The outlook for natural resources stocks is mixed. Gold is expected to do well in 2008, as downward pressure on the U.S. dollar and concerns about inflation fuel increasing demand for the precious metal. Other resources, however, aren’t expected to fare as well, as U.S. and global economic slowdowns moderate demand.

As a result, this could be a good year to pick up some oil and base-metals equities at bargain prices. The medium- to longer-term outlook for these resources subsectors is bright, with industrialization in emerging markets expected to boost demand. There is one caveat: costs are also rising, so there could be a squeeze on margins.

Benoît Gervais, manager of several resources funds for Toronto-based Mackenzie Financial Corp. , recommends investing in companies that have a way to offset the margin squeeze — increasing production, discovering new deposits, supplying the sectors or producing substitutes such as solar panels for conventional energy resources.

Demand for grains has also risen. The fast growth in Asia, where higher incomes are leading to more demand for high-quality grains and grain-fed meat, and the increased production of alternative fuels such as ethanol — brought on by high energy prices and environmental concerns — is creating demand.

But the one resources sector in which no one is interested is forest products. Demand for paper is moderating as more and more advertising goes online. Lumber prices are depressed as a result of dropping housing prices in the U.S. Competition from low-cost producers in countries such as Brazil, where trees grow quickly, is also making it tough for companies based elsewhere to make money.

Here’s a look at the resources subsectors in greater detail:

> Energy. High oil prices are here to stay. They will probably fall back to the US$70- to US$80-a-barrel range this year from the recent US$100 level; they could even drop to around US$60 a barrel if the U.S. goes into recession. But the days of US$50-a-barrel oil are over, let alone US$10-US$20, which was the norm at the beginning of the decade.

The question, then, is not how much oil prices will come down in the short term, but how high they will go in the years ahead. The majority view among money managers is that US$70-US$80 is a reasonable mid-term equilibrium price at which demand resulting from healthy world growth will be met.

Others subscribe to the “peak oil” thesis, which says conventional oil production is peaking or has already peaked, and we will see higher and higher prices as energy demand increases.

Charles Oliver and Jamie Horvat — co-managers of AGF Canadian Resources Fund, AGF Precious Metals Fund and AGF Global Resources Class for AGF Funds Inc. in Toronto — are proponents of the “peak oil” thesis. They expect oil prices to migrate higher over the next 20 years and figure it will take that long before consumers get fed up with paying such high prices and accept alternative energy sources.

Certainly, the evidence of the past three years favours those who expect continued oil price increases, given that oil prices each year have averaged at least US$10 higher than most analysts had expected. But the majority’s view of US$70-US$80 oil could be right. It may just be taking a few years for markets to reach the new equilibrium.

Bill Sterling, chief investment officer at Trilogy Advisors LLC in New York and manager of $4.2 billion in fund assets for Toronto-based CI Investments Inc. , believes oil prices have been high enough for long enough that this is starting to affect demand, with consumers buying more fuel-efficient vehicles.

On the other hand, Fred Sturm, Mackenzie’s chief investment officer, thinks additional oil supply will come into production, gradually easing the oil price to the US$70- to US$75-a-barrel range, which reflects today’s marginal cost of producing an additional barrel.

If the majority view is correct, Gervais’ warning that production costs are likely to rise by 5%-10% a year becomes important. It will be necessary to pick the right stocks to produce good returns.

Natural gas is another story, however. The mild winters of the past couple of years have resulted in large inventories, so prices haven’t moved up in step with oil prices. A recent report by Oliver and Horvat says natural gas stocks are likely to “tread water” — even with a cold winter this year. But if investors have a longer time horizon, this is a good time to pick up the stocks of companies that have solid balance sheets and good management teams.

@page_break@Scott Vali, vice president of CI’s Signature Advisors division and co-manager of Signature Canadian Resource Fund, suggests watching liquid natural gas shipments; he notes that a lot of production is coming onstream in the next couple of years, which could further dampen prices.

Vali likes Calgary-based Suncor Energy Inc., as do Oliver and Horvat, who describe it as “probably the best oilsands company in the world.” Its stock was recently trading at an attractive 18.7 times 2008 earnings.

Other companies mentioned by Vali include Canadian firms Addax Petroleum Corp. and Talisman Energy Inc., as well as U.S. firms XTO Energy Inc., Occidental Petroleum Corp. and Ultra Petroleum Ltd.

Gervais is overweighted in energy, and particularly likes service firms and global companies. For example, he likes Russia-based OAO Gazprom, the largest gas producer in Continental Europe. Other picks include two U.S. companies with attractive valuations: Diamond Offshore Drilling Inc. and refiner Valero Energy Corp., which is trading at only 60% of the replacement cost of its equipment. Smith International Inc., a leading global provider of drilling fluids that has an accelerating earnings profile, and Calgary-based Trican Well Service Ltd. are other favourites

Dom Grestoni, head of North American equities at I.G. Investment Management Inc. in Winnipeg, notes that many global energy companies are trading at valuations that are lower than those of Canadian firms, even though they have equally compelling prospects.

> Base Metals. Prospects for this subsector are also driven by the fast growth in Asia, but demand is more volatile. As a result, base metals will continue to experience large variations in price.

Base metals are mainly used in the construction of buildings and infrastructure, as well as in the manufacturing of machinery and consumer durables — activities that can be delayed when economies slow.

The Oliver and Horvat report notes that base-metals companies were recently trading at about half the price/earnings ratio of the S&P/TSX composite index. The analysts particularly like Toronto-based Inmet Mining Corp., which mines both base metals and gold. Inmet now has five significant mines spread around the world vs three six years ago. It also has other growth projects. The company has $15 a share in cash on its balance sheet and was recently trading at only 8.5 times 2008 earnings.

Gervais and Vali both like Brazil-based Vale (formerly Companhia Vale do Rio Doce), the second-largest mining company in the world. Vale, which recently traded at 10 times current earnings, is a major producer of iron ore, one of the few commodities still rising in price because a few companies control most of the production. (See page 45.)

Vali also likes coal, both thermal (used in energy production) and coking (used to make steel and aluminum). He favours Calgary-based Fording Canadian Coal Trust, one of the world’s largest coke producers, and giant Pittsburgh-based aluminum producer Alcoa Inc.

> Precious Metals. Gold prices tend to be driven by speculators. These “gold bugs” tend to buy gold for two reasons: to hedge against rising inflation, on the theory that gold will hold its value while paper currencies are eroded by inflation; and to hedge against a drop in the US$. The greenback is the world’s reserve currency, so if it is falling in value, gold bugs will invest in something that they believe will hold its value.

Oliver and Horvat think gold has better prospects than oil. They see a continuing movement away from paper-based currencies to hard assets because of downward pressure on the US$, concerns about the U.S.’s fiscal and trade deficits, and signs of rising inflation.

They particularly like Yamana Gold Inc., which has just taken over Meridian Gold Inc. Yamana is a Brazilian company domiciled in Canada. Yamana has done a “great job” developing several mines in joint ventures in South America.

One of Gervais’ picks is Van-couver-based silver producer Wheaton River Mineral Ltd. As a royalty company, it won’t be hurt by rising production costs. He also likes London-based Randgold Resources Ltd., which has found three world-class gold deposits in 10 years.

> Agriculture. Grain prices can be as volatile as base metals, but for reasons related to weather and the crop yield rather than changes in demand.

Although valuations in the sector are above historical norms, Vali says, one can argue that some should be higher given the outlook for demand. He prefers firms that supply the industry rather than producers. P/E ratios for potash producers are high and he wouldn’t buy now — although he’s happy to hold the stocks he currently has.

Another company whose valuation is quite high is Bunge Ltd., a Brazil-based fertilizer producer and the largest soybean processor in that country. It is one of the few publicly traded global agribusinesses.

Vali also likes U.S. agriculture equipment manufacturer Deere & Co., although he notes that its stock isn’t cheap.

Peter O’Reilly, global money manager for I.G. Investment Management Ltd. in Dublin, also thinks Deere is a good way to play the agriculture boom. IE