As we pointed out last week (see VRI, July 17, 2008, The Switch), the ongoing big money trade is out of previously red-hot raw materials. The selling seemed to begin as simple profit taking of the explosive gains recorded earlier this year. But it’s accelerated in the past several days on further worries about the US economy and the potential for further decreases in demand and falling prices.

Ironically, a good chunk of that cash has found its way into extremely battered banks and financials. This group has been hit hard over the past year by economic worries. On the whole, they’ve been reporting poor second quarter earnings. The key is the results haven’t been as bad as many feared. The stocks have also been supported by US government statements and actions to ease tough conditions currently facing our economy.

How long this trade will last is anyone’s guess. We saw a similar move earlier this year that also triggered a considerable pullback in vital resource stocks and was reversed rather quickly in subsequent weeks. That remains our expectation this time around as well.

First, although the US is definitely using less copper and other resources, there’s still no hard data to indicate our malaise has spread to developing Asia. For example, China reported economic growth of more than 10 percent for its most recent period. Meanwhile, Asian stock markets appear to be rallying, in part because of subdued inflationary pressures. Lower inflation means more room to grow, and the recent drop in oil prices will only help on that score.

Unless Asian demand really drops off a cliff, demand will remain robust for a wide range of commodities. Keep in mind that China now consumes more than twice as much copper per year as the US. Every 1 percent rise in Chinese demand has the same impact on global demand as a 2 percent decrease in US demand. And the Asian giant has literally no choice but to keep using more of the red metal as it accommodates the ongoing influx of millions of people to already-stretched cities.

The other side of the equation is supply. Copper market psychology is now squarely focused on the US economy and the impact a prolonged recession would have demand for the red metal in auto manufacturing and home building. As a result, copper prices actually fell this week, despite the announcement that output from the world’s biggest copper mine–Chile’s Escondida–will drop 10 to 15 percent this year.

Escondida’s fate is basically a metaphor for production of wide range of resources, particularly in areas the world now heavily depends upon. According to the mine’s majority owner BHP Billiton (NYSE: BHP), the loss of output is due chiefly to lower ore grades, a problem increasingly encountered by older mines globally. For example, the world’s largest copper producer, Chile’s Codelco, now expects a 4.2 drop in its overall 2008 output, and its CEO doesn’t expect production to return to 2007 levels until 2010.

The sliding production of established mines is the main reason companies have increasingly had to go further and deeper just to keep up with existing demand (see VRI, July 10, 2008, Focus on Supply). That’s a problem that won’t disappear without huge new investment, which would undoubtedly slow because of any prolonged downturn in prices and is already suffering from rising costs and emerging resource nationalism.

It may be days, weeks or even months before the market impact of supply challenges start to trump threats to demand. But it’s inevitable that they will eventually. And when they do, prices will return to the upside in earnest.

Vital resource stocks react far more violently to these macro factors by nature than prices of actual commodities themselves. Over the past several weeks, we’ve seen what would amount to mini-bulls and bears in any market play out again and again with VRI Portfolio stocks seemingly daily. And the action has been wilder still with less solid sector bets. 

Unfortunately, that looks like it will be the case for the near future, and none of our recommendations are likely to be immune from the volatility. Earlier this year, we recommended taking money off the table in some of our positions that had run up substantially, either holding the cash or shifting to other positions.

That hasn’t spared us from this pullback by any stretch. But that was a prudent move nonetheless. Last week’s simultaneous buy recommendation for Monsanto (NYSE: MON) and sell recommendation for Syngenta (NYSE: SYT) has already paid dividends. Heavily bid-up Syngenta has pulled back, while undervalued Monsanto has actually ticked up slightly.

With the ongoing pullback, similar profit-taking opportunities are harder to come by. But we’ll continue to look for them. Meanwhile, our strategy is to stick with–and even add to–strong positions in our targeted vital resource industries–precious metals, industrial metals, agriculturals/water and raw materials–and ride out the ups and downs.

There is one company in the VRI Portfolio we’ve become very concerned about: Russia’s dominant steelmaker Mechel (NYSE: MTL). This stock has been one of our biggest winners since we first added it Oct. 18, 2007. The primary reason has been its ability to control costs and ride robust demand for steel in Russia and the emerging economies of Eastern Europe.

That formula still appears to be working rather well. The company’s ability to provide most, if not all, of its iron ore, metallurgical coal and electricity needs has dramatically improved its cost position versus other global manufacturers over the past year. Unfortunately, its success may now be attracting too much attention, particularly from the Russian government.

Specifically, last week Russia’s Federal Anti-Monopoly Service (FAS) opened an inquiry into price-rigging and other anti-trust violations by Mechel’s coal division. The seriousness of the matter was underscored this week, as Prime Minister Vladimir Putin said in a conference that prosecutors should “pay special attention to the company, which sold commodities abroad at prices twice as low as domestic and global ones in the first quarter of 2008.”

The result: A dramatic drop in the company’s shares, punctuated by a 30 percent drop in value today alone during trading in New York. The stock is now trading back in the mid-20s, or basically the point at which we jumped in last October.

Mechel is Russia’s leading specialty steelmaker and one of the leading producers of coking coal in the world. It’s been one of our favorite VRI steel plays, especially because it offers great leverage in the sector. As we’ve noted in previous issues, the biggest positive for the company is its coal and iron assets that allow for a vertically integrated setup in which Mechel can supply 80 percent of its raw material needs.

That said, a lot of these coal assets have been purchased by the company under the government’s watchful eye. The upshot: Igor Zyuzin, Mechel’s main shareholder, has been aware that the company could be required to sell some of its steel assets in order to concentrate on developing its coal, nickel and iron divisions for at least the past year.

This, according to well-informed people in Moscow, was the deal that Zyuzin agreed to when he gained access to some coal deposits last year, beating out rival bidders such as Arcelor Mittal (NYSE: MT). Furthermore, management has been planning for separate stock listing of its coal and iron ore divisions. A preferred share offer was also planned but was postponed for later this summer.

In another twist, Zyuzin recently bought an additional percent of the company on the open market, taking its share past the 70-percent mark. Allegedly, he wasn’t in attendance at the meeting when Putin delivered his critical comments, though he was invited, according to local sources. We haven’t been able to verify these sources. But if the story holds true, it adds another troubling element to the story.

Putin has significantly helped the country’s metallurgical industry during his presidency, Mechel in particular. Zyuzin focused more on coal before 2001 and was actually dubbed “The King of Coal” after last year’s deal. Glencore, the outfit behind portfolio holding Xstrata (OTC: XSRAF), sold a controlling interest in Mechel to Zyuzin’s Yuzhny Kuzbass Group.

The stock is currently trading on the fear that Putin is out to destroy Zyuzin and, by extension, Mechel. As the destruction of former oil giant Yukos shows, there’s little doubt this could happen, particularly if there’s been a real falling out between Zyuzin and Putin.

The truth behind these speculations remains unknown. We’re inclined to wait and see for now. All of Russia’s big businessmen are deeply involved with the state, and that definitely includes Zyuzin. As a result, the state holds a lot of evidence regarding the deals they’ve acquisitioned over the years, which aren’t always virtuous. It would be a relatively easy matter to bring down Zyuzin, or anyone else, on some sort of corruption charge, if that was the state’s intent.

The vulnerability to resource nationalism is one reason we’ve recommended taking profits from Mechel several times in the past. In fact, even without the intrigue, it’s a leveraged and volatile steel play. The big drop in the stock price over the past week is fairly clear evidence few expected the government’s move against it. And we didn’t foresee it either because Mechel has long been a well-connected Russian company.

Of course, that’s history. And the question is, what do we do now? At this point, our advice is to retain the company in the portfolio and wait for more details on the case. The market is obviously pricing in a lot of bad news now, though the shares can certainly give up more ground if things turn really ugly.

On the other hand, if this proves to be only a temporary rift between the company and the government, this stock will be off to the races again, and the ongoing drop will prove a great buying opportunity into a company that holds an array of stellar assets.

Mechel was never for the risk averse, and these events certainly up the ante considerably. Bottom line: Sell Mechel if it’s one of only a few you own, but hold it for now if it’s part of a larger, well-diversified portfolio.