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The commodity or miners if you are going for gold?

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While gold prices set to hit USD2,000/oz, the producers of the metal remain cheap. Should investors consider exposure to the commodity or to its miners?

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Gold prices are predicted to hit $2,000/oz this year from current levels of around USD1,670/oz as a number of factors combine to support the yellow metal.

Despite this - and the fact that gold prices have been elevated against historical norms over the course of the crisis - gold producers themselves remain cheap. Why is this and should investors consider exposure to the commodity or its miners?

Smith and Williamson Global Gold and Resources fund co-manager Ani Markova highlights restrained supply, demand from emerging markets and central bank policy as supportive factors for gold prices.

Today twice as much rock needs to be mined in order to extract the same amount of gold as in the 1980s and 1990s due to high grade reserves being located in politically unstable regions such as Mali.

Markova says: “It takes a lot of years to take a mine from discovery to production. A lot of permitting, a lot of dealing with social economic issues and dealing with governments, and capital is needed to build infrastructure.”

While restricted supply keeps the metal’s price high, for gold miners it reflects higher production costs and hampered revenues - neither of which is helpful for their share price.

MFM Junior Gold fund manager Angelos Damaskos, who thinks gold will reach $2,000/oz this year, is worried by the drop in production.

He says: “It is expected the global rate of gold will drop in the future because the global mining industry has been hit by very rapidly rising costs of producing commodities.”

However, Damaskos says gold mining executives are currently concentrating on cost control. This means they are focusing on their profitable operations and producing from the higher grade zones, while considering closing mines that are more expensive to run.

The growing demand for gold in emerging markets, which is highlighted by the World Gold Council as being responsible for the majority of physical gold demand, is another reason the metal is likely to stay high.

Markova notes that China is increasing its holdings of gold. She estimates the country has 425 tonnes of the metal in its stockpiles. As the People’s Bank of China only holds about 310 tonnes in its vaults, this suggests the growing Chinese middle class is channelling its wealth into gold.

She says Chinese buyers tend to hold onto gold, further reducing the amount available for sale and pushing up prices. Markova says: “My contacts tell me that gold does not leave the country. So where is it going? It is going into jewellery and into investments.”

Furthermore, India has historically been a very big importer of gold. Although the country has well publicised economic problems, Markova thinks gold demand could rise this year as it is a traditional wedding gift and more people are expected to get married in 2013.

Continued easing from the world’s central banks is another commonly accepted factor as supporting further gains in gold prices, as many investors turn to precious metals to act as an inflation hedge.

Markova says: “This is an environment in which we see a lot of printing going on. We think the US Fed will continue to print until it sees unemployment fall to 6.5 per cent.”

Close Brothers Asset Management chief investment officer Nancy Curtin, who forecasts gold will hit $1,800/oz this year on the back of continued quantitative easing by the US Federal Reserve and improved US economic growth, understands the demand for physical gold but thinks investors should not ignore the miners despite their recent weakness.

She says: “Why do people want gold? As an investment it is not really productive and it does not produce cash flow. It is a psychological investment.

“If you like gold, then gold equities is the way to play it. You can buy at 25 per cent of the price because of a lot of stock specific issues, management and political issues due to Mali, rising production costs and problems with companies. We think mining gold stocks are very cheap.”

Curtin says Close Brothers Asset Management has exposure to gold of between 3 and 5 per cent through the gold miners. Gold equities have been constituents of the firm’s portfolios for the past two or three years.

Hargreaves Lansdown senior investment analyst Rob Morgan points out that gold tends to be a volatile asset but holds its value over a long period of time.

He says: “Gold is a security blanket for some people. You can see it, you can touch it and you can bury it in your garden and dig it up later.

“As interest rates are kept low and inflation is high and people are seeing there are nominal savings reducing in real terms in value, quite often they do turn to gold because it should maintain its spending power.”

Physical gold could play an important role as a portfolio diversification tool, Morgan adds, while the concerns surrounding the miners could create an opportune entry point for investors.

He says: “A lot of gold mining companies have underestimated getting gold out from under the ground and how much they will make for selling gold. I think for investors at the moment gold equities look like good value.”

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