(FORTUNE Magazine) – "I'VE GOT CHEMICALS IN MY BLOOD," SAYS FRANK MITSCH. No, he's not talking about illicit substances. As an analyst with institutional research firm Fulcrum Global Partners, Mitsch helps his clients pick winning stocks in the chemicals sector. And there's a lot for investors to like right now, says this formally trained chemical engineer, who spent more than a decade working in the industry before devoting his time to stock picking. FORTUNE's Janice Revell recently caught up with Mitsch to discuss tight supply, sizzling prices, and why breaking up--even in the chemicals industry--is still hard to do.

Chemical stocks had a red-hot year in 2004, but you say there's still lots of upside for investors. Why?

The industry fundamentals haven't looked this good since the middle to late 1980s. I think we're in the earlier part of the recovery as opposed to the latter part of the recovery, in terms of the petrochemical cycle. So I believe we're looking at an extended period of very high margins and earnings.

What are the key factors driving this rosy outlook?

The most critical is that the supply side is looking very good for the current participants in the industry. By that I mean there's not a lot of new capacity coming on line. Over the past seven or eight years we've seen an underinvestment in the chemical space. So it's good for pricing and it's good for people with existing assets, because they're able to run those plants at higher operating rates and raise their margins. If you look at ethylene operating rates, for example, they're in the 93% to 94% range right now, and they haven't been that high in a long time.

Why has there been such underinvestment in the industry?

There are a couple of factors at work. The 2001 to 2003 recessionary trough was very brutal on these companies, and people were questioning whether or not their cash flows would be sufficient for them to cover their dividends. So in that sort of environment, you can fully understand that the domestic chemical companies were not about to embark on a major capital-expenditure cycle. Second, if you look at the oil companies and their appetite for the chemical sector, it has waned significantly of late, particularly given the terrific returns that they're achieving on the energy side. So we haven't seen the investment coming from the folks who traditionally would be investing. And last, there was a lot of concern about new capacity coming on line in Saudi Arabia and Iran in the 2006 and 2007 time frame. Because of the political instability of those regions and some of the awful terrorist incidents that have occurred there, the time frame for those plants has slipped.

But isn't the prospect of rising natural gas and crude oil prices a real threat to the profitability of chemical companies--and ultimately to the stocks?

Obviously those are very important input costs for the chemical companies. But one of the things that I think is a bit of a fallacy is that high energy prices in and of themselves mean low profits for the manufacturers buying at those high prices. I believe that profitability is more a function of operating rates than it is of input costs. So you may get a very near-term hit if for some reason oil or natural gas prices spike up. But over a medium-term time frame, the chemical companies will be able to price accordingly and pass it through. Let me give you one example of why I believe that the power has shifted to the chemical companies rather than to their customers: Between October and December, the price of crude oil dropped from $55 a barrel to the low 40s. During that same time frame the spot price of ethylene, which is a bellwether chemical, went from 32 cents a pound to 47 cents a pound. It just shows you that there's a shortage here.

Then what about rising interest rates? Wouldn't that put a damper on the industry?

If you think about some of the reasons the Fed raises interest rates, it's because the economy is expanding and doing materially better and the Fed has concerns about the economy overheating. If things are good economically, they for sure are good for the basic-materials companies. Demand is robust. Going back to 1994, when the Fed was raising interest rates from 3% to 6%, you saw the commodity chemical companies significantly outperform the S&P 500.

How big a factor is China in the growth of demand?

China is roughly 15% of the consumption of those basic materials. It's not insignificant. We keep tabs on what's going on in that part of the world on a weekly basis, and we feel quite good about China continuing to increase its demand in chemicals.

So what stocks in particular do you like right now?

The stocks at the top of our list are the ones with more leverage to the commodity chemical cycle rather than just the economic cycle. Dow Chemical (DOW, $49) is our favorite large-cap name. It has done a phenomenal job of reducing its cost structure, which in our opinion is going to allow it to generate significant profitability as we head into this up cycle. The company's got a lot of exposure to the petrochemical cycle, and it's also the largest producer of chloralkali --a combination of chlorine and caustic soda. Pricing is near all-time highs. The price of caustic soda, which was $60 a ton in April 2004, is essentially $300 a ton today. So you can just imagine the guys who are selling it are raking in the dough.

Can prices stay that high?

They will not stay that high indefinitely, because at some point we will see companies announce new capacity. But think about it: We're just 18 months removed from companies shutting down plants, and the reason they were shutting down plants was that they weren't making any money. So you have to let them make some money for a while, and then we'll see reinvestment.

What other stocks do you like?

Georgia Gulf (GGC, $49) and Olin (OLN, $20), which also have chloralkali leverage. Nova Chemicals (NCX, $45) is one we've been bullish on for a while. It offers the most leverage to the ethylene and styrene cycles, which we think have a couple of years to run.

In a recent report you said that within chemical industry circles, the decision by DuPont and Dow to split up one of their joint venture projects was "even more upsetting news than the breakup of Bennifer last year." Was it really that traumatic?

Listen, this is the chemical sector I'm talking about, so you've got to jazz it up a little bit.