PGM Bull Markets
Scott Wright February 29, 2008 3111 Words
The precious metals are in the midst of fantastic secular bull markets. And one of the most precious of metals, platinum, has been getting a lot of attention in recent weeks. With geopolitical strife accentuating platinumís current supply shortfalls, speculators have grabbed hold of this metal and launched its price into a parabolic ascent.
While gold still remains king of all metals for a variety of fundamental reasons, platinum is more precious simply because of its price. Its rarity in the earthís crust combined with the challenges of economically extracting it keeps its value typically about twice that of gold.
And like the trend for virtually all natural resources, global platinum demand has been on the rise. According to the U.S. Geological Survey, platinum demand just ten years ago was only 5m ozs. In 2008 demand for the metal that was once considered an unwanted impurity in silver is expected to exceed 7m ozs. A 40% increase in consumption of one of the most expensive metals on the planet, in just ten years, is quite impressive.
But this rapid increase in platinum demand has really strained the suppliers. According to platinum group metals (PGM) expert Johnson Matthey (JM), in eight of the last nine years the platinum markets have experienced an imbalance where supply has fallen short of demand. This of course is a textbook economic catalyst for rising prices.
And this supply shortfall is expected to continue for at least the next couple years as news from South Africa continues to create uneasiness in the markets. SA is not only the second-largest producer of gold in the world (China now holds the number-one spot), but it is the number-one producer of platinum. And since it provides over 75% of the global platinum supply, even the slightest hiccup can send waves through this metalís tight market.
In 2007 a number of problems in the SA platinum mining industry led to the end of a seven-year streak of supply growth. According to JM there was actually a 2% drop in annual platinum supply last year. With demand growing by nearly 3% and supply falling year-over-year this creates an imbalance that will naturally drive prices higher.
Well new developments coming out of SA this year have raised even more alarm in the platinum markets. A country-wide power shortage has exposed the poor job the horrendous SA government has done in managing this countryís infrastructure. Because it turned its shoulder on decades-old warnings of an impending power crisis, the entire country must now pay the price and absorb major structural shortfalls of electricity from the national power grid.
This is a serious issue not only for the SA economy as a whole but especially for the mining industry. While this country is blessed with incredible geological structures that host the worldís largest and richest gold and platinum deposits, deep subterranean mining operations require immense power to ventilate and cool the shafts and hoist the ores to the surface.
And the SA mining industry has been greatly impacted by these power problems. So much so that not only was there a temporary halt on all mining operations earlier this year, but most of the largest miners have had to restate their operational guidance to the downside in order to game the power problems that will likely continue.
On the development front even the emerging platinum producers must account for these power issues. One of the larger developments in the prolific Western Bushveld mining district is finding it necessary to adjust its mining plan to account for the risk of shortages in available grid power. This project must now consider the expensive option of diesel-generated power in order to supplement possible grid shortages or rationing programs.
These SA problems will not only continue to hinder supply but increase the costs associated with bringing platinum to market. And this brings us to our next matter. Will the rising price of platinum resulting from these supply issues abate the continually growing demand for this metal?
Well looking at what is likely the most elastic of platinumís sectors, jewelry, you wouldnít think so. With platinum up an impressive 37% in 2007, jewelry demand held up rather well. By JMís calculations jewelry demand fell by only about 1.5% year-over-year with the help of strong demand in China and Europe. Weíll see if $2000+ platinum in 2008 takes more of a chunk out of the jewelry business.
Interestingly the bulk of platinumís demand is not being driven by the preciousness of the metal, as jewelry accounts for less than 25% of total demand. And even though platinum jewelry serves as a status of wealth, unlike gold this metal does not serve as a store of wealth. Platinum is not known as a safe haven and its investment characteristics just donít compare to gold.
Platinumís primary source of demand and growth is actually industrial in nature. Of its many industrial applications it is found in LCDs, hard disks, oil refining, and the exciting development of fuel cell technology. And by far the biggest single consumer of this metal is the automobile industry.
Platinumís presence in the automobile industry results from a decades-long environmental push to reduce automobile emissions of particulate matter, nitrogen oxide, and hydrocarbons. This push has led to stringent regulations that now require vehicles to be equipped with catalytic converters. In non-technical terms platinum (and the rest of the PGMs including ruthenium, rhodium, osmium, iridium, and palladium) serves as a catalyst inside these converters enabling chemical reactions that treat vehicle exhaust emissions.
Because of platinumís incredible catalytic properties, it has largely been the dominant PGM to comprise these converters. And most people have no idea how much precious metal they are actually sitting on when they drive. The average catalytic converter surprisingly houses about 5 grams of PGMs (measured by platinum in this example). So this means at todayís prices each vehicle contains roughly $300 worth of platinum.
And on a side note platinum is not only a catalyst for emissions, but with its lofty price it is now a catalyst for thieves. Provocatively there is a growing epidemic of catalytic converter thefts. A well-trained thief can remove a catalytic converter from a parked car in less than one minute and pawn it off for a hefty chunk of change to willing buyers that illegally recycle the metal.
Shifting to economics, for a car that retails at $20k its PGM component at todayís prices accounts for about 1.5% of the cost. And this percentage is even higher pre-markup for the manufacturers. So in an industry with already-tight margins a skyrocketing platinum price (this year alone platinum is up an impressive 39%!) is sure to hurt the bottom line.
Ultimately automobile manufacturers do not have a choice and must pay the going price for the metals that comprise their vehicles. Much of this obviously gets passed on to the consumer, but the manufacturers aggressively seek to control costs and are finding methods to do so even in catalytic converters.
Interestingly in gasoline-engine vehicles platinum is not the only PGM that serves as an effective catalyst to control emissions. While palladiumís properties donít convert emissions as efficiently as platinum, gasoline-engine catalytic converters are able to contain a higher percentage of this PGM and still meet code.
And this cheaper PGM alternative is very appealing to the manufacturers. In recent years the price of palladium has been running about a quarter the value of platinum. Because of this palladium is actually overtaking platinum as the PGM of choice in gasoline-engine catalysts. In fact, according to JM, there is a running five-year decline in the use of platinum in gasoline-engine catalysts.
This of course has led to growing auto-catalyst demand for palladium, an 8% year-over-year increase in 2007, and has been the primary driver of an overall 2% demand increase for this metal. JM estimates that the proportion of palladium now used in the manufacturing of gasoline-engine catalytic converters now exceeds 75% of the PGM load.
But as you can see in this chart, palladiumís bull market has not reflected the continually growing demand for this metal. And the reason for this is its economic imbalance is skewed inverse to platinumís due to an actual oversupply. This is countertrend to not only platinum but nearly the entire commodities complex.
Interestingly this oversupply is in large part due to Russiaís massive palladium stockpiles. These stockpiles are the result of aggressive palladium accumulation in the 1970s and 1980s. And once the strategic nature of this metal was deemed non-strategic, Russia began releasing its surplus to the markets beginning in the 1990s. Other than the bubble in 2000, Russiaís endeavors have indeed suppressed palladiumís price until recently.
As for this bubble not surprisingly Russia was the impetus of this volatility as fears emerged that it would stop releasing its stockpiles. This led to Ford Motorsí gaffe of over-speculating the market to game Russiaís purported supply stoppage. Ford of course bet wrong as Russia continues to pilfer its stockpiles to this day. Currently palladium supply is about 25% greater than demand, and this is usually a recipe for swiftly declining prices.
But even with this oversupply, the price of palladium has noticeably marched higher to break through its long-time non-bubble $200 barrier. Zooming in on the last few years, we can see in this next chart that palladium finally broke out of its funk and surprisingly began an impressive bull market of its own.
The overall strength in the PGM complex finally started to rub off on palladium in the second half of 2005. Since its low of $174 in July 2005 palladium has soared over 200% to reach a recent six-year high. And in 2008 alone it is up a whopping 47%!
But this rally still doesnít make sense from a fundamental perspective. With such a large surplus, prices shouldnít be rising in this fashion. Well with a three-year run to the upside the markets seem convinced that pricing palladium higher in the face of oversupply is the appropriate course of action.
There are a number of factors that I suspect go into this unusual trend. First it seems logical that palladium is just piggybacking platinumís strength. It is running a fairly tight correlation of 0.895 with platinum since 2005 and is sporting an r-square of 80%. This means that 80% of the daily behavior of palladium can be explained by the daily behavior of platinum.
It is also rumored that Russia is quickly running out of its palladium stockpiles. If this supply channel suddenly halts then the mined and recycled palladium supply would be really tight with demand. Interestingly according to JM palladium supply from the miners was actually down by about 5% in 2007. So perhaps palladiumís strong levels are a result of traders gaming a not-too-distant-in-the-future shortage of the metal.
Whether riding platinumís coattails or betting on future supply problems this metal is showing incredible strength. And demand for palladium should continue to grow both on the auto-catalyst front as well as in the jewelry sector. This growth will come not only as a platinum substitute, but on the heels of a fast-growing global auto market.
Back to platinum, you may be wondering how this metal could possibly be running a supply deficit considering its use in gasoline auto-catalysts is trending down. Well gasoline is the key word here. Interestingly platinumís role in the auto-catalyst sector is primarily driven by diesel-engine vehicles.
While in the U.S. the only diesel vehicles we typically see are trucks, the rest of the world, especially Europe, is seeing incredible growth in diesel. And much of this growth is driven by fuel economy. European drivers in particular pay vastly more to fuel their vehicles than Americans, thus actually creating an incentive to improve energy efficiency. And diesel-engine vehicles indeed provide much better fuel economy.
Platinum comes into play as a result of dieselís much higher levels of emitted pollutants versus the gasoline engine. These increased pollutants must still be controlled and are in turn counteracted by a more efficient filtration system. Since diesel engines, or compression-ignition engines, operate at a high-temperature permanence they need a more ďactiveĒ catalyst. And platinum is the qualified member of the PGMs hosting the acceptable physical and atomic properties.
Up until recently platinum was the only PGM loaded in catalytic converters in diesel-engine vehicles. But palladium can now be used sparingly. Even with this palladium creep though, according to JM platinum still covers around 90% of the PGMs currently used in diesel-engine catalysts.
And with regulations only tightening up in the future, platinum should continue to dominate the diesel-engine market. Ultimately even with palladium chipping away at platinum in the auto-catalyst sector, according to JM platinum demand from the auto industry still rose by over 2% in 2007.
And with over 50% of the passenger vehicles sold in Europe now diesel coupled with a super-hot global auto market led by Asia, platinum demand from the auto-catalyst sector is not likely to subside. According to JM 61% and 66% of platinum and palladium demand respectively comes from the auto-catalyst sector. And this sector will continue to dominate the economics of PGMs going forward.
Another factor that has and will have an effect on PGM fundamentals is ETFs. In 2007 platinum and palladium ETFs launched in Europe and of course caused some excitement. And since these ETFs are backed by the physical metals they have indeed pinched the liquidity of above-ground stockpiles.
Iíve seen estimates that PGM ETFs already account for up to 5% of total annual platinum demand. And this absolutely affects the market for this metal. So much so that the ETFs may single-handedly be responsible for supply deficits in the coming years. Platinum investment is perhaps taking a page out of goldís book.
More and more interest in the current PGM ETFs and perhaps new ones hitting the market really have consumers of the metals nervous. The PGMs have such a small market relative to other commodities that mainstream investor and speculator interest could really be disruptive from a liquidity standpoint.
In 2007 there was even chatter that several banks were attempting to launch US-based PGM ETFs. With the successes of the big gold and silver ETFs in the States a PGM ETF would likely attract great interest. But most folks believe this will never happen as the custodians dropped their ETF bids when they realized there was a slim chance of ever getting them approved by the SEC.
Ultimately researching and learning about the PGMs brings us to our primary focus, profitably trading these metals. While trading futures and European ETFs is certainly a good way to go, the average North American investor simply does not have access to these vehicles.
At Zeal we prefer to invest and speculate in the commodities bull markets through the stocks of the companies that explore, develop, and produce the commodities. Investing in stocks certainly comes with individual company risk, but the right companies can be highly leveraged to the performance of their underlying commodity and can provide investors with legendary gains.
Unfortunately on the platinum and palladium fronts there a not many miners that generate their primary source of revenues from these metals. These markets are still very small (about one-seventh that of gold measured by market capitalization) and the barriers-to-entry are enormous. And though there is a growing number of primary-PGM explorers starting to hit the markets, the producers are few and far between.
Provocatively I have found that gold serves as one of the best proxies to trade platinum. And if this next chart doesnít give you a stimulating visual picture of the relationship between these two metalsí respective bull markets, then the mathematical correlation ought to.
Since the beginning of 2002 gold and platinum have had a stunningly-tight daily price correlation of 0.979 with an r-square of an incredible 96%. With this type of correlation these metals have so far in their secular bulls proven to run near-lockstep with each other on a daily basis.
We can also use correlation analysis to show that gold stocks follow platinum closer than even platinum stocks do! Using Stillwater Mining (SWC) and North American Palladium (PAL) as examples, their correlations with platinum come in at 0.194 and 0.425 respectively. This translates to r-squares of 4% and 18%, almost no correlation at all with platinum. Only in their recent parabolic ascents have these stocks been the least bit enticing to traders.
Now take these poor correlations and contrast them to gold stocks and platinum. Since gold and platinum have a tight correlation, and from past studies we know that gold stocks and gold have a tight correlation, then gold stocks and platinum ought to have a tight correlation. Measured by the venerable HUI gold-stock index, gold stocks indeed prove to have an impressive daily correlation with platinum of 0.960 with an r-square of 92%.
Ultimately I am very bullish on platinum even though I believe euphoria currently has a grip on this metal. And the producers of the PGMs should be wildly profitable if they are managed well. But it is still apparent that gold stocks provide a better proxy to play platinum in the stock markets.
In our acclaimed monthly newsletter we publish a Watch List of stocks within various commodities sectors that pique our interest. And while a handful of PGM stocks seem to cycle through this list each month, we continue to find that the gold stocks offer the highest probability for large gains.
And since these gold stocks, and even silver stocks for this matter, provide the best correlation and leverage to the entire precious metals complex, our focus lies here on the trading front. If you are looking for high-probability-for-success stock picks and an action-packed newsletter dialed-in on the commodities markets, then subscribe today!
The bottom line is PGM demand continues to grow led by the auto-catalyst sector. But a growing number of problems on the supply side of the metal have been cause for growing concern among traders. And this concern has manifested itself into wild parabolas that are likely to correct hard once these markets stabilize and the speculators exit stage left.
But even upon stabilization PGM prices are likely to consolidate on the high side. And since platinum and most likely palladium are still in the first half of spectacular secular bull markets, high prices are probably here to stay. Traders who have been betting long on the physical metals in recent years have seen legendary gains. But for stock market investors and speculators, so far gold stocks have been the best vehicles to leverage the PGM bulls.
Scott Wright February 29, 2008 Subscribe at www.zealllc.com/subscribe.htm