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Fear and Loving of Hot Commodities

Eric Sprott could have told you this was coming. Canada's top fund manager was buying energy stocks long before oil -- and other commodities -- became the hottest investing trend since the technology bubble.

"We like to be early on things," says the chief executive officer of Sprott Asset Management Inc., whose resource-laden Canadian equity fund returned a sizzling 38 per cent last year, earning top spot in its class. The Sprott Energy Fund, launched last year, soared 72 per cent in the six months to Feb. 28.

The world is riding a commodities boom that is shooting prices skyward for everything from crude and copper to soybeans and coffee, and investors who got on board early are making a killing. Driving the rally are demand from China, looming shortages of key raw materials and speculation by hedge funds.

With the benchmark Commodities Research Bureau index zooming to a 24-year high, some are warning of a bubble that could soon burst. But others say the party is just getting started.

"I believe that investing in commodities will represent an enormous opportunity for the next decade or so," says Jim Rogers, a U.S. fund manager and author of the book Hot Commodities.

For investors who think they've missed the train, there's reason to believe the ride may be far from over. Mr. Rogers, co-founder of the Quantum Fund with George Soros, points out that the last big commodities cycle lasted a full 14 years, from 1968 to 1982.

The boom won't be without its bumps, he warns. Look no further than oil, which climbed to $55 (U.S.) a barrel last October only to plunge to less than $41 in December, before beginning its latest uptrend.

No commodity is drawing more attention than crude, which set jaws dropping again this week as it briefly pushed through $57 a barrel. But even as oil hits new highs, investors such as Mr. Sprott are betting on where the big money will go next.

While he remains a huge fan of oil, he's also gambling on coal and uranium, which have already risen sharply in price and could go higher as the world exhausts its finite supply of crude. Plenty of investors appear to share that view.

Mr. Sprott's biggest problem is that investors are handing over cash faster than he can invest it, forcing him to close the Sprott Canadian Equity fund on March 1 -- the second time he has shut the window since last June. Today, the nearly $1-billion (Canadian) fund has 23 per cent of its assets in cash. Its heaviest weighting is in energy stocks, at 37 per cent. Next are gold shares and bullion, at 31 per cent.

Mr. Sprott has been tarred as one of the biggest bears on the Street. And while it's true that he has a pessimistic view of the debt-bloated U.S. economy, the U.S. dollar and stock markets in general -- hence his attraction to gold -- he is wildly bullish about energy.

Two words explain why: Hubbert's Peak. After watching in amazement as crude began to climb sharply several years ago, Mr. Sprott began to study the influential theories of the late Marion King Hubbert, a geophysicist whose 1956 prediction that U.S. oil production would peak and start declining around 1970 was initially dismissed by critics but later proved to be remarkably accurate.

Particularly influential on Mr. Sprott was the book Hubbert's Peak: The Impending World Oil Shortage, by Kenneth Deffeyes, a Princeton University professor and former colleague of Mr. Hubbert's. Taking the theory a step further, the book predicts world oil production will top out this decade, plunging economies into recession as supplies fall and oil prices soar.

"The peak is this year. We're there . . . Most of the evidence shows that," says Mr. Sprott, as he launches into an explanation of why the petroleum age is drawing to a close.

At the root of the shortage thesis is the observation that, in any oil field, production follows a bell-shaped curve, rising sharply as the easy oil is extracted, before hitting a peak and declining as the difficulty of pumping the oil increases.

Oil discoveries follow a similar pattern. Today, the vast majority of the world's oil comes from fields discovered before 1973, most of which are in decline. New discoveries account for just one-quarter of oil produced annually, he says. The emergence of China and India is only going to drive up demand.

An oil shortage is unavoidable, and "everybody's got to get a grip on it," he says.

Others say the Eric Sprotts of the world should get a grip.

"The world isn't running out of petroleum." Merrill Lynch analyst John Herrlin says in a recent note to clients, in which he questions whether crude will hold above $46 (U.S.) a barrel in 2005 and 2006. "The degree of groupthink on higher oil or natural gas prices we've not seen in our careers," he says.

Some analysts are even drawing comparisons with the tech-stock bubble of the late 1990s. In a report this month titled "Energy Domination: Sustainable or Just Another Mania?", Scotia Capital analyst Vincent Delisle warns that the "complacency" among investors in energy shares "could prove harmful."

To illustrate his point, the report features a chart of the S&P/TSX energy index rising steadily from 1999-2005, superimposed over the Nasdaq composite index climbing from 1994 to 2000 -- and then falling off a cliff.

The charts aren't the only similarities between oil and tech. When tech stocks were soaring, pundits were also heralding a new era where the old rules no longer applied. "Traders dubbing the current environment for oil as a new paradigm also serve as an eerie reminder of hype," Mr. Delisle says.

In yet another warning sign, data that should be bearish for crude prices -- such as a recent buildup of oil inventories and signs of softening demand in China -- are being largely ignored by markets, he adds.

Not surprisingly, Mr. Sprott scoffs at comparisons between oil and tech. "I don't think it's a bubble. I think it's a long-term secular problem," he says.

And that problem will usher in sweeping changes as society searches for alternative ways to heat their homes, power their cars and keep factories humming, he says.

Coal and uranium would appear to be unlikely candidates to solve the world's energy woes. Coal, after all, is responsible for most of the world's greenhouse gas emissions. And nuclear power, though cleaner, is plagued by questions about safety, with memories of Chernobyl and Three Mile Island casting a pall over the industry.

But when the world realizes it is running out of oil and gas, people will have little choice but to embrace coal and uranium, which are relatively cheap and abundant, he says. And, unlike solar, hydrogen and wind power, they have proven they are up to the job, despite their many shortcomings.

The demand and supply sides of the uranium equation are both promising. With electricity use in China growing at about 15 per cent a year, the country plans to boost its nuclear generating capacity fivefold by 2020. Western countries are also taking another look at nuclear power to reduce emissions and mitigate rising costs for natural gas to generate electricity.

On the supply side, the world's nuclear facilities consume about 170 million pounds of uranium each year, roughly double what is pulled out of the ground, according to figures from Sprott Asset Management.

"Given the continued proliferation of nuclear power stations, the prospects for uranium producers are good," Malvin Spooner, president of Toronto-based Mavrix Fund Management Inc., writes in his book Resources Rock.

Underscoring the bullish case for uranium, UBS Securities Canada Inc. this week upgraded Canadian uranium giant Cameco Corp. to "buy" from "neutral."

The shares gained $2.90 (Canadian) to $58.20 on the Toronto Stock Exchange yesterday, up from about $20 a year ago.

In keeping with his desire to stay ahead of the curve, Mr. Sprott has already sold his position in Cameco and is adding smaller companies that offer the potential to become "multibaggers."

His Canadian holdings include Strathmore Minerals Corp., UEX Corp. and International Uranium Corp. Foreign companies include Aflease Gold and Uranium Resources Ltd., which trades in South Africa, and Paladin Resources Ltd., which is listed in Australia.

On the coal side, his holdings include Western Canadian Coal Corp., Pine Valley Mining Corp., Fortune Minerals Ltd. and Australia-listed Macarthur Coal Ltd.

Although coal -- which accounts for a majority of China's electricity generation -- is a massive polluter, new technologies show promise for dramatically cutting emissions, Mr. Sprott says. To that end, his funds have invested in KFx Inc., a U.S. company that developed a clean-coal technology.

Mr. Sprott isn't bullish on commodities across the board. He's especially wary of copper and other cyclical metals, which could be sideswiped by a slowdown in the global economy.

"Let's face it, all commodities look pretty hot here," he says. "It's a game that's very rewarding when it's working, and when it decides to shut down it will be brutal."

But if his instincts about energy are right, "we're going to scrape through."

Cover Story

How to profit form the commodities boom

Eric Sprott and other money managers have made huge gains on their bets on commodities, especially in the red-hot energy sector. Is there more money to be made in oil and other energy plays such as coal and uranium?

Coal

+107%

May be a big polluter, but Chinese steel mills and power plants are gobbling it up as fast as it comes out of the ground.

Uranium

+129%

With the long term supply of oil and natural gas in doubt, investors are betting that nuclear power will rush in to fill the void.

Oil

+175%

Soaring demand from the Far East and questions about long term supply have driven crude up more than five fold since it traded at less than $11 in 1998.

Increase in commodity prices since Jan. 1, 2002.

Coal: Future contract on N.Y. Mercantile Exchange.

Uranium: Yellowknife (processed) per pound.

Oil: Future contract per barrel on N.Y. Mercantile Exchange.

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