Commodity prices soared during the first decade of this century. But now the party is over. New sources of supply are coming online just as demand from China is slowing, leading to expectations of price declines.

Should investors shun commodity-related investments? We don’t think so. Still, the new environment will require that investors take a more focused approach to extract commodity returns.

From 2001 through 2010, commodities posted double-digit price increases year after year, with only a brief pause during the global financial crisis. Those days are over. Decades of underinvestment, along with China’s unexpectedly strong emergence, drove the so-called supercycle, which has now given way to new dynamics.

Today significant investment combined with China’s growth slowdown has fueled expectations of supply surpluses and spot price declines. While each commodity faces a unique supply-demand situation, the cases of iron ore and crude oil highlight how investors can effectively navigate a more challenging pricing environment.

Chart 1: Commodity Prices Poised for Further Declines

Iron ore is the poster child for commodity oversupply concerns. Iron is the fourth most common element in the earth’s crust, and so it is only a matter of time before investment allows lower-cost supply of the ore to catch up with demand — likely around 2017, according to Macquarie Group. In the meantime, higher-cost supply from China’s coast and smaller non-Chinese producers must plug the gap between lower-cost supply and demand. These higher-cost mines require prices of around $120 per metric ton (MT) to break even on a cash basis. If prices fall too far below that level for too long, these mines will shut down.

Spot iron ore prices are averaging more than $130/MT so far in 2013, but we expect them to fall toward this $120/MT marginal cost over the next couple of years. Yet despite the likelihood of falling prices, iron ore is still an attractive investment in our view.

Here’s why. Direct exposure to iron ore prices occurs through futures contracts. Today futures contracts for the average spot price of iron ore in 2016 are trading at around $100/MT. This pricing structure means that if spot prices fall to the $120/MT marginal cost and stay there for all of 2016, an investment in the 2016 futures contract at current levels will produce a 20 percent gain. The investment would only lose money if spot prices average less than $100/MT in 2016, which the consensus believes but which our analysis suggests is highly unlikely.