer sectors thatwere in their infancy. At thebeginningof2010,Chinahada total debt to GDP ratio of159percent,whiletheUnitedKingdom’s was an eye-popping 466 percent—anearlythreefolddifference.Is

it any wonder that Asia’sgrowth remains unrestrained,while Western growth issluggish?

The investmentopportunities of the futurewill increasingly come fromthe fast-growing economiesof Asia, not the stalwarts oftheWest.Andthat’sgoodforcommodities, the real stuffthat makes economicexpansionpossible.TheWest

hasgorgedon toomuchdebtfortoolong.Therepercussionofthisbingeingwillbeyearsof slower than normaleconomic growth as theeconomies of the West arerebuilt. Between 2000 and2009, U.S. stock marketreturns were negative andjoblessnessrosedramatically.

While economic growth intheWesthasbegun,it’sbeingdriven by the government

sector rather than bycorporations or consumers.The unemployment rateremains stubbornly high andconsumersaresittingontheirwallets, terrified of gettingwalloped again. Can thetraditional investmentmix ofstocks,bonds, and real estatereally be expected tooutperform in this low-growthenvironment?

Inalow-growthenvironment,canthetraditional

investmentmixofstocks,bonds,andrealestatereallybe

expectedtooutperform?

Nope. During the 1970s,commodities roared whilestocks and bonds wentnowhere.During thatdecade,America was strong, Europewas reemerging as an engineof global growth, and theeconomies of South Korea,Japan, and Taiwan were onthe move. This time around,four-fifths of the world’spopulation is emerging from

an economic funk—creatinghundreds of millions of newglobal consumers. Demandfor commodities continues tosurge. There are nosubstitutes for these criticalfeedstocksofindustrializationand urbanization, and supplyremains constrained. Apowerful rallying crywill beheard around the world asinvestorsclamortobepartofthe next great bull market—

not in stocks, bonds, or realestate, but rather, incommodities.

DollarDowner

Helping to propel the bullmarketincommoditieshigherareanAmericandollar that’ssagging under the weight ofpersonal and government

debt, which are in nosebleedterritory, and investors’ fearthat the Federal Reserve (theFed) will be forced to crankup the printing press to paydownthenation’sdebt.

Record low interest ratesand a national balance sheetthat looks positively sickly,with no immediate prospectsfor improvement, haveconspired to drive the dollarlower.Andthat’sbeenaboon

for commodities—which arepriced in U.S. dollars—asinvestorscorrectlyreasonthatthe value of tangible assetscannot be inflated away.Theworldmayonedaybeawashin American dollars, but theamount of copper incirculationisfinite.

To combat the recessionand get consumers spendingagain,UncleSamhasshotthelocks off his wallet—

spending money like adrunkensailoronshoreleave.And with trillions ofadditional dollars hitting thenation’s money supply,China,our largestcreditor, isworried. Already they’vepubliclyvoicedtheirconcernsoverthedirectionthedollaristaking and its potentialimpact on their foreigncurrency reserves. If Chinaever decides that holding

mostofitsreservesinrapidlydeclining U.S. dollars andreceivingapaltryinterestratein return is a bad deal—lookout.Were theBankofChinatoshift15or20percentofitsreserves into gold, or anyotherhardasset, instead—thedollarwouldimmediatelyfallsharplylower.

DiscoDays?

Discoandcommoditiesshareone thing in common: theyboth had their heyday in the1970s. During that decade,while the stock market andthe economy went nowhere,commodities were on fire—and so too was inflation.Millions of middle-classAmericanbabyboomerswereentering the workforce,starting families, and buyinghouses, cars, and appliances

—thestagewassetforalongbull run in commodities.Germany and Japan werereindustrializing after theSecond World War, and agrowing global middle classwas demanding houses, cars,and appliances—allcommoditydependent.Allofthis helpedmake commodityinvestingtheplacetobefrom1968to1982.

This demand for essential

goods helped drive inflationhigher. As basic rawmaterials, commodities aredirectly linked to thecomponents of inflation,making them ideal inflationhedges. Inflation erodes thevalue of a bond and stockportfolio, but not acommodity portfolio. Highlevels of inflation areassociated with boomingeconomies and surging

demand for commodities.Strong demand forcommodities translates intohigherpricesforthem,whichmore than offsets the effectsof inflation. As a result,commodities providepurchasing power protection.That’s important, becauseinvestorscareabouttheirreal—or inflation-adjusted—purchasingpower.

Commodities,asbasicraw

materials,aredirectlylinkedtothecomponentsofinflation,making

themidealinflationhedges.

Today,many of our banksare a mess, and both theconsumer and the Americangovernment face years ofpainful deleveraging as theytry to work off the excessesofadebt-fueledbender.Withgovernmentandconsumersindebt up to their eyeballs, theprospect of a slow-growingeconomy looks increasinglylikely. This economic

restraint will slowinvestment, profits, andpayments to investors in theform of dividends andinterest. As America, andmuch of the West, enters aslow-growth era, buying abasket of S&P 500 stockslooks increasingly like asucker’s bet. Commodities,fueled by the fast-growingeconomiesofAsia,shouldbethego-tosectoroverthenext

decade. Bell bottoms anddisco may never stage acomeback, but we may begoing back to an investmentclimate like the 1970s,whencommodities soared and justabouteverythingelsetanked.

Whilebell

bottomsanddiscomaynotbeyourthing,wemaybegoingbacktoan

investmentclimatelikethe1970s,whencommodities

soaredandjustabouteverythingelsetanked.

GetReal

There aremany things that Ienjoyaboutbeingaportfoliomanager,butImostenjoythetimeswhenIget to leavemyspreadsheetsbehindandheadoutoftheofficetoseetheoilfields, mines, shippingterminals, and natural gasplants that dot the landscape.Thefeelingisthesameeverytime I venture beyond my

computer screens: I alwaysmarvelatthesize,scope,andtechnical complexityof theseoperations and at the critical,yet unheralded, role theseassets provide in making theworldwork.

In spite of the crucial rolecommodityproducersplay inenablingtheglobaleconomy,most of us know almostnothingaboutthem;andwhatwe do know is often

jaundiced. In a world ofglitzy new product launchesand expensive marketingcampaigns, the world ofindustry seems woefully outof date. Yet we have justlived through an era whereWall Street and its world-class marketers badly misledtheinvestingpublicabouttheriches that lay ahead incutting edge technology andhighfinance.

Commodities can soarwhen stocks and bonds aregoing nowhere and inflationis running amok. In a worldof too much complexity andtoo few solutions, investorsare looking for somethingsimple, something tangible,where the accounting isn’tflawed and the path forwardis clear. As real things thatyou can hold and touch,things thatyouuseeveryday,

commodities seem to be thesolid store of value in thesetroubledtimes.

Best yet, armed with aknowledge of commoditiesyou will be better able tounderstand markets, wholeeconomies, and the world inwhichwe live.More than aninteresting niche area ofinvesting, commoditiesprovide uswith an importantwindow on the world of

investing and understandingthemtransformsusintobetterinvestors; not just bettercommodity investors, butbetterstock,bond,realestate,currency, and emergingmarketinvestors.

Mostinvestmentbooksarelong on theory but short onpractical no-nonsenseinformation and knowledgefrom which you can profit.This book is different. This

book is about companies,about whole industries, andaboutavaluechainthatspansthe globe and interconnectsthemarketsoftomorrowwiththe markets of today. Thisbook explains the worldaround us—how it works,whatmakesmarkets rise andfall,andhowyouasinvestorscan come out ahead of thepack.

The tried and true

investment path led manyinvestors to ruin in the2008-2009 market collapse. Whatworked before is unlikely towork again. The world haschanged and so too hasinvesting. Commodities zigwhen stocks and bonds zag,and thisoften-overlookedbutcrucial part of the investinglandscape is finally about togetitsdue.

Thisbookisyourblueprint

for navigating the world ofcommodities—the world oftomorrow. Itexamineswholeindustries, how they fittogether in thebiggerpuzzle,andwhatmakes them tick. Itexplores the worlds ofagriculture, mining, andenergy, as well as thecharacters and countriesbehind the production andconsumption of these criticalraw materials. You’ll learn

the various ways investorscan get commodity exposureandwhy thesebetsare likelyto be savvy rather thanfoolhardy.

Commodities are alreadypart of your daily routine—from the coffee that powersyou throughyourmorning tothe gas that fuels your car.And from the farmer’s fieldtothefoodonyourtable,theworld of commodities is

global and interlinked.Developments halfway roundthe world can have a bigimpact on the action in thetrading pits of Chicago andon your portfolio. In short,commodities are a vitallinchpin connecting marketsand providing powerfulsignalsabout thedirectionofthe world economy and thestockmarket.

And yet, they just don’t

figure as part of mostinvestment portfolios. Thisbookwill change that. Itwilldispel the myths aboutcommodities and make twobold claims—thatcommodities belong in everyportfolio and that you ignorecommodities at your owninvestmentperil.

The goal of this book issimple—to sweep away themystery surrounding

commodities and exposethem for what they are—thesinglebestassetclass for thenextdecade.

ChapterOne

CallingonCommodities

WhyCommodityInvestingIsaSavvyBet

A MASSIVE BULLMARKET INCOMMODITIES is about towash up on our shores,powerednotbythestagnatingWest, but by a surgingAsia.The big money of the nextdecade won’t be made inbonds or real estate, andcertainly not in the so-called

U.S.bluechipstocks—itwillbe made in commodities.Savvy investors know thatfollowing global growthwhereit’sgoing—asopposedto where it’s been—is thewinning bet. And aseconomicinfluencecontinuesto shift toward the East, thesmart money is investing inthe basic raw materials thatsupport economic growth—commodities.

A rapid reordering of theglobal economic peckingorder is underway. In 1987,one-third of the world’seconomic output came fromdeveloping economies andtwo-thirds came fromdevelopedeconomies.By theend of 2009, theircontributions were evenlysplit. By 2020, two-thirds oftheworld’seconomicactivitywill come from developing

economies, while the so-calledricheconomieswillberesponsibleforjustone-third.Thepaceofeconomicchangewe are witnessing is bothunparalleled andunprecedented.

By2020,two-thirdsof

theworld’seconomicactivitywillbecoming

fromdevelopingeconomies,whilethe

so-calledricheconomieswillberesponsibleforjust

one-third.

Commodities are realthings that we rely on everyday.Fromthetimewegetup

to the timewego tobed,weare surrounded bycommodities. The coffee wedrink and the sugar wesweeten it with arecommodities, so too are thesteel that holds our carstogether, the oil that makesthemrun,andthenaturalgasthatheatsourhomes.

Nothing aboutcommodities is bush-league;in2009,theproductionvalue

of seven of the mostimportant commodities wasnorth of $3.6 trillion. Thevalue of the commoditiestraded on theworld’s futuresexchanges dwarfs the dollarvolume of transactions onU.S. stock exchanges.Commodities and theexchanges that setpricesandmarry up buyers and sellersofthesecrucialrawmaterialsare so important to our way

of life that the world as weknow it just wouldn’t bepossiblewithoutthem.

Thevalueofcommoditiestradedontheworld’sfuturesexchangesdwarfsthedollarvolumeof

transactionsonU.S.stockexchanges.

Plenty of experts willespouse themerits of stocks,thebenefitsofbonds,andtheadvantagesofrealestate.Butwhen it comes tocommodities, there isn’tmuch of a fan club, despitecompelling evidence thatwhen stocks and bonds are

goingdown,commoditiesareusually going up. Wheninflation is heading higherand bonds and stocks areheading lower, commodityprices will be on fire.Commodities have beenproven to boost returns andchop risk in an investmentportfolio, but evensophisticated investors givethem short shrift. For mostinvestors, commodities just

don’tfigure.

TradingPlaces

Commodities trade oncommodityexchanges,wherethey are bought and sold forfuture delivery. The firstcommodity futures tradingcan be traced back to 17thcenturyJapan,wherefarmers

sold rice to local merchantswhostoredityear-round.Notcontent to just sit on theirinventory of rice, themerchants raised cash to payfortheircostsbyselling“ricetickets,” which were receiptsagainst the stored rice. Overtime, the rice tickets becameaccepted as a form ofcurrency and rules wereestablished to manage theirtrade.

Almost 200 years later, in1848, a group of Chicagobusinessmen formed theChicago Board of Trade(CBOT), a member-ownedorganization that offered acentralizedplacefortradingawiderangeofgoods.Withitsconvenient location betweenMidwestern producers andthe east coast market,Chicagowasanaturalhubforcashtradingincommodities.

As time went on, buyersandsellersnegotiateddirectlywithoneanothertosellcropsat an agreed upon price notonlyonthatday,butalsoonafuture date. These negotiatedtransactions, known as“forwardcontracts,”arestillafixture in the world ofcommodities. As trading inforward contracts increased,the CBOT decided that mostdetails could be standardized

tostreamlinethedeliveryandtrading of the contracts.Under thisnewsystem,priceand delivery date would betheonlyvariables.

The standardized contractsthe CBOT ushered in wereAmerica’s first futurescontracts.Allbids,offers,andtransactions were publishedby the exchange, whichincreased the transparencyand popularity of these

marketplaces. Withstandardizedcontracts, itwaseasy to trade commodities.Investors who wanted toprofit from a drought in theMidwestcouldeasilyuse theexchange to buy futurescontracts for wheat, and iftheir views changed, theycould sell their contracts justaseasily.Standardizationwasaboontotrading.

Commodityfuturesarestandardized

contractsthattradeoncommodityexchanges;priceandquantityaretheonlyvariables.

Other futures exchanges

quickly sprang up. TheChicago Butter and EggBoard,foundedin1898,laterbecame known as theChicago MercantileExchange. Kansas City, St.Louis, Memphis, and SanFrancisco all got into the actby forming their owncommodity exchanges; yettoday, Chicago still reignssupreme as the epicenter ofU.S. futures trading.

Globally, there are majorcommodity exchanges inmorethan20countries.

Yeah,But...

Commodities get a bad rap.Inspiteoftheirimportancetotheglobal economy, they areamong the mostmisunderstood of all asset

classes. Bonds, stocks, andreal estate all have plenty offollowers and universalagreement amongst expertsregarding their importancewithin a well-diversifiedportfolio.Butventureintotheworld of commodities, andyou’re into a fringe area ofinvesting whereunderstanding is limited andsuspicionsrundeep.

Inthe1983movieTrading

Places, Eddie Murphy andDanAykroydteamuptoturnthe tables on their formeremployers, Mortimer andRandolphDuke,byplacingawinning bet on commodities.In a single trading session,Louis Winthorpe III(Aykroyd) and Billy RayValentine (Murphy) becomefabulously wealthy whiledestroying the Dukesfinancially. To skeptics,

reversals of fortune like thatare all too common in theworld of commodityinvesting, where volatilityand complexity are the orderoftheday.

But peek behind thecurtain, and most of thecriticismsofcommoditiesjustdon’t hold water. Whilecommodities are morevolatile than bonds, theirvolatilityisaboutthesameas

that of stocks. Commoditieshave no funky accounting,scandalous behavior bymanagement, orincomprehensible off-balance-sheet items that canskewer your financesovernight. The problem withcommodities—if there is one—is the amount of leverageinvestorscanemploy.

Leverageisadouble-edgedsword. It can boost your

returns when prices areheadinghigherandtankyourinvestments when prices aresinking. “Leverage,” usingotherpeople’smoney,isquitecommon. For example,whenyoubuyahouseandtakeouta mortgage, you’re usingleverage. Both stocks andcommodities can be boughtonmargin,butbylawastockbuyer needs to pony up atleast 50 percent of the

purchaseprice.Incommodityinvesting, marginrequirements are skinnier—sometimes as little as 5percent.

Supposeyoudecidetobuycrudeoilcontractswhenoilistrading at $50 per barrelbecauseyouthinkit’smovinghigher. You open a futurestrading account, slap downthe minimum margin of$5,000 per contract and—

presto—you’re instantlycontrolling $50,000 worth ofcrude oil ($50 per barreltimes 1,000 barrels perfuturescontract).Ifoilmovesfrom $50 per barrel to $55per barrel, your position isworth$55,000($55perbarreltimes 1,000 barrels) andyou’ve doubled your moneyand are no doubt feelingpretty smart. But if oil goesfrom $50 to $45 per barrel,

you’ve lost your wholeinvestment. Still feeling sosmart?Idon’tthinkso.

WaitaMinute

TheYaleInternationalCenterfor Finance, in theirworkingpaper Facts and FantasiesAbout Commodity Futures,1concluded that an unlevered

basket of commodity futuresgave as much bang for thebuck as stocks.Not only didfuturesoffersimilarreturnstostocks, but they tended toperformwellwhenstocksandbondsweredoingpoorly.Byadding futures to a well-diversified portfolio, theresearchers found you couldchop risk while boostingreturns—a nifty trick.Because the value of

commodities is tied totangible assets, theyperformedwellininflationaryperiods,ortimeswhenpriceswere rising. Includingcommoditiesinyourportfoliocannotonlyhelpdiversifyit,but may also help youpreserve wealth wheninflation is gobbling away atthe value of your stocks andbonds.

Includingcommoditiesinyourportfoliocannotonlyhelpyoudiversifyit,butalsohelppreservewealthwheninflationis

gobblingawayatthevalueofyourstocks

andbonds.

In a separate study oncommodity returns, IbbotsonAssociates2foundthataddingcommoditiestoaninvestmentportfolio helped to reducerisk and increasediversification by generatingsuperior returns when theywere needed most. Theresearchersconcludedthatallportfolios could be improved

by the addition of a healthydollopofcommodities.

Ricochet

Shell-shocked investorswatched in horror as thecommodity markets tumbledwith the collapse of LehmanBrothers in September 2008.Executives at commodity-

producing companies nearlywent into cardiac arrest astheir share prices cratered,forcing them to slashexpenses just to keep theircompanies afloat—mineswere closed, oil fields werecapped, and steel millsslammedshut.

However, as the globaleconomy picks itself up offthe mat, the demand forcommodities—the stuff that

economic recoveries aremade of—will soar.Commodity production is atime- and capital-intensiveundertaking requiringextensive engineering,environmental, andpermitting procedures beforework can begin. Lead timesfor obtaining most majorpieces of equipment aremeasured in years, notmonths. In addition, a severe

shortage of well-qualifiedpeopleandinvestmentcapitalmeans new sources ofcommodity supply will be alongtimeincoming.Sluggishsupplyandvoraciousdemandhavesetthestageforournextbull market—one that won’tbe in North American realestateorbluechipstocks,butincommodities.

Sluggishsupplyandvoraciousdemandhavesetthestageforournextbullmarket—onethatwon’tbeinNorthAmericanrealestateorbluechipstocks,butincommodities.

ABulgingMiddle

An exploding global middleclass, fueled by global trade,is supplying the liquidhydrogen to the commodityrocket.Overthelast30years,hundreds of millions ofpeoplehavebeenliftedoutofextreme poverty andtransformed into globalconsumers. According to a

recent World Bank report,between1990and2002some1.2 billion people joined theranks of the developingworld’s middle class. Thesepeople are not rich byWestern standards, but arerich enough to leave asubsistence-level life behindand begin to spend. Moreremarkable, the report notedthat four-fifths of thisemerging middle class were

fromAsiaandhalfwerefromChina.

Others have predicted thatthe pace of thismiddle classexpansion will accelerate,likely reaching its zenitharound2018.GoldmanSachsestimates that by 2030 afurther two billion peoplecould join the global middleclass (defined as having ahousehold income in therange of $6,000-$30,000).

Wemay bemoan the declineoftheAmericanmiddleclass,yet researchers at Goldmanhave found that thedistribution of global incomeis becoming more, not less,equal,atrendthatislikelytocontinue. The surge of theworld’s middle class ishappening on anunprecedented scale.Affectingmorethanone-thirdoftheworld’spopulation,the

shift dwarfs the massivetransformation of the globaleconomythatoccurredduringthe19thcentury.

A mass migration isunderway through much ofAsia, as people leave thefieldsinsearchofbetterlivesinthecities.Withmillionsofnew factory workers hittingthe big cities, tremendousdemand is being created for

housing and other crucialinfrastructure. This demandwill underpin the boom incommodities as these newworkers and their familiesbegin to buy appliances,apartments,andcars.Thelastgreat bull market forcommodities lasted from1968to1982,whentheBabyBoom generation was on abuying spree. But this timeround, the scale of the

economic transformationwilleclipse anything we’ve seenbefore.

The key to understandingcommodities is tounderstandChina—a country that for 18of the last 20 centuries hashad the largest economy inthe world. China is alreadythe world’s largest consumerof iron ore, copper, zinc,aluminum,nickel,andcokingcoal. It’s also the second

largestconsumerofcrudeoiland the largest producer ofsteel—byacountrymile.Notonly is China growing at afurious clip, but so too areother emerging economiessuch as the Philippines,Vietnam, India, andMalaysia. Billions of people,all with aspirations like youand me, will demand thechance at a better life—andthat’s a good news story for

commodities.

Thekeytounderstanding

commoditiesistounderstandChina—acountrythatfor18ofthelast20centuries

hashadthelargesteconomyintheworld.

ADecadeofDecline

For investors in America’sbenchmark index, the S&P500, theperiod from2000 to2009 ranks as the worstdecadeinnearly200yearsof

American stock markethistory.Noteventhe10yearsencompassing the GreatDepressionwasasdismalforU.S. investors as the onewehave just witnessed. By thetime2009drewtoaclose,theS&P 500 index finished thedecade 24.1 percent belowwhere it had started—despitehaving two 50-percent-plusup moves. Investors wouldhavebeenbetteroffinvesting

inalmostanythingotherthanthe U.S. stock market.Stuffing theirmoney under amattress for safekeepingwould have been a savviermove than investing in theS&P500.

Forinvestorsin

America’sbenchmarkindex,theS&P500,theperiodfrom2000to2009ranksastheworstdecadeinnearly200yearsofAmericanstockmarkethistory.Stuffingyourmoneyunderamattressforsafekeepingwouldhavebeenasavvier

movethaninvestingintheS&P500.

The world witnessed aseismic shift in economicpowerduringthefirstdecadeof the 21st century. Thefastest growing economy intheAmericasisnolongertheUnited States, but rather,Brazil.Thosewhoinvestedinthe U.S. stock market at theheight of America’s powerarepoorerfortheexperience.

First they suffered throughthepoppingofthetechnologybubble and then the collapseof Wall Street. Globalinvestors fared somewhatbetter but, because U.S.stocks account for almostone-third of world marketcapitalization, they too gotcaught in the downdraft. Atthe start of the 21st century,America’s stock marketcapitalization was more than

$15.1 trillion, but by the endof the decade it stood closerto $13.7 trillion. Over thesame time period, the stockmarketcapitalizationsofbothBrazilandChinasoaredmorethan fivefold while India’sstock market increased morethaneightfold.AndChina,atthe start of 2010, is set toovertakeJapanastheworld’ssecond-largesteconomy.

Worse yet,America enters

2010withoutaworld-leadingmajorindustry.Atthestartofthepastdecade,Americahadtwo industries that werevisible symbols of itseconomic preeminence: hightech and high finance. Bothindustries expanded rapidly,promising to enrich theiremployees, but instead theyimpoverished many. Topromote their industries toinvestors, they relied on the

notion that creativity waslimitless and so too wereprofits. After all, Americanfinance and technologyappeared to be reshaping theworld. America and itspublicly listed companiesbenefited from the globalperception that in all thingsthat mattered most, Americawas simply the biggest andthe best. But by the end of2000, the technology boom

thatmade somanypeople inCalifornia rich had quicklyturned to rot. In the process,SiliconValley becameDeathValley, sinking the state’seconomic hopes andprospects.

After the tech wreck of2000, Wall Street and theworld of high finance stoodalone as the engine for stockmarket growth. When theGlass-Steagall Act, which

separated investmentbankingactivities from commercialbanking, was repealed, WallStreet’s power and influencegrew dramatically. Itsdominance was reflected inits weight and overallimportance in the S&P 500stock index. By the end of2007, the financial servicessector accounted for 40percent of all S&P 500earnings—upsharplyfromits

historical contribution of 15percent.

BondBlues

In the investment game,bondsareoftencharacterizedas the steady performers,great for cranking out solidinvestment returns but not asfleetoffootassexystocks.In

spite of that reputation, overthe last 25 years bondinvestors have had it good—theyearnedgreat returnsandwere exposed to very littlerisk.Thegoldeneraforbondswas the 25 years followingthe 1968-1982 commoditybullmarket.

The 1970s, on the otherhand,wereagreatdecadeforcommodities but not muchelse. Inflation was rampant,

hitting13.3percentinAugustof 1979, and prompting adesperate President JimmyCarter to appoint PaulVolcker to the post ofchairman of the FederalReserve. Only by ratchetingup the benchmark federalfunds rate to a high of 20percent in July 1981 wasVolcker able to tame theinflationbeast.Intheensuingdecadesinterestrateswereon

a steady downward path,settingthestageforamassivebull market in bonds. Wheninterestratesarefalling,bondprices move higher,rewardinginvestorsbygivingthem both capital gains andinterest income. But can thepartycontinue?

No. With interest rates onU.S. government bonds atmulti-decade lows, there’snowhereforbondpricestogo

butdown.Rightnow,centralbanksintheWestarekeepinginterest rates artificially lowin an attempt to breathe newlife into their comatoseeconomies, but eventuallyrateswillhavetorisetostaveoff inflation. And wheninterestratesrise,bondsfall.

WithinterestratesonU.S.government

bondsatmulti-decadelows,there’snowhereforbondpricestogo

butdown.

TheHouseIsA-Rockin’

In2000,awaveofnew,moreaggressive lending practiceshadtakenrootintheU.S.realestate market, which, whencoupled with loose lendingstandardsandaneasy-moneyculture, helped propel U.S.house prices into thestratosphere. For the averageAmerican worker, long-conditioned to expect ever-rising levels of consumption,the rapid rise in residential

real estate prices offered asimple solution to thedilemmaofstagnantwages—theirhomes couldbeused toplugthegap.Ashousepriceswere rocketing ever higher,homeownersthrewcautiontothe wind and turned theirhomes into ATMs to fundtheir lifestyle—and nowonder, as realwage growthwas stagnant from 2000 to2007.

But economic disasterstruckas real estateprices intheU.S.havetumbledhard—down more than 30 percentfrom their 2006 peak. Sincethe credit bubble of 2008-2009 burst, average housepricesaredownmorethan50percent in some U.S. cities.While the American housingmarket has started tostabilize, it still facessignificant headwinds. A

stagnant economy, weak jobmarket, and a persistentlyhigh foreclosure rate are allmajorobstacles toovercome.Sincehousingaccountsfor20percentof theU.S.economy,animprovedoutlookwillbeakey pillar of any economicrecovery.

WhatAmIMissing?

Mostof theWest facesyearsof slow growth and sluggisheconomic prospects in thewake of the greatest marketmeltdown in a generation.The last decade has beenunkind to most investors.Stocks have tumbled badly,thebondrallyhasstalled,andreal estate has turned out tobeasucker’sbet.

But there is an alternativeto investing as you always

have; you can open yourmind to the world ofcommodities, to a worldwithouta legionof followersbut with plenty of upside.Driven by surging Asianmarkets, sluggish supply, asaggingU.S.dollar,andfew,if any, investmentalternatives, the next greatcommodity bull market isnow upon us. What are youwaitingfor?

HotCommodities

•Commoditiesarepartofoureverydaylivesandcrucialtomodernexistence.

•Commodityfuturesarestandardized

contractsthattradeoncommodityexchanges.Priceandquantityaretheonlyvariables.

•Whenstocksandbondsaregoingdownandinflationisheadinghigher,

commoditypricesmoveup.

•Therearelegionsoffollowersofstocks,bonds,andrealestate,butthereisn’tmuchofafanclubforcommodities.

•Chinaisthekeyto

understandingcommoditydemand.

•ForinvestorsintheS&P500,2000to2009ranksastheworstdecadeinnearly200yearsofAmericanstockmarkethistory.

•Withinterest

ratesonU.S.governmentbondsatmulti-decadelows,there’snowhereforbondpricestogobutdown.

•Commodityreturnsaresimilartothoseofequities,butcommodity

returnsarenotwellcorrelatedtothoseofstocksorbonds,makinganidealadditiontomostportfolios.

•Ifnotcommodities,thenwhat?

ChapterTwo

Gettin’Goin’

CompaniesorCommodities?

THEGLOBALECONOMICORDER is rapidly changing—creating tremendousopportunities for commodityinvestors. Demand forcommodities continues togrow despite the fact thatmuch of the world is stilllicking its wounds from theglobal economic collapse of2008-2009. Westerngovernments have tried topaper over the problem of

sluggish consumer demandby implementing stimulusprograms intended to jump-start infrastructure spending,for example, the Cash forClunkers rebate schemeaimed at the beleagueredAmerican car industry. Butdespite these efforts, thecollective credit cards of theU.S. and much of Europeremain completely maxedout.

The wheezing Westernrecovery aside, demand forcommodities remains strong.Commodities are a big deal,much bigger than mostpeople realize. Primarycommodities,suchasironoreand copper, account for 25percent of global trade.Supply has been sidelinedduring the global economiccollapse, creating a nearperfectstormforinvestors—a

situation that is likely to lastformanymore years.As thebasic feedstock for industrialand urban growth,commodities can be red hoteven when stocks and bondsare ice cold. And with theirdirect link to the drivers ofinflation, commodityinvestmentsareaheaven-senthedgeagainstrisingprices.

Commoditiesareabigdeal,muchbiggerthanmostpeoplerealize.Primary

commodities,suchasironoreandcopper,accountfor25percent

ofglobaltrade.

Despite these benefits,

commodities tend to begrossly underrepresented inmost investment portfolios.To be a total investor is toknow something aboutcommodities–especially witha commodity bull marketwashing up on our shores.Yet commodities are amystery to many investors:most haven’t a clue how tobegin.

DumbLuck

One way to get intocommodities is to luck out.You could find oil on yourproperty as happened in the1960s television show TheBeverly Hillbillies, or youcould stumble upon a majorgold discovery. You mighteven inherit the family farm.In any of these situations,

you’d be in the commoditybusiness, but if you haven’tyet struck oil on yourswampland, chances are youwon’t.

Even if you do get lucky,you’ll need plenty of helpdeveloping your find beforeyou can pull up stakes andmove to Beverly Hills.However, while it may looksimpleonTV,capitalizingona producing commodity

businessisanythingbuteasy.It is a highly sophisticatedand complex undertakingrequiring millions of dollarsand decades of experience—nottomentiongoodluckandexcellentjudgment.Owningafarm, mine, or oil field justisn’t a practical way to addcommodities to yourinvestmentlineup.

GoAlongtoGetAlong

Investors love index fundsand exchange traded funds(ETFs) because they mimicthe pricemovements of theirunderlying indices and giveinvestors an inexpensive andtransparent way to get directcommodity exposure. Thereareseveralmajor indicesand

plenty of exchange tradedfundstochoosefrom.

The granddaddy of allcommodity indices is theReuters/Jefferies CRB Index,which dates back to 1957.The index has gone through10revisionsovertheyearstohelpkeepitbothrelevantandreflective of the underlyingeconomic demand for thevarious commodities itrepresents. Most recently, in

1995, natural gas was addedto the index while lumber,pork bellies, unleadedgasoline, soybean oil, andsoybeanmealweredropped.

In 1992, investment bankGoldman Sachs created acommodity index knowntoday as the S&P GSCI.Another big player in thecommodity index game isUBS, which has two widelyfollowed indices: the Dow

Jones-UBSCommodityIndexand the UBS BloombergConstant MaturityCommodity Index (UBSBloombergCMCI),createdin1997. Jim Rogers, the WallStreet investment legend,created his own index in1998, called the RogersInternational CommodityIndex(RICI).

A problem for allcommodity indices is how to

weight their variouscomponents toprovidea truereflection of their overalleconomic importance. Moststock indices are constructedandweightedaccordingtothemarket capitalization of theircomponents. In commodities,however, the concept ofmarket capitalization (sharesoutstanding multiplied bystock price) just doesn’tapply. Commodities are held

in a variety of forms,including over-the-counterinvestments, offsettingfutures positions, andphysical producer stockpiles—the combination of whichmakes complete accountingimpossible and thecalculation of commoditymarket capitalization anelusivetarget.

Moststockindicesareconstructedand

weightedaccordingtothemarket

capitalization(sharesoutstandingmultipliedbystockprice)oftheir

components.Incommodities,theconceptofmarket

capitalizationjustdoesn’tapply.

Without the availability ofmarket capitalization figures,commodity index creatorshave been left to their owndevices, constructing andweighting the variouscomponents as they see fit.The result is awide rangeofmethodologies that can

dramatically skew theweights of the index and itsrelevance as a barometer forgauging activity levels incommodities.Somebasetheirweights on an assessment ofthe economic importance ofeachcommodity,whileothersbase them on a quantity ofproductionbasis.Subjectivityoften plays a major role inthis process, oil being a casein point. As the most

economically important andactively traded commodity,oil’simportancetotheglobaleconomy cannot beoverstated. In November2009, the target weights forenergyintheS&PGSCIwerea whopping 67.83 percent,yettheReuters/JefferiesCRBIndex set its energy targetweight at just 18 percent—adifference of nearly 50percent.

Investors buy index fundsand index-linkedETFs underthe assumption that theywillmimic the price appreciationtheyexpectfortheunderlyingcommodities. Unfortunately,they are often disappointed.Not only do all commodityindices struggle to find anappropriate weighting ofcomponents,butmostalsodoa poor job of measuring thehere-and-now price

movements of commodities.Aninvestorwhoseesthatoilprices are up $2 per barrelmay justifiably assume thathis or her commodity indexfundisflyinghigh;andifthatinvestor is lucky, it will be.What all commodity indexfunds do is buy a basket offutures contracts, usuallynear-month contracts, whichshouldcloselytrackthepricein the here and now (also

known as the “spot price”)movement of the variouscommodities. Unfortunately,they often don’t. During thefirst 11 months of 2009, forinstance, the price of crudeoil surged some 73 percent,yet the S&P GSCI, with itsheavytargetweightingtooil,was a laggard—increasingjust46.88percent.

Commodityindexfundsshouldcloselytrackthespotpricemovementofthe

variouscommodities—butunfortunatelythey

oftendon’t.

ReadytoRockn’Roll?

Youcanmakealotofmoneyinfuturestradingifyouknowwhat you’re doing. And ifyoudon’t—well,let’sjustsayyou can lose your shirt in ahurry.Commodityfuturesarejust that: contracts for thefuture delivery of a givencommodity. While

commodity futures pricesoften resemble what’shappening in the here andnow, or the “spot market,”this isn’t always the case.Complicating matters furtheris the fact that most futurescontracts trade monthly andneed to be rolled forward—unless you want to takephysical delivery of thecommodity you just bought.And discovering you’re the

proud owner of a thousandbarrels of No. 2 heating oil,currently waiting for you atNew York Harbor, can surethrow a wrench in yourweekendplans.

Depending on investors’expectations of commodityprices, the futures curve caneither be upward sloping(contango) or downwardsloping (backwardation). Thefuturescurveisnothingmore

than a compilation ofindividual futures contracts,so if investors expect oilpricestobegoinghigherovertime, then you should expectanupwardsloping(contango)futures curve. If, manymonths into the future, theprice of a commodity issignificantly higher than it istoday (contango), itmay payto hoard the physicalcommodity in the hope that

you can sell it later for aprofit. Oil traders andcompanies did just thatduring the 1970s when theyhired tankers to store crudeoil for months until theycouldsellitataprofit.

In commodity investing,the devil really is in thedetails, and the shape of thecommodity curve is noexception. We’ve alwaysheard that successful

investing is all about buyinglow and selling high, but ifyou’re buying futurescontracts when thecommodity curve is incontango, you’re doing justthe opposite. During the1980s and 1990s, the futurescurves formost commoditieswere downward sloping (inbackwardation), yetcommodity funds werepostingexcellentresultssince

theywereabletobuylowandsellhigh.

Duringthe1980sand1990s,thefuturescurvesformostcommoditieswere

downwardsloping,yetcommodityfundswere

postingexcellentresultssincetheywereabletobuylowand

sellhigh.

Figure2.1BuyingLowandSelling High—It’s theShape of the Curve thatCounts

ManagingtheFuture

Between 2002 and early2008,commoditieswereback

in vogue after a 20-yearhiatus, and commoditytradingadvisors(CTAs)weresuddenly in demand,movingtheirproductsfasterthanfreeice cream on the Fourth ofJuly. The idea behindmanaged commodity futuresis simple. A commoditytrading advisor manages apool of investments, takingcare of the pesky details likecontract rolling, and giving

youexposuretoawiderangeof products. Rather thanstudying the supply anddemand variables for thesoybeanmarket into the weehours of the morning, youhire an expert to makedecisionsforyou.

Of course, managingfutures contracts doesn’tcome cheap. There aretremendous benefits toobtaining professional

management,butwhile someCTAs are provenmoneymakers,manyaren’t—which means that yourreturns are going to be onlyas good as your advisor’sexpertise. Regardless ofwhom you choose, it’simportanttoknowthatyou’regiving up both investmentcontrol and transparencywhenyouuseaCTA.IfyourCTA decides to move

aggressively into frozenorange juice futures becausehe’s spending winters inFlorida, for example, youmayfindthatyouroncewell-diversified portfolio is nowjuiced-up on just a fewcommodities.

CompanyMan

So what’s a commodityinvestor to do? Commodityindices andETFsare easy tobuy, but as I’ve explained,mosthaveseriousissueswithweighting and tracking. Ifgetting direct exposure tocommodities by snapping upfarmland in Ohio or panningforgoldinNevadaseemsliketoo much work, you shouldconsiderbuyingthestocksofcommodity-producing

companies. A key benefit ofowning these is the leverageyou get to rising commodityprices.Aslongasthegaininthe price of the commoditythe company producesoutstripsanyincreaseintheircosts,you’re laughing.Whenbuying stock, you’re alsomaking an indirect bet onmanagement—so nail thecommodity and themanagement call, and you’re

sitting pretty.Best yet,manycommodity producers areroutinely able to build theirreserves over time as theyuncover more resources onthe lands they lease. Buyingcommodity-producingequitiesallowsyoutoprospernotonly in thehereandnowas commodity pricesimprove, but also in thefuture as rising prices allowadditional reserves to be

discovered. Chosenprudently, commodity-producing equities can be agiftthatkeepsongiving.

In my career I’ve tried itall,andIkeepcomingbacktoa well-chosen basket ofcommodity-producingcompanies. With futuresthere’s the “roll risk” tomanage, plus a wide varietyof new markets to study upon. Most commodity index

funds are far too dependenton the shape of the curve togiveyouthekindofexposureyou’re looking for. For mymoney the choice is clear,commodity producers are theway for most investors toprofit from a roaringcommoditybullmarket.

Akeybenefitofbuyingthestocksofcommodity-producing

companiesistheleverageyougettorisingcommodity

prices.

HotCommodities

•Owningyourownoilfield,mine,orfarmisonewaytogetdirectphysicalexposuretocommodities,butitjustisn’tpracticalformostpeople.

•Thepriceofagivenfutures

contractwillalwaysconvergetothe“spot,”orcashmarketpriceatexpiration,butalotcanhappenbetweenthedateswhenfuturescontractsbeginandexpire.

•Duringthe1980sand1990s,thefuturescurveformostcommoditieswasdownwardsloping(backwardation),yetcommodityfundswerepostingexcellentresults

sincetheywereabletobuylowandsellhigh.

•Moststockindicesareconstructedandweightedaccordingtothemarketcapitalizationoftheircomponents.Incommodities,

however,theconceptofmarketcapitalizationdoesn’tapply.

•Commodityindicesareoftenpoorbarometersforgaugingactivitylevelsincommodities.

•Commodity-

producingcompaniesofferleveragetorisingcommoditypricesandtheopportunitytobenefitfromreserveadditionsovertime.

ChapterThree

Gusher

InvestinginOil

NONATURALRESOURCEIS MORE FIERCELYPRIZEDorjealouslyguardedthan oil. Ancient Egyptiansused it forembalmingand tosupportthewallsofBabylon.Wars have been fought andempires created anddestroyed in the epicconquest for the power andwealth that surrounds oil.Since 1854, when thekerosene lamp was invented,

we’ve increased ourdependence on the preciousstuff and have sucked some650billion barrels of it fromthe ground. Access toabundant cheap oil makessuburbia and much of ourmodern world possible. Oilfuels our cars, planes, trains,and buses and is a criticalfeedstockfor theplasticsandcosmetics industries. Enoughoil to fill a trillion barrels

remainsintheground,butthecheap, easy-to-get stuff isalready gone. As the worldeconomybeginstogrowafterthe global recession, oilprices will once again beheadinghigher.Muchhigher.

BigOil

Everything about the oil

business is big. Oil is theworld’s first trillion-dollarindustry, it’s the mostactively traded commodity,and it’s the single largestcomponent of world trade.It’s also the commodity thatgenerates the most debate.Whether it’s America’sreliance on foreign imports,concernoveryourneighbor’scarbon footprint, or themassive profits Big Oil (as

theworld’slargestoilandgasmanufacturersarecollectivelyknown) seems to be makingwhen prices are movinghigher—everyone has anopinionaboutoil.

ToErrIsHuman

Yet in spite of oil’simportancetoourwayoflife,

publicly listed energycompanies control just 15percentoftheworld’sknownreserves. The rest arecontrolled by governmentsand their national oilcompanies,andmanyarelessthanfriendlytotheWest.Theposter boy for poor oilrelationsisVenezuela’sHugoChávez,theleft-leaning,anti-Americanleaderwhocametopowerin1999.InMay2007,

in his quest to makeVenezuela into a socialist-inspired state, Chávez tookdramatic action by strippingforeignoilcompaniesoftheirmajorityinterestsindomesticoil fields. Bymandating thatstate-controlled Petroleos deVenezuela (PDVSA) had tohave at least 60 percentownership in these new so-called “joint ventures,”companies such as

ExxonMobil, Chevron, andTotal effectively had the rugpulledoutfromunderthem.

Publiclylistedenergycompaniescontroljust

15percentoftheworld’sknownoil

reserves.

But lately, with oil pricesplunging from theirpreviously lofty peaks,Chávez is humming adifferent tune. Once againhe’s soliciting bids from bigWestern oil companies—including many of thosewhose agreements hetrampledon in 2007.Chávezneeds Western money and

know-how tounlockhis vastreserves, yet he still holdsmost of the cards becauseWestern oil companies aredesperate to find large-scaleprojects in which to invest.As a result, once-spurnedWestern companies are stillwilling to take their chanceson Venezuela. Talk aboutdesperation!

Oil revenues account forabout 93 percent of

Venezuela’s export revenue.And with the unpaid billsstarting tostackupforsocialwelfare programs such ashealth care and highereducation, embracingWestern oil companies maybe Chávez’s best option forbalancingthebooks.Thedealmay be bad and the slice ofthepiemaybeshrinking,butVenezuela—unlike other oil-rich countries where the

national companies have astranglehold on production—is at least willing to letmultinational companiesparticipate in the drilling.Saudi Arabia, the world’slargest producer of crudeoil,and Mexico have barredAmerican and other foreignbusinesses from participatingin thesearchforoil formorethanhalfacentury.

FromRussiawithLove

InRussia,theworld’ssecondlargest producer of oil,muscle-flexing is the norm.For years, the Kremlin hasmoved aggressively toreclaim ownership ofRussia’s oil and gas industryfrom private firms. At onetime, Yukos was Russia’s

largest private oil and gascompany,worthanestimated$40 billion. But a personalrivalry with Vladimir Putincost Yukos founder MikhailKhodorkovsky, one of thenotorious so-called Russianoligarchs, both his companyand his freedom. For years,theKremlinandtheoligarchshad maintained an informal,mutually beneficialarrangement: the oligarchs

would stay out of politics inexchange for the Kremlinkeeping its nose out of thedubious circumstances underwhichthisgangoffabulouslywealthy businessmen gainedcontrolofformerstateassets.By Putin’s second term asRussia’s president, however,Khodorkovskyhadsouredonthe arrangement and startedfunding opposition parties intheDuma.ForPutin,thiswas

intolerable. On October 25,2003, Khodorkovsky, thewealthiest man in Russia atthe time, was arrested andchargedwith fraud. Six dayslater,theRussiangovernmentfroze trading in the sharesofYukosandbroughtchargesofincome tax evasion againstthe firm. In May 2005,Khodorkovsky was foundguiltyof fraudandsentencedto nine years in prison.With

this criminal prosecution andthe drawn-out dismantling ofthecompany, anunequivocalmessagehadbeensent:don’tcrosstheKremlin.

In 2003, BP, one of theworld’s largest energycompanies, acquired a 50percent stake in one ofRussia’s largest oilcompanies, TNK. The jointventure, calledTNK-BP, hadPresident Putin’s personal

blessing. But the happymarriage didn’t last long.Faster than you could say“oligarch,” BP and the fourRussian billionaires whoshared control of Russia’sthirdlargestoilcompanyhada falling out. The Russianpartners took objection toTNK-BP’s American chiefexecutive, Robert Dudley,accusing him of favoringBPand running the jointventure

likeasubsidiary.

In adealhammeredout inSeptember2008,BPcededtoall the Russian partners’demands. BP agreed todismiss Robert Dudley andappoint a Russian-speakingchief executive agreeable toits four major Russianshareholders. BP also agreedto create three additionalindependent seats on theboard of directors. While it

must have been a bitter pillfor BP to swallow, it helpedthe company preserve itsownershipinterestinthejointventure,andwithit,accesstothelargeoilfieldsofSiberia.Atatimewhenoilcompaniesare struggling to find newreserves,adealthatpermittedBPtopreserveaquarterofitsworldwide production wasoneithadtomake.

Whilepoliticalriskmaybe

part of the game forinternational oil and gascompanies, itdoesn’thave tobe a gamble that individualinvestors take. For mymoney, I prefer to bet oncompanieswhoseonlyriskisgeological rather thanpolitical. Investing can betrickyenoughwithouthavingto consult theminutes of thelast UN meeting to try andfigure out which way the

politicalwindisblowing.

HaveWeReachedthePeak?

No debate is morecontentiousintheworldofoilthan the debate overwhetheror not the world has passedthe peak of maximum oilproduction. The theory now

knownas“peakoil”wasfirstadvanced by Dr. M. KingHubbert, a geophysicist whoworked for Shell OilCompanyfrom1943to1964.During his career, Hubbertmade many significantcontributions to the field ofgeophysics, but his mostfamous theory was that therateofoilproductionforanygivengeography—beitanoilfield,anation,ortheplanet—

wouldalwaysresembleabellcurve. As time went by,production would increaseuntil it hit its maximum or“peak” production, afterwhich production wouldforeverfall.

Hubbertfirstpresentedthistheory, later dubbed the“Hubbert Curve,” at a 1956meeting of the AmericanPetroleum Institute in SanAntonio,Texas.Hepredicted

that the United States wouldsee oil production peaksomewhere between the late1960s and the early 1970sand thereafter enter anirrevocable decline in thelower 48 states. At the time,hewasderidedbycolleagueswho pointed out that allpredictions made about oilcapacity over the past halfcentury had proven false. Sowhen U.S. petroleum

productionpeakedin1970,asHubbert had accuratelypredicted 14 years earlier,you can guess who had thelastlaugh.

WhenU.S.petroleumproductionpeakedin1970,asHubberthad

accuratelypredicted14yearsearlier,youcanguesswhohadthe

lastlaugh.

According to theInternational EnergyAgency’s(IEA)reportWorldEnergy Outlook 2008,production from currentlyproducing fields was set tostart declining in 2009. The

shortfall between the amountof oil that the Paris-basedIEA figures the planet willneed and what is currentlybeing produced will have tocome from yet-to-be-discovered oil fields, fieldsalreadydiscoveredbutnotyetin production, natural gasliquids (NGLs), andnonconventionalsourcessuchasCanada’s oil sands.NGLsare liquids such as propane,

butane, and pentane, whichare often found in oilreservoirs. While NGLs canbe used in many chemicalprocesses, such as themanufacturing of plastics,theyaren’tmuchgoodasfuelfor your car. Over the nextfewdecades,withtheworld’sexisting oil fields tired andtheir production in decline,theoilindustryclearlyfacesamonumental task: finding

vast, economically viablenewreservestoexploit.

HopeSpringsEternal

Already, many of our mostpromisingsupplybasinshaverolled over and started todecline. The North Sea iscaseinpoint.Itstwomassiveoil fields, theForties and the

Brent, were discovered in1970 and 1971 respectively.The Forties field hit its peakproductionof523,000barrelsper day in 1980, while theBrent hit its maximum of440,000 barrels per day in1985. In an effort to keepproducing as much aspossible for as long aspossible, exploration andproduction companiesinjected massive amounts of

waterintothereservoirsinanattempttosweepoilfromtheedges to the center, where itcould be brought to thesurface and collected moreeasily. By 2000, however,production from the NorthSeahaddroppedlikeastone,aggressive water floodinghavingultimatelyexacerbateditsdecline.

The last major oil field tocomeintoproductionwasthe

giant Cantarell field inMexico, which wasdiscovered in 1975. Withpeakproductionofmorethantwomillionbarrelsaday,thiswastrulyaGoliathofafield.To keep the good timesrolling and boost productionlevels, Pemex, Mexico’snational oil company,initiated an enhanced oilrecovery program in 1998.Despite spending more than

$10 billion on the effort,Cantarell’sproductionstarteddroppingquicklyin2003.

ShiftingSands

In 2007, when I visited themammoth Syncrude projectnearFortMcMurray,Alberta,in the heart of Canada’s oilsands, I felt as if I was

standingonthesurfaceofthemoon. The earth had beenscarred andwas riddledwithpockmarks; years of surfacemining had altered thelandscape forever. In thedistance, I could see a smallyellow dump truck. As itclosedthenearly30-mile(48kilometer)distancetowhereIwas standing, it becameapparent that this was noordinary dump truck. Rather,

it was a massive Caterpillar797 haul truck boasting apayloadof400shorttonsandstanding more than 50 feet(15meters)high.

Projects such asSyncrude’s arewhat the IEAhopes will become thecornerstone of future oilsupply growth. Canada’s oilsands reserves are massive,rankedaclosesecondbehindSaudi Arabia. However,

getting all that gooey, sandyoil out of the ground and tomarket is no easy task. Itrequires either an enormoussurfacemining operation, or,when the resource is buriedtoo far below the earth’ssurface, a highly energy-intensive operation involvingtheinjectionofsteamintothereservoir to get the tar-likeresource flowing. Once theoil is recovered, sand and

impurities need to beremovedandtheoilupgradedbefore it can be sent bypipeline to refineriesthroughout North America.While the oil sands are atremendous resource,removing oil from sand isn’tcheap.

Decline

To hold oil production at2008 levels, the global oilindustry needs to find morethan four million barrels perday—an amount equal toIran’s total 2008 production—each and every year. In2008, the average oil fieldsaw production declines ofaround 9.7 percent. Byspending more than $250billion annually on waterflooding and other enhanced

oil recovery techniques, theoil industrywas able to slowthe rate of decline to 5.1percentperyear.

Toholdoilproductionat2008levels,theglobaloilindustryneedstofindmore

thanfourmillionbarrelsperdayofproduction—an

amountequaltoIran’s2008production—eachandeveryyear.

To find the huge new oilfields they require,exploration companies needto be drilling plenty of newexploration wells.

Unfortunately, energyinvestmenthasslumpedsince2008, as the effects of theglobalfinancialcrisismadeitharder for energy companiesto secure the necessaryfinancing. According to theIEA, global explorationspending plunged by over$90 billion, more than 19percent, in 2009—the firstsuch drop in more than adecade.

While exploration effortsremainmuted, oil demand isforecast to soar asconsumption in China andIndia increases. The IEApredicts that between nowand2030,fully93percentoftheincreaseinoverallenergydemand will be driven bynon-OECD3 countries, withChina and India aloneaccounting for 53 percent offuturedemand.Notonlymust

new oil fields be found tomake up for dwindlingproduction from existingfields, but the IEA alsoestimates that at least 20million barrels per day ofadditional production willneed to be found over thenext20years.Goodluck!

For Big Oil, a perfectstorm of slumping globalsupplies, voracious demand,and increasingly hostile host

governments have made itdifficult to grow its “reservebase”—that is, the inventoryfrom which oil companiesproduce their supply eachyear. For the large majorproducers, the lack of accessto quality projects and thehigh cost of finding andbooking reserves have lefttheminadifficultposition.In2008,theaveragereservelife(reserves/current annual

production)forthesixlargestpublicly listedoilcompanies,or “super majors,” was just12.2years.Atcurrentratesofproduction, and in theabsence of new discoveries,the super majors will be outofoilreservesinlessthan15years.

Atcurrentratesofproduction,andwithoutnew

discoveries,thesupermajorswillbeoutofoilreservesinlessthan15years.

ThatGreatSuckingSound

Big Oil has found itselftrappedbetweenarockandahard place. Shareholders aredemanding increases in bothproduction and reserves, yetWestern oil companies areoften stymied in their questfor new oil. Increasingly,companies are investingbillions in cutting-edgetechnologies to unlock moreof the oil that lies trappedbelowtheearth’ssurface.But

despitemajoradvancesintheindustryoverthelastcentury,a shocking two-thirds of alloilstillgetsleftintheground.

Despitemajoradvancesintheoil

industryoverthelastcentury,ashocking

two-thirdsofalloilstillgetsleftinthe

ground.

If international oilcompanies can raise therecovery ratesonexistingoilfields from a paltry 35percent to closer to 50percent, the world’srecoverable oil reserveswould soar.TheOil andGas

Journal, a leading industrymagazine,estimatesthatwithcurrent recovery rates, theworldhas1.34trillionbarrelsofrecoverableoilreserves.Ata 50 percent recovery rate,thatnumber could zoom to astaggering2.5trillionbarrels!Sofar,however,thedreamofrecovering vast new amountsof trapped oil has provedelusive.

Energy companies are

constantly looking for newways to unlock more oil.Water flooding is often usedin aging reservoirs, whiletechniques such as nitrogeninjectionareused to thinandmobilizeoilinmuchthesameway that detergent cuts thegrease on dinner plates. Yetinspiteofalloftheseefforts,global recovery rates remainalarminglylow.

SecondComing?

Whilenewoilfieldsarebeingdiscovered all the time, theyare increasingly in remote,inhospitable parts of theworld.Thelatestthingstosethearts racing are themassivediscoveries in Brazil, some180 miles from the coast ofRio de Janeiro in the SantosOilBasin. In all, threemajor

newfields—theTupi,Jupiter,and Sugar Loaf—have beenfound, comprising the largestoildiscoveriessince2000.Bysome estimates, the threefields could contain asmanyas 80 billion barrels of oil,enough to launch Brazil intothe big leagues of oil-producing and oil-exportingnations.

But there’s a catch. Thefields lie in ultra deepwater,

more than 2.5 miles belowthe seabed. And a biggerproblem is that these fieldsarelocatedintheocean’spre-salt layer, which makesdrilling for oil extremelydifficult and expensive. TheTupifieldalonecouldcostinexcess of $600 billion todevelop. Collectively, themajor fields in the SantosBasin will cost in excess of$1.5 trillion tobring into full

production—aheftypricetag.

Fill’ErUp

Demand for oil is alsoexpected to grow in the verysame part of the world thatwe’llbelookingtoforfutureoilsupplies: theMiddleEast.Outside of Asia, the MiddleEast is showing the fastest

rate of increase in demand,accounting for roughly 10percent of the incrementalglobal energy demandforecastedbytheIEA.

One reason for thisincreased demand is heavysubsidization at MiddleEasterngaspumps.Whilewestart togrumbleprettyloudlywhen the cost of topping upour tanks hits $4 per gallon,many of our pals in Saudi

Arabia are paying amere 45cents per gallon. And whileit’s cheap to drive in theMiddle East, operating a cabin Caracas, Venezuela, hasgot tobethebestdealgoing.Gasoline prices in Chávez’sSoviet-styled state clocked inat a jaw-dropping 17 centsper gallon in 2008. Oilsubsidies are a big dealthroughout most of the oil-producing world. According

to the IEA, the 20 largestnon-OECD energy-consumingcountriesspentanestimated $150 billion onsubsidies in 2007. Anafternoon spin is a lot morefun when someone else isfootingthebill!

NiceWheels

In theU.S., vehicle sales fell18 percent during 2008. InChina, however, theycontinuedtoclimbdespitetheworldwide recession. In thelastdecadealone,carsalesinChina have surged fivefold,leaving foreignmanufacturers, such asGeneral Motors Corp. andVolkswagen AG, and theirChinese partners scramblingto produce enough cars to

meetthedemand.InFebruaryof 2009, the manufacturers’hardworkpaidoff,asthesaleof vehicles in Chinasurpassed those of the U.S.forthefirsttime.

In August of 2009, Chinaachieved yet anothereconomic milestone when itbecame the largest carmanufacturing nation on theplanet,despite the fact that itdid not export a single car.

India’sTataMotors,ownerofthe Jaguar and Range Roverbrands,hasbegun toproducean entry-level car called theNano, which retails for just$2,000. With a sticker pricethat low, more drivers arebound tobehitting the roadsinIndiaandChina,whichcanonly mean one thing: highergasoline prices for NorthAmericans.

CrackShack

Refinersareakeycomponentof the oil and gas business,and yet they often get shortshrift. In the business, thejoke is that refiners are the“commodities’ commodity.”Refinery guys were alwaysthe ones wearing thechocolate brown suits andthick-soled loafers at the oil

and gas conferences. Thebusiness, while complex andindispensible, just isn’t allthat sexy or profitable.Whether they’re stand-aloneindependents or part ofintegrated oil and gascompanies, refiners are pricetakers.Theirprofitability liesin the razor-thin marginsbetween what they get forsellingrefinedproducts,suchas gasoline, diesel, and fuel

oil, and the costs of buyingthecrudeoilfromproducers.

Today, with crude priceshighandgasolinestoragefull,American refineries aregettingsqueezedonallsides.Adding to theirmisery is thefact that thecrudeoil they’rereceiving is increasinglybothsour (high in sulfur content)and heavy (doesn’t floweasily).MostrefineriesintheU.S.weredevelopedinanera

whenthelight,sweetblendofcrude oil (the type that theWTI contract is based on)was the norm. But today, asthe oil fields have aged andproductionisstartingtogetalittle long in the tooth, light,sweetcrudeoilmakesupjust15percentoftheglobalcrudeslate. And that means costlyretrofits (in the billions ofdollars per refinery) torearrangethevariouspotsand

pans necessary to handle theheavier sour grades of crudethat have become soprevalent.

With America awash ingasoline and refineriesworking at just 80 percentcapacityutilization, the stockmarkethassoldoffthesharesof the independent refiningcompanies. Refiners maketheir highest margin sellinglighter, more valuable

productssuchasgasoline.Toproduce gasoline from crudeoil, the oil molecules firstneed to be “cracked” indevicessuchashydrocrackersor fluid catalytic crackers.The profit margin thatrefiners make in the processis thus known as the “crackspread.” Today, the crackspread has collapsed from ahigh of $31.98 per barrel onDecember 31, 1998, to

around $7 per barrel—a lossofmorethan70percent.

Theprofitmarginthatrefinersmakein

upgradingcrudeoiltoproductssuchas

gasolineisknownasthecrackspread.

SlickOperators

Onceuponatime,billionsofdollars were chasing Internetstocks, but today the hotmoneyisflowingintooilandcommodity funds.Unlike theInternet investment fad, thisbullmarketisunderpinnedby

some pretty solidfundamentals: namely,sagging supply and soaringdemand.Andthat’smakingalot of people in London andNewYorkrich.

As a critical feedstock forthe modern economy, oil isquite simply themost visibleand important of all thetraded commodities. This isreflected on the trading floorat NYMEX, where oil is

traded alongside natural gas,coffee,andcopperbybrokerswhobuyandsellcontractstodeliver these goods for acertain price at a future date.Unlike the modern,computerized tradingplatforms such asNASDAQ,the NYMEX is an open-outcry system where,dependingonthecommodity,floor traders meet inpreassigned circular pits to

match buy and sell ordersfromthemarketplace.WhenIvisited the floor, it was amaze of activity, with phonecables everywhere, runnersgoing every which way, andtraders shouting at the topoftheirlungs.Butnopitwasasphysically large, boisterous,oraction-packedasthecrudeoil pit, where floor traderswere executing client ordersfromaroundtheworld.

Far away from thetestosterone-fueled tradingfloor of the NYMEX sit thereally slick operators in theworld of oil trading: thecommodity traders employedby hedge funds andinvestment banks. Here, anunexpected calm reigns asbillions of dollars arewagered on the spreadbetween light, sweet crude,and heavy crude oil prices.

Trades are executed in theblink of an eye by a bankofcomputers reacting to presettrading algorithms or bytraderswithadvanceddegreesin mathematics. Ascommodity prices movehigher, the demand fortrading talent has increaseddramatically.Today,adecentmid-level trader who knowsthe energy complexwell caneasilyearnbetween$1and$3

million per year—a levelonce reserved for the toptraders.

Nowadays, oil tradersaren’t just buying contractsfor the future delivery of oil,they’re also charteringsupertankers to store thecrudeinthehopeofresellingit for a profit months later.And in what’s been dubbedthe “trade of the year,”companies such as Citigroup

and Morgan Stanley havebeensnappingupthisfloatingstorage at deeply discountedrates. In 2008, when rentalrates plunged 78 percent,somesavvytraderssecured7percent of the global fleet oflargecrudecarriers.

PetrolProfits

As the global economybegins to grow again, oilprices will head higher.Strong demand, sluggishsupply, and technical andoperational challenges willcontinue to plague theindustry, making higher oilprices a foregoneconclusion.Investors looking to profitfrom the coming bullmarketin petroleum need look nofurther than the stocks of

well-run oil and gascompanies engaged inexploration and productionactivities. Companies withlong-lived oil reserves incountries with low politicalrisk should be the go-tonames for investors lookingtopumpuptheirprofits.

Companieswithlong-livedoilreservesincountrieswithlow

politicalriskshouldbethego-tonamesforinvestorslookingto

pumpuptheirprofits.

Big Oil, with its shortreserve lives and narrowingslate of internationalopportunities, will

underperform the explorationand production companies inthe oil run-up. But if themarket heads south in ahurry,asitdidin2008,largecapitalizationcompaniessuchas ExxonMobil will be theplace to ride out the storm.Refiners and integrated oiland gas companies willcontinue to be laggards forthe foreseeable future as lowmargins in the refining

business will continue to actasadamperonstockprices.

HotCommodities

•Nocommodityismorevisible,important,controversial,orcrucialtoourmodern

wayoflifethanoil.

•Publiclylistedenergycompaniescontroljust15percentoftheworld’sknownoilreserves.

•Withtheworld’sexistingoilfieldstiredandindecline,

theindustrywillfacethemonumentaltaskoffindingvast,economicallyviablenewreservestoexploitoverthenextfewdecades.

•Toholdglobaloilproduction

at2008levels,theindustryneedstofindsupplyequaltothatcurrentlyproducedbyIran—eachandeveryyear.

•TheIEApredictsthatbetweennowand2030,thelion’sshareof

demand(93percent)willbedrivenbynon-OECDcountries,withChinaandIndiaaloneaccountingfor53percentofthisfigure.

•Aperfectstormofslumpingglobalsupplies,

voraciousdemand,andincreasinglyhostilehostgovernmentshasmadeitdifficultforBigOiltogrowtheirreservebases.

•Despitemajoradvancesintheindustryover

thelastcentury,morethantwo-thirdsofalloilstillgetsleftintheground.

•Theprofitmargincreatedwhenrefinersupgradecrudeoiltoproductssuchasgasolineisknownasthe

“crackspread.”•Companieswithlong-livedoilreservesincountrieswithlowpoliticalriskshouldbethego-toinvestmentsforthoselookingtopumpuptheirprofits.

•Refinersand

integratedoilandgascompanieswillcontinuetobelaggardsfortheforeseeablefuture,aslowmarginsintherefiningbusinesscontinuetoactasadamperonstockprices.

ChapterFour

DrillingforDollars

ProfitingfromNaturalGas

NATURAL GAS HAS ALOT GOING FOR IT. It’sclean burning, cheaper thanoil, and a low carbon fuel—making it a great choice inthese environmentallyconscious times. Nearly 20percent of America’s powerplants burn natural gas, andthese plants can beconstructedinajiffy,makingthemasensiblealternative tocoal plants. Better still,

natural-gas-firedpowerplantsproduce just half the carbondioxide that similarly sizedcoal plants do—a very bigplus when you consider thatelectricity generation is thebiggest source of greenhousegasemissions.Yetinspiteofall these advantages, naturalgashasonebigweaknessforcommodity investors: it’sabundant.

BeCarefulWhatYouWishFor

Between 2005 and 2008,however, the worry was justthe opposite—a dramaticshortage of natural gas inNorth America. WithMexican imports falling andCanadian supply barelystaying level, Americaneededmore natural gas and

it needed it in a hurry. Lackof supply led to concernsaboutwhatwouldhappenifamassive category fivehurricane ripped through theGulf of Mexico, causingproducers to shut in muchneededcapacity.Andwhat ifother weather extremesforced a blazing hot summerorfrigidwinteruponusattheexact same time that gasproduction was struggling?

Suddenly, drilling rigs werebeing contracted at a furiouspace,andgasproducersweresucking asmuch gas as theycouldfromtheground.

As concerns mounted,pipeline companies andentrepreneurs startedproposing new natural gasterminals that could receivegas from abroad in liquefiedform. But to get gas toAmerica from Qatar,

Trinidad, or wherever it wasforsale,itwouldfirsthavetobe supercooled tominus 260degrees Fahrenheit (minus162 degrees Celsius),compressed to one six-hundredth its originalvolume, turned into a liquid(liquefied natural gas orLNG), and placed ontospecially designed, double-hulled ships. New receivingterminals would need to be

built throughout NorthAmerica to convert the LNGbackintoagassoitcouldbesentbypipelinetotheutilitiesand industries that needed itmost.

With the market abuzzabout yet another hurricanebarreling towards the Gulf,natural gas prices peaked onDecember15,2005,at$15.38per thousand cubic feet—aprice roughly equivalent to

$92.27 per barrel of oil.Suddenly, the tables hadturned.Naturalgas,aproductonce considered an annoyingnuisance by the oil industry,was now very much indemand, having seen aspectacular fourteenfoldincrease in value fromJanuary 2002—just threeshortyearsearlier.

FromImportTerminalstoAirport

Terminals

In2007,withgaspricesonceagain hitting all-time highsandexistingnaturalgasfieldsshowing average productiondeclines of about 15 percentperyear,moregasneeded tobe found. For a long time,

geologists had known thatmassive shale gas formationsexisted throughout NorthAmerica, but the cost ofgettingcommercialquantitiesof gas from the shale wasprohibitive. Everythingchanged, however, whensomeenterprisingoilandgasmen from Texas startedexperimenting with a coupleof new technologies in theBarnett Shale under the

Dallas/FortWorthAirport.

Horizontaldrillingwas thefirst thing they tried. Insteadof drilling straight down intothe resource, they trieddrilling down and thensideways to open up a largerarea of the undergroundformation. But to reallyliberate the trapped gas theyneeded a way to move ittowards the surface. So, nexton the list was a technique

called hydraulic fracturing—or “fraccing”—where waterand sand are injected underhigh pressure into thereservoir, resulting in manytinycracksorfracturesintheshale rock. Combining thesetwo techniques produced themost dramatic results. Inaddition to producing morethan 160 trillion cubic feet(Tcf) of natural gas between2000 and 2008, proven

natural gas reserves in theU.S. grew to 245 Tcf, upfromjust177Tcfin2000.

Thispotentcombinationofhorizontal drilling andfraccing has revolutionizedthe North American naturalgas business. In 1990, gasfrom unconventionalreservoirssuchasshale rock,so-called “tight” formations,and the seams of coal bedsmade up just 10 percent of

totalU.S. production.Today,new shale plays, as they areoften called, appear to bepopping up just abouteverywhere, accounting for40percentofU.S.productionand making unconventionalgasdrillingtheplacetobe.

Natural gas storage is alsobursting at the seams.Everybodythoughtgaspriceswere going to go higher,instead they slumped as

technology unleashedmassive quantities of shalegas that had previously beenlocked under the earth’ssurface. The conventionaldrilling rigs that once dottedthe landscape inWest Texaslieidle,havingbeenreplacedwith new-fangled pressurepumping equipment.According to the BakerHughes rig count, animportant barometer of oil

field service activity, therewere approximately 2,300drilling rigs active in NorthAmerica by the end of 2008.Ayearlater,thatnumberhadslumped to around 1,400—anearly 40 percent drop. Lowgas prices and technologicalinnovation have changed theconventional drilling worldforever.

WeatherBets

When I used to take visitorsaround the Enron tradingfloor in downtown Houston,Texas, I often got the sameresponse: “What? You guyshavenothingbettertodothanwatch the weather channel?”Littledid thesevisitorsknowthat weather explainedsomewherebetween50 to80

percentofthepriceofnaturalgas.Unlikeoil,whichisusedprimarily as a transportationfuel, natural gas is used forheating and cooling, as wellas by industry. Insummertime,naturalgas-firedelectricity plants help keepour air conditioning runningflat-out, and inwinter, gas isused to heat our homes andbusinesses.

Weatherexplainssomewherebetween50to80percentofthepriceofnaturalgas.

While ignorance may bebliss, it sure as heck isn’tprofitable. The sharks who

traded for keeps at Enronknew that nothing would getgas prices moving morequicklythanrumorsofafast-movinghurricane in theGulfofMexico that hadmanagedto shutter half of the naturalgas rigs in the area.Whetherthe rumor was real or justconvenientdidn’tmatter.Gasprices, which are morevolatile than oil prices, weregoing to be on the move

regardless—and that wouldmeanfatprofitsforthetraderon the right side of theweatherbet.

Naturalgaspricesaremorevolatilethanoil

prices.

To get an edge on thecompetition, savvy gastradersstudyeverythingfromtheamountofvolcanicashinthe atmosphere to the watertemperatures in the Gulf ofMexico. But one bet that issure to be profitable is thatwintergaspriceswill alwaysbehigherthansummerprices,especially when it’s freezingcoldintheU.S.Northeastand

storagelevelsarelow.

BackwhenEnronwasstilla going concern, they werestructuring all kinds ofproducts for large buyers ofnatural gas—such as localgas-distribution companies—to help offer price protectionfrom rising gas prices in themonthsofOctober toMarch.In the summer, explorationand production companieswere looking to lock-in a

bottom for gas prices toprotect their profits shouldgaspricestakeatumble—andEnronwasonlytoowillingtohelp.

APipelineofProfits

With its seasonal pricingpatternsandenoughvariablesand volatility to leave you

with worse whiplash than ahigh-speed collision, naturalgas futures trading is apotential bonanza for savvytraders. For energy traderJohnArnold,anumberswhizon Enron’s natural gas desk,the complexity of tradingnatural gas was secondnature. After the firm’scollapse, Arnold, then 28years old, decided to takesome of his 2001 year-end

bonus of $8 million andcreatehisownenergytradinghedge fund: CentaurusAdvisors. So far, it’s been agoodmove. Since the fund’sinceptionin2002,Arnoldhasreturned at least 80 percentevery year—making himoneof America’s youngestbillionaires,withanestimatednetworthof$1.5billion.

For those not so nimble,the volatile, high-stakes

business of natural gastrading can exact a painfultoll. One former wunderkindwho found himself on thewrongsideofArnold’stradeswas former AmaranthAdvisors natural gas traderBrian Hunter. For a while,Hunter seemed to be able todonowrong.Afterearningamaster’s degree inmathematics from theUniversity of Alberta and

working a short stint atTransCanada Corp., apipeline company based inCalgary, Alberta, Hunterheaded south to New YorkCity. He landed a job atDeutscheBank inMay2001.Inhisfirsttwoyearshemadeover$69millionforthebank,and was soon promoted tohead its natural gas tradingdesk. Not satisfied with thesleepy world of natural gas

tradingataninvestmentbank,Hunterwasluredawaybythebig money promises ofAmaranth Advisors founderNickMaounis,whowantedastar natural gas trader in hislineup.

Maounis’sgambleinhiringHunter,who earlier had suedDeutsche Bank over awithheldbonus,seemedtobepaying off. Hunter solidifiedhis reputation as a rising star

during2005,whenhebettheright way on natural gasprices after HurricanesKatrina and Rita rippedthrough theU.S.Gulf Coast,making a boatload of profitsforAmaranthintheprocess.

After posting such biggains in 2005, Hunter wasgivenmorelatitudetocontrolhis own trades throughAmaranth’s Greenwich,Connecticut, trading floor—

no longerhaving topre-clearthem before execution. Hewas named co-head of thefirm’s energy desk andallowed to operate fromCalgary, rather than fromConnecticut. Unfortunatelyfor Amaranth, the increasedpersonal latitude theyextendedtoHunterprovedtobeill-fated.Ayearandahalflater, the company implodedwith losses of approximately

$6billiononnaturalgasbetsgone bad—a staggering sumforafirmwithjust$9billioninassets.

A lack of proper tradingoversight,enormousleverage,faulty judgment, and poorrisk management practicescreated the perfect storm ofproblems that led toAmaranth’s dissolution inOctober of 2006. TraderssuchasHuntercouldemploy

tremendous leverage tomagnify both their gains andtheirlosses.Intradingnaturalgas futures on organizedexchanges such as theNYMEX,tradersoftenhadtopost collateral of only 10percentoftheirtotalposition.Small percentage moves inthe price for natural gas canhave a dramatic impact ontraders who are not fullycollateralized, and when

combinedwithgenerouslinesof credit from banks,commodity hedge funds canfast become heavilyleveraged.

Smallpercentagemovesinthepricefornaturalgascanhavea

dramaticimpactontraderswhoarenotfullycollateralized.

When the end came forAmaranth, it came quickly.Hunter placed bets in 2006that would pay offexponentially for the firm if,and only if, future gas pricesmoved sharply higher. Thistime, he was betting on the

prospect that a nastyhurricane or cold winterwould hit natural gasfacilities, sending Marchfutures prices higher. AsSeptember dragged on andthe evidence began toaccumulate that not onlywouldthewinterbemild,butthat the hurricane seasonwould also be a non-event,natural gas prices fell. BrianHunter’s disastrous weather

betwasmore thanenough tocrippleAmaranth.TakingtheopposingviewtoHunterwasnoneother thanJohnArnold,whomanaged tohaveoneofhis best years ever in 2007,after he bet that winter gasprices would fall rather thanrise. Arnold’s weather betwas a winner—his fund wasupover200percentthatyear.

MethaneMan

As I sat within a largesemicircle at the Bank ofAmerica hedge fundconference in Dallas, a hushdescendedoverthecrowd.AsT. Boone Pickens began tospeak, everyone’s eyes wereglued on the legend—acourtly, dignified southerngentleman. He talked about

his plans for his newcompany,ahedgefundcalledBPCapitalManagement.

To say that T. BoonePickenshasledacolorfullifeis an understatement. Aftergraduating from OklahomaA&M in 1951, PickensworkedforPhillipsPetroleumbefore venturing out on hisownasawildcatter insearchofoil.Helaterfoundedafirmcalled Mesa Petroleum and,

through acquisitions, grew itto become one of the largestindependentoil companies intheworld.During the 1980s,he led a string of takeoversand attempted buy-outs ofundervalued oil and gascompanies including CitiesService, Phillips Petroleum,Gulf Oil, and Unocal. Sincemost of his dealswere nevercompleted, Pickens gained areputation as a corporate

raider and greenmailer, butthat turned out not tomatter,sincethemeredisclosurethathe had acquired a substantialstake in a company wasenoughtosenditsstockpricesoaring. Along the way,Pickens has accumulated apersonal fortune ofapproximately $3 billion andiscurrentlyrankedbyForbesas the117th richest person inAmerica.

Today, Pickens is knownas much for his activism asforhisgutsy investments.Hebelievesthatoilhasenteredaperiod of irrevocable declineand that America needs tofind alternative fuels fortransportation. His solution,thePickensPlan,aimstoendAmerica’s addiction toforeign oil by replacing itwith natural gas. And afterinvesting $58 million in a

series of televisionadvertisements and YouTubevideos, he’s finally managedto get people talking aboutthepossibilityof fuelingcarswithcompressednaturalgas.

GasGlut

Oil and natural gas used totrade in tandem. The reason

was simple: theheat content,or British Thermal Unit(BTU), of a thousand cubicfeet of natural gas wasapproximately one-sixth ofthatcontainedinonebarrelofoil. If natural gas was goingfor$4perthousandcubicfeetand oil was trading for $24per barrel (4x6=$24 on anenergyequivalentbasis),thenallwasas it shouldbe in theworld of energy. If oil was

tradingfor$40perbarrelandnatural gas for $3 perthousand cubic feet, then theold logic was that powerplants burning #2 or #6 fueloil could switch over tonaturalgas to takeadvantageof the price discrepancybetween the two fuels. Intime, as more power plantsmade the switch from oil tonatural gas, the pricedifferential would eventually

close.Orsothelogicwent.

But the problem with thatlogic is that oil is a globalcommoditywhosepriceissetby supply and demand theworld over. On the otherhand, because natural gasmust be transported to themarket bypipeline, it’smorelikelytobeimpactedbylocalsupply and demand factors.The price of natural gas inJapan or Russia has limited

impacton thepriceofgas inAmerica.

Oilisaglobalcommodity,but

naturalgasispricedandtradedregionally.

BreakingUpIsHardtoDo

Old habits die hard.Throughoutmost of 2009, asoilpricesmovedupfrom$35tocloseto$80perbarrelandnatural gas prices remainedstuck at $4 per thousandcubic feet, many investorssensed an opportunity.Surely, they reasoned, with

oil and gas now trading at aratio of 20:1—instead of thehistorical 6:1—there weresomeeasyprofitstobemade.

To capitalize on thisapparent anomaly, manyretail investors piled intoexchanged traded funds(ETFs) linked to natural gas,reasoning that the fundswould do a good job oftracking the current price ofgas.Unfortunately,theywere

misguided. Most single-commodityETFsbuy futurescontracts, which are bets onthepriceofacommodityatafuture date. The problem is,the futures contracts that theETFsbuysometimesdoabadjob of tracking the price ofthe commodity in the hereand now (also known as thespotprice).

AcaseinpointwasUnitedStates Natural Gas Fund

(UNG—NYSE), a single-commodity ETF linked tonatural gas. Buoyed by thelogic that oil and gas priceswould eventually have toconverge on their historicaltradingrelationship,investorsstarted buying up units ofUNG.From thebeginningof2009 through mid-year, thefundattractedsome$4billionof new investor money—adramatic increase in assets

from the $300 million thefund had in December of2008. So much investormoney was flowing intoUNG that itwas becoming adominant force in themarketfor natural gas futures. Topreventthefundfromhavingundue influence on thenatural gas futures market,U.S. regulators temporarilybanned it from issuing newunits.

While futures prices aregenerally a good proxy forwhat commodity prices aredoing in the here and now,this isn’t always the case.UnfortunatelyforinvestorsinUNG,2009turnedouttobeadisappointing year. Not onlydidoil andnaturalgaspricesdecouplefromtheirhistoricaltrading ratio, but mildweather and slumpingdemand increased investors’

pain by causing natural gasprices to fall further.Makingmatters worse, while naturalgas prices tumbledapproximately 38 percent inthe first 11 months of 2009,units in UNG tumbled morethan 60 percent, a reflectionof the difference betweenfuturespricesandspotprices.

DrillingforDollars

With plenty of natural gasavailable from shaleformations and natural gasstorage facilities stuffed tothe brim, it may be a whilebefore gas prices startshooting higher. But becausenatural gas prices are sodependent on weather, afrigid winter or boiling hotsummer could be justwhat’sneeded to get gas pricesmovinghigheragain.

Big-name traders maysubscribetoawidevarietyofnewsletterswrittenbyexpertspurporting to be able toaccurately forecast theweather, but for most of usthis approach is a waste oftime. Proper weatherforecasting is made up ofsuch a dizzying array ofvariables that no softwareprogram I am aware of canaccuratelypredicttomorrow’s

weather, let aloneget it rightseveral months or years inadvance.Blowing your hard-earned money on weatherforecaststotrytogetahandleon the natural gas market islike consulting the psychichotlineaboutyourlovelife—it’sacompletewasteoftime.Abetter bet is to consult theWeekly Natural Gas StorageReport (available atwww.eia.doe.gov) put out by

the Energy InformationAdministration(EIA),partoftheDepartmentofEnergy, toget a sense of the amount ofnatural gas in storage (ameasure of natural gasinventory) and how itcomparestofive-yearaveragestorage levels. Given thatmost U.S. utilities aremandated by law to haveenough natural gas to meetworst-casedemandlevels,it’s

a pretty good bet that gasprices will head sharplyhigher if storage levels arenearempty.

Sincecloseto80percentofall drilling activity in thelower 48 states and WesternCanada is tied to natural gasdrilling, it also makes senseto keep track of the numberofdrillingrigsworkingatanyone time. TheBakerHughesrig count (available at

www.bakerhughesdirect.com)is a widely followedbarometerofwhatisgoingonin the field. If it shows thatmore drilling rigs are beingcontracted out at everincreasingday rates, you canbe sure that theprofessionalsrunning the nation’s oil andgas firms believe that, overthe long term, natural gaspricesareheadinghigher.

As oil and gas firms

evolved, they graduallycontracted out their drillingteams and other serviceprofessionalsinanattempttoshed some of their fixedcosts. Today, drillingcompanies operate in muchthesamewaythatconsultantsoperate—on a fee-for-servicebasis. When the natural gasmarket is on fire, thedrillingcompanies are working flatout.Butoncegasprices start

to tumble, the first thing thatexploration and productioncompanies do is slash theirdrilling budget. As a result,the stock prices of drillingcompanies tend to be evenmore volatile than those ofproducing companies. Wheninvestors sense that naturalgas prices are about tomovesharplyhigher,buyingsharesin a good quality drillingcompanyisawisebet.

Once natural gas pricesstart to move out of thebasement again, theproducing companies whohavedominantlandpositions,solidbalancesheets,andfirst-classmanagement teamswillbe the likely winners. Onecompany that fits the bill isEncana Corporation (ECA—NYSE), which has done amarvelous job of protectingits cash flows by locking in

favorable gas prices(hedging)atopportunetimes.Notonlythat,butEncanawasaccumulating dominant landpositions in someof the bestshale formations throughoutNorthAmerica longbefore itwasfashionable.

While gas prices havedroppedlately,allitwilltaketo get them moving higheragain is a wave of industryconsolidation, or an extreme

andlong-lastingboutofnastyweather.Withoutadoubt,thehistorical trading ratiobetweenoilandgasisallbutdead.Butgaswillonceagainhave its day, and when itdoes, the service companiesthat specialize in fraccingshale rock, the drillers whocanmaketheirdrillbitsmovebothdownandsideways,andthe producers who have thebestlandpositionsandlowest

cost structureswill come outahead.

HotCommodities

•Bycombininghorizontaldrillingandhydraulicfraccingtechniques,

massivenewgasfieldscanbedeveloped—agamechangerforthenaturalgasbusiness.

•ThereisasurplusofnaturalgasinNorthAmerica,whichhasdepressedgasprices.

•Naturalgaspricesaremorevolatilethanoilprices.

•Somewherebetween50to80percentofthevariabilityinnaturalgaspricescanbeexplainedbytheweather.This

relationshipisstrongerinthewintermonths.

•Oilpriceshavebecomedecoupledfromnaturalgaspricesandthehistoricaltradingratioof6:1nolongerapplies.

•TheBaker

Hughesrigcountisadecentleadingindicatorofoveralloilfieldandserviceactivity.

•TheU.S.DepartmentofEnergyissuesweeklygasstoragereportsthatcanhelp

investorsgaugetheamountofnaturalgasininventory.

•Whennaturalgaspricesrecover,thebestbetsforinvestmentarelikelytobeintheservicecompaniesthatspecializein

horizontaldrillingandreservoirfraccing,andintheproducersthatspecializeindevelopingtheso-calledunconventionalgasreservoirs.

ChapterFive

GoingforGold

ProsperingwithGoldandPreciousMetals

FEW SUBJECTS IN THEWORLD OF INVESTINGare as polarizing as gold. Itsuniqueemotional lure,datingfrom ancient times, capturesthe imagination of investorstheworldover.Tosome,goldisabarbarousrelic,toothers,it’s a currency whose timehas come. Skeptics point outthat,overthepast90years,a

bet on the Dow JonesIndustrial Average wouldhave won out over aninvestment ingold.But thereis one thing everyone seemstoagreeon,andthat’siftherewasever a time forgoldandpreciousmetalstooutperformallotherassets:thisisit.

Aperfectstormisbrewingthat will likely lift gold andprecious metal prices higherin the near term. Precious

metals often outperformstocks, real estate, andbondsduring timeswhen banks areunder stress and the U.S.dollar is weak. Addinflationarypressuresintothemix and you’ve got theconditions for an explosiverally in precious metals.Investors are beginning towarmuptogoldandpreciousmetals as they survey thepotholed road of

governmental finances andconclude that the West isdeeplyindebt.

Goldandpreciousmetalsoften

outperformstocks,realestate,andbondsduringtimeswhen

banksareunderstress,theU.S.dollarisweak,andinflationisrunningrampant.

AwashinDebt

During the global financialcrisis of 2008-2009, WallStreet banks faced a near-

death experience that left thesurvivors deeply indebted togovernment and wary of awave of regulatory reform.WallStreetmayhave led thecharge to governmentlargesse, but others werequick to follow. A lineupbegantoformaroundCapitolHill, as everyone from autoexecutives to concernedcitizens came to plead theircase for a pocketful of

governmentcash.In2008and2009, the U.S. FederalReserve pumped anadditional $2 trillion into theAmerican economy to helpstimulate consumption.Unfortunately, this massivecash infusion didn’t result inanuptickinGDP.

In December 2008, theU.S. Fed chopped itsbenchmark federal funds rateto near zero in the hope of

resuscitating the Americaneconomy by stimulatingspending with lots of cheapcash. But the averageAmerican consumer andbusiness was still toopetrifiedtospend,leavingtheU.S.government itself as themain engine of economicgrowth during 2009. Andspend they did. On February1, 2010, U.S. PresidentBarack Obama unveiled his

$3.83 trillion budget, whichprojected a massive $1.56trillion deficit for the fiscalyear. Even more worrisome,thebudgetalsoprojectedthatAmerica would be saddledwithtrillion-dollardeficitsforatleastthreeyears.

Even by the optimisticstandards of an incumbentpresidentpresentingabudgetto Congress, this documentcontained some stunning

revelations. The moststriking, buried deep withinit, was that even by thegovernment’s own rosyeconomic projections,America’s deficit would notreturn to what are widelyconsidered sustainable levelsuntil sometime around 2020.When that date begins toapproach, increasinghealthcare costs associatedwith retiring baby boomers

will put upward pressure onthe deficit, suggesting thateven this budget may bewishful thinking. With itsdebt rising faster than itsincome, America isattempting to keep its headabove water as the cost ofservicing the nation’s debtacts likeananchor,weighingdown future economicgrowth.

StartthePresses

America isnotalonewith itsfiscal problems. The UnitedKingdom,Greece,Spain,andmanyothercountrieshaveallsuffered under the weight ofmassivedebtsasthebadhabitoftoomuchspendingandnotenoughsavingenvelopsmostof the West. Faced with theprospect of sluggish

economic growth, or worse,outright default on theirdebts, governments at homeandabroadareall eyeing theprintingpressasawayoutoftheirpredicaments.

The value of the U.S.dollar,oranypapercurrency,is directly linked to theamount of currency incirculation at any one time.Increase the number of U.S.dollars in circulation and the

valuedeclines.Backin2002,U.S. Federal ReserveChairmanBenBernankesaid:“the U.S. government has atechnology, called a printingpress(or,today,itselectronicequivalent), that allows it toproduceasmanyU.S.dollarsas it wishes at essentially nocost.” When their debts getoutofhand,governmentsfindit all too tempting to fire upthe presses and flood the

market with dollars. Forpoliticians facing reelection,the choice between debasingthe currency, imposing sky-high taxes, or implementingdraconiancutsinservicesisasimple one. It’s easiest towarmup the printing pressesand trash the currency—something that savvypreciousmetalstradersarealltoohappytocapitalizeon.

Gold has proven reliable

and durable for thousands ofyears, having outlasted everysingle paper currency theworld has ever known. Andbecause the supplies of goldandotherpreciousmetalsarefinite, central bankers can’tinflate away their value.What’smore,unlikefinancialassets, gold and preciousmetals are nobody else’sliability.Venezuelaiscaseinpoint. In January 2010, with

the official inflation raterunning at 27 percent,President Hugo Chávezdecided to devalue theVenezuelan bolivar tostimulate exports and boostthe country’s economy.Withthe stroke of a pen, Chávezdevalued the bolivar by half—from2.15 to4.30perU.S.dollar—a move thateffectively reduced the valueof bolivar-denominated

savings by half. ThoseVenezuelans luckyenough tohavehad significantholdingsin gold or silver would havebeen safe from these drasticmeasures, since preciousmetals cannot be devaluedovernight on the whim of agovernmentleader.

AGoldenEra

Agoldeneramaybeuponusas concern mounts over themonumental debt beingracked up by the U.S.government. With thebanking system in distress,inflation running amok, andthe U.S. dollar in decline,gold is the go-to investment.Gold last peaked in 1980 at$850perounce,which,whenadjusted for inflation, is theequivalent of $2,189 per

ouncein2009dollars.

Goldlastpeakedin1980at$850per

ounce,which,whenadjustedforinflation,istheequivalentof$2,189perouncein

2009dollars.

When times are tough,people gravitate towardssomething tangible,something they can hold intheirhands,likegoldcoinsorbars.And lately, the demandfor gold bullion (physicalcoins, ingots, and bars) hasbeen high. According to theWorld Gold Council, retaildemand for gold bullion

zoomed in the fourth quarterof 2008, up nearly fivefoldfrom the previous year. Butbullion’s zenith was duringtheearly1980s,whenbuyingphysicalgoldhititspeak.

TheGoldenRules

Unlike paper money, goldsupply is finite, making

scarcity one of the bigbenefits of owning gold.Estimates have pegged theamountofgoldabovegroundat around 165,000 metrictons, with some 20,000metrictonsstillwaitingtobemined. Nearly 90 percent oftheknowngold in theworld,with a rough value of $4.5trillion, has already beenmined. That’s a big number,yet it pales in comparison to

themorethan$8trillionU.S.dollars in circulation and aworld stock marketcapitalization of roughly $40trillion. And stack gold upagainst the outstandingnotional value of theworld’sderivatives market—awhopping $800 trillion—andthe value of physical goldlooks puny. In fact, the ratioofgoldtopapercurrencies iscurrently at an all-time low,

which suggests that the stageis being set for a powerfulrally.

Nearly90percentoftheknowngoldhasbeenmined,withanapproximatevalueof

$4.5trillion—a

substantialsum,butitpalesincomparisonwiththoseofpaper-basedassets.The

globalstockmarketshaveamarketcapitalizationof

around$40trillion,andthenotionalvalueoftheoutstanding

derivativesecuritiesisastaggering$800

trillion.

TheancientEgyptians firstminedgoldin2000BC,butitwas during the RomanEmpire that it became prizedforitsbeautyandscarcity.Sorare is gold, that all the goldmined since it was firstdiscoveredwouldfilljusttwoOlympic-sized swimmingpools. Today, gold is mostoften used in jewelry (62

percent of consumption) orheld by retail customers inbar and coin form. It’s alsoheld in vaults to backstopvarious investment products,mostnotablyawiderangeofgold ETFs, which accountsfor around 9 percent ofoveralldemand.Becauseit isnon-corrosive and a goodconductor of electricity, goldis used in a number ofindustrial applications, such

aselectroniccircuitry.

South Africa was oncegold’s biggest producer, buttoday China has taken thelead—accounting for 13percent of world supply.South Africa’s productionpeakedinthe1970s,butnowthecountryproducesjusthalfas much as it did back then.However, it still accounts formore than 10 percent of theworld’smine supplyof gold,

while Australia and theUnited States round out thetop four producing countries.Gold is found all over theworld, but it’s gettingincreasingly hard to find andmoreexpensive tomine.The“grade,” or percentage ofgold in mineral-bearing rock(ore),hasdeclinedworldwidefromanaverageof9.6grams(0.3ounces)permetrictonin1977 to just under 1.5 grams

(0.05 ounces) per metric tontoday.Goldminingisalsothemost waste-intensive of allmining operations. Toproduce enough gold for asingle wedding ring, morethan 250metric tons of rockneeds to be moved, crushed,and sorted. In spite ofmassive operations, the huntfor gold is provingincreasingly difficult.Between2003and2008,total

globalmineproductionfellatanaveragerateof1.1percentperyear.

MoneyintheBank

The stage has been set forhighergoldprices,yetgold’sfundamentals are still theweakest of all the metals.Conventional explanations of

supply and demand ring alittlehollowwhenitcomestogold.Forstarters,allthegoldever mined is still inexistence—as jewelry andcoins, or tucked away incentral bank vaults. Duringthe 1990s, when commodityprices slumped and minersabandoned the search forcopperandotherbasemetals,goldexplorationcontinued torepresent almost 60 percent

of all mining projects. Golddemand is driven largely byfickle jewelry buyers andinvestment flows, both ofwhich are hard to predict.Supply is made up of mineoutput, inventory comingback on the market fromcentral banks, and recycledgold.

Of course, so-called goldbugsdon’t like itpointedoutthat the 3,600metric tons of

annualgolddemandcanonlybe met by smelting downyour grandmother’s jewelry.Recycled gold representsaround 24 percent of themetal’s annual supply, whilemineproductionaccounts forabout 68 percent. To keepmarket shocks toaminimumand to provide a balancebetween supply and demand,the central banks function asvirtual goldmines by selling

gold according to aprearrangedschedule.

According to the WorldGold Council, nearly 29,500metric tonsofgold isheld inreserves by central banksaroundtheworld.TheUnitedStates is the largestholderofgold with more than 8,100metric tons, representingaround 76.5 percent ofcurrency reserves. Germanyholds approximately 3,400

metric tons. Western centralbanks generally have fargreater gold holdings thanEasternones.WhileChina ischock-fullofforeigncurrencyreserves,itsgoldholdingsaresmall—just 600 metric tons,or roughly 0.9 percent of thecountry’s total foreigncurrencyreserves.

Baubles,Bangles,

andBling

Jewelry is far and away thebiggest demand driver forgold. And lately, gettingdecked out in baubles andbangleswill cost you plenty.Withthepriceofgoldhittingfresh highs, bling-lovers arenow on a budget. At theheightoftheglobaleconomiccrisis in November and

December of 2008, luxuryjeweler Tiffany & Co.reported that sales in theirAmerican stores plunged 35percent.Butwhenloversstartshunninggold,investorscozyuptocoinsandbars.

Gold is viewed as a statussymbol throughout Asia, butnowhere is it more prizedthan in India, where goldjewelry is the centerpiece ofthe gift-giving festival

season. Mistrust ofgovernment runs high inIndia,andsincegoldcan’tbedebasedandcanbeconvertedtocashinahurry,it’sseenasa solid investment. Saverswary of mutual funds canconvenientlybuygoldatoneof India’spostoffices,whichsell24-caratcoins inweightsassmallas0.5grams.Lately,Indiahasbeenexperiencingagoldrush,as rapidexpansion

has raised the economicprospects for millions andincreased the demand forgold. From 2000 to 2007,Indian demand accounted forone ounce out of every ninesold worldwide. SosignificantisIndiatothegoldmarket that gold pricesexperience strong seasonaltrends—rising in the latesummer and fall as thefestivalseasonbegins.

BillionDollarBaby

As the printing presses onPennsylvania Avenue and atcentral banks around theworldbegin tohum,physicalgold has become a hotcommodity among investors.Having once been thelinchpin of the globalmonetarysystem,goldisstillseen by many as a solid

hedge against inflation. Anddealersofgoldcoinsandbarsare reporting a surge ininterest from those worriedby paltry returns on savingsaccounts and recent stockmarket volatility. Bulliondealers in London reportedparticularly strong interestafter Lehman BrotherscollapsedinSeptember2008.Gold coins from SouthAfrica, known as

Krugerrands, have also beenswitchinghandsfrequentlyasof late, often at heftypremiumstothespotpriceofgold(about13percentabovegold’s prevailing marketprice). The price of a goldcoinvarieswidely,dependingnotonlyonthevalueofgoldat the time, but also on itsscarcity, value, andmanufacturingcost.

Gold coins have been

popular,butgoldbars,whosepremiums are closer to 5percent,offerbettervalue.Ofcourse, getting that pricemeans buying in bulk, andonce the cost of storage andinsurance are factored in,holdingphysicalbarsorcoinsas an investment makes nosense.However,formanythepeace of mind that comeswithholdingphysicalgold isworth the cost. They believe

that if theworldasweknowit comes to an end, physicalgoldwill continue tohold itsvalue.

The big thing in goldinvesting these days is theexplosivegrowthinexchangetradedfunds(ETFs)thattrackthe price of gold. An ETFinvestment offers directexposure to a financialinterest in stockpiles ofphysicalgold at a fractionof

thecostofholdingyourownstash.Andwithmanagementexpense ratios of less than 1percent,it’sawonderanyonewould consider owningphysical gold in any otherform. It’s a benefit that hasnot gone unnoticed. By thebeginning of 2010, theworld’s major gold-linkedETFsheldastaggering1,821metric tons of gold, worthmorethan$58.5billion.

Goldbarsarecheapertoownthancoins,butbothformswillincurstorageandinsurancefees.AninvestmentinanETFoffersdirectexposuretoafinancialinterestinstockpilesof

physicalgoldata

fractionofthecostofholdingyourown

stash.

ThelargestgoldETFistheSPDR Gold Shares (GLD—NYSE), which accounts foraround65percentofthetotalgold ETF market by marketcapitalization. Capital flowsintoGLDhavebeensostrongthat the fund now boasts a

higher market value thanBarrick Gold Corp. (ABX—NYSE), the world’s biggestgoldminingcompany.

MyTwoCents

Aninvestment ingoldwouldseemtobeasure thing,withplenty of upside and notmuch downside. Perhaps it’s

acaseoffamiliaritybreedingcontempt, but I can’t helpwondering if goldwill reallyrally as high as some of theother precious metals. In theinvestment funds that Imanage,Itendtolooktogoldas a trade, rather than as aninvestment.Ifthedollarindexfutures appear to beweakening(decliningDXY—ICE), thenIbuyall thewell-chosen gold equities that I

can squeeze into myportfolios,but if the inflationpicture is muted and thedollar isn’t dropping, I canusuallygetmorebangformybuckelsewhere.

For investors looking fordirectexposuretothemetal,Ifavor buying shares in theGLD rather than filling asafety deposit box chock fullof gold bars. The GLD willgive you all of the upside of

owning the metal directly,without the headaches andhigh costs. By the end of2009,twobighittersonWallStreet—John Paulson andGeorge Soros—made newswhen it was revealed thatGLD was amongst their topinvestment holdings. For mymoney, that’s a pretty solidendorsement for owning agoldETF.

TheFamilySilver

Silver, gold’s slightly shysister, is also in hot demandwhen gold’s fortunes arerising. Like gold, silver actsas money and as a store ofvalue.Gold and silver priceshave historically moved inlockstep,ziggingandzaggingtogether, but lately, thatcorrelation has broken down

—gold has soared, whilesilver has slumped. From1999to2009, thetwometalsmoved together only 51percent of the time. During2009, theprice ratiobetweenthe two averaged about 70:1—a huge increase from the200-year average of 37:1.Andthat’sgotmanyinvestorsexcited about the possibilityof a sharp upward correctioninthepriceofsilver.

Figure 5.1Gold and Silver—StillJoinedattheHip?

During2009,thepriceratiobetweengoldandsilverhasaveragedabout70:1—ahuge

increasefromthe200-yearaverageof37:1.

If the price ratio betweenthetwometalsweretorevertback to itshistoricalaverage,

then silver prices wouldoutperformgoldbymorethan2:1.Infact,thephysicalratioofsilvertogoldintheearth’scrustis16:1,sosilvermayberelatively cheap. During theinflationary 1970s, the ratiobetween gold and silverprices was at exactly 16:1—mirroring the proportions inwhichthetwometalsoccurinnature.

Like gold, silver has been

prized for its beauty andvaluedasapreciousmetalforthousands of years. AncientEgyptians believed that theskinofthegodswasmadeofgoldandtheirbonesofsilver.It has also been used as acurrency,mostnotablybytheUnited Kingdom, whosepound (£) originallyrepresented the value of onetroy pound of sterling silver.In France, the very word for

moneyisargent,orsilver.Upuntil the 1800s, the UnitedStatesandGreatBritainwereon a silver standard beforethey switched to a goldstandard and then, later, to apaper-based monetarysystem.

Silver has similarinvestment attributes to gold.It can be used as a hedgeagainst financial ruin, or, fora fat premium to value, you

can buy coins or bars andstore them somewhere safe.Silverware adorns manydiningroomtables,andsilveris a mainstay of the jewelryindustry. Investors can buythestocksofsilver-producingcompanies or invest in silverETFs. Silver is used 50percent of the time as anindustrialmetal.Gold,ontheother hand, is used as anindustrial metal a scant 11

percentofthetime.

SilverLining

Silverdemandsitsona solidfundamental footing, whilegold demand is just toodependent on fickleinvestment flows and flightsof fancyfromjewelrybuyersin theMiddleEast andAsia.

But when gold prices turnhigher and industrial demandrecovers,silver investorswillbelaughingallthewaytothebank.

The Anatolia region inTurkey was the first area tobeminedprimarilyforsilver.Following Europe’sdiscoveryof theNewWorld,productionshifted toBolivia,Peru, and Mexico, and thenlater to the United States.

Today,70percentofallsilveris mined along with othermetals, typically lead, zinc,and copper. Globally, annualsilverproductionismorethan600 million ounces (1.7kilograms) and growing,while gold production isaround80millionounces(2.3kilograms)anddeclining.

TheSilverScreen

Silver was once used inphotographyand in ahostofindustrial applications. Now,the use of silver inphotography has tumbled asdigital cameras have becomeall the rage. However,investment (ETFs) and otherindustrial uses have morethan offset the 30 percent ofminesupplythatphotographyhistorically soaked up. Withthehighestconductivityofall

the metals, silver is used inelectrical contacts andconductors, and is findingnewusesinLCDandplasmascreens as well as in silver-zinc batteries. It also servesas a catalyst for chemicalreactionsandasan industrialcoating on mirrors and solarpanels.

Silveralsohasanumberofmedical uses. The father ofmedicine,Hippocrates,wrote

that silver had beneficialhealing and disease-fightingproperties. The Phoeniciansused to storewater andwinein silver bottles to preventspoiling. Today, silver isknowntoreduceoreliminatethe risks associated withLegionnaires’ disease andother superbugs resistant totraditionalantibiotics.

Despite rising prices,industrial demand for silver

increasedeachandeveryyearfrom 2001 to 2007.Widespread computerizationand the growing use ofmobilephonesareallpositivetrendsthatwillhelpunderpinfuture silver demand.Investmentdemandisalsoonthe upswing. Coin sales andthe issuance of new silver-linkedETFshavebeendoinga brisk business based oninvestors reasoning that,with

increasing demand and aprice ratio between gold andsilverthat’swayoutofwhackfrom historical norms, silverpricescouldbereadytomovesolidlyhigher.

Platinum:TheNewGold

Gold helped put South

Africa’s economy on theworld map over a centuryago, but today, with itsreserves dwindling and itsmines going ever deeper,South Africa’s goldproduction is down while itscosts are up. And that hasmany mining companiesswitching to the new “it”metal: platinum. In 2006,sales of platinum groupmetals (PGMs)—platinum,

palladium, and rhodium—mined in South Africaoutstripped gold by 2:1 andaccounted for 15 percent ofmerchandiseexports.Andnowonder—South Africa hasenormous platinum reservesthat make up around 80percent of the world total.This big reserve base,combined with the country’simpressive mining expertise,haveturnedSouthAfricainto

the world’s biggest platinumproducer, with annualproduction of more than 5.1million ounces. The countrysupplies 76 percent of theroughlysixmillionouncesofplatinumtheworldconsumes.Infact,SouthAfricanowhasabout as many miningcompanies drilling forplatinum as for gold, whichwas good news forshareholders in 2006, when

platinum group metals salesweretwicethoseofgold.

Platinum mining isbringing good fortune tomining companies in SouthAfrica, but, unfortunately,that hasn’t been the case forforeign firms operating inZimbabwe—home of thesecond-largest platinumreserves in the world.Zimbabwe began miningplatinumas recentlyas1994,

and by 2005 it was alreadythefourth-largestproducerofthemetal. InMarch2006, asplatinum prices startedmoving higher, Zimbabwe’sminister of mines announcedthat 51 percent of thecountry’s foreign miningshare-holdings were to betransferredtothegovernment—halfwithoutcompensation.

LoveintheFastLane

Couples show their undyinglove by exchanging rings,manymadeof platinum.Themetal may be popular forwedding rings, but jewelryaccounts for just 21 percentof its overall demand, downfrom 45 percent in 1999.China is to platinum whatIndia is to gold: the largest

single market for jewelrymadefromthemetal.

But the big driver ofplatinum demand today isn’tlovers, it’s cars. Theautomotive industry sucksupmoreplatinumthananyothersingle industry, where it’susedincatalyticconverterstoreduceexhaustemissions.

SouthAfricaminesalmost76percentoftheworld’splatinum,whichisturnedintojewelryandcatalyticconvertersforcars.

Driving an increaseddemand for catalyticconverters and platinum arestricter environmentalstandards,whichhavehelpedboosttheamountofplatinumused per converter. Moredrivers in Asia and Europeand tougher environmentalstandards have been awinning combination forplatinum investors. The autoindustry accounts for a hefty

48percentofoveralldemandfor the metal. As platinumprices surged in the mid-1990s, North American carcompanies began redesigningtheir gasoline engines to usecheaper catalysts, such aspalladium and rhodium.Thatleft Europe, with 53 percentof the light diesel vehiclemarket, and Asia, with 30percentoftheoverallmarket,asthebigdriversofindustrial

demand for platinum.America,withonly4percentof the global light dieselvehiclemarket, just isn’t thatimportant when it comes toboostingplatinumdemand.

In hybrid cars, the use ofplatinumgroupmetalsisevenhigher than in conventionalcars.AutomobilessuchastheToyota Prius, which can runon both electricity andgasoline, have engines that

operateatcoolertemperaturesthan regular cars, requiringmore PGM loadings. Andsince platinum is a bettercatalyst than palladium,strong hybrid sales are goodnewsforplatinuminvestors.

MetalMeddling?

Investment interest in

platinum is growing, yet thelaunch of ETFs linked toplatinum has raised concernsthat speculative activity insuch a small market maydrive prices higher. Platinumand gold prices havehistorically moved inlockstep, but platinum hasseen higher highs and lowerlows. In July 2008, platinumpricesweremorethan$1,900perounce, butbyOctoberof

thesameyear,pricestumbledto around $760 per ounce.Slumping industrialproduction, big investmentflows in a tight market, andconcernoverlaborunrestandelectricity disruptions inSouthAfricaallhelpedmakeplatinum a volatileinvestmentin2008.

HammerandSickle

Platinum’s lighter, lessexpensivecousinispalladium—a metal used in cars,jewelry, and electricalapplications. Diesel, whichrequires platinum catalyticconverters, is thepredominant automotive fuelin Europe. However, 82percent of the world’s carsrun on gasoline, which canuse palladium, a cheapermetal. As with platinum, the

carindustryrepresentsaround48 percent of total demandfor palladium, while jewelryand electrical uses accountfor around 15 percent each.Automotive demand forpalladium began picking uparound1994,astechnologicaladvancements in catalyticconverters were made andU.S. relations with Russiaimproved. South Africadominates the platinum

supply, but Russia, whichcontributes 52 percent of theglobal mine supply, is thehammer in palladiumproduction.

Globally, Russian mininggiant Norilsk Nickel is thelargest single producer ofnickel and palladium. Withproduction of close to threemillion ounces of palladiumannually, the companysuppliesaround45percentof

theroughly6.5-million-ounceglobal market. Thecompany’s largest operationsare centered in the Norilsk-Talnakh region of northernRussia, an area known tohavethesinglelargestnickel-copper-palladium deposits inthe world. Since acquiringStillwater Mining Companyin 2003, the only U.S.producer of palladium,NorilskNickel has become a

global behemoth. In 2007, itextended its global reacheven further, acquiringassetsin Finland, South Africa,Botswana,andAustralia.

BlingFling

AstheU.S.andEuropewarmuptheprintingpressestohelpmonetizethestaggeringdebts

they’ve rungupover the last25years, investorswill flockto the traditional safe havensof gold and silver.And oncetheglobaleconomygetsbackonto solid footing andindustrial productionaccelerates, the prospect foran investment in preciousmetals becomes even morepromising.

Gold producers havehistorically offered leverage

to rising gold prices,makingthem a solidway to play thegold market. Once they getunderground and lookaround,mostmajorproducershave a pretty good trackrecord when it comes todiscovering more gold.Barrick Gold Corporation(ABX—NYSE), the largestgold company in the worldwith27minesandoperationson five continents, is a true

mining multinational. Sincesilver is usuallymined alongwith other metals, finding apure-play silverproducer canbe something of a challenge.Of the 20 largest silver-producing companies in theworld, only five (FresnilloPlc, Pan American Silver,Polymetal, Coeur d’AleneMines,andHeclaMining)areprimarysilverproducers.Onewaytoplaythesilverstoryis

through silver streamingcompanies such as SilverWheaton (SLW—S&P/TSX)or Franco-Nevada (FNV—S&P/TSX). Silver streamingcompanies purchase silverproduction for many yearsinto the future fromdiversifiedminingcompaniesfocusedon recoveringmetalsother than silver.Thebenefitof investing in thesecompanies is that they offer

directleveragetorisingsilverprices with no operationalrisks or ongoing capitalexpenditurerequirements.

Those looking to invest inthenichemarketsofplatinumand palladium shouldconsider investing in anexchangetradedfundbecausefinding a pure-play NorthAmericanpalladiumproduceris next to impossible andthere isn’t a wide range of

choice for platinumproducers. The three largestplatinum producers in theworld are Anglo Platinum(AMS—JO) and ImpalaPlatinum Holdings Limited(IMP—JO), both of whichtrade on the Johannesburgstock exchange, and Lonmin(LMI—LSE),whichtradesinLondon. ETF Securitiesoffers the largest marketcapitalization physically

backed platinum (PHPT—LSE) and palladium (PHPD—LSE) exchange tradedfunds.

Declining grades, surginginvestor demand, andrecovering global industrialproductionhave set the stagefor a pickup in the preciousmetalsmarket.Propelledbyastrong tailwind of too manydollars, yen, and euroschasingafteralimitedsupply

of gold, silver, and PGMs,precious metal investors willsoon be thanking their luckystarsfortheongoingfinancialfollies coming out ofWashington, Brussels, andLondon.

HotCommodities

•Goldandother

preciousmetalsoftenoutperformstocks,realestate,andbondswhenbanksareunderstress,theU.S.dollarisweak,andinflationisrunningrampant.

•Goldlastpeakedin1980at$850perounce,theinflation-adjustedequivalentof$2,189perouncein2009dollars.

•Nearly90percentofknowngold,withan

approximatevalueof$4.5trillion,hasalreadybeenmined.

•Thevalueofphysicalgoldisdwarfedbythevalueofpaper-basedfinancialassets,suchasthe$800trillionnotionalvalue

oftheworld’sderivativesecurities.

•AninvestmentinanETFoffersdirectexposuretoafinancialinterestinstockpilesofphysicalgoldatafractionofthecostofholding

yourownstash.•Silverdoesbestwhengoldisperformingwellandindustrialactivityishigh.

•During2009,thepriceratiobetweengoldandsilverhasaveragedabout70:1—ahuge

increasefromthe200-yearaverageof32:1.

•SouthAfricaminesalmost76percentoftheworld’splatinum,mostofwhichisturnedintojewelryandcatalyticconvertersfor

cars.•Russiaisthelargestproducerofpalladium,ametalwithsimilarend-marketstoplatinum.

ChapterSix

DiggingIt

MakingMetalsandMinesWorkforYou

IFYOUWANTTO SWILLVODKA AND EATCAVIAR like a Russianoligarch,nothingwillgetyoutherefasterthanawell-timedinvestment in industrialmetals. Whenever cars,washing machines, andfridges are selling like hot-cakesyoucanbecertain thatmetals and the mining

companies thatproduce themwill be moving higher.Researchhasshownthatonceglobal industrial production(IP) begins to accelerate,commodity prices for hotrolled steel, copper,aluminum, and zinc are thefirst to move. And as theworld economy begins togrow again, the metals usedin cars, toys, and kitchenappliances will be in strong

demand, which will sendprices—and the fortunes ofinvestors—sharplyhigher.

Commoditypricesforhotrolledsteel,

copper,aluminum,andzincarethefirsttomovewhenglobal

industrialproductionbeginstoaccelerate.

Kerplunk

When the global economyfell out of bed in the fall of2008,factoriesslammedtheirdoors shut and industrialproduction careened off a

cliff. Detroit’s drasticallyreduced car manufacturingprowess took an even biggerblow when General Motors,once the largest carmaker inthe world, declaredbankruptcy.Demandforcars,iPods, flat-screen TVs, andwashing machines tumbledacross the globe, andmanufacturersjammedonthebrakes, shutting downfactories and laying off

workers.

As factories closed,industrial metals pricesdropped like a stone, wipingout fortunes and closingdownmines.Copper,ametalused in both industrial andelectronic applications, sawitspricepeakinApril2008at$3.96per pound. By the endof 2008, however, copperprices had slumped by morethan two-thirds while nickel,

ametalmostoftenusedintheproduction of stainless steel,fell more than 72 percentfrom peak to trough. Metalstraders, terrified of a worldthatappearedtobehopelesslybroken, decided to sell firstandaskquestionslater.

Perhapsnoonesymbolizedthe highs and lows of theglobal metals business morethan the notorious Russianoligarchs, a group of pirate

capitalists who controlledsome of Russia’s mostimportantresourceindustries.Yet even for this apparentlybulletproof group, thedownturn in the metalsmarkethasbeenugly.Beforethe collapse, Oleg Deripaskawas Russia’s richest man,with a fortuneof around$28billion. The crown jewel ofhisempirewasUCRusal,theworld’s top aluminum

producer. But excessivecorporate and personal debtproved a deadly one-twocombination for Deripaska.The crunch decimated hisfortune, reducing it to just$3.5 billion and turning UCRusalintoawardofthestate.

HeavyMetals

Heavymetalbandscameandwent, but heavy metals arehere to stay. The heavymetals, or “base metals” asthey are often called, are thebackbone of the world’sindustrial economy and areused in cars, buildings, andjust about every consumeritemyoucanthinkof.

Copper

TheStatueofLibertyismadeout of 81 metric tons ofcopper, one of the oldestknown metals. Prized for itscorrosion resistance as wellas its electrical and heatconductivity, copper is usedinamyriadofapplications—everything from electricalwiring and copper pipes tobrass musical instruments.Globally, construction andelectronic applications

account for 60 percent ofcopperdemand.

As the go-to industrialmetal, mining companies arealways on the lookout forcopper. But even for themining giants of the world,finding economical depositsof copper tomine is no easytask.Typicalore,ormineral-bearingrock,containsaslittleas 0.5 to 2 percent copper,with an average grade of 1

percent. These days, Chile isdoing theheavy lifting in theworld of copper, producing35 percent of the world’smine supply, but new areassuch as Mongolia, Zambia,and theDemocraticRepublicof the Congo also lookpromising.

Aluminum

Thefoilwrapthatyouusetostore your leftovers is madefrom aluminum—the mostabundant of all metallicelements. One-third theweight of steel but equallystrong, aluminum gets calledupon for a wide range ofconstruction andtransportation applications—the average car, for instance,contains more than 250pounds of aluminum. Of all

the metals, aluminum is thesecond-best conductor ofelectricity,makingitidealforuse in power transmissionlines. Finding and miningbauxite, the ore that containsaluminumoxide(alumina),isrelatively easy. Butconverting bauxite intoaluminum requires a smelterandlotsofelectricalpowertorun the operations, which iswhy access to cheap power,

rather than proximity tobauxite deposits, is the keyfactor in aluminumproduction.

Nickel

Ifyoueverdecideit’stimetothrow everything out,including the kitchen sink,you might want to thinkagain. Kitchen sinks, and a

wholehostofotherconsumerand industrial products,contain nickel, a metal thatcanbecombinedwithsteeltoform stainless steel. Thefortunes of nickel are thuscloselytiedtothedemandforstainless steel, which is usedin the production of cars,aircraft, and consumerproducts. Nickel is relativelyabundant, yet just threecountries—Russia, Canada,

and Australia—areresponsibleforalmosthalfofitsglobalsupply.

Zinc

The red-headed stepchild ofthe large-scale miningbusiness is zinc, a metalcommonly used in theautomotive and constructionindustries. Zinc is often

coatedontosteel or iron in aprocess known asgalvanizing, which increasescorrosion resistance. Nearlyhalfofallzincdemandcomesfrom the constructionindustry, which usesgalvanized steel in floorsystems, roofing materials,andductworkforheatingandairconditioning.

Zincisanextremelyusefulindustrial metal that has the

unusual disadvantage ofbeing reasonably abundant.China has both enormouszinc reserves and thousandsof artisanalminerswilling tograb their picks and shovelsandheadunderground,SevenDwarfsstyle,whenpricesarehigh. Zinc ore’s relativelyhigh grade (typically 5 to 15percent), ease of recycling,and the intense competitionamong its many small-scale

artisanal miners all conspiretomakeittheleastfavoredofmajor metals to mine. BothBHP Billiton and Rio Tinto,two of the biggest miningcompaniesintheworld,havebeen loath to get into zincmining, even though thebarrierstoentryaren’tallthatformidable.

The world’s top 10 zincmining companies churn outabout40percentoftotalmine

production, but just threecountries—Australia, China,andPeru—holdabouthalfofthe world’s known zincreserves. The two biggestplayers in the world of zincminingareAnglo/SwissgiantXstrata PLC (XTA—LSE)and Canadian mining majorTeckResourcesLtd.(TCK—NYSE).

Lead

Despite being a soft metal,leadissurprisinglyheavy.It’suseful for ballast in the keelof sailboats, but most of thetime (81percent) it’sused inbatteries. InChina, apopularform of transportation thesedays is a battery-poweredmotorscooterknownasthee-bike. With more than 80million currently in

circulation and an additional20 million a year rolling offthe assembly line, e-bikemanufacturing alone willensurethatleaddemandstaysstrong.

Tin

The odds of discovering tinare very low indeed. As the49th most abundant element

in the earth’s crust, tin isrelativelyrare.Today,peopleoften incorrectly attribute thetermtintoanythingshiny;tinfoil and tin cans are primeexamples of this mistake.Most of these products aremade from aluminum,however, not tin. Tin’scorrosion resistancemakes itideal for combining withsteel, but its most commonapplication is as a solder for

joining together pipes orelectriccircuits.

MetalFatigue

Mines were closed andexplorationactivitygroundtoa halt during the globalfinancialcrisisof2008-2009.Asmetalspricestumbledandfinancing evaporated, lots of

junior mining companieswentbelly-upasglobalminesupply, already strugglingbefore the collapse, crash-landed.

Once the world’s factoriesget back up to full steam,metals and mines will onceagain be in high demand.That being said, getting amine built and intoproduction is no small feat.Mining analyst Larry Smith

of Scotia Capital hasestimated that an averagecopperminecancostasmuchas $12,000 to $15,000 permetric tonofannualcapacityto build. This means that amine capable of producing200,000metrictonsofcopperayear could cost upwardsof$2.4 billion to put intooperation—which is hardlybush-league.Thenthere’sthelong wait time, sometimes

more than a couple of years,for environmentalassessments and permitting.What’s more, if the miningmarket is hot, lead times forcritical mining or millingequipmentcantakeanywherefrom 12 to 36 months fromthe time of order until thestuff actually hits the site.The bottom line is that ittakes at least five years andbig bucks to get amine into

full production onceeconomically viablequantities of copper, nickel,orzinchavebeendiscovered.

Ittakesbigbucksandatleastfiveyearstogetamineupand

runningandintofull

productiononceeconomicallyviablequantitiesofcopper,nickel,orzinchavebeendiscovered.

Once a mine is up andrunning, miners first have toblast and drill throughcopious quantities of rockbefore any metal can berecovered and this is only

getting more difficult overtime.Thepercentageofmetalin ore, or the “grade,” isdeclining in the traditionalmining regions of the world,and lower-grademinesmeanthat more ore needs to beprocessed through themill toget the equivalent productionof a higher-grade mine.Western mining companiesare often faced with adifficult choice: either they

mine lower-grade, lessefficient deposits in mining-friendly jurisdictions or theypursue higher-grade projectsinpoliticallyunstableregionsoftheworld.

OutofAfrica

One country that holdstremendous promise for our

copper-hungry world is theDemocratic Republic of theCongo (DRC), which isblessed with immensemineral wealth—it is theworld’s largest producer ofcobalt and a significantsupplier of industrialdiamonds—but,unfortunately,notawholelotelse. For most of its 50-yearexistence, the countryformerly known as Zaire has

been in a constant state ofcrisis, plagued by civil warand decades of authoritarianruleunderstrongmanMobutuSese Seko. In 1994, thecountry’s annual rate ofinflation hit a staggering10,000 percent. In 1997, theDRC exported just $2.6billion worth of goods—apaltrysumforacountryof60million people. It shouldcomeasnosurprisethatover

the last several years theWorld Bank has consistentlyranked theDRCas theworstplaceintheworldtoconductbusiness.

Yet despite this abysmalrecord,miningcompaniesaresettingupshopintheDRCinthe hope of capitalizing oncopper deposits in thecountry’s southern Katangaprovince.AndtheCongolese,fortheirpart,aresopoorthey

have little choice but towelcome whatever foreigncapital theycanget. In2007,China’s Export-Import Bank,through which the countrydisburses its foreign aid,pledged $2 billion towardminerefurbishmentprogramsand another $6.5 billion forgeneral infrastructuredevelopments within theDRC. To get access to thecountry’s resources, the

Chinese companies have hadtodomorethansimplyputupcash—they’ve had to hire araftoflocalsandalsotakeonGécamines, the state-ownedmining company, as apartner.

The Chinese aren’t theonly ones trying to developmining projects in the DRC.American miningconglomerate Freeport-McMoRan (FCX—NYSE)

has been trying to get theTenke Fungurume coppermine in Katanga provinceintoproductionformorethana decade. Although variousprospective investors havedropped out of Freeport’smining consortium over thedecadeoutofconcernfortheDRC’s instability, theprojectis now finally moving aheadwith financial backing fromthe European Investment

Bank, America’s OverseasPrivate InvestmentCorporation, and the AfricanDevelopment Bank. Addingto investors’ anxiety, theDRC’s government isconducting an opaque,lengthy review of all miningcontracts signed during thecountry’scivilwar.CanadiancopperminingcompanyFirstQuantum Minerals Ltd. (FM—S&P/TSX) has been

battling with the DRC overthe status of their Kolwezicopper-cobalt project foryears. In August 2009, FirstQuantum received a letterfrom the DRC’s primeminister effectivelydemanding the return of theminingpermitfortheproject.The DRC is an extremeexample, but expropriation,civil unrest, and a near-absence of private property

rights are unfortunately alltoocommoninmanypartsofthe world where globalminingcompaniesoperate.

The800-PoundGorilla

The 800-pound gorilla ofmetals demand is China,whose appetite for

commodities of all stripes isvoracious. Over the last 30years,more than 621millionChinese have moved out ofextreme poverty to join theranksoftheglobalconsumer.And like consumerseverywhere,theChinesehaveanalmostinsatiabledesireformore stuff—the differencebeing thatwhenmore than abillion people are suddenlyvying for a slice of the

middle-class lifestyle, theywillnotbedenied.

Chinaisthe800-poundgorillaofcommodityconsumption,

accountingfornearly100percentofglobal

demandgrowthforcopperduringthe2007bullmarketinindustrialmetals.

The rapid urbanization ofChina is spurring a bullmarket in commodities, andindustrialmetalsinparticular,as millions of people there,and in the developing worldgenerally, demand consumer

goodssuchasappliancesandautomobiles. And as theworld’s factory, China is alltoo happy to oblige.According to BarclaysCapital, China accounted foralmost 100 percent of theglobal demand growth forcopper during the 2007 bullmarketinindustrialmetals.

Figure 6.1 China ConsumesCommodities! (Percentage ofTotalGlobalDemand,2008)

With roughly a quarter oftheworld’spopulation,globaldemand growth in industrialmetalshasbeendrivenalmostentirelybyChina’senormous

economicexpansion.Chinaisnumber one in aluminaproduction (from whichaluminum is made), whichincreased by almost 400percent from 2000 to 2007despite the fact that thecountry has only 2.8 percentof the world’s bauxitereserves. While copper-smelting capacity in theUnited States shrank by 60percent over the last decade,

in China it doubled, makingthe country the largestproducer of refined copper.Chinaisthelargestconsumerof zinc (it tripled itsconsumption of the metalduring the past decade) andstainless steel—an importantdriverofnickeldemand.

LondonCalling

If you’re looking for theMeccaofmetalstrading,thenLondon is it. The activitylevel on the London MetalsExchange (LME) simplydwarfs that of the COMEX,itsnearestcompetitormarket.The most actively tradedmetal contracts on the fastandfuriousLMEarethoseofaluminum, copper, zinc, andnickel. Unlike other futuresmarkets where one-month

contracts are the norm, theactively tradedmetals futuresontheLMEarerollingthree-monthcontracts—areflectionof the average time that ametal spends in processinventory; that is, the time ittakes to move from minemouth to smelter, includingthetimeitspendsatsea.

Unlikeotherfuturesmarkets,theactivelytradedmetalfuturesontheLMEare

rollingthree-monthcontracts.Thisreflectstheaveragetimethatmetalisinprocess

inventory—movingfromminemouthtosmelter,includingthe

timeatsea.

TheLMEalsodiffersfromthe NYMEX in that itfunctions as a warehouse forfinishedproducts.Itdoesthisby licensing a series ofstorage facilities next tomajor manufacturing hubs

throughout the world. Theinventory levels within theseLME facilities form animportant, widely followedbarometerofthehealthoftheindustrial metals market. Ifinventory levelsarehigh, it’sgenerally safe to concludethat demand for metals isweak. However, if theexchange is experiencing arising level of cancelledwarrants, this indicates that

metalsdemand is firmingup.Why? Because LMEinventories are reducedwhenmetal moves out of storageand into factories, and awarrant,orcertificateoftitle,must be presented to theexchange for cancellationbefore the metal can bebookedforshipment.

SpringingaLeak?

Five hundred and forty-sixyards (500meters)belowtheearth’s surface lies thehighest-grade uranium orebody in the world: CamecoCorporation’s McArthurRiver property. Ventilation,underground flooding, andmine safety are all importantconsiderations inundergroundmining,butwithuranium they’re crucial.Duringthesummerof2009,I

visited the McArthur Rivermineandwasblownawaybythe ingeniousness ofCameco’s (CCO—S&P/TSX) mining engineers inovercoming tremendoustechnical challenges toproduce uranium fromMcArthurRiver.

Uranium ore bodies areoften found in porous rockssuch as sandstone. Ifunderground streams are

present, however, waterincursion in the mine canquickly become a seriousproblem, as was the case atMcArthur River. To solve it,Cameco’sengineersdevisedanifty solution. Beforebeginninglarge-scalemining,they first cleared horizontaltunnels, or “drifts,” runningadjacent to the uranium ore.Minersthendrilledaseriesofholes through the middle of

the ore body and down toanother drift that has beencleared more than 109 yards(100 meters) below. Theholes were filled with metalpiping,throughwhichabrinesolution, chilled tominus 22degreesFahrenheit(minus30degreeCelsius),waspumped.Sevenmonths later,asectionof theminehas turned intoagiant ice cube that can besafely mined without the

worry of undergroundflooding.

NukeReboot

As environmentalists fretover America’s dependenceon coal-fired powergeneration, nuclear power isenjoying a renaissance. Notonly is nuclear power one of

the cleanest forms ofelectrical generation around,but in an era of runawaycommodity prices, nuclearplants are cheap to operate.Uranium, the fuel used bynuclear power plants,representsabout25percentofthetotaloperatingcost—afarcry from the nearly 91percent that natural gasrepresentstoagas-firedplant.

Nuclearpowerisoneofthemost

environmentallyfriendlywaystogenerateelectric

power.Fuelcostsfornuclearpowerplantsareextremelylow

whencomparedwith

oil,coal,ornaturalgas-firedalternativesforgeneratingpower.

Today, worries about coremeltdowns seem a thing ofthe past, and youngergenerations are embracing,rather than fearing, nuclearpower. Approximately 17percent of the world’selectricity is generated by

nuclear power at some 440power plants, and France,which generates around 78percent of its power fromnukes, is at the industry’sforefront.What’s more, withenvironmental concernsstarting to become a majorissue in China, uranium andnuclear power are likely toexperiencestrongdemandforyearstocome.

Ninecompaniesworldwide

are responsible for nearly 90percent of global uraniumproduction. Francemay be aleader in nuclear powergeneration, but just twocountries—Australia andCanada—producealmosthalfof the world’s total mineduranium; Canada’s Cameco(whichsupplies16percentofworld demand) is the largestproducer. Total mineduranium production is 110

million pounds a year, or 64percent of electric utilities’fuel requirements. Theremaining third comes fromdecommissioned Russiannuclear weapons and otherforms of secondary supplyfromaroundtheworld.

MetalMania

As the world’s steel mills,factories, and manufacturingfacilities gear up, metalsprices are sure to movehigher. When the globalfinancial crisis of 2008-2009hit, miners everywheredropped their picks andshovels and headed for thehills as companies withdevelopment projects in theworks went into care-and-maintenancemodetowaitout

the economic storm. Giventhat theaveragemine takesarock-bottomminimumoffiveyears to bring intoproduction, supply willindisputably lag demand astheglobaleconomybeginstoexpand, and this will meansharply higher metals pricesforalong,longtimetocome.

HotCommodities

•Commoditypricesforhotrolledsteel,copper,aluminum,andzincarethefirsttomovewhenglobalindustrial

productionbeginstoaccelerate.

•Ittakesatleastfiveyearsandbigbuckstogetamineupandrunningandintofullproductiononceeconomicallyviable

quantitiesofcopper,nickel,orzinchavebeendiscovered.

•Chinaisthe800-poundgorillaofcommodityconsumption,accountingfornearly100percentofglobaldemand

growthforcopperduringthe2007bullmarketinindustrialmetals.

•Near-monthLMEfuturescontractsaretradedonarollingthree-monthbasis.

•Metalstraders

carefullyfollowtheinventorylevelsofmetalsontheLME,astheyserveasanimportantbarometerofindustrialdemand.

•Nuclearpowerisexperiencingarenaissance,anduranium

priceswilllikelymovehigherasconcernsovertheenvironmenttakecenterstageglobally.

ChapterSeven

BettingtheFarm

BingeingonFoodInflation

OVER ONE BILLIONPEOPLE WORLDWIDE goto bed hungry every night.And that figure is likely toclimbaschangingdiets,rapidurbanization, and globalpopulationgrowthcombinetoraise food pricesdramatically. At the UnitedNations’ first World FoodConference in 1974,American Secretary of StateHenry Kissinger pledged to

end child hunger within thenext 10 years.More than 35years later, however, globalhungerisstillaproblem,onethat will likely get worse.According to the UnitedNationsFoodandAgricultureOrganization(FAO),betweennow and 2050 the world’spopulation will increase bymorethanathird,thedemandfor agricultural products willrisebymorethan70percent,

and the global demand formeatwilldouble.Foodpricesmust rise to encouragefarmerstogrowmorefoodtofeed a hungry planet—acircumstance thatwill ensurethat millions more of theworld’s poor will go to bedhungryinthefuture.

FoodFight

Rising food prices are like asilent tsunami, shakinggovernmentsandstokingriotsin their wake. In the West,where food expendituresaccount for less than 15percent of personal income,rising prices are anannoyance, but in thedevelopingworld,where thisfigure can rise as high as 80percent,they’reacatastrophe.In2007,wheatpricesshotup

77 percent while the cost ofrice, a staple in half theworld’sdiets,rose16percent.In April 2008, World BankPresident Bob Zoellickwarned that 33 nations wereat risk for social unrestbecauseofrisingfoodprices.During the same month,Prime MinisterJacquesÉdouard Alexis ofHaiti was forced from officeas riots over thehigh cost of

beans, rice, and other foodstaplesspreadfromthesouthofhiscountry to thenation’scapital. United Nationspeacekeeperstryingtorestorecalm were pressed intoaction, shooting tear gascanistersandrubberbulletsatthousandsof rioterswhohadparalyzed the capital. InMarch 2008, Egypt’sPresident Hosni Mubarakordered his army to start

baking bread afterskyrocketingwheatpricesledtosocialunrest.Accordingtothe World Bank’s Zoellick,“For countries where foodcomprises fromhalf to three-quarters of consumption,there is no margin forsurvival.” Faced with thestark choice of rioting orstarving,manyoftheworld’spoor have been forced intothestreets.

IntheWest,foodexpendituresaccount

forlessthan15percentofpersonalincome,butinthe

developingworld,thisfigurecanriseashigh

as80percent.

About one billion peopleliveononlyadollaraday—the benchmark for extremepoverty. For these people,many of whom have beenforced to pull their childrenfrom school and to cut backonvegetablessotheycanstillaffordtoeatrice,malnutritionandmiseryaretheunpleasantrepercussions of rising foodprices. If food inflation

persists,afurther100millionpeople may be pushed intoextremepoverty.

Aboutonebillionpeopleliveononlyadollaraday—thebenchmarkforextremepoverty.

The recent price surgemarkedanendtoanearly30-year period of cheap, stablefood prices. Throughoutmuchoftheworld,farmingishighly subsidized andregulatedthroughabyzantinesystem of quotas and otherrestrictions. For mostgovernments, food securityranks right up there with

energy security, and theviability of a nation’sdomesticagriculturalindustryis often vigorously protectedthrough an aggressive arrayof tariffs. And as with anyhighly protected industry,inefficiencyisoftentheorderof the day. Because localgovernments, rather than theglobal marketplace, supplythe pricing signals, manyWestern farmers have

actually found themselves inthe bizarre situation of beingpaidnottofarm.

During the GreenRevolution of the 1960s,advancesinseedvarietiesandthe use of pesticides helpedincrease crop yields bybetween 3 to 6 percent peryear. As word of these newhigher-yield seed typesspread, adoption by farmerswas swift. By the 1970s,

some40percentoffarmersinthe developing world wereusingGreenRevolutionseedsandglobalfoodsupplieswererapidlyexpanding.

From 1954 to 1963,muchof America’s surplus grainwas exported to poorcountries under the USAIDprogram, peaking at 17million metric tons in the1965-1966 growing season.Today, America still

dominates the internationalfood aid system, providingmore than half of all globalfoodassistance.

Over the last 25 years,however, investments infarming have declinedsteadily. Between 1980 and2006, Western agriculturalaid decreased by 75 percent,while developing countriesmanaged to invest only 5percent of their government

revenuesinfarming.Politicalinstability,foodinflation,andgovernmental neglect havefurther exacerbated thedifferences between theagricultural haves and have-nots. Making matters worse,the rate of crop yield growthhasflatlinedinpoorcountriesandslowed tobetween1and2 percent in rich countries.Continued food inflationseems the likeliest outcome

of this combination ofdwindling surpluses in theWest and struggling supplythroughout the developingworld. Joachim von Braun,the head of the InternationalFood Policy ResearchInstituteinWashington,D.C.,is concerned that the worldmay be in for a nasty foodfight,warningintheApril19,2008, edition of TheEconomist that “World

agriculturehasenteredanew,unsustainable and politicallyriskyperiod.”

LandGrab

During the global food scareof 2007-2008, as food pricesexperienced their sharpestrise in 30 years, riots sweptthrough three dozen

countries. Many large food-producing nations hoardedkey crops and banned theirexport.During2008,Vietnamand Thailand, the world’sbiggest exporters of rice,wrought havoc in thePhilippines—the world’sbiggest importer of rice—bybanning the grain’s export.For countries like thePhilippines, the lesson fromthe most recent price spike

was obvious: world marketscouldno longerbe trusted tosupplytheirneeds.

Increasingly, countries aremoving toward greater foodself-sufficiency in an attemptto curb their reliance on theinternational market. ThePhilippines, for example, hasagoalofgrowing98percentof the rice it needs by 2010.In2008,IndonesianPresidentSusilo Bambang Yudhoyono

announced big increases infarmsubsidiesasafirstmovetoward food self-sufficiency.Senegal,which importsmorethan80percentofitsriceandwas rocked by food riots in2008, has responded to thecrisis with a governmentblueprintforagriculturalself-sufficiency in staple goodscalled the “Great Offensivefor Food and Abundance.”Elsewhere, Honduras,

Malaysia, Colombia, andChina are all currentlypursuingsimilargoals.

Inearly2009,SaudiArabiareceived its first shipment ofricefromEthiopia—theresultof a $100million investmentprogramaimedatraisingrice,wheat, and barley on foreignsoil. With mistrust of theinternational grain marketsrunning high, SaudiArabia’smove was part of a larger

trend—wealthy grain-importing countries out-sourcing grain production topoorer, land-rich countries inneedof investment. In recentyears, China, Kuwait, andSouthKoreahavealloptedtogrow food on land theycontrol abroad rather thanrely on imports, and alreadysomeof the best farmland inpoor countries has beenspoken for by foreign

interests.Bytheendof2009,nearly 50 million acres (20hectares) of prime farmlandwas sold or under long-termlease.

Alreadysomeofthebestfarmlandinpoorcountrieshasbeen

spokenforbyforeigninterests.Bytheendof2009,nearly50millionacres(20hectares)ofprimefarmlandwassoldorunderlong-termleaseinwhat

amountstoamassivelandgrab.

GoingGreen?

High oil prices and pressurefrom environmentalists haveforced lawmakers around theworld to pass legislationmandatingtheuseofbiofuels.While the U.S. consumesabout21millionbarrelsofoila day, it produces just 5.2million—it imports thebalance. In 2007, President

Bush signed into law theEnergy Independence andSecurityActwith thegoalofweaning the U.S. off itsdependence on foreign oilthrough the promotion ofalternative fuels and themandating of better vehiclefuel economy. The lawstipulates that 36 billiongallons of biofuels—or fuelfromfood—mustbeaddedtogasoline by 2022. In

America, the biofuel ofchoice is ethanol, a type ofgrain alcohol made fromcorn. When blended withgasoline, ethanol increasesthe octane level of the fueland reduces the carbonmonoxideemissions thatcarsproduce.

But in spite of ethanol’sapparent benefits as anecofriendly fuel, the debateover its use rages on and

serious doubts about itsusefulness persist. In onestudy, David Pimentel, aprofessor of Ecology andAgriculture at CornellUniversity, found that it took29 percent more energy toconvertcornintoethanolthanthe fuel actually produced.Othershave suggested that ifevery bushel of wheat, rice,soybeans, and corn in theU.S. were used to produce

ethanol, it would still onlycover about 4 percent ofAmerica’s energy needs. InFebruary 2008, theAssociated Press cited theworkof researchers affiliatedwith Princeton Universitywho found that, due toexpected land-use changes,the widespread use of corn-based ethanol could result intwice the greenhouse gasemissions of the gasoline it

wouldreplace.

Politicians concerned withgoing green have embracedbiofuelsasapotentialanswerto our addiction to fossilfuels. But by mandating asixfold increase in theuseofcorn-based ethanol by 2022,they have boosted thedemand for corn at preciselythe same time that worlddemand for food is on theupswing. According to the

International Monetary Fund(IMF),atleasthalfoftherisein corn prices between 2005and 2007 was attributable tocornethanolproductionintheUnited States (since theU.S.producesabout42percentofthe world’s corn, this shouldcome as no surprise), andincreases in biofuelproduction appear to be atleast partly to blame for thesingle-year quadrupling of

worldcornpricesthatcreateda crisis for the poor from2007 to 2008. In 2007, inresponse to the alarm overescalating prices, the UnitedNations’ independent expertontherighttofoodcalledfora five-year moratorium onbiofuel production from foodcrops.

ThisLittlePiggy

WenttoMarket

I enjoy a good steak everynowandagain,andasitturnsout, my meat craving isshared globally. With risingincomes, a fundamental shiftin eating patterns isoccurring: as people becomewealthier, they tend to eatmore meat. In China, wherehalf the world’s pigs are

raised and eaten, pork is thefavorite meat-based protein,while in America, whichproduces and consumes themost poultry in the world,chicken reigns supreme.Brazil tips the scales as theworld’s largest producer ofbeef. While the world’sappetiteformeatcontinuestogrow,nowhereisthedemandas great as it is in theindustrialized West. The

average person in thedeveloping world consumesjust62pounds(28kilograms)of meat per year, whileWesterners consume awhopping 176 pounds (80kilograms)—an almostthreefolddifference.

ThedevelopingworldmaylagbehindtheWestinannualmeatconsumptionperperson,but the overall meatconsumption rate is growing

attwicetherateofpopulationincreases. Sincemeat is verygrain- and water-intensive toproduce, the dramaticincrease in meat-based dietshas profound agriculturalimplications. For example, ittakes 4.4 pounds (twokilograms) of grain toproduce 2.2 pounds (onekilogram) of chicken, and itcan take as much as 22pounds (10 kilograms) of

grain and 180 gallons (680liters)ofwatertoproducejust2.2pounds(onekilogram)ofbeef.Ontheotherhand,rice,which is the most water-intensive grain to produce,requiresonlyone-tenthofthewaterneededtoproducebeef.Infact,thecreationofameat-rich diet is so resourceintensive that, on average, itrequires two to four timesmorelandthanisrequiredfor

the creation of a vegetarian-baseddiet.

To meet this risingdemand, millions of tons ofgrain—half the world’sharvest—are currently beingused as feed for livestockannually, but the FAOestimates that by 2030 astaggering one billion extrametric tons of cereal will berequired tomeet both humanandanimalneeds.

Halftheworld’sgrainharvestisfedtolivestock,andthe

UnitedNationsFoodandAgricultural

Organization(FAO)estimatesthattomeethumanandanimalneedsanextraone

billionmetrictonsofcerealwillberequired

by2030.

NothingRunsLikeaDeere

Three billion people globallymake their living as farmers,

about twobillion of themonfarms of less than 5 acres(two hectares). In Africa,small-scale farms representaround 80 percent of allagricultural output. In China,92 percent of the farms aresmall subsistence farms. Tofeed a hungry planet, futurefocus will need to be onincreasing theproductivityofsmall-scale farms such asthese.

In a September 2008report, investment bankCredit Suisse cited farmcommercialization—that is,any shift toward moresophisticated farmingmethods that helps producegreater,moreconsistentcrops—as the single mostimportant factor driving thenext decade of growth inagriculture.

InvestmentbankCreditSuisse,inaSeptember2008report,citedfarm

commercializationasthesinglemostimportantfactordrivingthenext

decadeofgrowthin

agriculture.

Unfortunately, agriculturalland is in short supply, andthere are only so manynationalparksandforeststhatcan be turned into farmers’fields.Overthecomingyears,thislimitation,combinedwithgrowing demand from anexpanding global population,willstressthefoodchainlike

never before. From 1961 to2005, available agriculturalland increased at just 0.2percent per year; however,food production increased by2 percent a year—a rate 10times faster than thecorresponding increases inarable land. The reasons forthe massive improvement inproductivity were simple:betteragriculturalpracticesinthe form of superior seeds

and fertilizers, coupled withimproved pesticides andstoragetechniques.

From1961to2005,agriculturalland

increasedatjust0.2percentperyear,however,food

productionincreasedby2percentayear—arate10timesfaster

thanthecorresponding

increasesinarableland.

During the bull market of2007-2008, Western farmersresponded to the run-up inworld prices for grains by

boosting their output.Harvests increased by 11percent in rich nations, butsadly,inpoorcountries(Indiaand China being theexceptions), grain outputactually fell during that timeperiod. Rising grain pricesthus benefited farmers in theWest, but penalizedsubsistencefarmerswhowereunable to boost productivityand capitalize on the rising

pricesforgrains.

Globally, levels of farmcommercialization varywidely.Duringthe1930s,thefamilyfarmwasthedominantfeature of the Americanagriculturallandscape.Butbythe 1960s, headlines warnedof “faceless corporatebehemoths” and “the end ofthe family farm” as largecommercial enterprisesbought up these small

operations; the newspapersseemingly ignored the factthat the moves createdeconomies of scale thatbroughtlowerfoodprices.

Brazil’s and Argentina’smoves toward greater farmcommercialization began inthe 1970s, and really pickedup steam in the 1990s. InEastern Europe and Russia,however,wherethelegacyofsocialism has impeded the

commercialization process,the story has been verydifferent. In Russia,agricultural decision-makingis still done locally ratherthan nationally, which hasslowed thebroadadoptionofmoderntechniques.

China faces severe waterpollution issues that willhamper its ability tocommercialize its farms, butthe country’s interest in

agricultural self-sufficiencyand its powerful centralplanningapparatusmean thatit could achieve large-scalefarm commercializationwithin a decade. On the flipside,withcloseto60percentof China’s total workforceactive in farming, large-scalecommercialization wouldmeanmassivedislocationandupheaval for millions ofpeople.

Asmillionsofsmall farmsaround the world getconsolidated into largercommercial enterprises,massive investment inmodern farm equipment willbe needed to make themviable. Equipmentmanufacturers,suchasgiantsCase New Holland (CNH—NYSE) and Deere andCompany (DE—NYSE),shouldbeprimebeneficiaries

of the global trend towardgreater agriculturalefficiency.

And that’sonlypartof thegood news story; oncefarmers select a tractor theytend tobe extremely loyal tothe brand—a loyalty thatoftenextendsforgenerations.

MoneyinManure?

A major reason that NorthAmerica leads the pack interms of farmcommercialization is itsliberal use of commercialfertilizers. All fertilizers,including cow dung, providecritical nutrients, or plantfood, that help spur cropgrowth and resist disease.Fertilizedcropsgrow30to50percent faster thanunfertilized crops, giving the

commercial farmsahuge leguponthecompetition.

Fertilizedcropsgrow30to50percentfaster

thanunfertilizedcrops,givingthe

commercialfarmsahugeleguponthe

competition.

In commercial farming,nothingislefttochance.Soilisanalyzed,croprotationsarestudied, andaprecise regimeof fertilization is worked outto ensure optimal growingconditions. There are a widevariety of commercialfertilizers available, all basedon the three key plant

nutrientsfromwhichtheyarederived—nitrogen,phosphate, and potassium—and all of which play aunique role in cropdevelopment.

Nitrogen-based fertilizersare made from natural gasand are the most prevalent,being used in 59 percent ofall applications. Phosphate-based fertilizers are createdbymixingcrushedphosphate

rock with water and sulfuricacid to produce phosphoricacid. Potassium-basedfertilizers are created frompotash (potassium chloride)and help to increase waterretentionandimprovediseaseresistanceincrops.

Access to cheap sourcedepositsisthemostimportantvariable for fertilizercompanies.Whilenaturalgasis pretty prevalent the world

over,phosphaterockdepositsare concentrated in Floridaand Morocco, and only 12countries are capable ofsupplying potash, the criticalfeedstock for makingpotassium-basedfertilizers.

While Morocco is aninteresting place to visit,Floridaiscloser,sorecentlyIdecidedtocheckoutsomeofMosaic Company’s (MOS—NYSE) operations in Florida

to bone up on the phosphatebusiness.Tosaythatthiswasno Mickey Mouse operationis an understatement.Standingonthecatwalkofan$80-milliondraglinewhileanoperator swung the massive350-foot-long (107-meter-long) boom towards thephosphate rock buried undera layer of clay and sandwasquite the thrill. To turn thephosphate rock into a

concentrate for furtherprocessing, a massive watercannonwith enough force tocut a man in half is used tobreak apart the phosphaterock and turn it into a slurry(a mixture of water andphosphate).Theslurryisthenpumped eight miles to theplantforprocessing.

Whileyoumightthinkthatthe Florida landscape wouldlook like one big gravel pit,

landreclamationisabigpartof the process of mining forphosphate rock. Oldphosphate mines aretransformed into wildlifepreserves and nature habitatsthat leave no trace of themassive movement of rockand earth that came before.This seems like one smartway to be in the resourceextractionbusiness.

DustBunny

As the doors of the skipopened, I was surprised byhow dusty the environmentwas. It was the summer of2009, and I was visitingPotashCorp’s flagshipLanigan mine in southernSaskatchewan.As one of theworld’sbiggestpotashmines,Lanigan is impressive. More

than half a mile (onekilometer) below the earth’ssurface an enormousunderground city unfoldedbeforemyeyes.Wemountedmodified half-ton trucks anddroveformilestowitnessthecontinuous mining of potashfrom the earth’s crust. Tokeep the dust down, theunderground roadways wereconstantlywatered.

Potash, a pinky, crystal-

likesubstance, isminedfromevaporated underground saltlakes. Standing by theexposed ore body, I wastaken by how massive thepotash seams were and therelative ease with which Icouldbreakpiecesoff.

Withaverageoregradesinthe 20 to 25 percent range,Saskatchewan is the SaudiArabia of potash. It is hometo companies such as

PotashCorp (POT—NYSE),Agrium (AGU—NYSE), andMosaic (MOS—NYSE),which supply almost 39percent of theworld’s needs.Even mining giant BHPBilliton Limited (BHP—NYSE) has realized that theeconomics of potash are justtoo good to sneeze at. Thecompany has opened anoffice in downtownSaskatoon, staffed it with

more than 200 professionals,andisplottingapathforwardto bring these specialty saltstoafarmnearyou.

Roundup

Simply applying commercialfertilizerstoafieldcanresultin strong gains in yield. In apreviously unfertilized field

thesegainscomequicklyanduniformly, but they begin toplateau over time. In thisregard, the biggest gamechanger for farmershasbeentheintroductionofgeneticallymodified (GM) seeds,whoseimpressive yield gains havealtered the competitivedynamicforfarming.

Thebiggestgamechangerforthefarmercomesfromgeneticallymodified(GM)seeds,whoseimpressiveyieldgainshavealteredthecompetitivedynamic

forfarming.

ByrecombiningseedDNAin the laboratory, companieshavebeenabletocreateseedsthat offer superior droughtand disease resistance. Butthe real appeal of theseproducts is their ability toboost the farmer’s bottomline by increasing yields andcuttingdownon theneed forcostly pesticides andherbicides.

Today, most of America’scorn crops are grown withGMseeds, andmanybelievetheir use will help to doublecorn output in the UnitedStates by 2030. In Brazil,Argentina, China, and Indiathey’ve been welcomed withopen arms. The EuropeanUnion, however, hasmaintained a closed-doorpolicy, banning their usesince1998.Manybelievethat

the human health impacts ofGM seeds are still unknownand that trace elements ofthem can still be detected inthe soil years after their usehas been discontinued—despite intensive efforts toeradicatethem.Todetractors,the benefits of the seedsaren’tworththerisks.

The undisputed worldleader in the biotechnology,or genetic modification, of

plants isMonsantoCompany(MON—NYSE)ofSt.Louis,Missouri. And while thedebateovertheapplicationofGMseedsis likelytopersist,Peter Brabeck, the chairmanof Nestlé SA, contends that“You cannot feed the worldtoday without geneticallymodified organisms.” Withthe world of agriculturetransitioning from a regionalindustry to a global one, the

inevitable growth in GMseeds will also result in themost sustainable trend inagriculture.

A decade or more ofunderproduction has set thestage for a surge in profitsand prices for all of theagricultural inputs. Movestoward agricultural self-sufficiency, natural limits onthe amount of arable land,and population growth will

all continue to driveimproved agriculturalproductivity over the nexttwo decades. Farmcommercialization willcontinuetobethebestwaytoboost sagging productivityand is the critical linkbetween stronger tractorsales,risingfertilizerdemand,and sales of geneticallymodified(GM)seeds.

HotCommodities

•Globally,aboutonebillionpeopleliveonadollaraday—thebenchmarkforextremepoverty.

•Halftheworld’sgrainharvestisfedtolivestock,

andit’sexpectedthatby2030anotherbillionmetrictonsofcerealperyearwillberequiredtomeethumanandanimalneeds.

•From1961to2005,foodproduction

increasedat10timestheratethatarablelandbecameavailable,asaresultofimprovedagriculturalpractices.

•Withrisingincomes,ashiftisoccurringtowardgrain-

andwater-intensivemeat-baseddiets.

•Farmcommercializationwillbethesinglebiggestfactordrivingthenextdecadeofgrowthinagriculture.

•Fertilizedcropsgrow30to50

percentfasterthanunfertilizedcrops—givingcommercialfarmsahugelegupontheirsmall-scalecompetition.

•Commercialfertilizersactasplantfood,delivering

variousformsofthethreecriticalnutrients(nitrogen,potassium,andphosphate).

•TheintroductionofGMseedsisalteringthecompetitivedynamicfor

farmers.

ChapterEight

OrderingtheBreakfastSpecial

FindingProfitsinFoodstuffs

IALWAYSSAVORTHOSERARE MORNINGS when Ican take the time toenjoyanunhurried breakfast with thenewspaper and a steaming-hotcupofcoffee.Formostofus, that’s what breakfast is:anenjoyablewaytokick-startthe day. But not everyonerealizes that behind the

typicalall-Americanmorningmeal of orange juice, eggs,bacon, and coffee lies athriving global commoditybusiness.

Overthelast11,000years,from the dawn of agricultureto the opening of the firstMcDonald’s, the story offood has been one ofglobalization. Steeped inmystery, the spice tradeusedto be characterized by exotic

tales and exorbitant prices;today, of course, every spiceimaginable is readilyavailable at your localsupermarket. While food isabundant in the West, thecountry of origin is often asurprise. Coffee, whichoriginated in Ethiopia, andsugar,which first came fromNewGuinea,arenow twoofBrazil’s dominant exports.Currently,Indiaisthebiggest

producer of peanuts andChina grows the mostpotatoes, even though bothcrops originated in SouthAmerica.

Foodstuffs are no passiveindulgence, they’re part of awell-balanced commodityportfolio. While copper wasthe best performingcommodity in 2009, rallyingmore than 150 percent fromitsDecember30,2008,close,

sugar came in second place,with a price move of morethan 100 percent. Orangejuice,withapriceincreaseofaround45percent,wasalsoasolidinvestmentduring2009,whilecocoa,thebeanusedtomakechocolate,ralliednearly35 percent over the year.You’ll never look at yourbreakfast special the samewayonceyouperkup to therealitythatwhatyou’rereally

staring at is a plateful ofpotentialprofits.

ReadyforaPerkUp?

Judging from the number ofexpensive coffee houses intoday’s metropolises, you’dthink that coffee producershad been making out like

banditsforyears.Butmostofus half-caff-latte-with-a-twisttypes who’ve been willinglyshellingoutthebigbucksforourmorning indulgencehavenoideaabouttherealupsanddowns of growing andharvesting coffee beans.Coffeepriceshaveperkeduprecently, shooting to theirhighest levels in a decade asrafts of new consumers inIndia and China develop a

tasteforacupofJoe.

Coffee originated inEthiopia, but was firstcultivated in theArabworld.In the 17th century, coffeearrived in Italy beforespreading to the rest ofEurope and, later, to theAmericas. Today, the UnitedStates is the largestnationofcoffeedrinkersintheworld.

Butcoffeeismorethanjust

a morning fix, it’s a topagriculturalexport,rankingasthenumberoneexportfor12countries in 2004. Over 100millionpeopleworldwidearedependent on coffee as theirprimary source of income,and it remains the economicbackbone for many Africancountries, includingEthiopia,Uganda, and Rwanda.However, Brazil is currentlythe world leader in coffee

production. In 2007, its totaloutputwasaround2.5millionmetric tons, followed byVietnam,whichproduced1.1million metric tons, andColombia, which produced780,000metrictons.

Coffeeoriginatedin

Ethiopia,butwasfirstcultivatedintheArab

world.Today,Americaistheworld’slargestconsumerof

coffeeandBrazilisthelargestproducer,

followedbyVietnamandColombia.

Twomainspeciesofcoffeeare grown worldwide:

arabica, the flavorful, mildercoffee preferred by manyNorth Americans, androbusta, a stronger, morebitter, full-bodied coffee. Asit contains about 40 to 50percent more caffeine,robustapacksabiggerpunchthan arabica, making it idealforblendingintoespressoandas an inexpensive substitutefor arabica in commercialcoffee blends. Because of its

milder flavor, arabica makesup roughly 70 percent of theworld’s total green coffeeproduction. But no matterwhat type it is, all coffeecomes from the seeds ofcoffee cherries, which growon small evergreen shrubsand are usually picked byhand. Coffee cultivationrequires lots of water, socoffee shrubs grow best inwarm, wet climates; in fact,

some have estimated that ittakes between 160 to 290gallons (600 to 1,100 liters)of water to produce just aquarter gallon (one liter) ofcoffee—which is a big dealfor the many coffee-producing nations facingwatershortages.

During the mid-1980s,coffeecommandedapriceofnearly $1.60 per pound;respectable,butstillafarcry

from its all-time peak of$3.36 per pound in April1977 (it bottomed at a paltry$0.415 in December 2001).Coffeeproductionhas soaredover the last few decades asnew countries, most notablyVietnam, have entered themarket. Big companies likeStarbucks may dominate thehigh-endretailcoffeemarket,but the beans that went intoyour four-dollar latte were

mostly grown by smallfarmingoperations invariousparts of the world. Coffeegrowing is backbreakingwork. Before the beans canbe sold, they must be hand-picked, hauled out of thefields, shelled, dried, andsorted. Nonetheless, carpingabout the cost of yourcappuccino is justified: theactual cost of the beans ismere pennies per cup—far

lessthanmilkorbeer.

Starbucks has ridden thewave of growing legions ofcoffee connoisseurs tobecome the largest coffeechain in the world. But inrecent years, over-expansionand rising commodity priceshave hit the company’sbottom line hard. In 2007,Starbucks’sharepricefell42percent,making it oneof theworst performing companies

on the NASDAQ.Compounding its problems,ConsumerReportsmagazine,in its March 2007 edition,gave McDonald’s filteredcoffee a higher rating thanStarbucks’ pricier alternative.Theglobaleconomiccrisisof2008-2009 hadmultitudes ofcustomers defecting tocheaper coffee joints likeDunkin’ Donuts, where adailyjoltcanbehadforabout

aquarteroftheprice.Tostopthe exodus, not to mentionthe proliferation of negativemonikers like “Fourbucks,”Starbucks developed Via, aninstant coffee aimed atcapturing a piece of the $17billion global instant coffeemarket. Via was first rolledout in the U.S., yet hadStarbucks studied thestatistics, it might haveconcluded that foreign

marketswereabetterplacetostart: 80 percent of Britishcoffee sales are in instantcoffee,versus just10percentinAmerica.

SugarHigh

The best sugar high you canget these days is frominvesting in it rather than

eating it. After India (theworld’s second-largest sugarproducer) curbed itsproduction by half followinglow rainfall levels in 2009,sugar prices soared to theirhighest level in 27 years.India is more than a largeproducer of sugar—it’s alsothe world’s largest consumerofthestuff.

Sugar is believed to haveoriginated in New Guinea,

but today sugarcane andsugar beets—the two mainsources of those whitecrystals on your breakfasttable—aregrowninover100countries worldwide.Sugarcane, the source ofaround 75 percent of allrefinedsugar,isgrowninthetropical and subtropicalregions of theworld that fallroughly between the Tropicsof Capricorn and Cancer.

Sugar beets, on the otherhand, typically grow best incooler climates with evenlydistributed rainfall.Regardless of whether sugarcomes from the beet or thecane though, its chemicalcompositionisidentical.

Global production of rawsugar is around 160 millionmetrictonsannually.Brazilisthe world’s largest producerof sugar, accounting for 20

percentofannualproduction,and is also the largestexporter—responsible for astaggering 42 percent ofworld output. Other largesugar producers are Indiawith a 14 percent share, theEuropeanUnionandThailandeach with 11 percent, andAustraliawith8percent.

Globalproductionofrawsugarisaround

160millionmetrictonsannually.Brazilisnot

onlytheworld’slargestproducerofsugar,accountingfor20percentofannualproduction,butit’s

alsothelargestexporter—accountingforastaggering42percentofexports.

Brazil’s sugar industry islikely to become even moredominant in the years tocome, as many of its bigcompanies were forced tomerge following the globalcredit crunch of 2008-2009.

Cosan, a company that aloneproduces 2.5 percent of theworld’s sugar, snapped upExxonMobil’s Brazilianethanol distribution businessin 2008. In April 2009,French commodity tradinghouse Louis Dreyfus boughtSantelisa Vale, a largeprocessor of sugarcane, in amove aimed at bolstering itsown sugar trading business.The result of these mergers

has been a far moreconsolidated Brazilian sugarindustry, with greatereconomiesofscaleandlotsofcashtopursuefuturebusinessexpansions.

But Brazil’s sugarproducers have another edgeover the competition. Manycan produce ethanol fromsugarcane,which serves as ahandy backup when worldsugar prices are low. Sharp

increases insalesof flex-fuelcars,whichcan runoneithergasolineorethanol,havehadthe market for ethanolgrowing at roughly 17percent per year. It’s a goodnews story that could get awholelotbetterifEuropeandAmerica ever reduce theirtariffsonBrazilianethanol.

FromGrovetoGlass

In the 1970s, Florida citrusgrowers came up with thepopular tagline: “A breakfastwithoutorange juice is likeaday without sunshine.”Nowadaysthough,it’sBrazil,not Florida, that dominatestheglobalorange juice trade.Harnessingaplentiful supplyof land and cheap labor,Brazil has not only becomethe world’s largest orangejuice exporter, it also

dominatesincoffee,beef,andsugar.Andunlikemanyofitsrivals, Brazil has room tocontinue growing as a globalagricultural powerhouse—without encroaching on thefragileAmazonrainforest,thecountry could easily addanother220millionacres(89million hectares) of farmlandto the 148 million acres (60million hectares) it currentlyoccupies.

Floridamaycometomindwhenyouthinkoforangejuice,but

it’sBrazil,notFlorida,thatdominatestheglobalorangejuice

trade.

Originating in SoutheastAsia and southern China,oranges have been cultivatedforthelast4,000years.FromAsia,orangesmigratedtotheMiddle East where Arabtradershelpedintroducethemthroughout theMediterranean. Spanish andPortuguese explorers broughtoranges to the New World.The orange juice industrygrew in the 1930s with the

development ofpasteurization techniques andagain later with thewidespread use ofrefrigerators.

There are three mainvarieties of oranges—Mandarin, Navel, andValencia—which are oftenblended to produce a widevariety of flavors. Globally,the orange juice market hasannual sales of more than

$2.3 billion, with the UnitedStates, Canada, WesternEurope, and Japan being thelargest consumers. In theUnited States, the Tropicanabrand of orange juice reignssupreme,havingsnaggeda65percent share of the overallmarket.

If Florida is big in orangejuice, then Brazil isabsolutely massive: thecountry produces 27 percent

of the world’s oranges, 53percent of its orange juice,and 50 percent of all frozenconcentrated orange juice.ThestateofSãoPaulo,inthecountry’ssoutheast,producesalmostallofBrazil’soranges—some 98 percent, grownfrom 1.7 million acres(688,000 hectares). Florida,by contrast, has seen landdedicated togrowingorangesshrink to less than 700,000

acres (283,000 hectares) aspopulation growthincreasingly means that landonce dedicated to groves is,instead, turned into shoppingmalls.

Brazilproduces27percentoftheworld’s

orangesand53percentofallthe

orangejuiceconsumedglobally.

In spite of Brazil’sdominance in agriculturalcommodities, the countryfaces significant obstacles toboostingoutputfurther.Weakinstitutions, creakinginfrastructure, and poor

contract enforcement are allchallenging its agriculturalsector’s development.Transportation is also a hugeissue.Thecountry’sriversdonotcrisscrosstheheartofthecountryanditsraillinesareashambles. As recently as2005, just 10 percent of theroadsinBrazilwerepaved—a major impediment togetting food from farm tofork.

DecadentDelight

It’s more than a sweetindulgence—it’s the world’sfavorite flavor. Chocolate,whichismadefromcocoa,iscertainly a delightfuldecadence, but it’s also animportant traded commodity.The Spanish, who firstdiscovered cocoa in SouthAmericamorethan500years

ago,calledit“thefoodofthegods.” While many wouldstill agree with thatassessment today, cocoa’s2009 performance as acommodity investment wasequally sweet. Cocoa futuresreturned23.4percentin2009.

Cocoa, the common namefor the powder derived fromthe seeds of the cacao tree,dates back to the time of theAztecs. To bring out their

chocolate flavor, the seedsmust go through the processof being picked, cured, driedin the sun, cleaned, and thenroasted. Two-thirds of allcocoa seedspicked todayareused tomake chocolate. Therest are ground into cocoapowder. The Ivory Coast isthe big hammer of cocoaproduction, supplying 37percent of the 3.4 millionmetric tons traded annually.

Ghana, another largeproducer, accounts for 20percent of global supply,Indonesia produces 14percent,whileCameroonandBrazil each supply about 5percent. The biggest sweettoothbelongstotheEuropeanUnion, which consumes 40percentoftheworld’sannualcocoa production (versus amere12percentbytheU.S.).

Two-thirdsofcocoaseedspickedare

turnedintochocolate,whiletherestbecomecocoapowder.TheIvoryCoastisthebighammerofcoffee

production,supplying37percentofthe3.4

millionmetrictonsofcocoatradedannually.

But despite soaring cocoafutures, there’s troublelurking in candy land. InGhana, farm productivity isslumping and the children ofmany of the country’s cocoafarmers aren’t interested inworking in the familybusiness anymore. For

Britain’s CadburySchweppes, the world’sbiggestconfectionerandnowadivision ofKraft, this grieffrom Ghana is bad newsgiven that the countryprovides all of the cocoa forCadbury’s U.K. operationsand 70 percent of its globalsupply. More importantly,Cadbury maintains that it isGhana’s high-quality cocoathat gives their products—

includingtheCremeEggandtheDairyMilk chocolate bar—their distinctive taste. InJanuary 2008, the companyembarked on a 10-yearcollaboration with Ghana’scocoa growers, called the“Cadbury CocoaPartnership,”with the aimofboosting cocoa yields byhelping cocoa farmers worktogether better and byencouraging the use of

fertilizers.

WhenPigsFly

American pig farmers havehad a tough time fatteningtheir wallets lately—risingfeedprices,swinefluworries,and a trend toward healthyeatinghaveallimpactedtheirbottom line. And that’s been

putting pressure on thefutures contracts for porkbellies(porkbellyisthemeatfrom a pig’s belly wherebacon comes from), whichrallied just 0.72 percent in2009. In contrast, orangejuice futures soared 80.9percent the same year.Normally, the strongest timefor pork bellies sales is thefiscal second quarter whenbarbeques start firing up.

Lately,however,thisseasonalcustomhasn’tbeenenoughtosupportsaggingsales.

Astheworld’sthird-largestproducer (and biggestexporter) of pork and porkproducts, America isparticularly vulnerable tofluctuationsintheglobalporktrade. When the globaleconomy slumped sharply in2009, exports faltered, andsuddenly far fewerAmerican

pigs found themselves goingto market. China, the largestconsumer of pork in theworld, cut back dramaticallyonitsconsumptionduringthefinancial crisis. In the U.S.,pork exports toChina all butdried up in May of 2009—downnearly96percent fromMay2008levels.

Astheworld’sthird-largestproducerandbiggestexporterofporkandpork

products,Americaisparticularly

vulnerabletotheglobaltradeinpork.

Pig farmers weren’t theonly ones taking it on thechinin2009,however,sotoowere the pork producers. InJune, Virginia-basedSmithfieldFoods,theworld’slargest producer andprocessor of pork, posted itsfirst loss in more than 30years.Withnearly67millionhead of swine in the U.S.slurping at the trough, pork

meat was soon piling up onsupermarketshelves.Becausecheap pork competes withbeef, particularly theexpensive cuts, the growingbacklog also put downwardpressure on beef prices.America, which has thelargest grain-fed cattleindustry in the world, isextremely sensitive to thedownturnsinporkpricesthatresultwhenconsumersswitch

to cheaper meat cuts. Andsince the majority ofAmerican beef is corn-fed,the country’s corn-basedethanol program has alsoincreasedmarginpressureforcattle farmers. In spite of itsindustry’s size, the U.S. stillimports beef, albeit mostly alower-valuegrass-fedproductthat later gets turned intogroundbeef.

The situation for poultry

hasn’t been much better. Inresponse to higher grainprices and slumping sales in2008, poultry producersbegan cutting back onproduction.UnfortunatelyforPilgrim’s Pride, America’slargest chicken producer, thechangecamea little too late:the company filed forbankruptcy protection inDecemberofthesameyear.

APlatefulofProfits

The easiest, most directmethodofcreatingyourveryown breakfast special is tochoose one of the manyfoodstuff-linked commodityETFs.Ohsure,youcouldbuyshares in Kraft Foods Inc.(KFT—NYSE) or Nestlé SA(NESNVX—SIX),theSwissfood powerhouse, but then

you’d be buying into a foodconglomerate.Although foodconglomerates can do wellwhen theirbrandsare strong,keep in mind that growth isoften hard to come by. In abid to boost sales and jump-start sluggish growth, Nestléis currently embarking on ashift towards health andnutritionbusinessesandawayfrom slower growthfoodstuffs. The company

alreadyownsJennyCraig,thechain of weight-loss centers,andishopingtoaddproductscatering to a more affluent,health-conscious consumer.Butwhiletheconceptmaybesound, turning an aircraftcarrier of a business likeNestléaroundwon’tbeeasy.If the effort fails, theconsequences for thecompany’s well-establishedbrandscouldbedisastrous.

Theeasiestandmostdirectmethodofcreatingyourvery

ownbreakfastspecialistochooseoneofthemanyfoodstuff-linkedcommodityETFs.

A single-commodity ETFisafarbetterwaytoplaythefoodstuffs than wadingthrough a quagmire ofearnings reports and investorpresentations. U.K.-basedETF Securities offers severalexcellent pure-playcommodity ETFs, such asETFS Sugar (SUGA), ETFSLean Hogs (HOGS), andETFSCoffee (COFF),whichalltradeontheLondonStock

Exchange(LSE).

A combination of factors,including inefficient andsmall-scale farming, aconcentratednumberofmajorproducing countries, and aglobal population boom,willresult in higher prices in theyears to come. With supplysqueezed tighter than theorangesinyourdailyglassofjuice, prices for commodityfoodstuffs can only increase.

Once you perk up to theinvestment opportunitiessitting right on your plate,you’ll never think ofbreakfastasjustfoodagain.

HotCommodities

•Foodstuffssuchascoffee,sugar,orangejuice,

andcocoaaremajortradedcommoditiesthathavebeenonatearlately.

•CoffeeoriginatedinEthiopia,butwasfirstcultivatedintheArabworld.Today,Americaisthe

world’slargestcoffeeconsumerandBrazilisthelargestproducer,followedbyVietnamandColombia.

•Globalproductionofrawsugarisaround160

millionmetrictonsannually.Brazilisnotonlytheworld’slargestproducerofsugar,it’salsothelargestexporter—accountingforastaggering42percentofglobalsugar

exports.•Floridamaycometomindwhenyouthinkoforangejuice,butit’sBrazilthatdominatestheglobalorangejuicetrade.

•Brazilproduces27percentoftheworld’s

orangesand53percentofalltheorangejuiceconsumedglobally.

•Two-thirdsofcocoaseedsareturnedintochocolate,whiletherestbecomecocoapowder.TheIvoryCoastisthebig

hammerofcoffeeproduction,supplying37percentofthe3.4millionmetrictonsofcocoatradedannually.

•Despitehavingthelargestbeefcattleindustryintheworld,

Americaisstillanetimporterofbeef.

•TheU.S.isthethird-largestporkproducerandtheworld’slargestpork-exportingnation.

•Theeasiest,mostdirectmethodof

creatingyourveryownbreakfastspecialisbyinvestinginoneofthemanyfoodstuff-linkedcommodityETFs.

ChapterNine

GaininginGrains

InvestinginGrains

AGRICULTURE HAS AWELL-DESERVEDREPUTATION as a cyclicalbusiness.Itwasn’timmunetothe 2008-2009 financialcrisis, as plummeting pricesfor grains like rice, wheat,soybeans, and corndemonstrated. Still, grainsheld up much better thanmost other commodities—today they remain 30 to 50percent above their price

averages of the past decade.What’s more, investorinterest in the sector is upsharply as savvy traderscorrectly reason that, nomatter how bad things get,peoplestillneedtoeat.

Helping to propel grainprices higher these days arethe shifting diets of millionsof people in the developingworld. China’s impact aloneon global grain consumption

has been profound. From2000 to 2009, China’sconsumption of wheatincreasedby25percent,beefby more than 30 percent,poultry by 60 percent, andvegetableoilby100percent.

FoodforThought

One of my summertime

pleasures is eating freshcornon the cob drizzled withmelted butter and a touch ofsalt. But corn is more thanjust a summer treat: it’s bigbusiness. Used primarily foranimal and humanconsumption, corn is thesingle most valuable cropgrown in the United States.TheU.S.producesotherfeedgrains such as barley, oats,andsorghum,butcorn,which

accounts for more than 90percent of total feed-grainproduction, rules the roost.Demand for corn has risenwith increases in globallivestock numbers and withthe passage of federallegislationmandating the useof corn-based ethanol,whichnow laps up 30 percent ofU.S. corn production. Witharound 80 million acres (32milion hectares) of farmland

(mostly in the Midwest)dedicated tocorn, theU.S. isthe world’s largest producerandexporterofthegrain.

Corn may be the numberone crop in the U.S., butsoybeans, a valuable oilseedused in the production ofvegetableoil,comeinaclosesecond. Soybeans are oftengrown in rotation with corn,so it should come as nosurprise that America is also

their largest producer andexporter.Tofuandothersoy-based foods are increasinglypopular these days, yet thevast majority of soybeansgrown in the U.S. aren’tconsumed by health-conscious yuppies. Instead,they’re crushed to producevegetable oil while theremaining meal is fed tocattle and other livestock.Although canola oil is

gaining in popularity, mostcookingoilsused in theU.S.are stillmade from soybeans—accounting for 55 to 65percent of all vegetable oilsconsumedthere.

Although the U.S. is thehammer in the global corntrade and the biggest singleproducer of soybeans, itsdominance in all things soyhasbeenchallengedlatelybya couple of upstarts from

South America—Argentinaand Brazil—which haveexperienced a phenomenalrise in terms of bothproduction and exports.Together,thesetwocountriesnowrepresentmorethanhalfthe total export market, upsharply from just 15 percentin1980.

SeedsofDoubt

Low-carbohydrate diets maybe all the rage in SouthBeach, but they aren’t toopopular with the Americanwheat farmer. Demand forwheat is closely tied to theoverall demand for breadsand other baked goodsmadefromwheatflour.IntheU.S.,wheatdemandpeakedat225pounds (102 kilograms) perperson per year way back in1879,decliningtoaround137

pounds (62 kilograms) today—the result of changingconsumer tastes combinedwith a general societal shiftfrom physically demandingmanual labor to office-basedwork.Whilewheat is still animportant field crop, it ranksa distant third behind cornandsoybeansintermsofbothacreage and farm receipts.Farmers, discouraged byforeign competition and the

poor economics of wheatrelative to other crops, haveslashed theacreagededicatedto its production by nearlyone-thirdsince1981.

Americanfarmers,discouragedbyforeigncompetitionandpoor

economicsrelativetoothercrops,haveslashedacreage

dedicatedtowheatproductionbynearlyone-thirdsince1981.

The international wheatmarket is fragmented; nosingle country dominatesproduction. This, along withseasonally balanced

production from both thenorthern and southernhemispheres, has resulted inwheat prices that arerelatively stable over time.TheU.S.isthelargestwheat-exporting nation, despiteproducing just 10 percent ofthe worldwide supply. Otherlargewheatexporters includeCanada, Russia, Kazakhstan,Australia, and Argentina.Wheat is consumed all

around the world, but Japan,Brazil, and South Korea aresome of the biggest wheatimporters.

YouReapWhatYouSow

No grain is more steeped intradition and mystique thanrice. A staple for half the

world’s population, rice isconsumeddailybymorethanthree billion people acrossAsia and Africa. In Japan,rice ismore than food: it’s asymbol of humility andharmony—qualities reveredin that country.Rice actuallyservedasaunitoftaxationinJapan throughoutmostof theMiddleAges,andthefarmerswho produced it had a highsocialstanding.Today,riceis

still central to Japaneseculture, and rice farming is aheavily subsidized andcoddledindustry.

Some 440 million metrictons of rice are producedgloballyeveryyear,makingitthesecondlargeststaplecropbehindcorn.Riceisproducedall over the world, but foroptimal growth it requiresplenty of water and highaverage temperatures. U.S.

rice comes from irrigatedfields, making America oneof the highest-cost (in termsof water, fertilizer, and fuel)and highest-yielding riceproducers. The U.S. ricemarkethasdoubled since themid-1980s, partly due to theinfluxandinfluenceofAsianimmigrants.

But in spite of the growthin American consumption,theU.S.produces less than2

percent of the world’s riceandexportsnearlyhalf of itsproduction. America mayhaveamodestshareofglobalrice production, but becausethe international rice trade isso small, America accountsfor 10 percent of the globalrice trade. In Arkansas, ricepaddies cover nearly 1.5million acres (607,000hectares) and are the state’smain farm export,

contributing about $1.6billiontotheeconomy.Manyof the state’s 20,000 riceworkers are employed atRiceland Foods, the world’slargestmillerandmarketerofthegrain.

Rice,likefoodandfarminggenerally, is sensitive to thepolitics of the countrieswhere it is produced. Recentevents in Venezuela offer acaseinpoint.Inearly2009,a

Venezuelan rice plantbelonging to Cargill, anAmerican company, wastemporarily seized forviolating the country’s so-called food security law,while a pasta plant, a tuna-cannery, and several farmsweretakenoverbytroopsandordered to concentrate onmaking price-controlledgoods. President HugoChávez justified these

assaults on the private sectorand its capitalist businessmodel with the rallying cry:“Letusconstructanewlogic,thatofsocialism.”

TheU.S.produceslessthan2percentoftheworld’sriceand

exportsnearlyhalfofitsproduction—accountingfor10

percentoftheglobalricetrade.

SweetHomeChicago

Farmingisacyclicalbusinessthatcertainlyhasitsfairshare

of ups and downs. Badweather can destroy afarmer’s crops and financeswithoutwarning.Abountifulharvest can mean abundantgrain supplies but depressedwheat prices. Uncertainvolumes and prices can alsobe a big problem for foodprocessing companies andothermiddlemenwhoneedtobuy crops for their ownoperations.

As far back as 1848,businessmen and farmers inthe Chicago area recognizedthisproblemandbelievedtheformation of a futuresexchangecouldbepartofthesolution. Chicago was agrowing city located at theheart of the U.S. Midwest.With vital rail and shippinglinks,itseemedlikealogicallocation. And so it was thatthe Chicago Board of Trade

wasborn,creatingaplaceforfarmers to sell their futuregraincropsforwardtobuyerslookingtolock-inthepriceofgrain.

ChicagoBulls

Agricultural trading is nogentleman’s pastime. Rather,it’saroughandtumbleworld

where loud, beefy men fromChicago’s gritty south sideface off against one another—jostling, shoving, andshouting their wagers in atrading pit where thetraditional open outcrymethod is used to match upbuyers and sellers ofagricultural commodities.Facilitatingthebettingontheprospective price ofeverything from next year’s

weathertothepriceofwheat,the Chicago Board of Tradeandthesharp-elbowedtraderswho work in its trading pitsare front and center in theworldofcommodities.

For years Chicago washome to two cross-townrivals—the ChicagoMercantile Exchange (CME)and the Chicago Board ofTrade (CBOT)—whichcompeted for control of the

lucrative exchange-tradedfuturesmarket.More than70percent of the world’s grainderivatives, a fast-growingarea of finance, are traded atthe CBOT, the older of thetwo exchanges. But in spiteof thetwoexchanges’heft infutures, options, and otherderivative products, bothhave been dominated bysmalltradingshops(“locals”)that control most of their

seats. At the CBOT, forexample, three-quartersof its1,402 seats had historicallybeen controlled by smallgrain-trading businesses andretirees who love exploitingthe inefficiencies of themarket.

For much of theirexistence, the sleepy,backward nature of openoutcry exchanges like theCBOT worked fine. The

locals loved the profits andthe gruff camaraderie thatcame from exploiting small,arcane futures markets likethoseforwheatandsoybeans.But agriculture hasincreasingly caught theattention of the world’sbiggest investors who have,in turn, demanded greatermarketefficiency.TheCBOTandtheCMEhavealsofacedcompetition in their

traditional businesses fromnewer, more flexibleelectronicexchanges,suchastheIntercontinentalExchange(ICE), which are cheaper toestablish and offer customerslower transaction costs. TheCBOT’s electronic Treasury-bond futures market tradesmore contracts and makesmore money than thetraditional floor trading ofgrain. Yet in spite of

electronic trading’s obviousvirtues,theCBOT,andmanyotheropenoutcryexchanges,have been steadfastlyresistant to progress. In theface of these pressures, andwithtrillionsofdollarsworthof daily trading at stake, theCME snapped up its formerrival, the CBOT, for $8.9billion in the summer of2007.

But for the CME, total

domination of the world’sfutures exchangeswas not tocome until 2008, when, in aboldmove,CMEGroupbossCraigDonohuenegotiatedthetakeover of the New YorkMercantile Exchange(NYMEX). Today, the CMEGroup is the world’s largestandmostvaluablederivativesexchange, trading everythingfrom contracts for oil andcorn to U.S. Treasury debt.

With more than $4 trillionworth of daily contracts and95 percent of Americanfuturestradingunderasingleroof, the CMEGroup is onedominantChicagobull.

Withmorethan$4trillionworthofdaily

contractsand95percentofAmericanfuturestradingunderasingleroof,theCME

GroupisonedominantChicago

bull.

GrainandBearIt

Prices for grains have beenrising lately, driven byincreased global demand forfood, feed, and fuel.Additionally, criticalstockpiles of cereals (rice,wheat, and other coarsegrains) are near record lowsand Wall Street is bettingheavilyonagriculturalfutures—both of which have alsosent grain prices higher. Inthe U.S., investment activity

linked to the buying of cropfutures was responsible forfully half of the rise in theprices of corn, wheat, andsoybeans in 2007. AndbecausetheU.S.isthelargestexporting nation of all thesegrains,speculativeactivityonAmericanexchangeshelps todriveglobalgrainpricesevenhigher.

From January 2006through April 2008, index

fund investment activity inCBOT wheat, soybeans, andcorn futures rose 66 percent.Over the same time period,investments in livestock andgrain futures more thandoubled to $65 billion from$25 billion, according toAgResource Co., a researchfirm based in Chicago.Institutional investors havebeen drawn to the cropsmarkets, inpartbecause they

are thinly traded and subjectto shortages—a situation thatcan help drive crop pricessharply higher. The grainsmarkets’unusuallysmallsizecan also cause pricedistortions:only20percentoftheworld’swheatproductionis traded, and only 7 percentofriceproductionisexported,letaloneexchangetraded.

Thegrainsmarkets’unusuallysmallsizecanalsocausepricedistortions:only20percentoftheworld’swheatproductionistraded,andonly7percentofriceproductionis

exported,letaloneexchangetraded.

International benchmarkprices for grains can also bedistorted by small shifts insupply and demand in keyexporting countries. Worldcorn prices and trade arelargelydependentonweatherin the U.S. Midwest. Adrought affecting U.S. cornproduction might result inhigher domestic prices, for

example, but itwill certainlylead to sharp cutbacks in the20 percent of corn intendedfor export—a move thatwould cause prices to soar.Smallexportvolumesfor thekeyglobalgrainsoftenresultin prices that are higherinternationally thandomestically.

FoodChain

Risinggrainpricesimpactnotonly the price of your dailybread, but also the cost ofmilk and meat. Soybeans,corn, andwheat are used forcattleandpigfeed, therefore,any rise in grain pricesdirectlyaffectsbeefandporkprices. By some estimates, a30percentriseingrainpricestranslates into a 10 percentincrease in livestock prices(with a three- to six-month

lag). But even that may beunderestimatingtheimpactofgrain prices on America’sbeef and poultry industries,considering that corn feedrepresentsabouttwo-thirdsofthe input costs for the beefindustry alone. While risinggrain prices may be a goodnews story for grain farmers,they’redefinitelyabadnewsstoryforranchersandpoultryproducers.

Cornfeedrepresentsabouttwo-thirdsoftheinputcostsfortheU.S.beefindustry.Whilerisinggrainpricesmaybeagoodnewsstoryforgrainfarmers,they’re

definitelyabadnewsstoryforranchersandpoultryproducers.

WeatherReport

Inventory levels, weatherconditions, and supply anddemand in key exportingcountriesall impact thegrain

market. Since the beginningoftime,farmershaveplantedtheir crops according to theseasons,butlatelytheseasonshave been anything butcertain.BritishcharityOxfamhas recently reporteda litanyofweather-relatedcomplaintsfrom small farmers aroundthe world, including shorter,more violent rainy seasonsandshrinkingperiodsofmoremoderate temperatures. The

International Food PolicyResearch Institute (IFPRI), aWashington think tank, hascited climate change as themajor reason for thesedramatic changes. One oftheir sobering conclusions isthat by 2050 global cropyields could be just half of2000 levels, which wouldpresentamassiveproblemif,as expected, the globalpopulation expands by 50

percent over the same timeframe.

In India,where agricultureaccounts for just 18 percentof GDP but 60 percent ofemployment, lackof raincanbe devastating. Planting isusually planned for thesummer months, when 80percent of India’s rainnormally falls. However,between June and mid-August 2009, there were 29

percent fewermonsoons thanaverage. In India, agricultureaccounts for 18 percent ofGDP,butemploys60percentofIndians,makingthisaverytoughpilltoswallow.

In 2008, following a coldspring, the state of Iowa hadthe opposite problem—itreceived too much rain. Bymid-June 2008, GovernorChet Culver had assigneddisasterdesignations to83of

99 counties after 16 percentof the state’s tillable acreswere left underwater. Itwasdubbedbysomeasthe“GreatFlood of 2008.” And forIowa, the largest producer ofcorn and soybeans in theUnited States, the summerwas a bust. But sometimesout of disaster comesopportunity. After the U.S.Department of Agricultureforecast that 43 percent of

that year’s corn crop wouldbe in fair to poor condition,corn futures for July 2008jumped to $7.46 per bushelon June 18, 2008, up 27percent from the May 19,2008, price of $5.87 perbushel.

PlowingforProfits

Record low stockpiles,changing diets, erraticweather patterns, and agreater number of mouths tofeed will result in highergrain prices in the years tocome.Butnotonlyaregrainsa profitable investment nicheto exploit on their own, theyalso serve another criticalfunction: as lead indicatorsfor fertilizer investments.Higher grain prices mean

fatter pockets for farmers,who are always looking forways to maximize theirprofits.Of course, improvingyields through increasedfertilization is a slam dunk,but farmers—a notoriouslyfrugal bunch—generallywaituntil they have cash in handbeforetheyspendit.

Grainsarenotonlyaprofitableinvestmentnichetoexploitontheirown,buttheyserveanothercriticalfunction—theyactasaleadingindicatorforfertilizerinvestments.

A large capitalization,pure-playgrainstockisaboutas rare as July snowflakes inTexas. One stock that doesgive you broad exposure tothe agricultural industry isArcher Daniels Midland(ADM—NYSE). A globalgiant operating in 60countries on six continents,ADM processes grains intovalue-addedproductsusedby

the food, beverage, andanimal feed industries and isalso involved in theproduction of biofuels.Additionally, the company’sAgriculturalServicesdivisionoperates an internationalnetwork of grain elevatorsand transportation services tostore, clean, and bring grainstomarket.Whereveryoulookalong the agricultural foodchain, from field to table,

ADMisthere.

Alargecapitalization,pure-playgrainstockisaboutasrareasJulysnowflakesin

Texas.

Another company thatspans the food chain byproviding everything fromfertilizers to food products isBunge Limited (BG—NYSE). Like ADM, Bungehas a large agribusiness thatbuys, stores, and sells grainsaround theworld.But unlikeADM, Bunge has a strongfocus on South America,particularly Brazil—makingit much more dependent on

agriculturaltrendsinthatpartoftheworld.

There’s even an ETF, thePowerShares DB AgricultureFund4 (DBA—NYSE), thatoffers broad exposure tograins, as well as cattle,cotton, cocoa, and hogs. Thefundbuysagriculturalfuturesand isdesigned tomimic thereturnsof theDeutscheBankLiquid Commodity Index—

an agricultural indexcalibrated to reflect theoverall performance of thesector.

Floods, famine, and foodall impact the business ofagriculture. But as theworld’spopulationgrowsanddiets change, the demand forhigh protein food will onlyincrease,underpinningstrongdemand for grains.Agriculturemaybeacyclical

business, but grain priceshave nevertheless exhibitedthegreateststabilityofallthecommodities over the lastdecade. After all, eating issomethingweallneedtodo.

HotCommodities

•Shiftingdietsandeconomic

growthinthedevelopingworldarebehindageneralriseinthepricesofmostgrains.

•CornandsoybeansarethebigcashcropsgrowninAmerica,withwheatadistant

third.•Riceistheworld’ssecondlargeststaplecrop.Americaproduceslessthan2percentoftheworld’sriceandexportsnearlyhalfofitsproduction—accountingfor

10percentoftheglobalricetrade.

•Chicagoistheglobalepicenterofgraintrading.

•TheCMEGrouptradesmorethan$4trillionworthofcontractsdaily,in

everythingfromoiltocorn,andcontrols95percentofAmerica’sexchange-tradedfuturesmarket.

•Thegrainsmarketsareamongstthesmallestofall

commoditymarkets,asituationthatcansometimesdistortprices.Only20percentoftheworld’swheatproductionistradedandonly7percentofriceproductionisexported,let

aloneexchangetraded.

•Cornfeedrepresentsabouttwo-thirdsoftheinputcostsfortheAmericanbeefindustry,sowhengrainpricesarehigh,beefandpoultry

producers’marginscomeunderpressure.

•Grainsarenotonlyaprofitableinvestmentnichetoexploitontheirown,theyalsoactasaleadingindicatorforfertilizer

investments.•Alargecapitalization,pure-playgrainstockisextremelyrare.

•Agrowingworldpopulationandchangingdietswillunderpinstrongdemandforgrains.

•Grainsareamongtheleastcyclicalofallcommoditiesbecauseeatingissomethingweallneedtodo.

ChapterTen

BulkUp

BenefittingfromBulkCommodities

NOTHING SAYSINDUSTRIALIZATION likethe steel industry. Steel isproduced all over the worldandisseenasakeyindustrialpillar because it provides thenecessary raw materials forprestige industries such asappliance and automobilemanufacturing. Since the1850s, steel has been

inexorably linked to theindustrial economy and hasremained front and centerthere as nations havecontinued to industrialize.Whether in America at theturn of the 20th century, inJapan and South Korea aftertheSecondWorldWar,or inChina and India today—where there’s industry,there’ssuretobesteel.

CheapThrills

As I stood on the catwalk,100 yards away from themassiveelectricarcfurnaceatLake Ontario Steel, I couldfeel a cold sweat movingdownmyback.After thelastload of car parts had beenemptied into the 850,000-metric-ton furnace, theoperator closed the lid and

three massive graphiteelectrodes were lowered intoplace. Soon an enormouselectrical charge would flowto the graphite electrodes,striking amassive arcwithinthe furnace and melting thescrap steel at temperatures inexcess of 3,272 degreesFahrenheit (1,800 degreesCelsius). The heat, noise,sparks, and sheer brutalphysicalpowerthatwouldbe

unleashed for a few shortminutes,transformingoldcarparts into steel billets, struckaprimalnervewithme.

Littledid I know then thatmy experience as a juniorplant engineer 20 yearsearlier would help me tounderstand one of the mostimportant and fiercelynationalistic of all industries.When steel mills around theworld are producing round

rebar and flat rolled steel forcarmanufacturing plants andconstruction projects, it’s asure sign that industrialproductionisontherebound.

FireandBrimstone

I’ve always loved the fire-and-brimstone primitivism ofthe steel industry, not to

mention the heavy dose ofsuperstition that goes alongwith it—attributes that usedtocontributetotheindustry’slegendary inefficiency. LakeOntario Steel, for example,used to pay its rolling millforeman a handsome salaryfor the core skill of hearingwhen one mill stand waspushingabillettoofastortooslow. Of course, that wasbefore the company decided

to spend millions on aSiemens speed-controlsystem aimed at taking theguessworkoutofformingthefinished structural steelshapes!

Steelisanalloycontaining97 percent iron plus carbonandothermetals(suchaszincor chromium) and isproduced in a basic oxygenfurnace(BOF)or,inthecaseof recycled steel, in an

electricarcfurnace.Accesstoplentyof scrap steel and lowelectricity prices have helpedmake America the primaryhome of electric arcsteelmakingtechnology.

The recipe for producingsteel in a basic oxygenfurnace is straightforward:combine between one- andthree-quarter metric tons ofmolten iron ore with three-quarters of a metric ton of

coke(processedmetallurgicalcoal), a quartermetric ton oflimestone, and four metrictonsofair, crankup theheatto 3,500 degrees Fahrenheit(1,297 degrees Celsius) andpresto! Soon you’ve got rawsteelthatcanbereheatedlaterandrolledintoawidevarietyof shapes and sizes. Mini-mills, whichmelt scrap steelinanelectricarc furnace,arethefastestgrowingmethodof

production today, havingincreased their market sharefrom 15 to 31 percent overthe last two decades. But inspite of this rapid growth,integrated steel mills thatutilize the BOF steelmakingtechnology produce a higherquality end product andaccountforover66percentofglobalsteelproduction.

IntegratedsteelmillsthatutilizetheBOF

steelmakingtechnologyproduceahigherqualityendproductandaccountforover66percentof

globalsteelproduction.

GrowthinGirders

No city symbolizes the riseand fall of America’s steelindustry better thanPittsburgh. With its strategiclocationat the intersectionoftheMonongahela,Allegheny,andOhioriversandsmackinthe middle of one of thenation’s most productivecoalfields, Pittsburgh’s

destinywas always steel. BytheendoftheAmericanCivilWar, the city was producingmorethanhalfofthenation’ssteel. Industrialists such asAndrew Mellon, Henry ClayFrick, and Andrew Carnegiebuilt their fortunes there.Yetby the 1970s and 1980s,Pittsburgh’s steel industrywas in decline, besieged bycompetition from cheapoverseas product. With the

collapse of the Americansteel industry in the 1980s,Pittsburgh lost more than120,000 jobs, amounting tomore than half of itsmanufacturingpositions.

EntertheDragon

China emerged as the newsheriff in steel country after

producing37.1percentofthealloy’sglobaloutputin2007,asharpincreasefromthe15.3percent it produced in 2000.China’s loveaffairwith steeldates back all theway to theHan Dynasty, 1,800 yearsago,whenprimitiveformsofit were produced. Today,China, known as theworld’sfactory,boastsmorethan700steel mills and nearly 7,000companies involved in

bending, shaping, orotherwise forming steel.China’s steel output is soplentiful that, by thegovernment’s estimation, itproduces more than 100millionmetrictonsofsurplussteel per year—an amountgreater than the entire U.S.production.

As foreign investment hasflowed in, China’s steelindustry has grown by leaps

and bounds, increasing bymore than 20 percent a yearover the last decade alone.Today, China producesmoresteel than Brazil, Russia,Ukraine, Germany, India,South Korea, and the UnitedStatescombined.

Today,ChinaproducesmoresteelthanBrazil,Russia,Ukraine,Germany,India,SouthKorea,andtheUnitedStates

combined.

To consolidate theirpolitical power and increaseregional revenues, provincialand local officials in China

eagerly court the steelindustry—sometimes evenleaning on banks to makeloans to the industry. Today,a patchwork quilt of steelmills has sprung up all overthecountry,resultinginhalfadozen major steel-producingprovinces and more than adozen smaller provinces allvying to out-produce oneanother.Theresultisahighlybalkanized, inefficient

industry where the top threesteel producers account foronly 20 percent of totalproduction. In South Korea,by contrast, two enormousmills account for 87 percentoftotalsteeloutput.

LettheGoodTimesRoll

Theglobalsteelindustryrollsout more than 1.3 billionmetrictonsofhotrolledcoils,sheets, plates, rounds, rebar,and various other productsannually. Unfortunately, amix of national pride,provincial politics, and thedesire to drive industrialexpansion into prestigemanufacturing has made theindustry extremelyfragmented. In copper

mining, for instance, the top10 producers control morethan 57 percent of globalmine supplies, whereas insteel production, the top 10global players accounted forjust 27 percent of worldproductionattheendof2007.

Incoppermining,forinstance,thetop10producerscontrol

morethan57percentofglobalmine

supplies,whereasinsteelproduction,thetop10globalplayersaccountedforjust27percentofworld

productionattheendof2007.

One company bucking thetrend and going global isArcelorMittal, the largeststeel company in the world,representing around 10percent of global output. Byorganizinghiscompanyalongglobal rather thannationalistic lines, Indian-born tycoon Lakshmi Mittalhas managed to turn thesleepynationalsteelcompanymodel on its head. Steel

began to decline in theWestwhen every country,regardless of its ability tocompete, decided it had tohave its own national steelgiant. The resultwas a spateofmoney-losinggovernment-owned mills that couldn’tcompete with newer, moreefficient operations in low-wagecountries.Byattractingglobaltalent,ratherthanlocalflunkies,andofferingtraining

at its own university inLuxembourg, ArcelorMittalhas created a truly globalcompany culture—amongstits top 30 managers, ninedifferent nationalities arerepresented. Mittal hasultimatelysucceededindoingwhat others have tried andfailed to do: build the steelindustry’s only truly globalproducer.

GristfortheMill

A constant supply of iron isneeded to keep the world’sblast furnaces operating atfull tilt. Luckily, iron ore, oriron-bearing rock, isrelatively plentiful—itconstitutes 5 percent of theearth’s crust. Iron is theworld’smostcommonlyusedmetal, with 98 percent of all

iron ore earmarked forsteelmaking.Steel,ofcourse,isthebackboneofthemoderneconomy and a keycomponent in cars, ships,buildings, and machinery.From 2002 to 2008, iron oreprices shot up fourfold,fuelled by strong globalgrowth, in particular fromChina. While Japan andSouth Korea are consideredhuge iron ore consumers,

China, the world’s largeststeelproducer,isawhaleofabuyer,snappingupmorethanhalfofallironoreexports.

Ironistheworld’smostcommonlyusedmetal,with98percent

ofallironore

earmarkedforsteelmaking.

Luckily for China, it’s notonly the world’s biggestconsumerofironore,butalsoits largest producer. But inspiteofChina’sdominanceasa producer of iron ore, itsdemand is so massive that itis reliant on imports to keepits steel mills humming.

Other major producers areAustralia, Brazil, India, andRussia. In total, the worldproduces about one billionmetric tons of ore annually,with production dominatedinternationallybythreefirms:BHPBilliton,RioTinto, andVale.

China continues totransform itself by investingmassively in infrastructure,and ironore is themostvital

of all the raw materials thatChina needs to keep itseconomic juggernaut movingfull steam ahead. LatelyChineseofficialshavetriedtooverturn the iron oreoligopoly by encouragingChinese companies tonegotiate collectively and bybuying stakes in iron oreproducers.

In 2008, China’s state-controlled aluminum firm,

Chinalco, bought a 9 percentstakeinAustralia’sRioTinto.At the time, Rio Tinto,reeling from the collapse ofcommoditymarketsandfrommassive debts incurred fromits 2007 acquisition ofCanada’s Alcan, welcomedthe investment. But ascommodity prices improvedin2009andChinalcodecidedto raise its stake to 18percent, Rio Tinto’s

shareholderssuddenlybalked.Rather than acceptingChinalco’s investment, RioTinto reneged on the deal ithad made with the Chinesealuminum giant and insteadformed a joint venture withfellow Anglo-Australianmining giant BHP Billiton.Under this new arrangement,the two mining companiesagreed to merge theiroperations in Western

Australia in an attempt tofurther concentrate theirdominant position over theworld’sironorebusiness.

RiskyBusiness

Prices for iron ore are setonce a year in annualnegotiations. The first priceagreed to between a big

Japanese, South Korean, orChinese steelmaker and oneofthebigthreemininggiantssets the benchmark for allother buyers and sellers tofollow. In recent years,rocketingChinesedemandforiron ore has meant sky-highprices and has turned theannual negotiations into aneagerly watched spectatorsport.

InJuly2009,thingstooka

dramatic twist, however,when Chinese authoritiesarrested four Rio Tintoemployees and two Chinesesteelcompanyemployeesandaccusedthemofoverchargingfor iron ore by a whopping$102.5billionoverasix-yearperiod. It likely wasn’t acoincidence that thesedevelopments came shortlyafter Rio Tinto rejectedChinalco’s additional

investmentandjustbeforetheannual iron ore contractnegotiations were set tobegin.

SootandSuccess

It’s probably a long timesince you’ve heard anythingabout chimney sweeps, but,believeitornot,coalwasthe

fastest growing fossil fuel ofthe last century—the AsiaPacific region aloneaccounted for 90 percent ofthe demand growth. As asourceof global energy, coalshouldnotbeunderestimated:it supplied 27 percent of theworld’s needs in 2009, justbehindoilat36percent.Andthe International EnergyAgency recently predictedthatdemandwill growat1.9

percent through to 2015,meaning that coal wouldoutpace the growth of allother fossil fuels exceptnaturalgas.

Coalwasthefastestgrowingfossilfuelofthelastcentury—with

theAsiaPacificregionaccountingfor90

percentofthedemandgrowth.

Coal comes in twodifferent forms:metallurgicalcoal,which is converted intocoke for use in steelmaking,and thermal coal, which isused in coal-fired electricitygeneration. Of the seven

billionshort tonsofcoal thatare mined annuallythroughout the world, 60percent comes fromundergroundmines.The vastmajority of coal that isproduced(roughly85percentofglobalmineproduction,orsix billion short tons) is thethermal coal used in powerplants. Metallurgical coal,used in steel production, isless abundant and comes

from high-quality deposits inthe eastern United States,Western Canada, andAustralia.

The Powder River Basin(PRB) in Wyoming andMontana is the single largestcoal-producing region in theU.S. and the fastest growingcoal region in America. Iremember standing in one ofArch Coal’s (ACI—NYSE)surface mines in Wyoming

and marveling at how largethe coal seam was. Three orfour feet thick and stretchingas far as the eye could see,thecoal seamwasquiteeasyto spot; it was not onlymassive,butitsblacknessandsmooth texture made it easyto distinguish from thesurrounding rock. Miningoperations are some of thecoolest things you can see.Perhaps it’s just the engineer

inme,butIalwaysmarvelatthe speed and complexity ofoperations such as Arch’s.For today’s bulk miningcompanies, these massivematerial handling operationsare all in a day’s work. Theother big coal-producingareas in the U.S. are Centraland Northern Appalachia,which, when combined withPRB coal, account for 75percent of U.S. mine output.

ThebiggestconsumerofU.S.coal is, far and away, theelectric power industry,which consumed 93 percentof domestic coal productionin2007.

ThebiggestconsumerofU.S.coalis,farand

away,theelectricpowerindustry,whichconsumed93percentofthedomesticcoalproductionin2007.

G’DayMate

In Australia, coal is a bigdeal.Coalwas firstmined in

Newcastle in 1797, and eversince then Australians havebeen reliant on it as a cheapand abundant source ofenergy. Australia is theworld’sbiggestcoalexporter,and the black stuff pouringthroughtheportofNewcastlehas become a vital economiclinchpin for the economy,accountingforone-fifthofitsforeignearnings in2007. It’salso become the critical link

for power generation there,with 83 percent of thecountry’s electricity comingfrom coal-fired generation.On the downside, coaldependence has madeAustralia one of the world’sbiggest emitters of carbondioxide. This has caused aheadache for Prime MinisterKevin Rudd, who’s had toscramble to find commonground between

environmentalists and thecoal mining industry, whichargues that Rudd’s proposedcap-and-trade policy wouldunfairly penalize it byallowing other countries toleapfrogaheadofAustraliaintheglobalcoalmarkets.

Indonesia, already theworld’s largest supplier ofthermal coal, potentiallystands to benefit from all ofAustralia’s environmental

handwringing. Demand forcoalhasgrownrapidlyastheAsian economies haveexpanded, and Indonesia hasfounditselfattheheartoftheboom. China may be thelargestproducerofcoalintheworld, but it’s often cheaperfor it to import coal fromIndonesiaratherthantorailitfrom its own interior; notonly is Indonesian coal lessexpensive, but its quality is

better too. Eighty percent ofChina’s electricity comesfrom coal. And that’s greatnews for Indonesia, whichexported 190 million of the230millionmetrictonsofthecoalitproducedin2009.

The seaborne, or export,market for coal is small,currently accounting for just13 percent of the globalmarket,or885millionmetrictons (metallurgical coal

represents about one quarterof this). While demand forcoalof all types continues togrow,exportshavebeenslowto respond and are oftenhamperedbyinsufficientportand rail capacity in largecoal-exporting countries suchas South Africa, Colombia,and Australia. In Newcastle,the busiest coal port in theworld, miles-long queues offreighters waiting to top up

their holds with coal havebecomeacommonsight.

Theseaborne,orexport,marketforcoalissmall—

accountingforjust13percentoftheglobalmarket.Insufficient

portandrailcapacityhashamperedthegrowthoftheexport

market.

ShipsAhoy

Ironore,coal,steel,andotherbulk raw materials used asinputs for finished and semi-

finishedgoods all have tobetransported by sea. There’sonly a set number of largeshipsintheworldand,withacouple of years’ lag time tobring on any new ones,freight rates move up anddown quickly in response tochanges in demand.Thankfully,youdon’tneedasavvy uncle in the shipbrokering business to keeptabs on global shipping rates

—all you need to know iswhat’s happening with theBalticDryIndex(BDI).

Tokeeptabsonglobalshippingrates,youdon’tneedasavvyuncleintheship

brokeringbusiness—

allyouneedtoknowiswhat’shappeningwiththeBalticDryIndex

(BDI).

Tocompileitsdailyindex,the London-based BalticExchange canvasses brokersaround the globe to find outthe cost of shipping variouscargoes. The BDI compilesthe associated costs of

shipping dry bulkcommodities (grain, iron ore,coal, etc.) by Handymax,Panamax,andCapesizeshipsalong 26 routes. BetweenJuneandOctoberof2008,theindex tumbled more than 90percent when LehmanBrothers went bust and theworld economy imploded.And as the world economycontinued to fizzle, the costof moving a standard

container from China toEurope slid from $1,400 to$400. Investors can restassured that when the globaleconomyshiftsbackintohighgear, cargo rates—and theBalticIndex—willbeheadinghigher.

ForgettheFuture

When shipping rates rise,investors should increasetheir exposure to bulkcommoditiessuchasironore,steel, and coal. But unlikemost other commodities,thereisn’tanironoreorcoalfuturescontractthattheeagerinvestor can trade. Luckily,it’s possible to increase yourexposure to “the bulks” byloading up on the companiesthat supply these critical raw

materials to the globalmarketplace. The global bigdaddies of iron ore are BHPBilliton (BHP—NYSE), RioTinto (RTP—NYSE), andVale (VALE—NYSE), all ofwhich trade as AmericanDepositary Shares (ADS) ontheNYSE.

Unlikemostothercommodities,thereisn’tanironoreorcoalfuturescontractthateagerinvestors

cantrade.

Asmartwaytogainaccessto the one-trillion-dollarglobalsteelmarketisthroughshares of companies thatsupply themetallurgical coal

(“met coal”) used insteelmaking.InvestmentbankMorgan Stanley sees BHPBillitonasthebighammeringlobal metallurgical coal,given that it supplied 32percent of the seabornemarket in 2006. But an up-and-comer for investors toconsider is the number twosupplier to the seaborne metmarket: Teck Resources Ltd.(TCK—NYSE), which also

happens to be Canada’slargest diversified miningcompany and the operator ofElkValleyCoal.

Another great way to getexposure to the global steelmarketistobuysharesinthebetterqualitysteelproducers.The largest, andarguably thebest, steelmaker in theworldis ArcelorMittal (MT—NYSE).Thoselookingtostaya little closer to homemight

also consider investing inU.S. Steel Corporation (X—NYSE). Despite being afractionofitsformersizeandjust the 10th largest steelproducer in the world, U.S.Steel, and other companiesthat produce bulkcommodities, will still be onthe move when globalindustrial production beginstoroar.

HotCommodities

•Steel,animportantindustrialpillarthatsupportsprestigeindustries,isproducedtheworldover.

•Steelcanbemadeineither

anelectricarcfurnace(usingscrapsteel)orinabasicoxygenfurnace(usingrawmaterials),whichproducesahigher-qualityendproduct.

•Chinaproducesmoresteelthan

Brazil,Russia,Ukraine,Germany,India,SouthKorea,andtheUnitedStatescombined.

•Ironistheworld’smostcommonlyusedmetal,with98percentofallironore

earmarkedforsteelmaking.

•Coalisthefastestgrowingfossilfuelofthelastcentury.TheAsiaPacificregionaccountsfor90percentofitsdemandgrowth.

•Ifshippingrates

areontherise,investorsshouldincreasetheirexposuretobulkcommoditiessuchascoal,ironore,andsteel,whichareallmovedinternationallybysea.

•Tokeeptabson

globalshippingrates,theBalticDryIndex(BDI)isyourbestguide.

•Unlikemostothercommodities,ironoreandcoaldon’thaveafuturescontractforinvestorsto

trade.•Investorslookingtobulkuptheirportfoliosshouldconsiderinvestinginthecompaniesthatproduceironore,coal,andsteel.

ChapterEleven

CapitalizingonCommodities

WhyCommoditiesAreHappening

OPENINGYOURMINDTOTHE WORLD OFCOMMODITIES is muchmore thanagreat investmentidea—it’s crucial to youroverallsuccessasaninvestor.Once you realize thatcommoditiesarerealthings—therubberthatmeetstheroadinanyeconomicexpansion—

you’ll also realize the broadinvestment implications ofrising commodity prices.Currencies, real estate,inflation, stocks, and bondsare all impacted whencommodities are on fire.When demand forcommodities is strong,countries rich in naturalresources are great places tolook for solid investmentopportunities, and not just in

commodities, but in realestate, currencies, and thestocks of the commodity-producing companies too. Asolid understanding ofcommodities will give youinsightintothewaytheworldworks and into why someinvestmentssoarwhileothersslump. Knowing somethingabout commodities meansthat everyday activities likeshopping for groceries or

paying at the pump are nolonger simply chores—theybecome important windowson the world. Addingcommodities to yourinvestment portfolio is aninvestment move that isn’tjusttimely—it’ssavvy.

Armedwithanunderstandingofcommodities,you’llrealizethewaythe

worldworksandwhysomeinvestmentswillsoarwhileotherswill

slump.

MaxedOut

ThecollectivecreditcardsoftheWesternworldaremaxedout. More than 20 years ofconsuming too much andsaving too little has finallycome home to roost in themost dramatic way. Theglobal financial crisis of2008-2009 swept back thecurtainontheworldeconomyand exposed the rot within.Theburstingofthebubbleledto the first worldwide

recessionsincethe1930sandleftamassiveburdenofdebtnowweighingonmostoftheWest.

As the world economyhung in thebalance, someofthe world’s biggest bankswentbustwhileotherscircledthe drain. “Bailout!” becamethe rallyingcryof thedayasgovernments were forced toperform emergency triage ontheir badly ailing financial

systems.Andintheaftermathof the banking bust-up,rumblings of the nexteconomic crisis can alreadybeheard.

As tax revenues tumbleandgovernment expendituresskyrocket, there is reason toworry that the banking crisishas simply morphed into along-term government debtcrisis;asituationthat’slikelyto get worse as the cost of

retirees’ benefits gets set toexplode. These difficultiesaren’t limited to NorthAmerica;themarketsrecentlyshifted their focus from theeye-popping deficits inWashingtonandconcentratedinsteadonthefiscalfolliesinEurope. The most problem-plaguedborrowershavebeengivenadisparagingnicknameby traders—PIIGS—anacronym for Portugal, Italy,

Ireland, Greece, and Spain.The financial markets areobsessedwiththePIIGS,andglobal investors have littleconfidence that thesecountrieswillbeabletorepaythe crushing governmentdebtstheyface.

BeltTightening

Governments forced to thewallbytheiraddictiontodebtarenothingnew.Butwithnoshortageof troubledassets tobe mopped up bygovernments around theworld, investors are right toworryaboutwherethemoneywillcomefromtopayforthemess made by too muchgovernment spending. Themoney may simply becreated. After all, America

managed to monetize awayitsdebtsafterboththeSecondWorldWar and the VietnamWar by printing additionalmoneywhenitsdebtloadgottoo high. And without fail,whenever and wherever theprinting presses have beenturnedontomonetizeawayacountry’s debts, a bout ofinflationhasalwaysfollowed.

Thecycleofgreedandfearand its economic

consequences are all part ofthe indelible landscape ofinvesting. In2001,Argentinafound itselfmired inaseaofdebt. Its solution was todefault on its sovereignobligations. Therepercussions of Argentina’sactions came swiftly—therewas a sharp currencydevaluation,adeeprecession,and Argentina became apariah nation in the

internationalcapitalmarkets.

In January 2010, theMcKinsey Global Instituteconducted a study on theeconomic consequences ofdebtanddeleveraging. In thestudy, the authors examined45 historical episodes ofdeleveraging wheregovernmental, business, andhousehold debts were shedsince 1930. The study foundthattherewerefourpathsthat

a highly leveraged economycould take to get rid of itsdebts. It could: enter aprolongedperiodofausterity,default on the debts, inflateawaythedebts,orexperiencea period of rapid growthwhereitisabletooutgrowitsdebtburden.

The authors of theMcKinsey study found thatthe austerity, or belttightening, response was by

far the most commonapproach—occurring inroughly half of the historicalexamples.Thesewerepainfulepisodes that often lasted formore than six years. Theauthors concluded that manyof the largest economies intheworldshouldexpectyearsof debt reduction in specificsectors of their economies,whichwillactasasignificantdrag on GDP growth. The

other significant conclusionthe researchers came to wasthat a country’s ability torespondtoafinancialcrisisisrelated to its debt burdenpriortothecrisis.

Deleveragingafterafinancialcrisisisa

painfulprocessandisoftenasignificantdragonGDP.

AsianAscension

Not surprisingly, thecountries with the mostrobust economies today arethe ones that went into the

global financial crisis withtheir economic houses inorder: the emerging marketeconomies. With largeforeign currency reserves, agrowing middle class, and acultural propensity to workhardandsave,thefuturewillbelongtoAsia.UnfortunatelyfortheWest,thetrendtowardhigher, not lower, levels ofgovernment debt seemsassured.Recentresearchfrom

the International MonetaryFund(IMF)forecaststhatthedevelopingeconomiesshouldshow stable debt trendsthrough 2014, while thedeveloped economies of theWest are expected to seeescalatinggovernmentdebt.

The underlying trend isundeniable. Asia, led byChina, is on an upwardeconomictrajectory.Between2000and2008,60percentof

the increase in globaleconomic output occurred inthe developing world—atrend expected to continue.After decades of gorging onconsumption, Americanshave turned thrifty whileAsiansarespendingmore.

Demand for cars in Chinais so high that would-bedrivers are putting theirnames on waiting lists forpopular models. Also in

2009, China overtook theU.S. for the first time as thelargestsinglemarketforcars.But it’s not just cars forwhichChina isbecoming thedominantconsumermarket—it’s also the world’s biggestmarket for appliances anddesktop computers. In 2009,for example, 185 millionrefrigerators were sold inChina compared with 137million sold in theAmerican

market.

As Chinese and Indianconsumers cross the incomethreshold at which cars andotherbig-ticketitemsbecomeaffordable, they will becomethe spark to ignite thecommodity price rally. Cars,homes,andappliancesarethebig influences on the globaldemandforcommodities.Butbest yet, China has ampleroom to consume more. Not

only are the government’scoffers full of cash, but thesavings rate is close to 40percent, suggesting thatChinese consumers have thepotentialtobuyevenmoreinthefuture.

AsChineseandIndian

consumerscrosstheincomethresholdsatwhichcarsandother

big-ticketitemsbecomeaffordable,theywillbethespark

toignitethecommoditypricerally.

BuyLow,SellHigh

During the summer of 2009,ships waiting to unload atChina’s booming QingdaoPort were lined up 10 deep.Piledhighwithironore,coal,crude oil, and other rawmaterials,up to90shipsatatimereportedlywaitedforupto twoweeks to unload theirprecious cargoes. Accordingto J.P.Morgan,Chinese coalimports were 168 percenthigher in April of 2009 than

they were a year earlier,refined copper importsjumped148percent,andironore imports were up 33percent. With an almostinsatiable appetite forcommodities,Chinahasusedthe financial crisis to itsadvantage by stockpilingthese basic raw materials ofindustrialization. Not only isChina the largest market formost commodities, it’s also

oneof the savviest buyersofthem.

Beijing’s interest incommodities is more thangood trade—it’s goodstrategy. In an attempt tobuild a strategic cache of oiland other crucial rawmaterialsincaseofacrisisintheMiddleEast or other keysupplyregion,Chinahasbeenstockpiling commodities foryears. The other key reason

the government is activelygrowing its commoditystockpilesisasahedgeawayfrom risky U.S. dollarinvestments and toward hardassets whose value can’t beinflatedaway.

Chinese Premier WenJiabao has openly stated hisconcern about the safety ofU.S.Treasuriesandcalledonthe U.S. “to guarantee thesafety of China’s assets.”

With a hoard of more than$750 billion in U.S.Treasuries, China isjustifiably worried that thehundredsofbillionsofdollarsthe U.S. has spent on bankbailouts will result in aweaker dollar and higherinflation. Amid theseconcerns,China’sstockpilingofcommoditiesgivesitawayto reallocate its sovereignwealth. It’s even been

rumoredthatChinaislookingtobuyCanadiandollarsinanattempt to shield the world’slargest currency reservesfrom a decline in thegreenback.

As China’s economicinfluence has increased, theChinese Investment Corp.(CIC)has emergedasoneofthe world’s largest and mostimportant investors. Thehulking $200 billion

sovereign wealth fund hasbeen buying up stakes inglobal resource companies.The CIC has a $652 millionstake in Brazilian iron oregiant Vale SA, has invested$1.5 billion in TeckResources Ltd., and alsoowns stakes in bothArcelorMittal and FreeportMcMoRan Copper and GoldInc.

The sharp drop in

commodity prices in 2008created an ideal opportunityfor investors tojumpintothefray. During 2009, the S&PGSCI Index of 24commodities rose rapidly aslead and sugar doubled inprice and gold hit new highs—amove that’sbeginning toget a lot of attention.According to BarclaysCapital, commoditiesattracted a record $60 billion

in 2009, as investors soughttodiversify their assetsawayfrom more traditionalinvestments.

Bonanza

The global economic playingfield has tilted irrevocablytowardAsia.Whattheglobalfinancial collapse of 2008-

2009madeplainwas a trendmore than 30 years in themaking: Asia is rising. Andthat’s a good news story forcommodities, the criticalfeedstockofurbanizationandindustrialization.

The West, on the otherhand, faces years of slower-than-average economicgrowth and painfuldeleveraging. The decadefrom 2000 to 2009 was

notable for negative equityreturns in many major stockmarkets as well as risinglevels of unemployment.Facing these headwinds, thefuture for most of thedeveloped West lookssluggish at best. Yet theprospectsforAsiahaveneverlooked better. The continentwith the money and thepeopleisabouttotakecenterstageonceagain.AndasAsia

continues its inevitableascent, hundreds of millionsofnewglobalconsumerswillbe created andabonanza forcommodities is likely toensue.

Many investors havereached a fork in theinvestment road. They cancontinue down the onethey’ve always traveled—theirportfoliosstuffedfullofstocks,bonds,andrealestate.

But from 2000 to 2009, thatroad led nowhere.Alternatively, investors canchoose the road that isn’tparticularly well traveled butthat’s been proven to choprisk and boost returns byincluding commodities in aninvestment portfolio. Thisroad directly links the Westwith the East—the epicenterof future economic growth.Investors face a choice: they

can invest as they alwayshave, with similar results, orthey can buy commoditieswhosefortunesaretiedtothesurgingeconomiesofAsia.

HotCommodities

•Knowingsomethingabout

commoditiesisn’tjusttimely,it’ssavvy.

•TheauthorsoftheMcKinseyGlobalInstitutestudyconcludedthatdeleveragingafterafinancialcrisiswasapainfulprocess

thatoftenactedasasignificantdragonGDP.

•Theunderlyingtrendisundeniable:Asia,ledbyChina,isonanupwardeconomictrajectory.

•AsChineseandIndian

consumerscrosstheincomethresholdsatwhichcarsandotherbig-ticketitemsbecomeaffordable,theywillbethesparktoignitethecommoditypricerally.

1

Gorton,GaryB,andK.GeertRouwenhort, “Facts andFantasies About CommodityFutures,” Yale InternationalCenter forFinance,Yale ICFWorking Paper No. 04-20,June14,2004.

2

Idzorek, Thomas M.,“Strategic Asset Allocationand Commodities,” Ibbotson

Associates,March27,2006.

3

The Organisation forEconomic Co-operation andDevelopment (OECD) is aParis-based organization thatis one of the world’s largestproviders of economicresearch. Its membercountries are developednations committed todemocracy and to a market

economy.

4

On January 19, 2010, theweighting towards grains,soybean oil, and soybeanmealwas34.3percent.