Should You Own Gold or the Gold Producer?

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 |  Includes: GDX, GDXJ, GLD
by: Jim Van Meerten

Most novice investors in Gold as with any commodity have the same question: Is it better to own Gold or the Gold Producer? The same holds true for any commodity like oil, sugar, coffee or orange juice. Every commodity and commodity producer has a different set of variables. There is no right or wrong answer. The answer really lies in how much research you are willing to do and how much risk you want to take. Let's look at the issues one at a time.

Own the commodity

The main issue is supply and demand. When supplies are low and demand is high the price goes up. When supply is high and demand is low the price comes down. Sounds simple but it's really not. Other things affect supply and demand: Like what causes the supply to go up and down and can the supply be controlled by any type of cartel? What causes the demand to go up and down and can another commodity be substituted if demand gets too high? Is supply affected by weather or political conflict? Is there another commodity that affects the demand for this one like the relationship between the prices of oil and ethanol? Is the supply and demand steady or variable? Should I just use technical analysis and charting to trend the price or can I read the news to ferret out variables I know will affect the supply or demand in the future and buy or sell before the move is evident?

You can see that supply and demand is the main issue but it sure isn't the only issue. Charting helps but it's just a start.

Own the commodity producer

Now things really get complicated. Producers' profits are not only affected by the price of the commodity -- which affects their revenue but all the other factors of an operating entity come into play. What is their cost of extraction? How efficient are they and do they just extract or do they also refine and fabricate? How effective is their management and sales force in marketing the commodity? Do they supply through long term contracts or do they just go to the spot market? Operations normally need to be financed-- how effective is their capital management in keeping financing costs down?

What is the quality of the ore they are extracting? At what price of the refined commodity is this producer meeting their break-even point? Do they have a high fixed cost or do they have high variable costs? What are the odds of this producer earning higher profits than the other producers. Are they a big fish in a big pond or are they a small fish in a big pond? Can a foreign government affect their competitiveness by giving their local producers subsidies? See it really is more complicated to analyze the producers than analyzing the price of the commodity.

As with all investments, the focus is on the relationship between risk and reward. It is easier to analyze the movements in the price of the commodity but futures contracts give you more leverage than margining the stock of a producer.

I'm sorry but in the first paragraph of this article I told you that there is no correct answer. The answer starts with you determining how much research you are willing to do and how much risk you're willing to take. Why should commodities be any different than any other investment decision?

It depends!

Disclosure: No positions in Gold or any Gold Producer at the time of publication