Mining is an expensive business. So if commodities prices fall sharply many mines are forced to close rather than operate at a loss. When this happens supply tightens and prices begin to recover. Chris Mayer says there are signs this is happening now… and a rally in mining stocks is on its way.

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The old-timers of commodity investing like to say the best time to buy commodity companies is when the industry is losing money. The old-timers have scar tissue to prove it. The idea is that miners will start to cut back on production, which gradually leads to a recovery in prices, profits and, ultimately, stock prices.

Such times come around every so often, as when the cost to produce nickel rises above the price at which you can sell nickel. Even the slow wits of the business see that you can’t make that up in volume. To keep digging under such prices is like digging your own financial grave.

So they shake their heads, lick the ends of their pencils and recheck the math. Then they order the mining to stop.

And so we see that nickel prices are down 30% this year and down 60% from mid-2007 highs. All the while, mining costs are rising. So Xstrata says it will shut down its 30,000-metric-ton nickel operation in the Dominican Republic. Russia’s Industrial Metallurgical Holding shuts down 30% of its nickel capacity. BHP Billiton (NYSE:BHP)’s  big Ravensthorpe mine, once a potential big moneymaker, looks as if it might never make any money. The industry shelves expansion projects. And new mines that looked promising suddenly look less so.

It’s not just the nickel industry that suddenly bleeds red ink. Zinc prices are also down more than 60% from their highs. OZ Minerals, one of the largest suppliers of zinc, reported a first-half loss last week in its zinc business.

In fact, it’s been a brutally tough summer all around in commodity land. Through June, commodities were sitting pretty. The first six months of 2008 were the best in 35 years, according to The Economist . In July, it was giveback time, and commodities posted their worst month in 10 years. The carnage has continued into August and September.

Commodity stock prices have fallen even further, as investors in the sector know too well. Many stocks have not merely stumbled, they’ve collapsed altogether.

But if you can’t buy commodity stocks now, you may never be able to pull the trigger.

The long-term thesis behind the names seems firmly in place. It has a lot to do with China and India and the rest of the emerging market crowd — but especially China.

For example, China represents almost all of the new growth in copper demand. Across the commodity spectrum, what happens in China makes big waves across the globe.

So far, industry has met that demand, which is why prices have been dropping. But challenges remain on the supply side — declines in the quality of mining seams, shortages of equipment and skilled people, power shortages and bottlenecks in distribution.

The conclusion of all this is not particularly novel, but sometimes forgotten. The fate of the commodity investors hinges largely on those rapidly growing emerging markets. China is the lead pony, though, and the main one to watch.

Stocks in the commodity sector might continue sliding for a while longer, but even so, long-term investors might want to consider dipping a non-essential digit into the water.

Source: Did You Notice – Buy When There’s Blood in the Mine