With many EU member states on the brink of default, gold remains one of the preferred stores of value and pundits are predicting the rise in value to continue for some time yet.
Angelos Damaskos, CEO of Sector Investment Managers, explains why gold and oil are good inflation hedges.
It is now generally accepted that the world consumes ever-increasing quantities of commodities. This is not surprising as the global population has grown from 800 million in 1800 to seven billion today and is on its way to over eight billion. In addition, the world’s rapidly growing population is demanding a much higher standard of living.
With the collapse of communism 15 years ago and the internet revolution, billions of previously suppressed people began thinking about private enterprise and were incentivised to work hard to enjoy economic wealth. The internet conveyed information and ideas that could be adapted to the local and regional needs.
The transformation resulted in a great industrial revolution that is still gathering pace and could eclipse that of the US in the early 20th century. China and India now account for the largest share of growth in consumption of commodities and energy and this growth is likely to continue in the years ahead.Protecting against inflation
Another trend that has developed in the last two decades is a proliferation of financial instruments and derivative products, stimulated by accommodative fiscal policies and low interest rates in the US, UK and the eurozone. This has resulted in massive leveraging in these economic areas, built upon un-regulated and misunderstood financial engineering that caused the financial crisis of 2008.
The frantic response to this crisis and printing of money by the respective governments compounded the debt level, large parts of it being assumed by the public sector. Inflation is now rising and the dollar, euro and sterling, have been losing their purchasing power against those of stronger economies such as Australia, Canada and Norway. In order to protect against inflation, it is sensible to buy things such as vital commodities as well as other stores of value that are tradeable, such as precious metals. Oil and gold are two commodities which can provide an effective hedge to inflation.il and gold
Demand for oil has been growing while current resources are declining and large new finds have been few and difficult to extract. Furthermore, geo-political instability in North Africa and the Middle-East, the largest producing regions in the world, threatens supply disruptions. Gold, on the other hand, has become a safe-haven for public and private investors seeking to diversify away from devaluing dollars, euros and sterling.
Its price has risen over six times in the last eight years and looks set to rise further. Some call this situation a bubble but only history can tell a bubble with the benefit of hindsight.nvstment selection
Under the current economic circumstances, I feel safer investing in oil and gold equities than any other investment. Companies that control large reserves/resources, have competent management teams that optimise economic production and continue to add to reserves through exploration can enjoy a premium to the sector. Market history proves that smaller companies tend to outperform their larger peers. Identifying those companies with solid fundamentals and a strong balance sheet to support their activities can offer better performance.
We have developed the following set of special criteria when selecting investments:
● Deposit is to be in a reasonably safe political territory. For example, no significant exposure in Russia, Venezuela, Kazakhstan etc.
● A strong reserve / resource position. Reserves are of course the ideal but regulatory-compliant resources are sufficient in most cases. Often there will be a combination of the two. We check the market capitalisation per unit of resources of the company – the cheaper per ounce of gold or per barrel of oil equivalent, the better.
● No serious environmental problems on the horizon. Permitting problems can kill even the most attractive project
● A strong balance sheet with cash, little or no debt and no major future capital liabilities.
● Future production to be unhedged.
● Strong cash flow on a multiple (PCF) below the average of its peer group.
There are always exceptions as few companies meet all the criteria perfectly. Two examples of companies where we have recently increased the positions include Focus Minerals Ltd (FML:ASX) which is set to prosper in the rising gold price environment. The company has successfully raised additional capital to accelerate production from its latest mine as well as exploration activities in a new deposit and has recently announced a merger with a smaller gold producer that can project the combined entity to the Australian mid-tier producers league with consequent positive effect on the company’s rating. Caza Oil & Gas (CAZA:LSE), has no debt and cash reserves equivalent to more than half its market capitalisation. It has growing production in the United States and highly prospective exploration projects in license areas that cover about 54,000 gross acres.uying opportunity
Investors have been somewhat puzzled by the recent weakness of smaller, exploration and production focused oil, gold and silver equities since the middle of February. The price of gold is reaching new all-time highs over $1,600/oz yet gold-mining equities trade between 15-20% below the high levels reached in February. Oil has fallen by 8.5% from its recent high on 4 April, yet oil small caps have dropped by more than 25%.
This mismatch doesn’t seem justified and indicates that either the stock market is discounting a significant further falls in gold and oil prices, or that investors have been taking profits on commodities producers across the board. This could be a good buying opportunity as debt problems of the developed world are unlikely to be solved easily and large-scale printing of money will continue, especially as some of the smaller EU member states are on the brink of default. Under the circumstances, gold should remain one of the preferred stores of value.
In the case for oil, the fundamentals supporting higher prices remain intact and, save for a major market catastrophe, patient investors should be rewarded.