The oil price is stubborn, like a two-year-old who refuses to eat his mashed peas. Despite all evidence that the market is well supplied, oil is over $70 a barrel again as I write. Taking the view out to the horizon, though, I think it will go higher and will drag the price of most commodities higher in its wake.

Part of the reason for the rise is weakness in the dollar. People often say that oil is denominated in dollars. But maybe it is the other way around; dollars are denominated in oil. A dollar is worth how much oil it can buy. Part of oil’s rise is simply marking down the value of the dollar. Weak dollar means higher oil prices.

People will blame the higher oil price on speculators, but something interesting is happening in the markets for minor metals like molybdenum. Prices are rising, too. The silvery metal, used to strengthen steel, is now $15 a pound — nearly double the $8 and change it fetched in April. This is significant, because there is no futures exchange for moly. It trades on a physical spot market. Speculators play a very small role here. The buyers of the metal use the metal.

So there is a demand story shaping up here, too, mostly focusing on a fragile recovery of some sort and mostly centered on China and the emerging markets. The market is looking ahead.

For instance, over the weekend, South Korea reported numbers that show signs of a recovery in that country. Industrial output fell less than expected, and trade volume surged to $60 billion. That was its best showing since last October. Also, South Korean companies have been reporting better-than-expected results.

The biggest buyer of South Korean goods is China. Still, it’s a confusing time because of all the stimulus money that governments around the world have been spending. So it’s hard to say what’s real and what’s just an illusion created by a temporary spending binge.

Another piece of the puzzle from last week: Spot iron prices in China (meaning iron ore for immediate delivery) topped $100 per ton. That’s the highest level since October 2008. The other breakthrough in iron ore last week came when BHP Billiton, the world’s largest miner, announced that a third of its customers were moving to prices linked to the spot market.

This is big news for the industry. The old way was to have annual contracts with a negotiated price. This was bad for iron ore companies because the contracted price lagged the increase in iron ore prices. And when iron ore prices fell, steelmakers just reneged on their contracts. As the iron companies found out, having contracts was a great way for iron ore producers to cap their upside and leave them with all the downside. Not so good.

The industry now looks like it is moving toward more spot pricing, which is a good thing for the producers. Iron ore prices have rallied too, along with crude oil and moly.

Every rally, like every bottle of beer, has a finite life span. There will be lots of bumps along the way, but the prices of many commodities — such as oil, iron ore and moly — will tack higher, in my view. Intelligent small-cap investors would be wise to pick up shares of their favorite companies in these sectors.

Sincerely,
Chris Mayer

August 4, 2009

Chris Mayer

Chris Mayer is managing editor of the Capital and Crisis and Mayer’s Special Situations newsletters. He also is a contributor to the Daily Reckoning. Graduating magna cum laude with a degree in finance and an MBA from the University of Maryland, he began his business career as a corporate banker. Mayer left the banking industry after ten years and signed on with Agora Financial. His book, Invest Like a Dealmaker, Secrets of a Former Banking Insider, documents his ability to analyze macro issues and micro investment opportunities to produce an exceptional long-term track record of winning ideas.

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