The past couple weeks have been somewhat choppy for many vital resource stocks. The primary catalyst: worries that the US slowdown is only beginning and that it will hit global demand hard later this year and into 2009.

To be sure, there are now clear signs the global economy is slowing down. And we’re already seeing demand for many resources decelerate, though absolute demand remains at elevated levels, especially when compared to previous cycles.

Global prices for vital resources, however, aren’t only affected by demand growth. In fact, over the next several months, supply concerns will increasingly take precedence. And the result is resource prices will stay to the upside, even in the face of moderating demand.

As we enter the second half of the year, our favorite bets are in the steel, diversified mining, agricultural chemicals and copper sectors. All four are experiencing severe and growing constraints on supply that are locking in higher prices, despite the tempered demand picture.

That’s a formula for rising share prices for our favorites for the rest of the year. And after the recent correction, our picks are in a sound buying range as well. See the Portfolio table on the left-hand side of the VRI Web site.

We would caution our readers to ignore the outright bull calls that some Johnny-come-latelys are now dishing out, as easily now as they were trashing resources a few months ago. Rather, it’s essential to focus on the big picture and the longer-term super cycle.

That means basing your vital resource portfolio on the strongest of the well-established, diversified companies: Anglo American (UK: AAL, NSDQ: AAUK), Rio Tinto (NYSE: RTC) and Xstrata (OTC: XSRAF). We also own some leveraged plays for some added spice. See VRI, 12 June 2008, In Size, Sureness.

We’ve said on numerous occasions that the natural resource bull market is a long-term story. We expect to keep booking short-term gains along the way, as stocks occasionally get ahead of themselves. But the factors we’re really playing here are deeply entrenched–on both the supply and demand sides–and will be for years to come.

Supply challenges are both manifold and complex. The further and deeper companies have had to go to replenish reserves and output, the greater the challenges of energy insufficiency, resource nationalism and labor issues.

Mining is a very energy-intensive process. The bigger the mine, the more electricity it requires to run, and the greater demand for fuel to run the needed power plants. With coal, natural gas and oil prices surging, the cost of power has soared in many places. Worse, some areas are getting hit with outright shortages.

As a result, a growing lack of affordable, reliable electricity has become a major impediment to boosting–or even maintaining–global resource supplies.

One particularly ugly example is South Africa, where years of poor organization and a lack of long-term planning have crippled power generation. Early this year, the country’s spare electricity generation capacity simply disappeared. The first signs of a potential problem were visible in 2007 when occasional blackouts started to occur.

Few paid attention then; South Africa was already known for energy problems, though some companies were worried about the increased frequency of the outages. Enter 2008, and heavy rains forced the closing of some coal mines, while the overall resource industry’s production started strengthening. The country’s reserve capacity vanished, and the result was serious disruptions in energy supply.

Starting Jan. 25, all deep-level underground mining stopped, as the power authorities requested more than 100 companies cut back on electricity usage. Six months later, there are still problems, and efforts to restore generation capacity continue.

Longer term, the situation is even more serious. South Africa hasn’t invested sufficiently in its electric power system for years. Even in a best-case scenario, it will take years of careful planning and billions of dollars just to bring the grid up to speed with the substantial increase in demand of late.

The local electricity monopoly, Eskom has been dealing with the near-term situation by cutting supply to a lot of major users and is trying to build up its coal inventories. That, incidentally, has diverted a fair chunk of South Africa’s coal from the export market, a major spur for the black mineral’s price this year.

Ironically, South Africa has traditionally been a low-cost electricity producer. That’s historically been a major advantage for its mining industry. However, those days are long gone, as the utility will be forced to add capacity and its customers–particularly mining companies–will have to pay for it. That’s another cost increase to absorb, which will further constrain production unless resource prices rise commensurately.

Why is South Africa’s power situation important to us? Because the country, like Australia, is a treasure house of vital resources and has been one of the globe’s major suppliers for many years. As we saw from the spike in metallurgical coal prices this winter, any disruption in output from South Africa has a direct impact on resource prices globally–mainly pushing them much higher.

Power problems for the mining industry aren’t just confined to South Africa. Brazil–home of VRI Portfolio pick Companhia Vale do Rio Doce (NYSE: RIO, CVRD) and a major producer of a range of vital resources particularly iron ore–has been deeply affected by the impact of drought on available hydro power supplies as well as import disruptions in its chief replacement fuel natural gas. Hydro power is extremely important to Brazil’s electricity generation, while gas is mainly imported from politically turbulent Bolivia.

Like South Africa, government in recent years has mainly focused on keeping power rates low in the near term, rather than encouraging investment in the system. As a result, there hasn’t been any serious generating capacity expansion in the last five to six years, drying up spare capacity and putting the overall system under increasing stress.

Encouraging, the government has been moving to encourage investment in recent years. But unless it’s able to orchestrate a rapid ramping up of power generation, production disruptions and forced downsizing will become the norm in Brazil. That means higher costs for miners as well as the potential for interruptions in output.

Chile’s mines have historically been able to rely on the country’s rich hydropower reserves, a benefit of the country’s extreme variation in elevation and abundant rainfall. This year, however, the world’s leading copper producing country has increasingly encountered energy problems that have affected production of the red metal.

As in Brazil, the key problems in Chile are a regional drought, coupled with a reduction in imported natural gas to fire up power plants. To date, the country has managed to use diesel to cover some of the shortage. But industry experts see no permanent solution until 2010, when additional generating capacity is due on-stream. As for this year, the lack of rain will be a major negative and could lead to even more severe power shortages and output interruptions than are currently expected.

At this juncture, worries about the economy, not supply, are governing metals prices. That particularly applies to copper, which is often referred to as “the only metal with a PhD” because of the close relationship of its price to the level of economic growth. The result is speculation has been basically knocked out of the copper market, eliminating a major spur for price volatility and, therefore, investment risk.

As for fundamentals, over the past five years, Chinese demand for copper has grown from roughly one-half US demand to more than twice its previous level. As a result, China is a far more important market now, and growth in demand there has easily made up for the drop in the US. Further, we expect a jump in Chinese demand later in the year after its currently high inventories have run down. This will offer big support for copper prices in the next couple years as a new cycle starts.

Freeport-McMoRan Copper & Gold (NYSE: FCX) is our favorite play in the strong copper market. Buy Freeport-McMoRan Copper & Gold at current prices.

In Europe, more than USD3 trillion will be needed to upgrade and add electricity generating capacity to keep up with demand growth for the next 25 years. Unlike many other nations, the problem in the EU has been recognized, and there’s money to get the job done. Unfortunately, a big part of the planned investments have been stonewalled by environmental issues, even where there’s a rough consensus among most parties. As a result, the problem will get worse before it improves.

In the US, as our colleague Elliott Gue has pointed out repeatedly in The Energy Strategist, around 60 coal-fired plants have been canceled or delayed in the last year, and it is unlikely that any new nuclear plants will operate in the US before the end of the next decade. That leaves natural gas and wind to fill the gap, which means higher costs and power prices. And we’re likely to see power shortages here as well, particularly as older coal and nuclear capacity inevitably shuts down.

Most affected by this emerging squeeze is aluminum production. This is a very power-intensive process, and producers have already been squeezed in several countries by power shortages and higher costs.

Unfortunately, this has been a big problem for VRI Portfolio pick Alumina (NYSE: AWC). Earnings this year have been hit dramatically because of costs issues and quality access to energy. The stock now trades at deep discount, but we’re increasingly worried about the company’s ability to perform well earnings wise.

To be sure, Alumina’s base appeal–a major producer and potential acquisition target–is still intact. But the magnitude of its emerging energy problems threatens to dramatically upend its economics and future development. As a result, we’re taking the 30 percent loss since recommendation and selling Alumina. We’ll continue to track the shares in the How They Rate coverage universe.

We still want to have some exposure to aluminum. The metal’s price remains strong, rallying close to 40 percent this year on solid demand and supply disruptions caused by the aforementioned power shortages. As we noted several months ago, China has been a major factor pushing aluminum higher, largely by forcing a lot of smaller smelters to close down to prevent power shortages and force more efficient use of power. 

In retrospect, our mistake here was picking an aluminum play that had too much exposure to rising energy costs. We’re currently looking at a couple of candidates to replace Alumina and should have a recommendation in a couple weeks.

Until then, portfolio favorite diversified miner Rio Tinto (NYSE: RTP) offers good exposure to the aluminum market, controlling 12.1 percent of the global market since its takeover of Alcan. Still a takeover candidate in its own rights, Rio Tinto remains a buy at current prices.

Source: Bloomberg