The price of a barrel of crude oil reached a record US$92 in November, and the prices of many other raw materials have also been climbing quietly. Everything from copper and lead to soyabeans and coffee has seen double-digit price rises this year.

We have, therefore, just upgraded the FTSE Materials & Mining sector to an ‘outperform’ recommendation. Along with Financials, that makes this sector our favourite in the market. While many mining stocks have had a turbulent time in recent months, we think that over the medium term the metals and mining sector will be driven by three key themes: strong demand; constrained supply; and compelling valuations.

Demand still strong

Global demand is likely to remain strong over the next couple of years, even though the US economy may slow during 2008. Chinese growth is still around ten per cent a year and offsetting any slowness in the US (China consumes a quarter of the world’s copper, more than twice as much as the US). In addition, emerging Asian economies, such as India, should remain hungry for commodities, as industrialisation and urbanisation continue apace.

Meanwhile, the supply of many metals will remain pinched. The industry has had limited scope for capital expenditure over the past five years and is constrained by the time it takes to open new mines, typically at least seven or eight years from identification to production. And many new projects are in risky areas, such as Africa, Central Asia and Russia.

It now takes, on average, around 25 per cent more capital expenditure than five years ago to produce the same amount of metal. At the same time, in the base metals market we expect demand to grow by around 3.8 per cent a year globally, and supply to grow by just 3.5 per cent. Many commentators have recently raised their long-term price forecasts for base metals, some by as much as 25 per cent. In the oil market, too, fundamentals follow the same pattern. Demand for crude oil and its related products is growing rapidly while inventories remain low. Supply is limited from both OPEC and non-OPEC sources.

Attractive valuations

The final factor in our analysis is valuation, which is still compelling for this sector compared with similar stages of previous economic cycles. Stocks are currently trading at a discount to consensus expectations for 2008 and 2009. We think earnings are likely to continue to grow in the coming months, which gives us confidence in the sector’s earnings growth forecasts. As a result, at the beginning of October, we reviewed our fair values for the FTSE’s mining companies, raising our estimates by an average of 12 per cent.

In this sector, we generally prefer large-cap, diversified stocks that produce a wide range of commodities. ‘Pure-play’ mining stocks, which focus on one metal, are generally higher risk. Our favourite companies in the sector are two diversified and defensive mining groups. Both BHP Billiton and Vedanta Resources are financially strong, with healthy balance sheets, low gearing levels and strong cash flows.

Well diversified

BHP Billiton, the world’s largest mining company, is our top pick in the sector. We like its attractive product portfolio and useful exposure to oil prices, and are impressed by the diversity, quality and growth prospects of its operations, which include petroleum, aluminium, base metals and stainless steel. Petroleum accounts for around 15 per cent of BHP’s assets and earnings, and its petroleum assets are regarded highly within the industry. On top of this, it has an appealing dividend and buy-back policy.

Indian metals and mining group Vedanta Resources runs zinc, copper and aluminium operations in India, Zambia and Australia. It is a higher-risk play on growth in the Indian economy and global metal consumption. India is at an early stage of its development, but industrial production rose by eight per cent in 2005, and metal demand should benefit from a targeted rise of 14 per cent in infrastructure spending over the next few years. Vedanta has quality mining assets and a strong, competitive position.

Henk Potts is equity strategist at Barclays Wealth