Natural resources are often viewed as a compelling alternative allocation and portfolio diversifier for stock and bond holdings. Resources have an appealing, tangible quality in times when financial assets experience instability. Questions regarding resource supplies and the impact of inflation on wealth make natural resources even more attractive as an investment holding.

But resource investing defies generalities, and presents a wide array of risk and return factors to be considered. As a basic definition of natural resources, "assets occurring in a natural state and having economic value" will suffice. The journey from a natural state to your portfolio can take many paths, and investment performance can also vary widely. For example, if your client wants to invest in commodities, he can get very different investment outcomes if he buys a futures-based index fund versus an equity stake in a commodity producer or distributor.

It is safe to say, however, that once naturally occurring assets enter the flow of commerce they become subject to many of the same economic forces that affect traditional asset classes. Supply and demand, shortage and surplus, political and regulatory uncertainty, as well as the whim of capital markets are inescapable influences on all investment returns. A few examples may clarify the complex interaction of fundamental and capital market drivers that investors should consider.

Investment Dynamics

Resource investing is uniquely influenced by a combination of socio-political, economic, technological and natural forces. The potential investment returns of natural gas, industrial metals and timber all will be shaped by environmental regulations not yet written and technological advances still on the drawing board. Change most often represents a risk as well as a potential opportunity, and the change caused by government action can be the most disruptive.

As public sector balance sheets are strained all over the world, the privatization of some resources has become a potential source of revenue for governments. And while this may face considerable public outcry over the notion of selling off national treasures, it also arguably moves resources to more efficient management and, in turn, will cause an increase in market supply. An opposing trend-nationalization of natural resources-has also sprouted periodically. Strategic resources such as fossil fuels and mineral deposits form the backbone of political power for many regimes-Russia and Venezuela come to mind-whose ideology presents a potential stumbling block to optimal supply. The bottom line for investment purposes is that inefficiency due to political considerations creates less supply.

In addition to political risk, the technological challenges presented by many new deposits have resulted in a bifurcated energy market. The major integrated players, such as Exxon and BP, have taken a more conservative approach with their exploration dollars, leaving the higher risk and reward of more aggressive exploration to smaller companies willing to take a chance on greater geological uncertainty. This higher risk profile of smaller exploration and production companies can be expected to have less correlation to unrelated stocks, but they may also be more vulnerable to changes in either credit conditions or investor risk appetite.

The majors by comparison, and the capitalization weighted energy exchange-traded funds holding them, will tend to deliver returns similar to the S&P 500. Healthy cash flows, strong balance sheets and attractive dividends are the compensation offered by Big Oil for less diversification and lower potential capital appreciation.

Investors seeking a diversified energy holding that also has attractive income possibilities may want to consider a Master Limited Partnership (MLP). The attractions of MLPs include liquidity, quarterly income distributions and inflation-hedged revenue streams. And given the unique tax status of MLPs, whereby investors avoid the double taxation of corporate dividends, these vehicles can provide healthy yields similar to that of Real Estate Investment Trusts. However, when compared to REITs, energy MLPs should be viewed as having lower volatility and less potential for outsized returns. This is due to the greater stability of the underlying energy asset values and revenue streams (think pipeline instead of shopping mall). Access to tight lending markets can be a thorn in the side of any leveraged entity. MLPs may share in the pain of REITs in this regard. So, it's best to scrutinize the capital structure, borrowing needs and cash flow outlook of MLPs on an ongoing basis. Other risks to consider are potential regulatory changes that raise costs or threaten the favorable tax treatment of MLPs.

The cyclical nature of supply and demand is evident, to varying degrees, with natural resource investments. Water serves a basic need that would seem immune to the volatility of economically sensitive sectors such as industrial metals and lumber. Indeed, steady growth in demand for industrial, agricultural and residential water usage appears assured, particularly across developing economies.