Riding the Palladium Roller Coaster

Thu, Jun 10, 2010 - 10:01pm

As I discussed in my February article, “Palladium Still Shines,” palladium is a versatile element used in everything from electronics to polyester production to cancer therapy. In most applications, such as autocatalysts, cheaper metals can't be substituted. In fact, if hydrogen-based fuel cells become significant in local power and automotive applications, those high-tech uses would also require palladium.

I argued that palladium was still undervalued despite the 117% gain in 2009, and was too cheap compared to its sister metal, platinum. I wasn't surprised that palladium rose more than US$120 after publication, taking out my short-term target of $512.

Considering the metal's tumultuous history, I was also not shocked to see a correction a couple months later, although the speed was breathtaking. Palladium had a huge run-up from the lows at $160, and was close to challenging the spike high of 2008, so it was due for a break.

While it's been a fun 16 months, with the current price at $447 per ounce, is it time to get off this ride? After all, many analysts are expecting vehicle sales to drop in the third quarter of 2010. If the global economy turns down again, commodity demand could fall, and investors could liquidate the palladium ETFs, swamping the market with supply.

Powerful Demand

As nearly half the demand for palladium comes from autocatalyst production, a study of the car market is crucial to forecasting palladium use. While bearish pundits cite the eurozone crisis as a reason for sales to retrench, the situation is not so simple. Although analysts predict Western Europe’s vehicle sales to drop anywhere from 7.4% to 12% in 2010, Russian purchases jumped 20% in April due to the government’s own version of “Cash for Clunkers.”

Struggling areas like Western Europe and Japan will be counterbalanced by many bright spots. The US may be in a slump, but Americans are expected to buy 13% more cars than last year. Sales are up strongly in India and South America as well.

The largest vehicle market, China, should see a double digit increase in purchases in 2010. This nation mostly purchases small, gasoline powered cars which require palladium in their catalysts, not platinum. China's GDP is rising and there is a large amount of pent-up demand, as the Chinese only have 20.5 cars for every 1,000 people. In addition, the government is offering incentives to buy cars which continue through December. China should push global demand into positive territory, with total vehicle sales expected to rise 4% this year.

Two secondary sources of palladium demand, jewelry and electronic devices, dropped 17% and 7% respectively last year. Although consumption dropped, these industries are increasingly substituting palladium for more expensive metals like rhodium or platinum. Any economic recovery will benefit palladium more than other platinum group metals. With the BRIC countries expected to have higher GDP growth in 2010, demand for these discretionary items should increase.

Much of the drop in industrial use last year was offset by the 49% jump in investment demand. Investor interest for the metal is growing rapidly, consuming approximately 10% of supply in 2009. According to the Financial Times, palladium ETFs held 1.8 million ounces of the metal as of June 2 – 25% of annual production. While I am skeptical about the actual bullion holdings of PALL and securities like it, the desire to own palladium is putting a tremendous amount of pressure on this market. Even with the correction, few investors sold out of ETFs, demonstrating they are holding out for much higher prices.

Shrinking Supply

Unlike currencies, metals can't be printed so it's difficult to increase supply. Production of palladium is only 10% that of silver, and it’s usually a byproduct of nickel mining. It's rarely feasible to chase higher prices with more palladium production.

In addition, palladium deposits are only found in a few countries. Russia now dominates the market, supplying 50% of global demand. Unreliable producer South Africa has fallen to second place with 35% of global output. North America contributes a little more than 10% of the total.

Although palladium production from Canada and the US should increase in 2010 due to reopened mines, it won’t affect supply significantly. In reality, any production boost in North America is likely to be swallowed by cuts this summer in South Africa. Despite government spin, the nation has not solved its energy generation problems. The public utility Eskom has another huge challenge this summer when the World Cup arrives in Johannesburg on June 11. This month long event will take priority for power, so Eskom is expected to cut electricity to the country’s mines. The last time mines were closed by “load shedding” directives, the palladium price spiked.

Primary mine supply of palladium doesn't satisfy global demand, so some of the deficit has been filled by reuse. As I mentioned in February, most of the “Cash for Clunkers” subsidies have ended, shutting off a large supply of recycled vehicles. In fact, refiner Johnson Matthey reported that recycling from all sources dropped more than 11% last year.

Metal stockpiles were a major source of palladium supply during the last decade, but the Russian government is the onlyone left. As recently as 2008, Johnson Matthey estimated that over 13% of global palladium was supplied by this national stockpile. The company’s analysts assumed that Russia would sell approximately 960,000 ounces in 2009, the same amount as the previous year, causing a surplus of 655,000 ounces. However, credible sources such as Mining Weekly and Norilsk Nickel assert that the Russian stocks are nearly depleted, and it’s unlikely that any sales occurred in 2009. If JM’s other data is correct, the market has already slipped into deficit.

Brilliant Future?

Technically, palladium is correcting its long term move from $160 to $567.45. The price slashed through the .382 Fibonacci level at $411 and even penetrated the 200 day moving average at $400 intraday before bouncing off long-term support at $390. The recovery has been erratic, reaching $474 two weeks ago before settling back to $447 today. Palladium seems to be consolidating with the 200 DMA acting as support at $408.

Although I think it’s unlikely, a significant drop below this support level could see the metal testing the .50 retracement level at $364.

Although palladium had a dramatic 16 month run, skyrocketing 254% before correcting, I believe it is still undervalued. Demand for the metal is growing as manufacturers substitute palladium for more expensive metals. Asian countries, especially China, are buying more electronics and jewelry that increasingly use this metal. Globally, new buyers are choosing the smallest cars which tend to be gasoline powered, benefiting palladium demand at the expense of platinum.

Although many analysts believe palladium is expensive at this price, a shortage trumps any other fundamental factors. Knowledgeable observers believe the Russian stockpile is nearly gone, and it’s unlikely there will be any further substantial destocking. South Africa will almost certainly have to cut electricity to the mines during the World Cup, ceasing production from the second biggest source of metal. Increased production from Canada, the US and Zimbabwe will not be able to compensate.

I don’t believe the market fully understands the implications of these facts. Once traders realize that palladium is now in a supply deficit, I predict we will see another price explosion this summer that will take out the 2008 high of $600. A strong rebound in the euro or more serious mining issues could see palladium top $700 per ounce later this year.

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