Diversify Your Commodities for Big Profits

07/04/2012 9:00 am EST

Focus: GLOBAL

Investors tend to look to one strategic commodity sector or another, but the secret is to buy into a piece of all of them to balance your commodities strategy, reports Harvey Jones of The National.

Here's a riddle for you: What's black, wet, and shiny, and could make you rich? Answer: oil, water, and gold, three of the most valuable commodities on the planet.

Oil, water, and gold don't mix, except you might want to combine them in your investment portfolio.

Oil
Until recently, the oil price only seemed to be heading one way. A barrel of Brent crude topped $125, and some analysts predicted it could soon beat $150.

But it has gone sharply into reverse, thanks to the Eurozone crisis and slowing global growth. Yesterday, it was edging above $93 a barrel. Credit Suisse says it could fall to $50 if the Eurozone crumbles.

Oil will struggle to recover recent losses, says Rob Pemberton, the investment director at HFM Columbus, the London-based wealth manager. "Emerging market demand is sliding, while US oil inventories recently hit an all-time high. Geopolitical risk has reduced as tensions ease over Iran. It is hard to see where the extra demand is coming from."

While shares in big oil have spilled between 5% and 15%, smaller stocks such as Ithaca Energy (Toronto: IAE) have dropped up to 60%.

This makes now a great time to buy oil stocks, says Angelos Damaskos, who manages the Junior Oils Trust mutual fund. "Oil shares have been mispriced by weak, risk-averse markets. Patient investors who share our belief that oil prices will continue their long-term trend will be rewarded."

Investors should brush off recent oil price volatility, says Daniel Lacalle, the portfolio manager for the Ecofin Global Oil & Gas Fund. "Oil companies don't base their long-term planning on $125 a barrel, they view $50 to $70 as an acceptable return. Recent falls won't hit their capital expenditure or balance sheets, but they do create M&A opportunities."

Short-term demand may have slipped, but oil will remain the most important source of global energy for at least the next 30 years, Lacalle says.

Higher-risk investors should consider oil-exploration company Tullow Oil (London: TLW), says Sheridan Admans, the investment research manager at The Share Centre. "Its drilling operations have had a tremendous success rate and there is the chance of more good news to come."

Admans also tips BP (BP), which is steadily recovering from the Gulf of Mexico spill and has reinstated its dividend. "After the recent pullback in the share price, there is more value for long-term investors."

Water
Water is the world's most precious commodity, the one nobody can live without. With the global population growing, the planet is getting thirstier.

Last year, Willem Buiter, an economist at Citigroup, boldly claimed that water would eventually become "the single most important physical commodity-based asset class, dwarfing oil, copper, agriculture, and precious metals". So, should you sprinkle some water stocks in your portfolio?

Water is everywhere—in the oceans, ice caps, glaciers, and underground, but only about 3% is fit to drink. A growing number of water-services companies are working hard to boost supply by extracting water, treating it to make it drinkable, building desalination plants, and transporting it to cities.

Investors can choose from several specialist mutual funds investing in water companies such as the PowerShares Global Water Portfolio (PIO), which invests in global water companies like United Utilities (London: UU) and Severn Trent (London: SVT), and Ecofin Water & Power Opportunities (London: ECWO), the UK-listed investment trust.

Lacalle, from Ecofin, says water has traditionally been seen as a defensive sector dominated by utilities. "Companies enjoy strong cash flow and pay attractive dividends, which appeals to many investors right now. But we are also seeing increased M&A activity among privatized water-treatment and water-services companies, which could throw up attractive opportunities."

But Pemberton, of HFM Columbus, is more skeptical. "There will undoubtedly be much greater pressure on the world's water resources, but how do you make money out of that? No company can be seen to be making big profits from water. It isn't politically sustainable."

His favorite mutual fund is the Pictet Water Fund, which is based in Luxembourg. "This is a global fund that invests in water technology and treatment, and performance has been good. It has risen 60% in the past three years."

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Gold
Gold is the ultimate safe haven. When investors panic, the dollar weakens, and central bankers devalue paper currencies through rampant moneyprinting, gold sparkles. It hit an all-time high of about $1,900 an ounce last August, but is now trading around $1,560.

Angelos Damaskos, who advises on the specialist fund Junior Gold, says gold has rebounded sharply in recent weeks, largely thanks to capital flight from beleaguered European banks and worries over growth in the United States and China. "That's good news for gold-mining shares, whose balance sheets have never been stronger."

Adventurous investors might buy stocks such as Fresnillo (London: FRES), Goldcorp (GG), Kinross Gold Corporation (KGC), and Randgold Resources (GOLD).

But be warned: they can be highly volatile. The Fiji-focused miner, Vatukoula Gold Mines (London: VTM), for example, has seen its share price crash by 70% over the past year.

Most private investors prefer to spread risk by investing in a gold exchange traded fund, such as the ETFS Physical Gold ETF (Tokyo: 1672) or iShares Physical Gold (London: SGLN).

Gold is a good way of diversifying your portfolio because it behaves differently to equities and other assets, says Pemberton. "But I'm worried that it has changed its nature. What was once a safe haven now looks like a speculative investment."

The proliferation of ETFs has made buying gold much easier, but may also make the price more volatile: "People held onto gold coins for years, but thanks to ETFs, you can trade gold in a few seconds," says Pemberton. This has transformed it from a hard physical asset into a speculative paper asset."

If the Eurozone crisis worsens, gold may glitter again, especially if the US Federal Reserve launches a third round of quantitative easing to stimulate the economy, forcing down the value of the dollar.

But at some point, it could lose its shine, Pemberton says. "The problem with gold is that it doesn't produce any income, unlike, say, cash or bonds. With interest rates so low, that hasn't been much of a sacrifice. But once interest rates rise and cash pays an inflation-beating return, gold will come under pressure."

When that happens, this safe haven could suddenly look rather dangerous.

The global economy can't run without oil. People can't live without water. They might be tempted by gold, but when there's a recovery, most of us can happily live without it.

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