The markets might be in rally mode, but it always pays to keep a good solid hedge or two in play to counter the surprises that lurk just over the horizon, writes David Chapman of Investor’s Digest of Canada.

Despite continuing efforts to tamp down tensions, war with Iran remains a very real possibility.

The world has been brought to a boil by decisions by both the US and the European Union to hem Iran in with economic sanctions.

The West says Iran is building nuclear bombs. Iran says its nuclear program is purely peaceful. Evidence from intelligence sources, as well as the International Atomic Energy Agency, suggests Iran’s nuclear program is nowhere near advanced as the West says.

Among the West’s sanctions is a ban on international banks dealing with Iran’s central bank, along with penalties if they do. The ban is intended to strike at Iran’s oil exports, for which payment is normally made in US dollars. Iran has responded by cutting deals with Russia, China, India, and other Asian countries for payment in gold, yuan, or other currencies.

The Ban Thickens

The EU then banned any dealing with Iran’s central bank in gold or other precious metals, as well as banning all new contracts to import, purchase, or transport Iranian oil.

Both India and China rely heavily on Iran for oil—in China’s case, for 15% of its supply. Iran now pumps out 3.5 to 4.2 million barrels of oil a day, of which it exports 2.5 million barrels.

It’s the world’s fifth-largest oil producer behind Saudi Arabia, Russia, the US, and China. Iran also boasts the third biggest oil reserves in the world, estimated at 136 billion barrels. In addition, it has the world’s second biggest reserves of natural gas.

What’s particularly scary about the growing crisis is the willingness of countries to pay for Iranian oil in currencies other than the US dollar, thus allowing Tehran to thumb its nose at the West. That these countries depend on Iran to fuel their economies isn’t lost in the rhetoric that now characterizes the Iranian debate.

Moreover, the willingness of China, Russia, India, and others to evade the sanctions raises the potential for broader conflict.

These countries are also prepared to thumb their noses at the US dollar. True, the greenback remains the world’s reserve currency. But if its use in global trade were to decline, there could be grave consequences not only for the currency, but for the US economy as well.

From America’s perspective, the trillions of US dollars now sloshing around the world must remain in circulation. A drop in demand for dollars could send the US into a deep recession.

Gold Still a Good Bet

What, then, is an investor to do?

Certainly, he should continue to hold gold and bullion as a base for his portfolio. And investors can buy stocks or funds that hold bullion on a segregated basis.

Investors can also buy the Sprott Physical Gold Trust (Toronto: PHY.U), or the Sprott Physical Silver Trust (Toronto: PHS.U).

Another vehicle, the Central Fund of Canada (CEF) holds both gold and silver, but isn’t segregated. As a closed-end fund, it can trade at a discount or a premium to its net asset value.

Investors can also consider parking their money at The Royal Canadian Mint (Toronto: MNT). Its notes hold gold, but are not segregated.

And can investors hold oil? Yes, they can. And they can do so through an exchange traded fund, the Horizons Winter Term NYMEX Crude Oil (Toronto: HUC).

Derivatives Used

By using NYMEX crude oil futures, the fund mimics the rise in oil prices. But unlike the bullion funds, the Horizons ETF uses derivatives.

Other ETFs worth considering include the United States Oil Fund (USO) and the United States Brent Oil Fund (BNO). The latter tracks the price of Brent crude.

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