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Editor's note: Today, we're featuring the next installment of our "how-to guide" on commodity investing. More than any other sector, natural resources can produce gains of 1,000%, 5,000%, or even 10,000%. But you have to know what you're doing. And you have to have the right tools for the job...

An Essential Toolkit for Resource Investors

By Matt Badiali, editor, S&A Resource Report
Wednesday, December 28, 2011

OK... let's say you realize that to succeed as a commodity investor, you must master the resource cycle. Let's say you know "you're either a contrarian or a victim." And let's say you've found a specific sector – like gold or oil – that allows you to take advantage of contrarian bargains.
 
Now you need to "get long." And the decision you have to make is what tool to use for the job.
 
There are several ways to make a bullish bet on commodities. Each has its pros and cons... its particular risks and rewards. One investment might be a great idea for some folks, but terrible for others.
 
Today, I'll show you how to choose...
 
When it comes to resources, we can put our trading "tools" in seven broad categories.
 
Below, I'll give you a "thumbnail" overview of each category and rate it on a scale from 1 to 10, from relatively conservative to relatively risky. (Only experienced traders who can handle volatility should even consider putting money in anything with a 10 risk rating.)
 
One more note before we begin: These ratings are specific to the resource market... I'm not considering how risky any of these categories are relative to bonds, real estate, or blue-chip stocks, for example.
 
Let's get started on the "low risk" end...
 
THE PHYSICAL
 
If you're bullish on a given commodity and you have the means, just buy the stuff! That's the advice you'll hear from investors who don't want to trade in and out of stocks.
 
The problem is, most commodities don't lend themselves to low-cost, efficient storage. Sure, you can buy 10 ounces of gold bullion and store it in a vault. But most folks don't have the means to store corn, crude oil, natural gas, uranium, or cotton.
 
Generally, buying the physical commodity itself only works with precious metals like gold, silver, and platinum. They have tremendous "value density" – just a handful of one-ounce coins can add up to $10,000.
 
So owning a stash of gold, silver, and platinum coins is a great idea, in my opinion. It's real, tangible wealth to keep on hand in case of a dollar crisis... or if you need to discreetly transfer a large amount of wealth.
 
Risk rating: 1
 
THE "BIGGIES"
 
In any given commodity sector, there are usually a handful of giant producers that dominate the industry. They have the money to hire most of the best people, they manage the biggest projects, they buy the most equipment, and their capital spending "sets the tone" for the rest of the industry.
 
In the gold sector, for example, a handful of large producers mine most of the world's gold. These include Barrick, Goldcorp, Newmont, AngloGold Ashanti, and Newcrest. In the oil sector, you have ExxonMobil, Royal Dutch Shell, and Chevron (in addition to large, state-owned companies that aren't publicly traded).
 
The "biggies" typically have been around a long time and have fairly stable businesses. They have a mix of assets around the world. Their market caps are anywhere from $10 billion to $300 billion (depending on the industry). Many pay dividends.
 
This means they are less volatile than smaller companies... and are appropriate for conservative investors.
 
They are not without risk, however. A big fall in the price of the commodity they produce can send their shares lower. Likewise, shares might stall if increases in their costs of production outpace increases in the price of the commodity they produce.
 
Risk rating: 2
 
EXCHANGE-TRADED FUNDS, PART 1
 
When it comes to resource investing, exchange-traded funds (ETFs) come in two different "flavors"...
 
One owns a diversified basket of exploration and production firms. For example, the iShares U.S. Energy Sector Fund (IYE) owns a broad swath of oil producers, explorers, and various other energy firms. As I write, the fund owns more than 50 different energy stocks.
 
When it comes to gold, a popular fund is the Market Vectors Gold Miners Fund (GDX). This fund owns 30 different gold stocks, some large, some small.
 
When you own a diversified basket of stocks, you give up much of your upside. You'll also end up owning lots of "so so" companies. But these ETFs can give you exposure to a sector, without subjecting you to the risk of owning just one or two companies. These are appropriate for risk-averse investors.
 
Risk rating: 3
 
ROYALTY FIRMS
 
This is one of my favorite categories. Royalty companies are a unique and efficient way to invest in a given resource trend.
 
Most royalty companies are in the gold and silver sector. But they mine no metals of their own. Instead, they finance a lot of early-stage exploration or production projects. When a mine they finance starts producing, the royalty company gets a cut of the cash flow.
 
Royalty companies are high-profit-margin, diversified, and leveraged ways to speculate on higher commodity prices. The large royalty firm Royal Gold, for example, climbed 23-fold from mid-2001 to 2011. The large silver royalty firm, Silver Wheaton, climbed 14-fold from its credit-crisis low in 2008 to its 2011 high.
 
If you buy quality royalty firms when their underlying commodities are out of favor, you can set yourself up for huge gains. But always keep in mind that their share prices can fall if their underlying commodity enters a bear market.
 
Risk rating: 4
 
PICKS AND SHOVELS
 
Another one of my favorite ways to invest in a resource boom is with "picks and shovels." These companies provide vital equipment and services needed to explore for and extract resources.
 
The classic "picks and shovels" success story is set in the 1850s. Back then, a German immigrant moved from New York to San Francisco to participate in the California Gold Rush. Rather than the "all or nothing" route of looking for a big gold strike, this guy sold basic goods to the miners. He eventually started producing a new type of durable pants. They became a huge hit... and he got rich.
 
His name was Levi Strauss. Levi didn't risk it all on trying to find the big strike, he just sold the stuff everyone else needed to try to find the next big strike themselves.
 
The idea of owning "picks and shovels" has become an investment cliché for good reason. It can be an incredibly profitable, diversified way to profit from rising commodity prices.
 
When it comes to modern day "picks and shovels," we have a wide variety of ideas to consider...
 
You have companies like Schlumberger and Halliburton. These two companies are giant "oil service" providers. They sell equipment and services to large oil companies... You have Joy Global, which sells mining equipment... You have Core Laboratories, which performs advanced seismic research so oil companies know where to drill... You have companies like Trican Well Services and Calfrac that perform the new type of "hydraulic fracturing" services that have revolutionized North American energy production... You have Kennametal, which sells extremely durable cutting teeth and blades to explorers. You have Bristow Group, which sells helicopter services to the offshore oil and gas industry.
 
The variety of "picks and shovels" choices is extraordinary. And one well-timed buy when these companies are out of favor can make for hundreds of percent gains. But always keep in mind that these companies boom when times are good and bust when times are not so good.
 
Risk rating: 4
 
THE MID-TIER PRODUCERS
 
You can consider "mid-tier" producers as "biggies in training." Mid-tier producers are still relatively large companies, with market caps ranging from $1 billion to $50 billion (again, depending on the industry). But mid-tier producers typically have a narrower asset base. For example, a gold mining "biggie" might operate 10 large mines around the world, while a mid-tier producer might operate just two or three large mines.
 
Because mid-tier producers have less asset diversification, they are riskier than larger, more diversified companies. If a mid-tier producer has a major problem with one of its mines or oil fields, it will cause a huge swing in its profitability and a huge swing in its share price.
 
Still, these companies can be great investments if they have smart managers. There's more potential for growth with mid-tiers than there is with "biggies."
 
Risk rating: 5
 
EXCHANGE-TRADED FUNDS, PART 2
 
The second "flavor" of resource ETFs are "pure play" funds. There are funds that rise and fall in lockstep with gold and silver prices, for example. There are funds that attempt to rise and fall with oil, natural gas, and copper prices.
 
I'm generally not a fan of these funds. Most of them "bleed" value because they have to trade in the futures market... and they charge substantial fees.
 
Also, when it comes to owning "real money" assets like gold and silver, why own "digital" when you can own the real stuff?
 
Risk rating: 8
 
NONPRODUCERS WITH GOOD ASSETS
 
"Nonproducers with good assets" is an odd class of resource stock. These are companies that own one or two large assets that could be turned into mines or oil fields... but for some reason or another, have not been put into production.
 
Seabridge Gold is one of the highest-profile companies in this class. It owns the "KSM" project in British Columbia, Canada. KSM is one of the world's largest undeveloped gold and copper deposits. It's an absolute monster, with nearly 40 million ounces of gold and 10 billion pounds of copper in proven and probable reserves.
 
The problem with KSM is that it's in an inaccessible area of Canada. Huge investments in roads and electrical infrastructure are required to mine KSM. We're talking billions of dollars. Still, if gold prices were to soar, it would be worth it.
 
You can make good money in these types of plays if you buy them when their underlying commodity is in the pits... and on the cusp of a big rally. From 2005 to 2008, for example, Seabridge Gold rallied more than 1,000%.
 
But investors have to be very careful buying these companies. Often, these big deposits have big factors working against them... like environmental concerns, political concerns, or, in Seabridge's case, a remote location. They are among the riskiest plays in the resource market.
 
Risk rating: 9
 
JUNIOR EXPLORERS
 
Junior explorers are the "bloodhounds" of the resource industry. Their market caps are typically in the $5 million-$100 million range, miniscule next to a "biggie." (ExxonMobil is 1,000 times larger than a $38 million "junior.")
 
The business model here is to find a prospective area that could be rich in metals or oil, raise money from investors, hire geologists and some drilling equipment, and look for a big strike. If it finds that big strike, the junior will sell it to a larger company.
 
Early investors can make 1,000%... 5,000%... even 10,000% here. But this is the "Wild West" of the resource stock world. Junior explorers are the riskiest area of the market. They are inappropriate for 99.9% of investors. They have little in the way of tangible assets. They are essentially a group of corporate managers and geologists with a dream and a story.
 
The vast majority burn up their cash and find nothing.
 
In any given industry, however, there are some folks who are habitually successful when it comes to finding big resource deposits. If you stick to investing with proven, honest managers, you can make great money in "juniors." Just keep in mind that out of a random selection of 1,000 junior explorers, just five or 10 are worth considering as a speculation.
 
Again, most investors should steer clear of this market, which has less trading liquidity and lots of worthless companies masquerading as "investments."
 
Risk rating: 10
 
IN SUMMARY
 
When it comes to "playing" a resource trend, you have lots of tools. You have to decide for yourself how much risk and volatility you can tolerate.
 
"Biggies," mid-tier producers, royalty firms, the physical, selected funds, and picks and shovels can all work well.
 
I recommend avoiding most "pure play" funds. I only recommend "juniors" to folks who are comfortable with handling risk and volatility (like readers of my S&A Junior Resource Trader).
 
You might note that I've left the futures and options market off this list. I know many folks who are successful in this area of the market, but it's totally inappropriate for most individual investors... and these ideas are outside the scope of what I do. Please only swim in these waters if you are an advanced trader.
 
Good investing,
 
Matt Badiali
 
P.S. In my next essay, I'll cover the best strategy to "ring the cash register" with resource stocks. You can follow this plan to safe, triple-digit gains. Check your inbox tomorrow.




Further Reading:

Despite its recent selloff, gold is still one of the best commodity investments in the world. The yellow metal has soared over the last decade, holding up through the 2008-2009 financial crisis and this year's rout in the commodities markets.
 
To learn why gold is so valuable – and why it's so important to own – the Daily Crux sat down with Doug Casey, chairman of Casey Research and one of the world's best-known experts on gold and resource investing. For gold investors and anyone still on the sidelines of the gold bull market, this interview is required reading. Find it here.

Market Notes
Natural gas prices have been cut in half over the past five years. Oil prices have jumped more than 50%.
 
Utilities were big dividend winners in 2011... Dominion, Southern, Con Edison, Duke, and Progress Energy are all up over 20% this year.
 
Long-term U.S. Treasury bonds are up 20% since S&P downgraded the U.S. credit rating in August.
 
U.S. crushed BRIC countries in 2011... S&P is flat for the year, while foreign indexes fell 20% or more.
Best of Daily Crux: 2011
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Monday, May 2, 2011
"Not all areas of the United States are equal..."
 
Tuesday, September 6, 2011
"So what will happen? I see two possible outcomes..."
 
Wednesday, September 14, 2011
"Born in the Great Depression, Russell knows what it's like to live in hard times..."
 
Thursday, October 6, 2011
"This is a problem that runs through the system at all levels..."
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