Dwight Anderson, managing partner of Ospraie Management LLC, always keeps his eyes on commodities. Today he is focused on three major economic elements that will drive commodity prices: economic stimulus, interest rates and U.S. dollar weakness. He’s also keeping a close watch on the country that continues to drive prices across the commodity spectrum: China.

For all the talk about the effects of the Federal Reserve Bank’s stimulus efforts – inflation and fiscal debt woes – the value of storable commodities is getting remarkably little attention.

Dwight Anderson, managing director and founder of Ospraie Management, says the flood of stimulus money into the U.S. economy means investors need to consider holding storable commodities as a way to retain purchasing power.

A combination of a supportive monetary backdrop and demand from emerging markets has created an environment for commodities that encourages investment in storable resources. These include platinum and palladium – known as the platinum group metals – and cotton on the agricultural side.

Despite the financial opportunities that commodities provide, many investors have little exposure in their portfolios to this sector. For those who are looking to increase exposure, the best chances for solid returns in commodities reside in select markets that have strong fundamental demand and the potential for supply constraints in the coming months and years.

Speaking at CME Group’s Global Financial Leadership Conference, Anderson says there are three “tailwinds” pushing commodities higher: monetary policy, demand, and supply constraints/supply shocks.

While most market watchers cite the Fed’s decision to expand the balance sheet after the 2008 financial crisis as the linchpin to the current commodities rally. Anderson looks further back to understand the genesis of today’s financial situation.

“I don’t think people really appreciate how disruptive the exogenous shock of 9/11 back in 2001 has been to our economic cycle and to our monetary system,” Anderson says.

Fearing the terrorist attacks on New York and Washington would cause a recession, the Fed lowered interest rates immediately. That resulted in a “materially looser” monetary policy that affected the U.S. economic cycle, from housing to interest rates to currencies, he says.

The combination of general “stimulative liquidity” and the Fed’s interest rate policy has driven real interest rates to a negative level, all the way to the five-year note in the bond market, as recently as late 2010. What that means is the financing and opportunity cost of holding storable commodities is lowered, which makes commodities an attractive asset, he says.

What’s more, this policy and liquidity translate into a significantly weaker dollar, and that is a positive for commodities. As most commodities are denominated in dollars, buyers using other currencies find these staple goods are now at a lower price, which helps to stir demand. Demand, especially lately, has come from emerging markets, and the biggest driver of demand is China.

“If you combine this monetary and currency backdrop with the stunning rates of Chinese demand growth, you have the six-and-a-half-year bull market that was temporarily interrupted by the financial market crisis of 2008,” he says.

When the Fed tried to withdraw liquidity in April, financial and commodity markets fell, so the Fed pumped more money back into the system, allowing rallies in bond markets and storable commodities, according to Anderson.

“The conclusion for this is pretty clear: as long as the Fed is this stimulative, you need to stay in net-long, storable commodities if you want to preserve your purchasing power,” Anderson says.

The top market beneficiary of this monetary policy has been precious metals. On Sept. 11, 2001, gold was trading at $260 an ounce. While some market participants say gold is rallying because of Federal Reserve Bank driven inflation concerns, Anderson disagrees.

“Currency fear and purchasing-power fear have been driving the flight to precious metals and gold, not the second derivative effect of possible future inflation,” he says. “That gold price alone isn’t so much a commodity. It really just tells us what paper money isn’t worth.”

Gold prices have risen to all-time nominal highs, but overall there has been scant participation in the commodities rally, according to Anderson. For example, over the past decade $300 billion has been invested in commodities, but, comparatively, from January 2010 to July 2010, more than $185 billion flowed into bond funds, even with negative interest rates.

In other words, Anderson says, the commodity sector is woefully “under-invested” compared to interest rate markets.

China buffet

Liquidity is one price-support for commodities and demand is the second, Anderson says. And no discussion about commodities demand is complete without including China.

China has grown to become the world’s largest market for automobile production and consumption, which hits on many commodities: aluminum, iron ore, steel, and the platinum group metals. As an example, China’s demand for aluminum has grown by 500 percent in 13 years, while the rest of the world, including other emerging markets, has increased by 15 percent, he says. China consumes 50 percent of the world’s iron-ore market.

On the agricultural side, China’s consumption of soybeans has led the country to become the world’s largest importer. That appetite enabled Brazil to turn pastureland into farmland and supply this need. For supply to continue to grow, strong prices must continue to incentivize farmers to produce crops and feed the world.

Anderson says it is critical to have prices rise to provide producers with an incentive to create more supply, so they can remain profitable on existing capacity. Otherwise prices need to go up in order to kill demand, or supply shocks occur.

Supply constraints and, on the more extreme end, supply shocks can come from numerous external forces, such as nature and political issues, Anderson says.

In 2010, the world saw the impact that weather can have on crops, particularly with summer droughts and fires in Russia and the former Soviet Union states that hit wheat and sugar-beet crops. Anderson says cotton is one agriculture market he is watching closely for supply shocks. He says supplies have dwindled, even as consumers purchased fewer materials during the economic downturn.

“People wouldn’t normally think that a row crop is supply constrained, but cotton is unique,” he says. Since the equipment used in cotton production differs from soybean or corn production, farmers can’t easily switch without buying expensive new machines. That limits how quickly farmers can enter the market, notes Anderson. Furthermore, several farms are needed to be able to support a cotton gin, which means consensus view and cooperation are needed. Those factors have helped cotton move into a supply deficit for four years, he says.

Anderson is watching the platinum group metals – platinum and palladium – for potential rallies. These metals serve dual roles: industrially, as part of a catalytic converters in cars, and as currency.

He says it is possible that platinum production reached a peak in 2006, and that prices will need to rise over the next few years to ration demand. Additionally, platinum is mined primarily in South Africa and in Zimbabwe, where political and investment landscapes are tenuous.

Commodity risks

Still, there are risks. If inflation picks up because of quantitative easing and the Fed raises interest rates, commodity prices could suffer. Another concern is competitive devaluation by other countries trying to kick-start their economic growth.

But, fundamentally, Anderson sees several elements pointing the way for the bullish commodity market. “The U.S. government, especially the Federal Reserve, has driven real interest rates negative,” he says. “And they pumped a massive amount of liquidity into the system. So when you combine negative real interest rates, plus that much money in supply growth – open any economics textbooks and it says it flows to the hard assets, commodities, especially precious metals, most of all.”