A Fool's Gold

Lately, Mother Earth's resources have been very popular with investors. In particular, stocks associated with oil, industrial metals, and gold have been seeing incredible returns. There are many reasons for this, but one that keeps coming up time and time again is China's increasing urbanization.

Recently, I had the opportunity to listen to Edward Morse, a former deputy assistant secretary of state of international energy policy, speak at Princeton University's Woodrow Wilson School of Public and International Affairs. One of the reasons Morse provided for today's energy situation, which he described as far more problematic than the one we faced in the 1970s, is the global phenomenon of urbanization, but particularly in China.

Morse pointed out that the United States, which is considered a Western industrialized nation, currently has nine cities with populations over 1 million. China, on the other hand, is only 39% urbanized, but it already has 98 cities of over 1 million people. He added that the Chinese government has a plan in effect to increase its urbanization from 39% to 69% over the next decade. Unprecedented urban growth, along with inadequate operational refineries, is creating what he calls a crisis. Data from the International Energy Agency (IEA) validates Morse's analysis by projecting that China will increase its oil consumption by 7.2% in 2006.

But in any crisis, there is opportunity, and refinery shortages have helped propel Valero Energy's (NYSE: VLO  ) stock to more than double over the past year in response to oil supply concerns. Fellow Fool Robert Aronen provides excellent analysis on the refinery situation and the price of oil.

Beyond oil, prices for industrial metals have also increased in response to China as it consumes massive amounts of steel to keep up with the demand of explosive economic growth. A staggering figure: In 2004, China spent $13 billion on roughly two-thirds of the world's iron ore supplies. Fool contributor Stephen Simpson discusses the outlook for steel and iron in 2006. Titanium demand is also on the rise as aircraft manufacturers like Boeing (NYSE: BA  ) respond to higher energy costs, with the development of lighter aircraft using more of the lightweight metal. The net result of Chinese economic expansion and the need for more fuel-efficient aircraft caused metal manufacturer Allegheny Technologies' (NYSE: ATI  ) stock to increase approximately 100% over the past 12 months.

In addition to oil and industrial metals, gold prices are also being substantially affected by China's expansion. Why gold, you ask?

The demand for gold
Last week, the price of gold jumped $20 per ounce in large part because of China's announcement that it plans to diversify its foreign reserves holdings. Many economists anticipated this, since China is currently the second-largest holder of U.S. Treasuries behind Japan, creating a need for China to create a stronger hedge against a weakening dollar.

This follows a previous statement by Teng Tai, China's chief securities dealer, when he advised the country to increase its current gold reserve of roughly 600 tons to 2,500 tons in the near term and maintain around 3,000 tons over the long term. Gold speculators have anticipated such a move for some time, as China's current gold position is only 1.4% of its total foreign exchange reserve, according to figures from the International Monetary Fund. This percentage ranks it the lowest among the top 15 central banks with bullion reserves, according to a recent report from Credit Suisse First Boston. A move to 2,500 tons would make it the fifth-largest bullion holder, behind countries like the United States and Germany.

Gold speculators are partying over the possibilities. Since 2001, the price of gold has doubled to its current level of around $535 per ounce. It provided investors with an 18% return in 2005, outpacing the S&P 500's 3% over the same period. We have to warp back to the late 1970s to find the last time there was such fervor for gold. But in addition to the China situation, there are other reasons why investors are adding more of the precious metal to their portfolio.

For one, at no other time in the history of the stock market has gold been as accessible to armchair investors as it is today. The formation of superfunds streetTRACKS Gold (NYSE: GLD  ) and iShares COMEX Gold (AMEX: IAU  ) make it possible by a click of the mouse to designate a portion of your portfolio to the sole purpose of tracking gold prices. For example, since gold prices increased 18% in 2005, investors were awarded with an equal return by holding streetTRACKS Gold.

But these funds have another effect in that every investment dollar put into them is matched by its equivalent in gold. So, as more and more investors flock to streetTRACKS Gold, the fund, in turn, buys more gold, essentially increasing the metal's demand on the market. And just how high has the demand for this fund risen? Consider that over the past year its total net asset value has increased an astounding 27.8% to $4.9 billion.

China and individual investors, however, aren't the only ones eyeing gold. Economists have pegged other central banks like South Korea and South Africa as likely to increase gold positions. The Central Bank of Russia, for instance, recently announced that it plans to double its holdings of the precious metal.

A piece of the action
To get a piece of the gold action, in addition to the prior-mentioned funds, investors have other options. Miners like Newmont Mining (NYSE: NEM  ) offer the potential for massive gains, but like any business, they also carry operational risks. Fool contributor W.D. Crotty also cautions that many mining stocks already have future gold appreciation priced into their valuations. Another possibility is the Central Fund of Canada (AMEX: CEF  ) , which maintains its assets of actual gold and silver in bank vaults. I looked into this fund last May, and since that time it has provided investors with over a 30% return.

Yet another way to form your own hedge against economic uncertainties is to buy American Gold Eagle coins. There's nothing like owning the real deal. The problem with this option, however, is that commission fees and, in many states, sales taxes make an investment in coins less worthwhile.

The rule of thumb I hear most in creating a hedge is allocating 5% of your portfolio into gold. My rule of thumb is whatever you're most comfortable with. I wouldn't bet the house on gold -- it's been a massive underperformer historically against the stock market. But the effect of China's rapid expansion, as well as domestic economic uncertainties, does lend credence to the strategy of shifting a portion of your portfolio into old faithful.

For more metal madness, watch these Foolish Takes pan out:

Do you like shiny objects? Try a 30-day free trial subscription to theMotley Fool Hidden Gemsnewsletter service and see what gleaming stocks Tom Gardner and crew unearth each month.

Fool contributor Jeremy MacNealy does not own gold or shares of any companies mentioned. The Motley Fool has a disclosure policy.


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