Commodities: Long/Short

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With ten-year Treasury rates spiking fast and stock prices moving down, it's remarkable to see how resilient commodity prices have been during the past few weeks. Here I make a supply and demand analysis of three popular commodities. Whether you have them in your portfolio or not, you may want to take a look at what has been happening in this markets. Here I will also offer some ideas to play those demand/supply dynamics. 

Crude oil: Stability on the horizon
The outlook: Oil prices remain remarkably resilient given the bearish consensus and a highly uncertain world. As a matter of fact, I do not see a strong enough shift in the fundamentals to knock prices out of their their quarterly average range. Nevertheless, rising risks to emerging market economies (China and Brazil are growing at slower rates), which are the engines driving oil demand growth, mean that oil consumption shouldn't rise by more than 1% in the second half of the year. That said, price support keeps coming from the supply side. Production outside the US is still underperforming, while flows from sovereign producers remain well below expectations.
The suggested trade: When prices remain flat the correct strategy is selling out of the money call options. Hence, I would suggest selling October 2013 United States Oil (NYSEMKT: USO) call options. Since the ETF that reflects the price movements of light-sweet crude oil trades at around $33 (1x NAV), I would sell calls with a strike of $35 since they offer a great 3.5% premium (+$1.10 per contract).
North American gas: rising expectations
Not only do I expect the US natural gas supply to remain abundant, I also expect production of US dry-gas to keep on growing. Nevertheless, I think price momentum is building, essentially since an unusually long winter created a deep inventory deficit compared to the 5-year norms.
I would expect second half 2013 prices to average $4.20 per million thermal units (MMBtu) against today's $3.67 per MMBtu. This 14% upside potential could be realized on the basis that lower storage levels will require higher gas prices relative to coal to adequately loosen the summer supply/demand balances.
That said, I would also expect prices to go down to $4 per MMBtu in 2014, as supply grows thanks to new processing plants. Besides, the second wave of the Marcellus pipeline at the end of 2013 should also put some pressure on prices.
The suggested trade: Go long United States Natural Gas ETF (NYSEMKT: UNG), which is designed to follow the movements of the price of natural gas as delivered at the Henry Hub, Louisiana. The ETF, which trades at a 5.5% discount to NAV and has a 0.60% expense ratio, is a good way to go long on short- and medium-term natural gas prices. I would buy it now having in mind a price target of $22.5.
Iron ore: Near-term downward revision
Reasons to go short: As expected by everyone in the market, a huge supply of iron ore is coming to the market in 2014. All miners - Rio Tinto, FMG, BHP Billiton and Vale (NYSE: VALE) - are poised to deliver significant volume growth over the next year and a half. On top of this, China’s steel production is likely to slow in the second half of the year as credit, construction and infrastructure cycles all appear to be turning down.
Reasons to go long: Everyone is expecting supply to go up and demand to go down so a lot of those dynamics are already embedded into current prices. From the second quarter of next year, iron ore should head back towards $95 to $100 per tonne and stabilize around those levels.
The suggested trade: Buy Vale. The Brazilian mining giant is trading at a very cheap level (even when taking into account the current iron ore price dynamics). Moreover, the depreciation of the Brazilian currency (the real, which is down by 8% year-to-date) should defend the company's profitability level since the company has most of its costs denominated in the local currency and its revenues entirely denominated in US dollars. Trading at 2013 6.2 times P/E, 4.8 times EV/EBITDA and paying a 3% cash dividend yield I think its moment to buy into this iron ore champion.
Bottom line
The commodity market is adjusting to a new world: higher interest rates, somewhat higher growth in developed markets (the US and Japan) and lower growth in emerging economies. That said, every commodity should be treated differently and, as I depicted above, the market always offers opportunities. You just need to keep your eyes wide open! 

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Federico Zaldua has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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