One step forward, one back, and a whole lot of volatility in between: That pretty much sums up this week’s action in commodities and our favorite companies that produce them.

That prices are the lowest they’ve been in several years isn’t in dispute. Nor is the fact that Asia needs ever-greater quantities of raw materials to develop its economies, or that adequate supplies are increasingly difficult to obtain. Rather, what’s ruling the market are two great unknowns. That’s how much the global economy is going to slow in the next few months, and how far demand will slide before it starts growing again.

The good news here in early November is the flood of liquidity unleashed in the markets by global monetary authorities and governments seems to be doing its job. The London Interbank Offered Rate (LIBOR) has moderated dramatically, hitting the 2.5 percent range the past few days. That’s still well above the Federal Reserve’s target of 1 percent, but it’s already been enough to unfreeze at least some lending.

The bad news is the liquidity crisis has already done some major damage to the broad economy that will take a while to recover from. This week, the Institute for Supply Management announced its index of service sector purchasing managers spending plunged to 44.4 for October. That was well below September’s reading of 50.2 and the consensus estimate of 47.5, as well as the 50 level considered the harbinger of an economic contraction.

That said, value continues to be present in the vital resource sector, although during periods of wholesale selloffs this doesn’t matter very much. 

Nevertheless, shares of Freeport McMoRan Copper & Gold (NYSE: FCX) have fallen to the price they last held when copper was a full one-third cheaper than it is today. The stock now trades at barely four times trailing earnings and 7.8 percent of book value. Rio Tinto (NYSE: RTP) sells for barely five times trailing 12-month earnings. Potash (NYSE: POT) trades at one-third its 52-week high and just nine times earnings, despite an expectation-smashing five-fold jump in third quarter profits and management’s expectation that supplies will remain tight into 2009.

Our developing world plays are even cheaper. Russian integrated steel/coal/iron ore play Mechel (NYSE: MTL) sells for just 1.5 times expected 2009 earnings. And other stocks sell for barely the value of the cash they hold.

If the global economy does weaken markedly from here, commodity producer earnings will surely weaken from this year’s levels. But with little debt, a lot of cash and a lock on resources the world needs, only a total economic meltdown on the scale of the Great Depression of the 1930s would come close to justifying producers’ current valuations.

At the height of the global financial panic last month, a new depression certainly seemed possible. But with the money pouring into the system and apparently loosening credit conditions, it’s a whole lot less likely today, and becoming less still by the day. In fact, it’s far more likely that this unprecedented degree of stimulus will eventually trigger the precise opposition of a deflationary depression. That is a lot more inflation, a much lower US dollar and ultimately much higher commodity prices.

As we’ve stated here many times, our strategy in this advisory is not to bet on such macro disasters. Rather, it’s to take positions in stocks of strong producers to take advantage of two long-term trends: rising demand in the developing world and increasingly tight supplies.

With investors focused on global recession and lower demand, few are noticing that securing supplies is increasingly expensive, unreliable and politically dangerous. And although the bottlenecks aren’t really affecting prices now, it’s pretty clear they will when the global economy stabilizes.

That’s what we’re playing for here. And the best way to take advantage is to take positions incrementally in the best resource stocks. As long as market psychology remains so emotionally stretched and volatile, this is certain to be a frustrating exercise. The past couple weeks, for example, we’ve seen day after day of extreme volatility, sometimes pushing our stocks higher, sometimes lower.

That’s the price of bottom-fishing, as we’re doing now. The silver lining is this state of affairs can only last so long. And as long as the world does avoid a downturn along the lines of the Great Depression, there’s only one way it can resolve itself: With a very strong and sustained rally in well-placed resource stocks.

This week, we again point out our favorite buys for new positions. If you already own them, stick with them, even if you bought in at higher prices. When this thing turns, it’s going to happen quickly. And this is the time to establish and hold positions in the best plays, which are clearly already discounting the worst.

Please note that sometimes we recommend a stock we like but won’t add it to the Portfolio right away. Usually we’re waiting for a better entry point. If the recommendation is to buy, you can scale into it, but more money should be committed to a stock once it actually makes to the Portfolio.

A recent example is Nucor (NYSE: NUE), which we recommended last week but didn’t add to the Portfolio. Steel demand remains weak at the moment, and market participants are busy downgrading demand and supply numbers. We will be adding the stock soon, and we may do that in between issues through a Flash Alert; stay tuned.

Also, China Molybdenum (Hong Kong: 3993, OTC: CMCLF) has rallied significantly–it’s up 40 percent from its lows–and readers who did buy it at those low levels can take some profits of the table.

The company is one of the lowest-cost producers in the world, but given weakness in steel and the decline in the price of molybdenum, the stock could face short-term headwinds.

We like the company for the long term, and you could certainly buy during times of weakness. Keep in mind that this is a leverage play in the sector and is therefore more volatile.

Portfolio holding Goldcorp (NYSE: GG) is our favorite major gold company. The acquisition of Glamis Gold in late 2006 vaulted Goldcorp to the forefront of global gold producers. The company now has growing gold production, low cash costs, solid earnings generating ability, large reserves, strong balance sheet and one of the most respected management teams in the industry. In terms of cash position, it has the best of the senior gold producers, sitting on USD454 million.

In the third quarter of 2008, the company reported higher output with higher costs versus year-earlier totals. Specifically, output reached 550,500 ounces at a total cash cost of USD346 per ounce, compared to 524,000 ounces at a cash cost of USD160 per ounce a year earlier. The realized selling price was USD865 per ounce for the quarter. Net earnings increased to USD297.2 million, or 42 cents per share, from USD75.8 million, or 11 cents per share, in the same period last year.

Overall, Goldcorp has been doing an excellent job of controlling costs, and we expect that this will continue in coming quarters. Costs will rise in line with the industry’s norm, but we believe the company will keep a lid on them.

Goldcorp announced a friendly offer of USDD1.5 billion cash and stock in June for Gold Eagle Mines, which owned the Bruce Channel discovery zone–now a Cochenour-Willans mine property–which is located adjacent to Goldcorp’s Red Lake mine. According to industry sources, the mine has a solid gold deposit that will fit in well with Goldcorp’s resource base. The acquisition was completed Sept. 25 after Gold Eagle shareholders approved the deal, upon which Goldcorp paid USD701.3 million in cash and 15.6 million common shares.

Management has calculated a purchase price of less than USD650 per ounce and that the mine has close to 7 million ounces of gold to mine. Development time will be between four and five years.

Elsewhere, the company is on time and on budget with its expansion projects and should increase gold output from 2.4 million ounces this year to 4 million in 2012. Its strong balance sheet will allow for easy project financing, which will add straight to the bottom line. Goldcorp remains a buy at current prices.

Lihir Gold (NYSE: LIHR) controls one of the world’s most important gold properties, on Lihir Island in Papua New Guinea, with reserves of 23 million ounces. Operations upgrades are expected to lift the mine’s gold production from the current 700,000 ounces per year to 1 million from 2011.

The company acquired Ballarat Goldfields in Australia in 2007, and the merger with Australia-based Equigold is expected to take the company’s gold production to above 1.2 million ounces from 2009 onward.

On top of efforts to improve its current operations, management has also been expanding globally. The company has been granted 11 exploration licenses in the Ivory Coast, covering an area of 7,936 square kilometers. Lihir has the option to acquire a 95 percent interest in an additional 11 licenses covering another 7,062 square kilometers.

Lihir has been our speculative recommendation on gold, as it offers considerable leverage to a rising gold price through its large reserve base. But it hasn’t performed as well as we would like, and investors continue to question management’s consistency in delivering results in both its current operations as well as the new growth projects.

That said, quarterly production numbers for the most recent period were quite good; production was up nicely, and expansion plans are progressing on time and on budget. The company is planning on a loan to complete some of its operations-related expansion plans, and should be able to get good terms because of its strong cash flows.

The company’s operating costs are at USD412 per ounce. That’s a little high, mainly because of high energy prices for fuel the company had to secure before the price of oil started coming down. We do expect costs to improve going forward. We continue to recommend Lihir Gold as a speculative play.

Source: Bloomberg