“Despite all the advances and promises of the 21st century, we still need those basics,” says Chris Mayer in The Daily Reckoning.

This is worth keeping in mind as commodities prices continue to slide. Just look at oil. Earlier this year, the black goo was touching $150 a barrel. Today, the same barrel of the same stuff is down near $100.

Chris says that, despite oil’s precipitous slide, its long-term prospects are good. Two factors support this bullish outlook. Firstly, demand is surging in China and India. Secondly, this demand has eaten away difficult-to-replace reserves.

We’ve always needed them, but there is new urgency to the quest. The motor for that demand is a sort of second Industrial Revolution, in China and India, in particular. But it’s a revolution that broadens out to many emerging markets. The analogy is not lost on certain investors.

Jeremy Grantham heads up GMO, a respected money manager. Grantham has been largely spot on in the big-picture sense of staying bearish on stocks for the last eight years or so. He is bullish long term on commodities. In his latest quarterly letter, Grantham makes some good points about the future of commodities and emerging markets.

His conclusion first: ‘In the short term, slowing world economic growth combines with credit, currency and inflation problems dominate the outlook and offer poor prospects for emerging markets and commodities. Longer term, the reverse is true, and they look like the assets to own.’

It is mostly the long term (looking out a couple of years) that interests me, although I obviously don’t aim to step into any immediate problems if I can help it.

Longer-term backing for commodities demand comes from two sources, Grantham says:

‘The first is that if enough people enter economic take-off at approximately the same time, as 2.3 billion Chinese and Indians have now done, then the pressure on resources might happen to increase marginal costs slightly faster than technology could offset them.’

This has already happened. It’s why the price of oil, for example, is so much higher than historical averages. All that demand hits very quickly, but it takes time to bring new supply to market. In the interim, higher prices result.

This seems well-known already. Most investors realize that behind the commodities boom stands surging demand from countries such as China – former ‘runts’ now muscling in on the global dinner table.

The second reason is more interesting. Grantham believes that the global growth spurt has come at the expense of eating away at some hard-to-replace resources:

‘Underground water resources that currently sustain some of our most productive land but, like a metronome, tick off a reduction of several feet each year; rain-fed waters that, although renewable, are finite and already so overused that previously valuable lakes retreat to sometimes disastrous local effects and river volumes, once seemingly limitless, are now fought over; subsoil, which took thousands of years to form, is depleted through casual use (in the Midwest, for every bushel of wheat produced, it is said that a bushel of subsoil is lost.

Our farmers are in the mining business! Yes, the soil is incredibly deep, but it is still finite); high-grade mineral ores are fully developed, the very best are long gone and all are irreplaceable; previously fertile land has often been overgrazed and turned into desert.’

At Mayer’s Special Situations, we’ve been on the water beat since this publication began in summer 2006. We’ve also watched the agricultural boom unfold, and we’ve picked up nice profits along the way. We are, in fact, still invested in these ideas.

Along with these ideas, oil, natural gas and base metals all have become more difficult and expensive to produce. Recently, we’ve had to sit through a pretty tough correction on the commodity names. Stocks in these sectors have sold off in a big way this summer, as I’ve noted. Based purely on fundamentals, though, these stocks haven’t looked this cheap in years.

But short term, such drawdowns are common on the way to eventual higher prices. Grantham, too, says as much:

‘The prices of commodities are likely to crack short term, but this will be just a tease. In the next decades, the prices of all future raw materials will be priced as just what they are: irreplaceable. Oil, for example, will never again be priced on the marginal cost of pumping a marginal barrel from some giant Saudi oil field, as has been the practice for most of the last 100 years of oil production. Real cost is always replacement cost, and oil, a precious feedstock for chemicals and fertilizers, simply cannot be replaced.’

I don’t take as hard a plumb line as old Grantham does. I believe there is, even now, lots of room for innovation and replacement. Oil, for example, is replaceable in a broad sense. We can get energy from a broad array of sources. But it’s not an easy or painless transition.

Slowing economic growth is the bigger issue. That’s problematic for most commodities, short term. The market, though, is probably punishing the commodity companies too severely. That creates some interesting opportunities.

You can more easily pick up stocks trading for discounts to readily ascertainable net asset values now than anytime in the last five years, in my view. It doesn’t mean making money in commodities is a lock or that it will be easy. Lots can go wrong with individual companies, and the drawdowns will probably be more than most investors can stomach. But longer term, looking out a few years, I think an investor will be happy with the portfolio assembled in the doubtful summer days of 2008.

Source: Investing in the Age of Scarcity