Market Wrap: Gold Hits 3-Month Low Amid Dollar Surge; Platinum At 5-Year Low; NatGas Outperforms

Precious Metals

Gold is the granddaddy of precious metals. It’s been used as money for as long as money has been around, and for good reason: It’s easily identifiable, easily minted, nearly indestructible and quite limited in supply. Despite the fact that the reality of Gold is Money has all but evaporated, it still serves the world as the primary store of value outside of currency.

That gold has significant value is almost entirely because of convenient fiction. Jewelry is made from gold for aesthetic reasons, and because of its association with wealth. Gold is stored in bars and coins because people believe it will retain and potentially appreciate in value. But gold, in and of itself, has limited utility. It’s an excellent conductor, so it gets used in circuits, high-end stereo connectors, and such. It’s got optical properties that make it useful for satellite reflectors and other obscure applications. Because it’s so malleable, dentists use it for fillings.

But in terms of actual demand, industry barely matters — less than 20% of the gold sold every year goes to a useful buyer. The rest goes into jewelry and under the mattresses of investors. If the collective delusion that gold is valuable disappeared overnight, then perhaps gold would be used in all sorts of industrial applications. because suddenly, it would get cheap. As it is, gold’s usefulness is limited precisely because of its value.

As an investor, gold is attractive because of its value-store characteristics. It remains a fact that an ounce of gold has been a useful measure of value for centuries.

More than any other precious metal, gold trades in reaction to macro-events and speculation. It is the place conservative investors plow their money in response to geopolitical turmoil, and where inflation hawks look for sacred ground. It is, for most investors, a hedge against really bad stuff. When it gets nasty out there, you want to own gold.

Gold is so important to the commodities market that we devote an entire article to it in here: The Case For Gold .

Living on its own, silver is a far more useful metal than gold. Silver shows up in myriad places — water purification, electronics, solar panels, medical devices, batteries. One of the largest uses of silver remains photography. Silver crystals are the magic that has made pictures work for almost 200 years. And despite the rise of digital photography, plain old silver halide film isn’t actually disappearing as fast as you might think. Silver film remains cheap, permanent, and is well-entrenched in industrial photography (like X-rays).

But silver is also money, in this case, literally. Mexico still mints 2 million ounces of coins that go into circulation every year. Beyond Mexico, silver isn’t widely stamped out into circulating coins; rather, the mints use silver like they use gold — as bullion. Silver’s use as money spills over into jewelry and silverware.

Unlike gold, however, the long-term case for industrial demand for silver is very strong. Silver typically gets used up in an industrial application: It’s generally consumed and doesn’t enter the supply chain again (outside of recycling from photographic uses). Moreover, the industrial uses of silver go up every year, especially in electrical and medical applications.

On the supply side, silver is more complicated than gold. Gold comes essentially from one place — gold mines. Silver more often than not comes as a by-product from multi-ore mines; miners might uncover some silver while digging for lead, zinc, copper or gold. As a result, silver supplies can rise and fall not just in response to demand, but in response to demand for all those other metals as well. It makes it hard to judge supply/demand factors for the metal.

Precious metals investors point to historical relationships between gold and silver, and some believe that the two are inexorably linked. Ten seconds in Google will uncover what this correct ratio is: 15:1. In other words, every ounce of gold should buy you 15 ounces of silver, give or take. The reason behind this is often lost in translation, but comes down to the same musty thinking that drives people to assume gold must be valuable in the first place. Back in the 1800s, for reasons based not on natural laws but on minting and convenience, England, France, and the United States separately set the value relationship between gold coins and silver coins such that, by weight, the 15-1 relationship was more or less intact.

But throughout the 20th century, as gold and silver were demonetized (legally removed from their relationship to money), the ratio has exploded. An ounce of gold as of this writing buys you 56 ounces of silver, give or take. But to use this as the reason for a bull-run in silver for the next 100 years seems a bit far-fetched. We prefer to fall back on Jim Rogers’ logic — nobody can repeal the law of supply and demand — and suspect that silver’s price will trend with industrial demand for some time to come.

Beyond silver and gold, platinum is the next most important precious metal. And while it’s certainly pretty, the odd thing about platinum is that it is actually an industrial metal. While brides pine over platinum rings, less than 20% of all platinum ends up in jewelry each year. The rest gets used in all the strange and wonderful ways industry has devised — catalytic converters in cars, inside medicines, in electronics, and in diesel engines.

Platinum is certainly rare: Total production is less than 5% of gold’s every year, and all the platinum ever mined would fit in a 25-foot square room.

Supply, not surprisingly, remains incredibly tight. Virtually all of the platinum and palladium in the world comes from one of two regions: South Africa and the most extreme reaches of Siberia. This tight supply butts against very real industrial demand, which is where platinum is coming into its own as an investment.

While platinum showed a surplus for the first time in decades in 2006, the market remains so tight that even a modest uptick in demand from investors can have a big impact. Jewelry, coinage, and ETFs aren’t huge factors in the platinum equation today, but as commodities in general and precious metals in particular become more mainstream, platinum is poised for substantial growth — or at least, substantial volatility.

Getting Access

There are more ways to tap into the precious metals space than almost any other type of commodity. Investors can easily access the space in the physical market, through company shares or by buying futures contracts. Each has its advantages and disadvantages.

Spot Commodities

Unlike oil or copper, it’s easy for investors to physically own gold, silver and platinum. Bullion dealers like Kitco will sell you physical coins and bars for delivery; you can even get palladium bars, which are a lesser metal that fills a similar role as platinum in industrial settings.

Alternatively, groups like Kitco will sell you shares in a gold pool. Essentially, they aggregate money and buy gold, holding it in one central location. As a member of the pool, you get an economic interest in the physical metal without the pesky delivery problems.

Increasingly, investors are turning to exchange-traded funds (ETFs) as the easiest and least expensive way to tap into physical bullion. Bullion-based ETFs function much like gold pools — the funds hold physical bullion in a vault, and when investors buy shares in the fund, they get a stake in that bullion.

Gold bullion ETFs are available all over the world, with the largest being the StreetTRACKS Gold ETF (NYSE: GLD) in the U.S. which has over $14 billion in assets. U.S. investors can also access silver bullion through the iShares Silver Trust (AMEX: SLV). In London, investor can buy not just gold and silver, but also palladium and platinum. Other markets have other options.

The advantages of a physical bullion investment are its simplicity and low costs: Your investment return is based solely on changes in the prices of the underlying metal. The disadvantages include the tax treatment: In the U.S. bullion holdings are taxed as collectibles, subject to a 28% capital gains tax rate; this includes the bullion-based ETFs.

Gold, silver and platinum futures are heavily traded on the New York Mercantile Exchange (NYMEX), and palladium (and even uranium) has contracts as well, although not with the kind of liquidity most individual investors have come to expect.

Alternatively, investors can buy an ETF that holds a position in precious metals futures. PowerShares offers the PowerShares DB Gold Fund (DGL) and PowerShares DB Silver Fund (DBS), which track the price of a rolling futures position in each asset. This means that the funds capture not just the spot price, but also collateral interest income and any roll yield.

Over the past year, spot prices and rolling futures positions have tracked one another almost perfectly, but that needn’t always be the case.

Futures and futures-based funds also have a unique tax treatment. For most investors, gains are marked-to-market at the end of each year, which means the IRS treats the position as if you sold it — if the position is up, you own taxes on the gains. Those gains are taxed as 60% long-term gains and 40% short-term gains.

Company Shares

As always, buying the cow remains an option. Most of the major gold mining companies (Barrick Gold, Newmont Mining) have ancillary and not-so-ancillary businesses in the other precious metals. The notable exception is in platinum, where, as we pointed out, production is concentrated in a very few places (Platinum Group Metals (AMEX: PLG) remains one of the only pure plays on the U.S. exchanges).

There are numerous stock-based ETFs that focus on the mining sector, and some investors even take a regional approach, buying something like the iShares MSCI South Africa fund (AMEX: EZA) in the hopes that its performance will be linked to the fate of gold by South Africa’s heavy reliance on the mining industry.

Buying company shares, as always, comes with corporate risk: Companies can make bad investments; management can abscond with cash; regulators can crack down on environmental overruns; etc. On the flip side, of course, companies can also make smart investments, improve efficiency or stumble onto the next great gold mine.

The biggest difference with buying company shares is leverage. Most mining firms take on gobs of debt to finance new production, and as a result, almost trade as if they are leveraged to the price of whatever it is they mine.

One final factor is hedging: Although fewer producers do so today as in the past, some companies still hedge their exposure to changing commodity prices by selling ahead in the futures market. This means that the company’s profits aren’t as strongly linked to changes in the price of the underlying metal.

Gold is such an important part of the commodities market that we will devote an entire article to it here .

LINKS FOR MORE INFORMATION

World Gold Council www.gold.org