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In its regular report on June iron ore production, delivered on July 22, BHP Billiton (BHP) gave investors the key to investing in commodities over the next year. Ignore this at your portfolio’s peril. BHP just told us all what to buy, what to avoid, and when.

Ready for those words of wisdom: “Commodity prices will be influenced by supply responses due to latent capacity currently existing in the industry.”

Let me translate into language useful to investors: Yes, commodity prices are climbing as consumers of raw materials rebuild their stock piles.  And yes, we are seeing what is a real increase in demand and not just a result of inventory rebuilding. But don’t get carried away by short-term spikes in commodity prices. So many commodity producers have idled mines or wells or whatever that any big increase in price will be temporary as it will bring that idled capacity back into the market. And that will depress prices–for a while. Expect, then, a start-stop price chart where the trend is gradually higher, but where the trend is punctuated by spikes and plunges as demand and supply lurch toward equilibrium.

And from that I think investors should be able to figure out what commodity stocks to buy. I’ll lay out three general prices of commodity investing–in the current scenario–in this post. And I’ll give you a stock to buy later today.

Look at the iron ore market if you want to see what BHP Billiton’s words mean in real terms. Spot iron ore prices–including shipping–hit $93 a metric ton this week. That’s a huge 62% surge from an April low of $58 a ton. Clearly iron ore prices are headed back to the heights they hit in 2007, when iron ore sold at $140 a ton under long-term supply contracts and even higher on the spot market.

But wait a minute. Forecasters at  Barclays Capital and UBS say that while iron ore could easily hit $100 a ton in the near term, investors shouldn’t expect the run up in prices to continue for long at recent rates. Barclays, for example, is forecasting a 5% price increase in the spring 2010-spring 2011 iron ore year. And another 10% increase the following year.

Why the slowdown in price gains? Because each time the price of iron ore goes up, it pulls more idle capacity back into production. In the case of iron ore, much of that capacity is at high-cost mines in China. I’ve seen estimates that as much as 70% of China’s domestic iron ore production is now idle.

That casts recent record Chinese imports of iron ore in a different light, no? Chinese steel makers buy from the cheapest sources of ore they can find. At recent prices that leads them to buy imported ore. At some point, though, as prices climb Chinese steelmakers will start to substitute domestically produced iron ore for imported ore. That will bring more iron ore into the market as Chinese miners reopen mines and that will add new supply to the global market that will temper the rate at which iron ore prices climb.

And, of course, China’s iron ore industry isn’t the only national mining industry to have excess capacity just waiting on the sidelines.

I think this scenario leads to a few rules for commodity investing right now.

1. Look for commodities where recent price increases haven’t yet led to increases in production. Stocks in those sectors are good picks for short term gains because since it does take a while to get a mine back into production, new supply will lag demand giving curent producers a big share of recent price increases. Nickel, I think, fits this bill. Nickel production has been essentially flat in 2009 to date although nickel prices are up about 40%. Add in a strike by Canadian nickel miners at Vale (VALE) that began on July 13.

2.   Look for commodities where production increases at consuming companies and price increases for end products will be enough to soak up at least some added supply and higher commodity prices. For example, it’s good news for iron ore producers that U.S. Steel (X) is recalling idled workers at its Fairfield, Alabama tube plant and that steel maker Nucor (NUE) recently raid prices on rebar, merchant bars and structural products by an average of $40 a ton.

3. Look for commodities where a few–or even better–a single company controls enough capacity so that they can determine how quickly idle capacity goes back into production and puts downward pressure on prices.

I’ll have a pick of a company in exactly that kind of commanding position later today.