The third quarter was a rough ride for the VRI Portfolio. The silver lining is our recommendations continue to outperform their benchmarks. That’s what an industry letter should be able to do. More important, that outperformance is the best assurance we’re going to be in prime position when the financial system’s great debacle finally works itself out.

This issue marks our one year anniversary at the helm of VRI. In retrospect, the latter part of those 12 months have basically marked a great pause in the multi-year natural resources bull market that began earlier this decade.

To date, our best calls have been winners that we’ve later recommended taking profits on. As we stated in our inaugural issue a year ago, that remains a cornerstone of our strategy. In a sector as volatile as this one, every investor should always act accordingly when big profits have been accumulated in a relatively short period of time. And we intend to do more of it going forward.

At this point, of course, the resource market is at low ebb. The sector has been particularly buffeted by concerns the US financial crisis will now trigger a massive global economic slowdown, depressing demand that had been so insatiable just a few months ago. And our picks haven’t been spared the carnage.

Our aim, however, isn’t to dodge these ups and downs. Rather, it’s to always recommend the best companies to own in the resource sector. Our goal is to enable your portfolio to participate in long up cycle in commodities. And despite the current market action, we’re firmly convinced this one has a long way to run. In fact, this global slowdown will only prolong it, as depressed commodity prices discourage permanent demand destruction through conservation and new technologies and as plans for aggressive exploration and development of new reserves are put on hold.

Looking down the VRI Portfolio, it’s no real surprise that our most leveraged recommendations have been the hardest hit, while the big diversified companies have fared relatively better. We’ll continue to offer a combination of both: the fry for their ability to generate huge profits as conditions improve and the best of the biggest to leaven out the downside.

On the numbers, the VRI Portfolio is down 16 percent since we released our first issue Oct. 4, 2007. During the same period, the MSCI World Material Index and the S&P 500 Materials Index are down 32 percent and 22 percent, respectively. See the chart below.

The big question: When can we expect a turn in this market? (i.e., a resumption of the long-run bull cycle.) The answer lies in the fate of the banking system.

Basically, commodities and producer stocks have declined because of investor worries about the global economic slowdown and its consequences for demand. Those, in turn, have been magnified by the complete uncertainty the credit crisis has brought to the markets, which has had a particularly negative impact on high beta markets such as commodities.

The credit crisis has disturbed the commodities markets in ways that few thought possible before. Many big investment banks, for example, have held huge positions in commodities this year. Those that have failed have had to liquidate those massive holdings. That’s pushed prices lower as physical positions are sold. 

Furthermore, positions held against commodity indexes have also been liquidated on heavy volume because of counterparty risk. American International Group is a good example here, as the company is the administrator of the second largest commodity fund, which only recently resumed normal trading. The most worrisome unforeseen development has been the closing of short positions as markets are beginning to function improperly, and investors simply don’t want to take the risk.

The counter rally the dollar is staging has also been negative for commodities. But that’s not nearly as important as the above mentioned market dysfunction stemming from the credit crisis. Simply, this isn’t a dollar strong/commodities weak scenario. As we noted just more than four months ago, the dollar had been due for a rally because the bearish sentiment on the currency had reached extreme levels. And since then, the greenback is up almost 10 percent versus the major currencies in the world. See VRI, May, 15 2008, Metal Stocks to Buy Now.

When all is said and done, we’re in for a rough ride with an uncertain outcome. And yet, once the crisis passes—as all of them eventually do—investors will look back at this time as a classic entry point for participating in the next wave of the cycle.

Our view now is the next leg up will be much stronger then the first one. Even now, demand for raw materials remains robust, particularly from urbanization and industrialization in emerging economies. And supply constraints will be more pressing than ever, as any slowdown in new development due to the global crisis comes back to haunt us.

Finally, there’s the issue of restocking. During times of slowdown and most importantly crisis, demand can be satisfied to a point by drawing down existing stockpiles. Those supplies, however, must eventually be replenished, which will be exponentially more difficult and expensive when demand resumes to the upside.

Again, unless you have a clear read on the financial system’s fate–we don’t claim to–timing the next leg up is problematic. But then again, if you’re patiently buying and holding the best resource companies, you won’t have to. You’ll be ready to reap the benefits whenever the rally resumes.

Steel has been a big disappointment for us over the past several months. Simply, despite very strong long-term fundamentals, the vital resource’s cyclical characteristics have led to bad performance as the global economy retreated.

One of the few positives now is that dramatic change in the industry has left it better positioned than in past decades to deal with these stresses–mainly much improved management on the supply side. The first price cut announcements have been made, and production cuts are also starting to take place with more to come, especially for the US producers.

Global giant ArcelorMittal (NYSE: MT) has led the production-cut race. It recently slashed 25 percent of its output in Kazakhstan, closed down three US-based blast furnaces and is also considering a 10 to 15 percent cut in European production. US Steel (NYSE: X) is also geared for shutting down facilities in the next two months, and Nucor (NYSE: NUE) is planning along similar lines. In short, they’re now all positioned for a global slowdown in steel demand next year by about 1.5 percent, a sharp reversal from rapid growth of previous years.

Ultimately, demand will have to revive for steel to resume to the upside. But these adjustments to supply will almost certainly shorten the current down cycle. That’s ultimately very good news for these companies, despite the pounding their shares are taking in this market.

Our favorite way to get exposure to steel is through Mechel (NYSE: MTL). One reason is the company is the best positioned steelmaker in the world to cash in on the Russian infrastructure story. Another is it offers good exposure to thermal coal, a resource in increasingly short supply globally.

As the essential ingredient of steel, it’s to be expected that iron ore is being affected by the weakness in still production. Here, the magnitude of the Chinese slowdown will play a big role in the final outcome. China currently absorbs 45 percent of global demand for iron (760 metric tons for 2008) and also represents 75 percent of global demand growth, which is still quite strong given the global turmoil.

Another reason for the weakness in the iron ore prices is the collapse in freight rates. Rates for Capesize—the largest dry bulk ships that mostly carry iron ore, coal and grains—are now USD35.60 per ton from Brazil to China. They’re USD11.50 per ton for runs from Australia to China and USD20 per ton for the India to China route.

To date, Chinese iron ore demand has remained solid, though some market disruption has been taking place. Mainly, Chinese traders that own high quality iron ore prefer to sit on paper losses than to sell at the current depressed prices. Lower grade ore isn’t being sought after by the mills at this juncture. Therefore, we see it being accumulated in warehouses.

Our expectation is that iron ore demand will also slow in the fourth quarter, pushing the market to a relative surplus next year. In such a scenario, we expect the major players to fare better, as they have better production economics than the minor ones. In fact, they’re likely to use any pullback to improve their own market position.

The VRI favorites for iron ore exposure are Rio Tinto (NYSE: RTP) and Brazilian-based Vale (NYSE: RIO, formerly CVRD), because of their supreme quality.

Of the steel materials, coking coal remains the most favorable one, as the supply constraints are still formidable. The major problem is in Australia, where supplies have been especially tight this year because of the massive flooding in Queensland. As the chart below indicates, Australia is the world’s largest exporting region.

Xstrata (UK: XT, OTC: XSRAF) remains our favorite for exposure to coking coal.

The most favorable fundamental for copper is that supplies are still in deficit. That’s kept prices higher than they’d normally be in times of economic stress. Production in Chile–the biggest copper producer–has been lackluster with a lot of low-grade copper, increase in strikes and bad weather.

Nevertheless, if the global economy is severely damaged or supply improves, prices could fall considerably from these levels. The good news is that’s now certainly reflected in the prices of copper stocks, which have sold off radically. As a result, we think a big part of such a negative scenario is already built into the prices.

Demand for copper from the developed world isn’t currently being taken into account because it’s been weak for the past two years. Therefore, all calculations are being done based on emerging market demand. Once demand growth from developed markets begins to stir again, the red metal will look even better.

Copper has been further weakened this year by US dollar strength, which has prompted an increase in short selling in copper, with speculators being net short copper. Once the US dollar resumes its long-term downward trend, short covering will boost prices higher very quickly, as the short position is the largest since early 2007. See the chart below.

Freeport-McMoRan Copper & Gold (NYSE: FCX) remains the preferred way to gain exposure to copper.

This metal has been hit extremely hard this year, with higher supply and lower demand doing most of the damage. On the positive side, nickel prices have been hit so hard that we don’t expect any further deterioration.

The short-term story remains cloudy. But ultimately, we look for big diversified players to weather the storm, while smaller ones will be forced to shut down. The result will be long-term margin expansion for the survivors.

Our second Russian recommendation is Norilsk Nickel (OTC: NILSY). The company produces 20 percent of the world’s nickel, 47 percent of palladium, 11 percent of platinum, 37 percent of rhodium, 13 of cobalt and 2.7 percent of copper. The company is self sufficient in energy, with a heavy reliance on stable-priced hydro power.

Unfortunately, we still don’t see any near-term catalysts for recovery in nickel. But Norilsk is a strong value at these levels and we’re still buyers (See VRI, Sept. 11, 2008, Resources: The Long View.)

Overall, we’re standing pat with our positions in this period of turmoil. But there are a couple of situations that deserve action.

Specifically, we’re selling out of Anglo American (NSDQ: AAUK) and Posco (NYSE: PKX) this week. Anglo was basically a way to get exposure to platinum. Under the current conditions, you can gain exposure to platinum through a company we like much more, Xstrata. Posco has been hit hard with the steel selloff. That alone doesn’t bother us, but the stock also didn’t benefit as much we expected from its position as a low producer of steel. Sell Anglo American and Posco.

Our best five stocks from the VRI Portfolio to buy now are the following, in order of preference: Rio Tinto, Paladin Energy (Australia: PDN, OTC: PALAF), Xstrata, China Green Holdings (Hong Kong: 904, OTC: CIGEF) and Monsanto (NYSE: MON). See VRI, Sept. 25, 2008, The Bailout and Beyond.

We would also like to point out that VRI now has a new search feature (on the upper right-hand corner of the page) that we urge you to use when you want to research previous company or investment thematic analysis.