It’s striking that, although investors understand the reasons behind the recent strength in metals and commodities (i.e., emerging market demand and problematic supply), they aren’t able to grasp this commodities cycle’s massive potential.

The main reason is that few investors are willing to accept the big transformation that’s taking place in several emerging market economies, led by China and India.

We’ve been advocating this change for quite some time. And after several years of doing so, investors are more receptive. However, they’re not totally convinced yet. This is the main reason this bull market in emerging markets and commodities has another strong leg up before it reaches all-time highs.

But we’re far from that point. And we see the current mild underperformance of metals as a pause to breathe rather than the beginning of the end.

The decline of the US dollar has certainly played a role in this bull market, but it’s only the icing on the cake. Former dollar devotees now tell us that the commodity bull market is directly correlated to dollar weakness, overlooking the fact that the two commodities the US dollar affects the most is gold and oil, not rice and copper.

Those who argue against the short are naïve, particularly following six years of dollar weakness. It’s now time for the US dollar to stage a rally, even if it’s only short term. Although their rationale may be correct, they’re too late in the game. See VRI, 8 May 2008, The Destructive Dollar.

The more important development in the commodities universe over the past couple years is that developing economies are pushing past the US to assume the price-setter role as they try to integrate into the global economic system.

This process has created unprecedented demand and has led to supply and capacity constraints, driving prices higher after a three-decade-deep sleep. Add in the weak US dollar and investment flows into the sector, and you have a true long-term bull market that has the basic characteristics of one: strong demand, weak supply and investment flows.

And provided that our assessment regarding the strength of the emerging economic transformation is here to stay, commodities will transform from an extremely cyclical asset class to an industry with more stable characteristics. The transformation process of Asia, Africa, Eastern Europe, South America and the Middle East is a long process that’s built on solid foundations.

Current weakness in metals–the result of a slowing global economy, a stronger dollar and investors’ lack of enthusiasm–should be viewed as a buying opportunity.

Looking ahead to the second half of the year, our long-term supply constraint theme is still intact because it will take time to address these issues. Production problems remain and have escalated in many cases (i.e., copper and iron). We expect more problems, especially in China and South Africa, as power outages pick up during high-power demand in the summer months. At the same time, consumption remains strong. See VRI, 7 February 2008, The Great Game, for more on infrastructure problems.

Copper remains one of our favorite metals, and our long-standing recommendation to take advantage of its strength is Freeport-McMoRan Copper & Gold (NYSE: FCX). Copper suffered from supply challenges along with investors’ underestimation of its potential early in the year.

According to industry sources, there are relatively few major copper projects coming online within next 10 years; grades are falling as the Chilean mines are aging; labor disputes continue to disrupt production; and nationalization issues present serious obstacles.

The stock has been white-hot for the last few months, but we’re still looking for great things from Freeport. It’s less likely the US economy is going to melt down enough in 2008 to take down the rest of the world–particularly China, which has emerged as a key market for the red metal. That should keep prices high despite lower demand from the US.

Also, Freeport has a rising production profile, which promises much higher earnings—and further advancement for Freeport’s share price—in the coming years. The second half of 2008 could be particularly explosive. That’s because the majority of the company’s production takes place then, and it’s likely to coincide with the beginning of a recovery in US demand.

Freeport doesn’t hedge because its management believes that demand for copper over the longer term is assured. We agree and continue to recommend Freeport-McMoRan Copper & Gold as a buy at current prices.

Source: Bloomberg

Steel and its raw material have been in the forefront of our investment themes this year, and the gradual strengthening of steel prices supports our recommendations. Steel strength came courtesy of Chinese demand because prices in China were up by 20 percent in the first three months of the year.

Iron ore has also been on a roll. Its contract prices have risen up to 87 percent, and it remains strong. We noted the following last week:

We’re still bullish on iron ore because prices should remain stronger for longer. Chinese iron production seems to have picked up, and steel production continues to increase. Spot iron prices are trading at USD190 per ton, and as steel production remains healthy, iron producers should be able to negotiate even higher prices.

We’re more confident now because steel producers continue to pass through these higher costs as demand remains resilient, despite growing fears of an economic slowdown.

Companhia Vale do Rio Doce (NYSE: RIO, CVRD) is our favorite iron play. Brazil-based CVRD is the largest producer of iron ore in the world and a leading producer of nickel following the acquisition of Inco. The group also has presence in the aluminum market and is developing copper deposits in Brazil. Buy CVRD.

We continue to favor Russian-based Mechel (NYSE: MTL) as a strong steel play. The company’s mining business focuses on raw materials used in making steel, primarily coking coal, iron ore, nickel and steam coal. The company’s steel business is 100 percent self-sufficient in coking coal, 80 percent in iron ore and 50 percent in electricity.

This aspect of Mechel (i.e., vertical integration) is critical in an environment in which raw materials prices continue to rise, and it should support the stock. Buy Mechel.

Platinum faces tightening supplies and rising demand that should last at least another four to five years. South African and Russian producers–the biggest platinum producers in the world–have repeatedly warned of production problems that have translated into shortages. Platinum supply fell last year for the first time since 2000.

Industry experts have noted that supply growth in Zimbabwe would improve markedly if the nation can regain a modicum of economic and political stability. But such an outcome remains elusive for now, and we continue to expect supply shortages.

Auto industry demand, specifically for catalysts and filters for diesel engines, is the single largest application for platinum. The European market is the largest because diesel engines are particularly popular there. Meanwhile, the global push toward more efficient engines and lower carbon dioxide (CO₂) emissions will increase demand further.

The rise of the emerging economies in Asia is another key factor, especially India and China, where imports increased this year despite high platinum prices. That will be instrumental for the metal’s demand because auto sales continue to grow strong, particularly for smaller, cleaner cars. An additional kicker will be an upcoming change in US emissions legislation, which will make platinum one of the most important metals by far.  

Traditionally, southern Africa has been the biggest single source of platinum. It currently churns out 80 percent of the global supply. Therefore, it’s no surprise that the world’s leading producer of the metal is VRI Portfolio holding Anglo American (London: AAL, NSDQ: AAUK), which supplies 40 percent of the global market. The company is also a producer of another VRI favorite, nickel. Buy Anglo American.

Industry experts forecast that nickel usage will pick up this year again as stainless steel demand continues to strengthen. China is one of the fastest-growing nickel consumers. At the end of the 1990s, China used around 40,000 tons of nickel a year and accounted for less than 4 percent of global demand.

This year, it will use more than eight times that amount of nickel and account for 23 percent of global nickel demand. Over the same period, China has emerged at the world’s largest producer of stainless steel–the main end-use for nickel.

Norilsk Nickel (OTC: NILSY) is the largest mining company in Russia, and it’s our favorite play in which to gain exposure to the nickel story.

It produces four main metals–nickel, copper, palladium and platinum–and a variety of by-products, such as cobalt, rhodium, silver, gold, tellurium, selenium, iridium and ruthenium.

The group is involved in prospecting, exploration, extraction, refining and metallurgical processing of minerals and producing, marketing and selling base and precious metals. The company is the world’s leading producer of nickel and palladium. It’s also the fourth-largest producer of platinum and one of the largest copper producers. Buy Norilsk Nickel.

Source: Bloomberg

Finally, diversified miners are one of the best ways for longer-term investors to gain exposure in the commodities bull market. That’s why the first stock we recommended when we started VRI last October was Rio Tinto (NYSE: RTP). The stock is up 60 percent since our initial recommendation, and we still favor it.

Rio is the second-largest iron ore miner in the world after CVRD and offers exposure to aluminum, coal and other base metals. In addition, VRI How They Rate play BHP Billiton (NYSE: BHP) hasn’t given up in its attempt to buyout Rio, which has helped its stock price remain elevated. But Rio’s fundamentals and future outlook remain bright as a standalone company for now. Buy Rio Tinto.