By Martin Hutchinson
Contributing Editor
Money Morning

In a Money Morning column last December, I predicted that “commodities may be due for a recovery in 2009.” It’s always nice to be right, but I have to say the move in some commodities has surprised me. Just look at the performance figures for the 12-month period that ended in mid-November.

When it comes to commodities, most of 2010 will be a reasonably close repeat of 2009. You may think that sounds dull – until you look at the accompanying chart (see chart below) and realize just how much more there is to go.

Although the rally started at an admittedly low point in January, by mid-November it was very clear that commodities were once again in a major bull market. A few commodities have been left out – coal, natural gas and many foodstuffs have experienced lackluster performance – but many of the others (such as the metals, in particular) have had an exceptional year.

Three Factors That Will Drive Prices

The reasons for this aren’t hard to find. Three catalysts in particular figure to keep commodities on their upward trajectory.

First, the U.S. Federal Reserve has kept short-term interest rates close to zero all year, and other central banks around the world have pursued similar policies. Even countries that haven’t had significant recessions – such as China – have pursued exceptionally expansionary monetary policies: China’s M2 money supply was up 29.4% in the 12 months through October, far above the country’s economic growth rate for that period.

All that money had to go somewhere. It hasn’t gone into housing – the global housing markets are still bombed out after their earlier excesses. It hasn’t gone much into stocks – they have had a very nice rally, but are still well off their all-time highs.

Instead, all the stimulus money has gone into commodities.

Second, while the rest of the world has been mired in recession, China has had a pretty good year, and so has India. In the third quarter, China’s gross domestic product (GDP) increased 9.5% over the previous year, and India is expected to post a rise of at least 6%. That has caused soaring demand for raw materials, because lifting the 2.5 billion inhabitants of those countries out of poverty generally requires lots of goods you can drop on your foot.

With sales of 11 million cars and light trucks, China leapfrogged the United States this year to become the world’s largest automobile market. China and India show no sign of dropping back into recession. Far from it, in fact.

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This escalation in demand is likely to continue. And that will put added pressure on global raw materials supplies. In general, we have plenty of commodities, but opening up new production takes lots of time and money, so rapid demand growth pushes up materials prices.

Third, and last, hedge funds and other speculative investors are piling into commodities. What’s more, they are buying not just futures, but physical commodities. The supply of most commodities is a small fraction of the volume of hedge funds outstanding, meaning that prices could shift quite sharply as supply disruptions occur.

Don’t forget: While a hedge fund buying commodity futures eventually has to roll its position over into the next fund, a hedge fund buying a tanker full of oil or a freighter full of copper ore is tying up part of even higher prices.

Commodities to Play For Maximum Profit

In virtually any market, in terms of which commodities to go for, there are two key factors to consider: genuine industrial demand and speculator interest.

Given current economic backdrop, a third factor must be considered: How quickly can new supplies be brought on stream?

For some commodities – chiefly gold and oil – ramping up on new supplies is a difficult and lengthy process. Gold production has declined by about 2% in the last few years, in spite of rising prices, and most gold ores are in low concentrations – hence ramping up production is very difficult, whatever the price. The same is more or less true for oil, with the added challenge that many of the best potential fields are in countries run by tinpot dictators, who get greedy when the prices rise, and try to push them up further.

At the other extreme, agricultural commodities are unlikely to see much of a bubble – it’s just too easy to farm more land or use better seeds. Price run-ups in agricultural commodities tend to be short-term, caused by bad harvests.

Coal has some upside potential, as does natural gas (to a lesser extent). There is unlikely to be much speculative demand for them, but increasing supply is difficult and demand from China and India is increasing fast.

On balance, the metals are the best bets for upside, together with oil.

U.S. Federal Reserve Chairman Ben Bernanke has said he will keep interest rates around zero “for an extended period.” This fits with his record, which has been consistently to have the lowest interest rates possible while prattling incessantly about non-existent deflation.

With interest rates, the bottom line is that Bernanke is likely to keep them at a low level for far longer than he should. When he eventually does start to raise them, he’ll do so only grudgingly, at first, even as inflation races away. That has to be good for the commodities market.

At some point, this will all reverse. The world’s central bankers will get serious about interest rates, and commodities prices will crash as they did last autumn. However, because the world economy is just staggering out of a deep recession, that’s unlikely to happen before the second half of 2010, and maybe not before the early months of 2011.

So, for at least the first half of the new year, commodities and commodity-related stocks look to provide excellent returns. I’d recommend that individual investors look at the major mining companies involved in metals production, as well as those that mine coal.