How to profit from gold and oil

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Against a global backdrop of rising inflation, economic turmoil and political instability, investors are turning to gold and oil as a way to profit from uncertainty.

The BlackRock Gold & General fund, which has plenty of exposure to the precious metal, has been the most popular investment choice among TD Waterhouse's ISA and Self-Invested Personal Pension (SIPP) customers for the past two years and, on the spread betting and CFDs side, IG Index reported a threefold increase in oil trades in March on the back of events in Libya.

There are a number of reasons for this increase in interest, with both commodities offering plenty of benefits to investors in uncertain times.

Mike McCudden, head of retail derivatives at Interactive Investor, says: "When there's any sort of market calamity you often see an uptick in gold as it's regarded as a safe haven. This makes it an ideal tool for hedging against these events."

This is because, although there are always new attempts to mine gold, there is only a finite amount and it's impossible to manufacturer it artificially. However, demand keeps rising. For instance, India is the world's biggest buyer of gold, with events such as the Indian wedding season, which runs from September to December, fuelling demand and often causing a spike in the price.

Gold is also a powerful hedge against inflation.

"It has a negative correlation with real interest rates," says Peter Day, partner at Killik & Co. "As inflation rises and real interest rates fall, the gold price tends to rise as it attracts investors unable to get a decent return from interest-bearing investments."

It can also act as a hedge against currency debasement. When governments use steps such as quantitative easing to revive their exports and reduce the pain of heavy levels of debt, this devalues the currency. But this can't happen to gold, so providing demand remains the same, its price will increase. Day adds: "Printing money creates inflation, which also helps the gold price to rise."

Given all these conditions that help to push the price up, it's not surprising that returns have been impressive.

Michael Hewson, market analyst at CMC Markets, says that since 2000, when the price bottomed out at $250 per ounce, gold has increased in value by around 700%. "John Maynard Keynes described gold as a 'barbarous relic', but I wouldn't call that performance barbarous."

And the good news for gold investors is many believe the conditions that stimulate demand are set to continue. Day says that while governments in the West are looking to stimulate economic recovery, interest rates will remain low with inflation a natural side product.

The arguments for investing in oil are slightly different, but it is also regarded as a relatively safe bet when the stock market isn't performing so strongly. "People need to use oil whatever the economy is doing," says James Daly, investor centre representative at TD Waterhouse.

The emergence of other energy sources means that oil hasn't quite cornered the market in the way that gold has, but a healthy demand remains for it. "It's not as much of a hedge as gold, but the supply and demand dynamics means it presents good investment opportunities," says Day.

These dynamics are strengthened by constraints over supply resulting from the political unrest in North Africa and the Middle East. And, while the Japanese tsunami has reduced demand for oil in that country, the growth of emerging markets continues to make oil an attractive investment. Indeed, according to Longview Economics, China's share of world oil consumption is set to increase from 9% in 2008 to 20% in 2020.

Gaining exposure to gold and oil

Given the demand for both gold and oil, many advisers recommend holding some in your portfolio and there are a number of ways to achieve this.

With gold, it is possible to hold it directly, for instance as coins, such as krugerrands and sovereigns, or as gold bars. But there are disadvantages. Unless you want to keep your investment at home, in which case insurance will need consideration, you will be charged storage. For example, bullion house Gold Investments charges an annual fee of £2 per ounce to hold gold in its vaults.

Exposure to both commodities can be gained through shares, albeit in slightly different ways. For oil, it's possible to invest directly in companies producing oil - such as Shell (RDSB), BP (BP.), Tullow Oil (TLW) and Premier Oil (PMO).

With both commodities, you can also get exposure by investing in gold mining companies and the oil exploration and production sector.

"This is highly speculative but it can also be regarded as a highly geared way of playing the commodity price," says Day. "If the company finds a good source of gold or oil, its profits will increase, while its fixed costs remain the same."

It's not the easiest market to tap into, though.

Daly says the investors he sees going into these companies tend to come from that background. "The companies tend to be very small, which can make it difficult to research which ones are likely to perform well. It can be quite intimidating," he explains.

For anyone looking to speculate on short-term moves, the way gold and oil prices move also make them ideal candidates for spread betting and CFDs. "Gold and oil appeal because of the volatility in the price," explains David Jones, chief market strategist at IG Index. "The price can also move a lot in a short period."

As an example, Jones says that as a result of all the turmoil in the Middle East and North Africa, the oil price moved from $96 to $106 dollars in a few days, with a movement of $6.50 happening in just one day. "That's 650 points, which can be scary if it moves against you," he adds.

As well as being able to go short as well as long on both gold and oil, you could also consider taking a position on companies that are heavily influenced by the fortunes of these commodities. While this is less of an option with gold due to its luxury status, the price of oil is a significant factor for many companies and industries.

McCudden explains: "Many industries are dependent on oil, for instance the airlines and other travel firms and haulage companies. If there's a spike in the oil price, the increasing cost to run the business will affect the share price, usually causing it to fall."

Another suitable option for gaining exposure to gold and oil is an exchange traded fund (ETF) or exchange traded commodity (ETC). These track the price of gold or oil, either by holding the commodity directly or by using derivatives to replicate it, and are bought and sold like shares.

"There's plenty of choice, including ones that go short rather than long and ones that leverage your investment," says Daly. "Although there are exceptions, ETFs do tend to be regarded as a more long-term investment than spread betting and CFDs."

Charges are also a consideration. Although ETFs and ETCs are not subject to stamp duty, there are dealing charges when you buy and sell, and an annual charge is included in the pricing.

Dos and don'ts of gold and oil

* Do consider gold as a hedge against inflation, currency debasement and stockmarket falls.

* Do consider a spread bet or CFD for short-term speculation on gold and oil as these allow you to go short as well as long.

* Do weigh up the potential losses on a spread bet or CFD if the price moves against you.

* Don't expect a smooth ride. Prices of these two commodities are very volatile and can jump quickly.

* Don't overlook the influence of oil on other companies in your portfolio.

* As well as the obvious candidates such as BP and Shell, the oil price will affect the performance of companies such as airlines, haulage firms and transport companies.

* Don't forget ETFs. These offer the option to go long or short on gold and oil and their low costs make them more suitable than spread bets and CFDs as a long-term investment.

This article features in the May 2011 issue of Money Observer.

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