Gold Or Oil: Which Is The Hotter Investment?

By Eric Fox | March 18, 2011 AAA
Gold Or Oil: Which Is The Hotter Investment?

Financial innovators have issued a wide variety of financial instruments over the last decade, giving investors exposure to many asset classes that were unavailable in past years. These instruments include ones leveraged to the price of oil and gold, two of the more popular areas for investors. However, this freedom to invest is not without risk, and those interested in exposure here should research carefully before jumping in. (Gold is a very useful investment during periods of instability and high inflation. Check out Why Gold Matters.)

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Gold and Oil Performance
Gold has provided an extraordinary return to buy and hold investors over the last 10 years, with the metal rising in price from under $300 per ounce to the current level of approximately $1,425 per ounce. The return on oil over the last 10 years has also been extraordinary with the price moving from less than $20 per barrel in 2001 to the current level of just under $100 per barrel.

Gold Investing Rationale
Investors have historically purchased gold as a hedge against inflation or as a reaction to a financial or political crisis. Many also invest in gold for protection when a currency is being debased or devalued by a government.

Others believe that there are strong fundamental reasons for the increase in the price of gold, as supply increases have lagged the rising demand from the market. The jewelry industry is the largest user of gold, and has seen an increase in demand for gold jewelry from the emerging economies.

Another reason for gold investing is price momentum or trend investing. As more investors pile into gold, the price keeps going up and this performance gets at10tion in the financial media. This, in turn, motivates others to buy so that they don't miss out. This type of behavior has created bubbles in other financial instruments and markets in the past. (Find out more in The Myth About Market Bubbles.)

Oil Investing Rationale
The fundamental investment case for oil is based on increased demand for energy as China, India and other emerging economies accelerate growth above historical baseline levels. This increased demand is difficult for oil producers to meet in the short and medium term as increased production requires large capital investments in multi-year projects. Some have even predicted that the world's oil supply has peaked and rising prices for oil are inevitable. (Not sure where oil prices are headed? This theory provides some insight. See Oil As An Asset: Hotelling's Theory On Price.)

Modern Innovations
Another reason that might explain the increased price of gold and oil is the ease with which investors can get exposure, as the financial industry has created many securities designed to track the performance of gold and oil.

Many of these instruments trade on the major exchanges and are extremely liquid. Investors can buy an instrument on the long or short side of gold or oil, and can leverage that exposure as well.

The SPDR Gold Trust Exchange Traded Fund (ETF) is the largest and most liquid gold ETF available (NYSE:GLD), with average daily volume of more than 14 million shares over the last three months. The trust held 1,217.3 metric tons of gold as of March 10, 2011. Another liquid ETF is the iShares Gold Trust (NYSE:IAU), which traded an average of 5.5 million shares a day over the last three months.

On the oil side, the United States Oil Fund, LP (NYSE:USO) attempts to track the spot price of West Texas Intermediate (WTI) crude and is also liquid, with average daily volume of 14 million shares a day.

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Buyer Beware
Bullish investors are passionate about the reasons to own oil and gold, and discount any talk that the strong investment performance in either of these are the result of speculation. Investors that are long these might want to think back to other investments over the last decade, where prognosticators sounded just as convinced that nothing could go wrong. Who can forget back in 1999 and 2000 when the consensus said that paying forty times the market's earnings was the right thing to do?

Another item to consider is that the downside of a bubble bursting is usually much more rapid than the ascent. The Nasdaq Composite index peaked in March 2000 and lost 87% of its value over the next thirty months until it reached the trough in September 2002. However, most of the decline occurred by early 2001, or less than a year. The price of oil fell even quicker in 2008, with the price peaking above $140 per barrel, before crashing down 75% in just five months. (These funds make investing in gold, oil or grain an easier prospect. Check out Commodity Funds 101.)

The Bottom Line
One of the advantages that we have over previous generations is the ease with which modern investors can invest in a wide range of securities providing exposure to asset classes and areas that used to be out of reach. Investing in gold and oil is now easy and cheap for investors, but not without risk.

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