Patience is a virtue

There have been some interesting developments occurring in the resources sector recently. We are witnessing a situation where the share prices of most resource companies are continuing to suffer from the recent fall-out on world equity and credit markets. This is despite the overwhelmingly positive evidence in world commodity markets, where prices remain strong and stockpiles are at worryingly low levels.

Fears about US economic growth and the possible knock-on effect on China, have not surprisingly caused doubts to flare in the minds of a lot of resource investors. This has impacted the share prices of companies both big and small, but companies at the smaller end of the scale have been particularly hard hit.

We have emphasised in our recent commentaries that we believe that the outlook for the resource sector remains sound, as we do not see any substantial drop off in either Chinese or Indian commodity demand, as a result of a US slow down. We believe the available evidence should help reassure those Members with a heavy resource weighting in their portfolios.

Of course, resource stocks by nature are inherently more volatile than their industrial counterparts. The primary explanation for this phenomenon is that resource stocks tend to move pretty much in direct correlation with the price of the underlying commodity in which they are involved. This volatility is magnified by the sorts of sharp movements we are seeing on world stock and commodity markets at the present time.

Diversified resource stocks like BHP Billiton and Rio Tinto will tend to be less volatile, as they source their earnings from across a broad spectrum of different commodities. On the other hand, resource companies that specialise in one particular commodity, such as gold, oil or one of the base metals for example, are totally exposed to the vagaries of that one particular commodity, whether that be up or down. And this can make investors nervous.

The Fat Prophets European Mining & Resources portfolio has a bias towards small to mid-cap resource stocks, whilst still maintaining exposure to larger resource companies. This is because we believe greater hidden value lies at the smaller end of the market, which can be realised over time.

Of course, this presents higher risks for investors, but we try to balance higher risk with higher rewards for our Members. The key to doing this is of course to have a diverse portfolio of resource companies so that one is not highly exposed to any single particular stock. And investors must try to be patient and not allow themselves to be easily spooked by market volatility.

Given the extraordinary strength in the share market over recent years, particularly the resource sector, it is not unusual that markets are going through a period of weakness. The key issue here is that we believe the commodities bull market remains firmly in place and that patient investors with a diverse portfolio of resource stocks should reap strong returns over time.

But what is the evidence to support our argument for a sustained positive outlook for the resources sector? Let's start with the China-India juggernaut we touched on earlier.

To help us, we have borrowed some very interesting slides from a presentation given by Vivek Tulpule, Rio Tinto's Chief Economist, to analysts at a recent Pilbara iron ore briefing in Western Australia.

As we know, both China and India have massive urbanisation and infrastructure programmes underway that involve massive amounts of spending. Both countries have massive rural populations that are engaged in the biggest urban migration the world has ever seen. These major structural changes will not stop because of short-term financial woes in the US.

As the world's two most populous nations, both China and India have incredible internal growth engines that will continue with their inexorable development, sucking in commodities at such a rate that the world's miners will struggle to keep up.

The slide above best demonstrates this. It shows that whilst China is a major exporter, internal demand is the key driver of its economic growth.

And exactly how important is the US these days and what would a slowdown in the US economy have on Chinese exports?

Between 2000 and 2006, the United States' share of the world economy fell from 31% to 27.7%. During the year 2000, the value of stocks listed on US stock exchanges represented close to 50% of all stock exchanges around the world, but this has since fallen to less than 33%. And the US now represents just 12.5% of world copper demand, whereas China accounts for double this at 25%.

The chart above demonstrates that the effects of a slowdown in US demand for Chinese exports will be more modest than many people imagine.

What we are saying is that the US is not disappearing; however it is becoming less important than it once was. So from a commodity demand perspective, we believe the picture is still extremely rosy.

Another interesting phenomenon supports our positive outlook. So let's turn our attention now to commodities themselves and a closer examination of how prices have performed of late, and importantly, how inventory levels have reacted.

When we discount the negative media rhetoric and actually analyse what is happening in commodity markets, we witness a very interesting picture. Commodity prices, whilst weaker in some instances in the wake of recent worldwide economic events, have not fallen out of bed and are in fact showing strong resistance. Indeed, a number have risen to record levels.

This does not sound like a recipe for doom and gloom. Rather, this tells us that overall commodity demand remains healthy, exacerbated by increasing supply side pressures.

Copper is a great place to start, as it is a bellwether commodity with respect to world economic growth. Prices for the red metal have this week recovered strongly to three-month highs, as both production and London Metal Exchange (LME) inventories have declined. This is despite recent hysteria about falling prices due to fears of a drop-off in demand and the likelihood of a big copper surplus this year.

In fact LME stockpiles fell by 1.6% over the past week to their lowest level since October last year, and have fallen 17% this year alone. Meanwhile, stockpiles in South Korea, the exchange's nearest warehouse location to China, have tumbled 36%. This paints a very different picture to what most market commentators and experts have been speculating.

Production issues are set to drastically reduce output both in China, due to severe weather, and in Chile, the world's biggest supplier, due to energy shortages. Production from Chile already fell by 5.3% last year.

The other commodity that we believe is a highly accurate barometer of world economic health is crude oil. Far from sinking like a stone as others had forecast in the wake of US recession fears, crude prices have instead held up extremely well, as we predicted. In fact, prices have this week have climbed to their highest level in a month, to more than US$93 a barrel.

Cold weather and power outages in the US are taking their toll on refinery output, whilst Venezuela's recalcitrant President, Hugo Chavez, is threatening to halt oil shipments to the US and wage ``economic war'' in retaliation for Exxon Mobil's bid to freeze Venezuelan state oil company assets. The oil industry is currently littered with supply side issues, of which this is merely the latest.

And what about precious metals? Well, they've been the best performers of all, trading at their highest levels since 1980.

The price of gold continues to hover not far below its all-time high reached last month in London of US$920 per ounce, while silver's rally has taken it to an all-time high this week of around US$17.50 per ounce. Gold and silver are up 11% and 17% respectively so far during 2008.

And let's not forget the other precious metal, platinum, which has soared to a record above US$2,000 per ounce last week, due to fears of big supply problems in South Africa. Anglo Platinum, the world's biggest producer of the metal, said this week that it expects its output will decline for a second straight year, due to mining disruptions caused by fatalities and power supply problems.

South Africa supplies around 75% of the world's platinum and the nation's state-owned energy supplier, Eskom, has told major customers it won't have sufficient capacity to guarantee adequate power until 2013. We believe therefore there are big question marks having over the viability of the South African mining industry over the next few years, which has to be hugely supportive of metal prices.

Finally, let's turn our attention to the bulk commodities, iron ore and coal, where prices are right now at all-time highs.

Thermal coal prices have risen to fresh records for a third straight week, as snowstorms in China have cut exports, adding to supply disruptions in Australia and South Africa. Power-station coal prices at the port of Newcastle on Australia's eastern seaboard rose by almost 8% last week to an astonishing US$125.48 a metric ton, which follows on from their 73% price surge during 2007.

The upward price pressure comes as coal suppliers and buyers are set to begin negotiations on 2008 annual contract prices to take effect from April 1. We forecast that the annual contract price will almost double to around US$100 a ton.

Meanwhile, iron ore price negotiations have kicked off with Chinese and Japanese steel producers, with the possibility of price hikes of up to 70%. Spot iron ore prices have this year surged up to around US$200 a tonne, which is around four times higher than current contract prices.

So what does all of this evidence tell us?

In our view, such a strong pricing performance across a whole range of commodities (copper, oil, precious metals, coal and iron ore), clearly indicates healthy demand and worrying supply side pressures. All this at a time when the world economy is supposed to be faltering. The current resources bull market is therefore a long way from over in our view.

Remember, LME inventory levels for most base metals still only represent a week or two's supply at most. This is a perilously small cushion. Historically, inventories have been measured in terms of weeks, or even months' worth of supply!

Therefore, whilst there is a lot of red ink throughout the resource sector at the present time, we believe this is more reflective of investor nervousness rather than any fundamental structural weakness. Commodity prices and inventory levels paint a very encouraging picture indeed.

We therefore remain entirely comfortable with the outlook for the resources sector and encourage Members to remain patient and maintain strong resource exposure in their portfolios.