Renewed bullishness within global markets amid hopes of a sustained China-led turnround in the global economy has seen commodity indices reach seven month highs, with the S&P GSCI spot commodities index (the asset class benchmark) up almost 30 percent this year. Due largely to improving investor optimism over price gains and rising inflation as the world economy progressively improves, a Barclays Capital report suggests that institutional investors, sovereign wealth funds and asset managers are heading towards an overweight position on commodities.

Adding to this momentum, a weaker US$ (the benchmark currency for raw materials) has also helped nudge commodities prices higher on the back of greater affordability for non-US consumers. Since early March base metals, including copper, nickel, and aluminum have risen 36 per cent, 48 per cent and 11 per cent respectively. And on the energy front, West Texas Intermediate crude oil, the US benchmark, rose to a seven-month high of $68.58/barrel, more than double this year’s low of $32.70/barrel back in mid-February. Growing investor appetite for risk – which is forcing investors out cash – also saw gold reach a near three-month high above $US980/ounce.

But while the worst might be over for commodities generally – especially since its March lows – the delicate nature of this rally has investors rightfully questioning: Which commodities will run hardest this year? What’s on the horizon to sustain such a sharp uptrend? And where should investments be placed in the mining sector to generate the best returns?

According to Citibank’s Justin O’Brien there are a couple of emerging themes that provide clues as to what commodities and stocks will benefit – notably, an expectant recovery in China, plus a u-shaped revival in the US economy in the second half of 2009. Based on this outlook, O’Brien, like many brokers, favours the fortunes of copper. A lead indicator of any housing recovery, copper has already experienced a recent rally to around US$2.28, having reached US$3.88 12 months ago.

Efforts to replenish stockpiles for its 4 trillion yuan ($750 billion) stimulus saw China increase imports of copper, aluminum and iron ore to record levels in April. Demand for pipes and wires saw copper futures in London jump 52 percent this year. And some analysts, like Macquarie Group’s Jim Lennon are questioning whether new supplies will even meet the estimated additional 4 million metric tons of demand by 2013.

As the most supply-constrained of the base metals, rival broker Goldman Sachs JBWere also rates copper its preferred commodity for investment exposure. Describing the rate of copper and iron ore imports into China as nothing short of extraordinary, the broker expects demand for raw materials, and commodities prices to be better in both 12 months and 24 months time than they are now.

Like Goldman’s, ABN Amro Morgans also favours Equinox Minerals (EQN), and PanAust (PNA) as copper ‘pure-plays’ – both of which have significantly strengthened their balance sheets earlier this year. But given the balance sheet and management issues confronting many other ‘pure-play’ stocks, O’Brien says more risk adverse investors might be better off taking their exposure through either BHP Billiton (BHP), which has 13 percent of its earnings in copper, or other diversified miners like RIO Tinto (RIO) or even Oz Minerals (OZL) – which is selling most of its gold and base metals assets to China Minmetals.

Despite large falls in spot and contract prices, Goldman’s also favours coal and iron ore with Chinese imports of both up by more than previously forecast this year; Chinese steel companies purchased record amounts of iron ore on the spot market in March and April (at 52 & 57 million tonnes respectively). Based on this outlook, Goldman’s also favours coal stocks, Felix Resources (FLX), and Whitehaven Coal (WHC).

Given the high probability that oil pricing will be sustained well above what the market is currently factoring into share prices (sub $50/barrel), Chris Brown analyst with ABN Amro Morgans has a strong outlook on oil stocks, notably Woodside (WPL), Oil Search (OSH) and Santos (STO). While most analysts expect oil to pull back from current levels (circa $70/barrel) the longer-term outlook is encouraging with Goldman’s and Wilson HTM forecasting longer-term prices of $80/barrel or above. Based on this long-term outlook, John Young analyst with Wilson HTM also expects the fundamentals to remain particularly strong for oil stocks like Santos, Woodside and Origin Energy (ORG).

With gas becoming increasingly linked to the oil price, Young also favours the long-term upside of stocks wired to the coal-seam gas (CSG) story, which local firms have already demonstrated their ability to produce at low cost. “Based on necessary bedding down of buyers, production and infrastructure, the first production from large-scale (LNG) plants is expected in 2014,” says Young.

Despite recent share price gains, he says there’s still significant upside for the largest pure CSG company in Australia, Arrow Energy (AOE), plus juniors like Bow Energy (BOW) and Molopo Australia (MPO) – which on a 12 month target he values at $5.40, $1.75 and $2.20 respectively.

As an explorer, he expects to see upgrades to Bow Energy’s reserve position leading to a re-rating in the stock. And as a fellow believer in the CSG gas story, ABN Amro Morgan’s Brown also likes the upside of NSW-based Eastern Star Gas (ESG) which unlike its Queensland counterparts has to move supply into the domestic market rather than use feedstock for an LNG plant.

Given that the bullish price outlook will continue to make gold a safe-haven for investors, Goldman’s has buy recommendations on BHP, Newcrest (NCM), Dominion Mining (DOM), Sino Gold Mining (SGX) and PanAust. While O’Brien also likes the gold story, he says investors need to question their appetite for pure-plays, notably Newcrest, over a diversified player, like BHP which alone comprises 14.57 per cent of the entire ASX 200.

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