Profiting from Higher Commodity Prices

We are a full year into the credit crisis, with bank losses close to $400 billion, high oil prices and a housing in a free fall. Inflation has risen so quickly in many parts of the world that countries such as Vietnam, where inflation stands at 27%, are hoarding gold.

Many are trying to say the credit crunch has run its course, but a closer look at what started the write-downs and failures is still showing signs that these credit issues have wide bands.

How far it can spread, when it will stop and what to invest in now are all of the important questions.

Profiting from Higher Commodity Prices: Prelude to Panic

The economy today has a lot in common with the trajectory of a hurricane. In fact, the stages of a hurricane are eerily similar to the destructive buildup we have seen in toxic paper (read: subprime) on Wall Street. At first, a hurricane starts out as a tropical disturbance. With all the right ingredients, however, it has the ability to morph into a destructive force with winds that can clock in at 200 mph.

In early 2007, a financial storm was brewing that had many telltale signs of a potential Category 5. At the time, very few people were paying attention to the credit problems brewing in the financial institutions. Sure, there were reports that mortgages were going bad at the world’s third-largest bank, HSBC (HBC:NYSE), but folks weren’t interested since everything was humming along.

But the winds started to shift in August 2007, when whispers swept through Wall Street that Countrywide Financial (CFC:NYSE):, the biggest U.S. mortgage lender, was facing bankruptcy. The stock fell 13% in one day — its biggest fall since the crash in 1987.

This news was like the eye of the storm, the dark spot found in the center of a hurricane. In market terms, the eye is like the prelude to a panic. It’s the outer bands of a hurricane and the eye wall that are the most destructive, and these have yet to truly make financial landfall.

While we are past the prelude to a panic, real financial panic has not yet set in. The storm is a Category 2, but the forces are building. The recent announcements of Fannie Mae (FNM:NYSE) and Freddie Mac’s (FRE:NYSE) insolvency did send the markets into a tizzy, but our friends, the Fed and the Treasury, are there to bail them out.

These are not small numbers, either: The combined total of these two institutions represent $1.5 trillion in on-balance-sheet mortgage assets.

Since the credit crisis became headline news, inflation has risen and the economy has slowed. The dollar is down, unemployment up and commodity prices have gone through the roof. The Commodity Research Bureau, a measure of commodity prices, is up 37 % this year, led by energy and precious metals.

It seems there is no end in sight to the credit crisis. While “subprime” is the culprit and on the news every day, wait until we start hearing more about the Alt-A loans — those carried by Fannie and Freddie.

The dollar value of these loans dwarf subprime loans and will take a long time to work out. Alt-A loans could very well be the eye wall, and if so, the Federal Reserve is going to stay very busy pumping the printing press.

Ben Bernanke finally acknowledged that inflation conditions have “intensified.” And now the statistical curtain the government has been hiding behind will soon be blown wide open.

People know instinctively that prices are going up and inflation is nowhere near the reported 4%. It is closer to 11%, and going higher for many reasons. The sound of the dollar crashing is also getting louder, and we are feeling the pain of our currency debasement as prices for “stuff” continue to escalate.

What’s an investor to do? Buy silver — the “poor man’s gold.” It will skyrocket as inflation heats up. We already have our gold position with Goldcorp (GG:NYSE), and now it’s time to add a strong silver play.

Profiting from Higher Commodity Prices: Silver Prices -- Demand on the Rise

Precious metals do well in rising inflation. Silver outperformed in the 1970s stagflation market, and this time shouldn’t be any different. People often forget about silver and focus on gold when thinking of an inflation hedge. But this is a mistake as silver is also used as a store of value and has been used as money for longer periods of time than gold.

Silver is favorable for three reasons. First, silver is cheap relative to gold. The ratio of gold to silver is currently at 53 and this puts it in the top quartile of its relative low. The historic price ratio of silver to gold indicates that 10 ounces of silver would get you 1 ounce of gold, or a 10-to-1 ratio. At 53, this ratio is overdone in favor of gold and needs to correct. As the gold-to-silver ratio comes back in line with the historical norm, an investor in silver could make four to five times more money in silver. And when the next leg of this bull market picks up speed, silver volatility will add to its ascent.

Profiting from Higher Commodity Prices: Silver Inventories

Recently, it has been reported that dealers are selling out of silver. “Out of inventory” is the message a local dealer at Scotia bank had to say. This is something we will be hearing more as investors flock to silver as a store of value. The good thing about silver bullion is that it can be easily moved and stored.

The introduction of the silver exchange-traded fund (ETF) (SLV:AMEX) in April 2006 has given investors the ability to accumulate silver. Barclays launched this ETF, and it has been a big success. It has also taken a large amount of physical silver bullion off the market. Today this ETF holds approximately 195 million ounces of silver, which shows growth of 828% in just two years. This is expected to grow as investors pile into the safe silver bet.

Profiting from Higher Commodity Prices: Silver Demand Grows as Supplies Slip

The demand side of silver comes from many different sources. People like to point to the fact that digital photography has replaced photography and has therefore decreased the need for silver. What they fail to see is there are other economic uses that more than make up for this, such as solar cells, fuel cells, catalytic use and biomedical applications.

Silver is also used in electronics and in water purification to reduce chlorine in drinking water. And we should see strong demand from China and India as their growing infrastructure is adding demand for silver in electrical and electronic sectors.

On the supply side, silver has actually risen over the last 10 years and yet the market has still remained in a deficit. Due to strong industrial demand and the ETF taking supplies off the market, silver stocks should remain tight.

With the Fed printing money like crazy to stave off severe recessionary winds and strong supply/demand fundamentals, silver will shine as we go forward in the next phase of the credit crisis. And there is one stock that should outperform in the months ahead.

Originally published September 18, 2008.

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Other Related Topics: Commodities Investment , Exchange-Traded Fund , Precious Metals , Sandy Franks , Silver Investment