It happened about six days before I expected it, but at long last the hardball tactics of iron ore giant Rio Tinto resulted in an 85% increase in iron ore prices this year. It happened earlier this week, after eight months of intense and sometimes rather unfriendly negotiations. The consequences could be very friendly for investors, though. More on that in moment.

But let me just repeat that in case you missed it - with the stroke of a pen, the value of a commodity exported by Australia went up 85%. Not even the oil market moves that fast!

The Australian resource boom is rapidly becoming one of the biggest missed boats in American investing. There are staggering (and growing) numbers being posted by Aussie commodity exporters. Since it is an election year in America and your senses are being assaulted (and likely offended) by noxious fumes coming from politician’s mouths, let me remind you of the extraordinary story taking place here in the Lucky Country.

Just yesterday, the Aussie organization that tracks these things forecast 40% year-over-year growth in the value of Australian mineral, energy, and farm exports. Can you think of many companies that report 40% earnings growth year over year?

GM? Washington Mutual? Citigroup?

Led by 21st century blue chips like BHP Billiton, Rio Tinto, and Woodside Petroleum, Australian companies will export over $212 billion worth of coal, iron ore, gold, crude oil, copper, and LNG (to name a few commodities) next year. These booming exports are evidence of the structural revaluation of global resources. And the booming stock prices of resource producers represent the structural revaluation of those stocks (once cyclical, now more like growth)

Gold to India. Coal to Korea and Japan. Iron ore to China. Copper, uranium, rare earth elements, and a host of other base metals and bulk commodities…they are all on big boats to points North and East. This is why American investors cannot afford to ignore the story any longer.

By the way, thanks to a huge spread in short term interest rates (2% in the U.S. and 7.25% in Australia) the Aussie dollar is nearly at parity with the greenback after rising 70% in the last four years. The strong Aussie currency derives much of its strength from the roaring commodities market. And it’s that commodities market that is lately under scrutiny from some investors.

The numbers above suggest that the commentators who are calling for a top in the commodity cycle are actually complete morons. But rather than name calling like a candidate for national office, let me suggest that the commodity market has evolved beyond a simple boom-bust cyclical analysis. It is still boom-bust, but with a twist.

No. I am not suggesting that, “This time it’s different.” The basic economics behind the business (and/or credit) cycle are as valid as ever. Early business investment based on real demand leads to good times. Good times lead to easy credit. Easy credit leads to more investment (some of it very bad).

As money and credit expand, prices rise. Rising prices attract new investment from commodity producers. Eventually supply exceeds demand, credit tightens, and the cycle of growth ends in inflation in energy that destroys demand.

Is that where we are now?

Sort of.

There is a popular theory here in Australia - where I moved in 2005 for a front row seat to the resource boom - that China will suffer a post-Olympic slowdown. It’s what happened in Sydney after the summer games there in 2000.

This theory nicely fits another theory advanced by other analysts that China’s industrial boom is almost entirely reliant on American consumption. If the credit crisis sinks the American consumer economy in the second half of 2009, China won’t be able to sell anything to America. And if Chinese producers can’t sell finished goods to American consumers, they won’t need Australian raw materials!

Poof goes the resource boom!

The only trouble with that theory is that it’s complete hogwash.

American’s who believe that China’s boom is utterly dependent on unsustainable patterns of American consumption are sadly misinformed, or deliberately in denial about the changing structure of the global economy.

The facts are the facts. And what are the facts? The urbanization and industrialization in the developing world is hugely resource intensive. These people (in China and India and Brazil and the Middle East and Vietnam and Malaysia) are not building economies to service the whims and fancies of American consumers.

They are building sewers, bridges, factories, cars, roads, railways, airports, power plants, grocery stores, movie theatres and probably even Wal-Marts. The studies here in Australia by both the resource companies and analysts have shown that even Australian resource firms badly underestimated the intensity of demand for Australian resources.

Much of that demand comes from steel for infrastructure, residential, and commercial real estate. Australia has some of the world’s richest ore bodies, from the high-grade iron ore of the Pilbara, to the black coal in Queensland’s Bowen Basin, to Olympic Dam in South Australia (home to 17% of the world’s known uranium reserves).

In the 1960s and 1970s, Japanese and Korean companies were on the ground and in the Outback, looking for joint venture deals to secure long term access to Aussie resources for their post-war, industrializing economies. It is like that today, but on a much, much greater scale.

Advertise here.

Today, the place is filled with Chinese, Russians, Indians, and even nomadic American newsletter writers. Australia is as big as the continental United States. Much of it remains unexplored. But there are plenty of investors on the ground from all over the world looking for their stake in key mineral and energy deposits.

Chinalco is looking to develop a huge bauxite deposit on Queensland’s Cape York peninsula. British-based BG has made an unsolicited $13 billion bid to get in on the coal-seam-methane business. A Saudi Arabian firm recently engineered the takeover of a small West Australian mineral sands company that makes titanium dioxide (key in the plastics industry).

My point in highlighting just a fraction of the activity that’s going on here every day is simple: this place is a bonanza for investors. There are far more intriguing resource companies than there are analysts to cover them. And remember, the market value of these company’s assets is generally going up (dramatically in some cases). The only other place on earth where you could find more uncovered stocks is probably the Indian Small cap market.

I was not willing to move to India in 2005, mostly because of my bad stomach, ruined by French cheese and room temperature English beer. But Australia seemed like the perfect place to follow the commodity and Asian booms firsthand, and gain a big edge on investors who weren’t here and accepted the conventional analysis of the resource boom. The meat pies are also excellent.

It’s a decision I have not regretted one bit. But let me clarify what I expect from here on out in the resource boom. In a word, I’d say you should look for “epicycles.”

There are now cycles within cycles in the resource industry. There are five general categories to keep your eye on: bulk commodities, base metals, energy, agricultural commodities, and precious metals.

Right now, high energy prices are putting huge cost pressures on base metal producers. This, plus the first wave of new supply coming on line last year (especially for zinc, nickel, and cooper) resulted in a cooling off in base metal price last year. Meanwhile energy stocks took off, along with agricultural commodities.

My forecast is that high energy prices are about to knock everybody back a peg or two and result in reduced demand for energy for the rest of this year. Supply will remain tight in oil markets. But consumers (industrial and commercial) will roll back demand. Oil traders will take profits and we’ll probably see oil somewhere around $105 before the end of the year (barring geopolitical events).

Meanwhile, bulk commodities have already seen big year-over-year increases. Coking coal prices tripled earlier this year while thermal coal prices were up 75%. The iron ore price gain of 85% certainly won’t hurt Rio’s earnings either.

Ironically, many Aussie coal producers will make more money on lower production volumes this year. Bottlenecks with rail and port infrastructure on Australia’s East Coast mean that producers can’t fully take advantage of the big price gains this year.

This infrastructure problem itself is actually a great investment opportunity too. Not only are Australia’s top engineering and infrastructure firms making a killing on the local boom, they’re active in South East Asia, the Middle East, and Africa. For the coal producers - if they are not swallowed up by Xstrata first - earnings won’t start to benefit until the second half of this year or early 2009 (although stock prices have already begun to reflect the higher coal prices).

I would not be a seller of energy stocks at this time. However, it looks to me and my team of analysts here like base metals are due to take over the leadership in commodities for the rest of the year. Ag and energy may cool. Most of the bulk commodity prices are still negotiated, although there is a move afoot to base coal and iron ore prices on an index. This reflects the added liquidity in the markets: there are a lot more buyers and, increasingly, a lot more sellers.

It’s the new sellers we’re interested in the most in our Aussie research. You could do a lot worse than own BHP, Rio, and Woodside, and Worley Parsons for the next twenty years. BHP alone is like a mutual fund of commodities.

But the big earnings growth and the massive revaluation of ore bodies is taking place with the smaller and newer producers too. And this is where I believe it’s actually to your advantage that there are so few analysts covering smaller Aussie stocks. In fact, as one mining executive I spoke with recently said, “Even the analysts that are covering us don’t know how to value us. They are all using discounted cash flow models and don’t know much about geology or commodities.”

In ignorance, there is opportunity!

Australia has an abundance of scarce resources. It’s a bit of a paradox. But then, the platypus is an animal native to Australia. That duck-billed, beaver-tailed, venom shooting, egg-laying marvel has DNA from both reptiles AND mammals. It’s one of a kind, just like the Australian economy, which has not suffered a recession in 17 years.

Dan Denning
The Daily Reckoning