Is the Commodity Squeeze Over?

We have seen commodities across the board tumble in the past few months. So is the commodity supply/demand squeeze over?

My view: Not by a long shot.

In fact, the pullback we’ve seen in major commodities may be enough to give stock investors heartburn, but it is pretty typical for consolidation in a commodity bull market.

For example, the CRB — a widely followed index of commodities that is weighted toward energy — is at price support now. It could bounce here, or it could keep pulling back to further support at 366. It may look like a cliff dive, but these kinds of retracements are normal and even necessary.

Meanwhile, the market is starting to react positively to good news. That sounds obvious, but for a while there, commodities were selling off even on bullish news — a sure sign that we were in a correction phase.

I’m in no way ready to pronounce this correction over. But here are some positive signs I’m seeing now in energy, gold, grains and uranium … signs that the commodity supply/demand squeeze is going to get TIGHTER — and that could squeeze prices much higher in a hurry.

Energy: Falling Production
and Rising Demand

Sure, you’ve probably heard analysts rush to grab the microphone on CNBC and pronounce oil’s bull market dead. Oh, really? Let me show you a chart that might put things in perspective …

This is a chart I got from theoildrumeurope.com and expanded with information through Tuesday’s close. Look at the pullback we’ve seen in oil on a percentage basis. You can see that it doesn’t even make the top three of pullbacks in oil prices we’ve seen since oil started its big bull run in 2002.

Now, look at what’s happening …

The IEA Cranks Up Its
Global Demand Forecast!

The International Energy Agency recently raised its forecast for global oil demand next year by 70,000 barrels to 87.8 million barrels per day.

Reason: The IEA expects Chinese oil consumption to rise after the Olympic Games, and Chinese oil demand is expected to increase 5.7% next year.

What is China doing with all that oil? Fueling cars. In China, car sales rose by 20% in the first quarter of this year to 1.85 million vehicles. And while SUV sales are tanking in the U.S., the number of SUVs sold in China rose 43% in May compared with the previous year. Indeed, China’s demand for gas is much of the reason for the run-up in global oil prices.

China alone accounts for about 40% of the world’s recent increase in demand for oil. Fifteen years ago, there were almost no private cars in the country. China now has 15.2 million private cars. Still, less than 4% of the country’s 1.3 billion people have already bought a car. That’s the same percentage of car ownership the U.S. had in 1915!

And it’s not just China. While demand does seem to be falling in developed nations, oil demand in developing countries is forecast to reach 800,000 barrels per day year over year in the third quarter of this year alone.

The world consumes 173 billion barrels of oil — about 14 Prudhoe Bays — every 2.4 years. And if the IEA is right, the world’s oil use will zoom past 1,000 barrels per second next year.

Meanwhile, oil production can’t keep up!

At the same time, we find enough new oil to supply just 3% of that demand. Global production is steady … for now … but the cushion in daily oil production is thin and getting thinner.

And there is some real UGLINESS out there …

First, Mexico’s crude oil production continues its waterfall decline. In July — when I set a short-term price target on crude of between $110 and $100 — I told you how Mexico’s exports dropped 19% in June.

Well, July was even worse! Mexico’s exports dropped 22% year over year, pushed lower by production that dropped 10% in the first seven months of 2008 to an average of 2.845 million barrels per day.

Production at Mexico’s big Cantarell field is imploding, down 36% in July from a year earlier. If the worst-case projections turn out to be correct — and they have been so far — by the end of this year, Mexico’s overall oil exports would decline by about one million barrels a day — equal to about 63% of its daily crude exports to the U.S. — from its current 1.8 million.

Second, Russia is also seeing its production drop. Russia is the world’s #2 exporter of oil after Saudi Arabia, and is the source of two-thirds of the increase in non-OPEC oil production between 2000 and 2007. But in the first half of the year, Russia’s oil production dropped 0.8% and its exports dropped 5.2% to 897 million barrels. Like most oil producers, Russia is using more and more of its own supply.

Worsening the problem is that the Russians are highly dependent on old oil fields that have been re-drilled with more advanced equipment. New fields are hard to find and not that big when they do turn up. According to a McClatchy interview with researcher Valery Kryukov, oil production could go into “serious decline” in 2010.

Third, Britain’s North Sea oil and gas fields are declining quickly. Production has dropped in seven of the last eight years, and dropped again by 2% last year, despite $22 billion worth of new investment.

There are plenty of other nations that are experiencing declines in oil production. The U.S. is one, and “drill-drill-drill” isn’t going to change that.

Bottom line: The fundamentals remain very bullish for oil.

Gold and Silver: Looking More Precious, Too

In June, South Africa saw its gold production plummet 12.3% year over year as power cuts interrupted mining. The country has now fallen firmly behind China in global gold production.

Meanwhile, demand is still rising from both funds (a new gold fund recently opened in Hong Kong) and people who tuck gold away under the mattress.

Last week, the World Gold Council reported that demand for gold rose 7% to 736 metric tonnes in the second quarter, compared with the first quarter. And the pace of buying may be picking up — gold dealers in Singapore and Dubai have reported turning away customers looking for one-ounce coins, while the Times of India reports “a shortage of the yellow metal” at local bullion banks.

Money is also pouring into Barclay’s iShares Silver Trust (SLV). It now holds 208 million ounces of silver — nearly 40% of annual global mine production — and the trust recently had to add more than 8.5 million ounces of silver in just three days!

In one of the more eyebrow-raising stories I’ve seen lately, the U.S. Mint briefly suspended sales of American Eagle bullion coins. Government officials say sales are about 50% more than in all of 2007.

“Due to the unprecedented demand for American Eagle gold one-ounce bullion coins, our inventories have been depleted. We are therefore temporarily suspending all sales of these coins,” the U.S. Mint told authorized coin dealers. “We hope to resume sales shortly.”

American Eagle gold coins are in short supply right now …

The Mint did resume sales, but on a limited basis — literally rationing American Eagles among its customers. Here’s a clear-cut case of supply being unable to meet demand.

It seems to me that the price of gold in the futures market is too low, pushed down by the frantic selling of hedge funds that are leveraged to their eyeballs.

There’s only one way to fix this disconnect — higher prices. And as hedge funds rush to cover, the snap-back could make your head spin.

One of the other metals I follow closely is also seeing some interesting new developments …

Uranium: As Cigar Lake Turns …

Cameco’s Cigar Lake Mine is the water-logged soap opera of the uranium industry. After all, Cigar Lake is one of the world’s most promising uranium deposits, with estimated reserves of 113 million pounds of U3O8. That supply, recently forecast to start hitting the market in 2011, has now been removed from the market indefinitely by more flooding.

You’ll remember my reports on this starting in October 2006, when a rock fall in the underground production area of the mine led to serious flooding.

Cameco’s engineers — some of the best engineers in the world — kept thinking they’d finally gotten a handle on how to drain and repair the flooded mine. And it sure seemed like Cameco had finally fixed the problem — that was part of what sent the spot price of uranium tumbling so low last year.

Well, get out your handkerchiefs, because it’s bad news again for soap-opera star Cameco. The company had expected to complete dewatering No.1 shaft in the second half of 2008. But then, yesterday, the water flow in the shaft suddenly increased to 600 cubic meters per hour. The company said, “[This rate] is beyond the range that can be managed while sustaining work in the shaft.”

In other words: “Get out! Run! Run!”

Cameco plans to let the water level in the shaft keep rising. It will monitor the flow to determine the next steps.

Is this back to square one for Cameco? I don’t know, but it sure puts a squeeze on uranium supply.

And it’s not the only squeeze. On Friday, South Africa, which produced 539 metric tonnes of uranium last year and has Africa’s biggest reserves, said it may limit exports of the white-hot metal to make sure it has sufficient supply of fuel for its existing and planned nuclear power plants.

On the other side of the equation …

Uranium demand was 66,500 tonnes last year, according to data from TradeTech. But consumption may jump to 102,000 tonnes over the next 12 years, according to a forecast from Australia’s Macquarie Group.

Currently, there are 440 nuclear reactors in operation that generate about 16% of the world’s electricity. Another 25 are under construction, 38 are on order and 115 are proposed.

Over the next 15 years, China alone is building 30 new atomic power plants, with as many as 200 needed by 2050. Japan is planning 11 more by 2010, Russia, India, South Korea and other countries are all busy, building away. The United States and United Kingdom are (finally!) making plans to build more nuclear power plants.

It takes seven to 10 years to find and bring a uranium discovery into production. Uranium mining production is only projected to increase 9% in 2007 over 2006. And if we have more mishaps like Cigar Lake, that production line could be stretched painfully thin.

I could also build strong cases for supply/demand squeezes in copper, iron, grains and more. My main point is this …

The Commodity Bull Market Is Very Much Alive!

The big commodity bull market is still intact. And there are a couple ways to play it.

For example, the PowerShares DB Commodity Index Tracking Fund (DBC) gives you exposure to six of the most heavily traded physical commodities in the world: crude oil, heating oil, gold, aluminum, corn and wheat. I think this is a good fund to ride the general rally in commodities.

Or, for specific commodities, you can choose funds that give you leverage.

Example: The Deutsche Bank Gold Double Long ETN (DGP) is designed to provide you with 200% of the monthly return of gold (or more specifically, the Deutsche Bank Liquid Commodity Index — Optimum Yield Gold Index).

Doubling the monthly return as opposed to the daily return should allow these notes to stick pretty close to the long-term price trends of the underlying index.

Hey, we could still see lower prices in gold, oil, and uranium in the short term … but I’m confident we’re going to see much HIGHER prices — and more volatility — longer-term.

It’s going to be a wild ride. But if you sit on the sidelines, I think you’re going to miss out on some great gains!

Yours for trading profits,

Sean

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