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JakilaTheHun (99.93)

Asset Prices, Commodities, and Palladium

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December 12, 2008 – Comments (1) | RELATED TICKERS: SWC , PAL

Asset Prices and Commodities 

If you took a look at some of my picks, you might believe I expect an economic recovery.  However, I find myself rather divided on that issue.  In some ways, I believe it's smart to buy into good companies now while the stock prices are beaten down.  On the other hand, I see the boneheaded moves our government continues to make and realize that many policymakers and companies still refuse to adjust to the times, and I wonder how much longer this can drag on and how much worse things can be become.  The one thing I do not find myself as conflicted on, however, is the outlook for commodities.   

For a variety of reasons, I believe that commodities will be the biggest beneficiaries over the next few years.  First off, even ignoring the actions of the US government (and various other major national governments), asset prices can not decline forever.  Even if the economy is in rough shape, there are certain assets on the market that have fallen too far as a result of rapid demand destruction.  The length of this process depends on a few factors, but one of the most important is production/replacement costs.  If it costs more to create/extract/build/produce/etc an asset than the market currently sells it for, the situation must be corrected as no one will be willing to stay in that industry if it is not.  For a number of commodities, I believe that point has been reached.  This post will deal with one of those in some detail: Palladium. 

First, however, let's talk about the other dynamic --- government intervention.  There has been a lot of discussion about the various bailouts and all the money the US government is throwing around; while we are currently experiencing deflation, I do not think that situation can last all that long.  The supply of money is much greater as a result of governmental interference; however, due to fear in the markets, the velocity of money has not necessarily increased all that dramatically.  Once people start open their wallets and financial institutions start lending out again, this excess money is going to flood the system and create a great deal of inflation.  This will also benefit commodity prices since the real prices of the goods will not necessarily change, but the instruments used to purchase them (i.e. money) will decline in value. 

Due to these reasons and a few others, depending on what market we are talking about, I believe  that gold, silver, platinum, palladium, other metals, agriculture, and probably a few other commodities will continue to go up.  Which brings me to my next point of topic: palladium.

On Palladium

My thought on physical palladium right now is that the vast demand destruction could actually make the prices skyrocket at some point.  The logic is tricky, but here's how it works:

Roughly 50% of all purchased palladium comes from the auto industry.  As the auto industry has experienced a huge slowdown and many automakers have searched for ways to lessen their palladium usage in catalytic converters, demand has shot downward sending prices to the floor.  Prices have probably been about 30-50% lower than production costs, which means all the palladium producers have taken steps to reduce supplies.  A few of the most major Pd producers have actually stopped production for the time being.

Palladium is still a very useful metal one way or another and there will always be demand for it so it's not like it's going to disappear.  However, with supply dramatically diminished at this point, there seems to be two paths forward:

 

If the auto industry recovers and starts buying again, that's good for the Pd companies because prices rebound and probably shoot up past their equilibrium price (for at least awhile as the market overcorrects).  Palladium producers will reap the benefits.  In such a case, North American Palladium (PAL) and Stillwater Mining Company (SWC) would both be great buys.  (And in fact, I believe both are *good* buys now regardless).

On the other hand, what if demand destruction continues in the palladium market due to the auto industry?  That's a bit more difficult of an issue to tackle.  However, my thought on this is that while this will probably not be as beneficial to palladium producers, it may end up being even more beneficial to holders of physical palladium.  The logic is tricky, but follow me:

Palladium producers can not survive without meeting their costs of production and hence, do not produce again until that point is reached.  However, as less of the metal is mined, the average production costs go up further (since companies will have more difficulty covering their fixed costs without higher prices).  So it's possible that even while the producers can not sell nearly as much, the end result is much higher prices. As such, I can see reasons why one should be more bullish on physical palladium precisely because demand is currently weakening. 

Even additional benefits could be reaped if the market reached this stage and then new uses of palladium are developed and/or demand once again skyrockets.  Since miners will have reduced supply and prices will have gone up, it will take awhile for production to be ramped up and a new equilibrium to be reached.  As such, prices could shoot up even more in the event that the demand destruction were eventually followed by a wave of demand creation.

This is a bit of speculation on my part and maybe there are holes in my logic; I am more or less thinking aloud on this and curious as to the thoughts of others.  One way I could be wrong is if palladium was like oil and it was much cheaper to mine it in certain places.  If that were the case, the lower cost miners would prevail as supply weakened and the prices might not go up all that much.

Conclusions 

To sum this up, my current belief is that physical palladium is a good investment one way or another.  Even if I'm wrong about the demand destruction scearnio, palladium prices almost have to go up at some point because producers simply aren't profitable right now.  This could also make palladium producers a good investment when you consider how much of a discount they are currently selling at; but if the severe demand destruction scenario plays out, they might not be nearly as profitable as they could have been before. 

However, the one big advantage I see with buying into the producers is that the prices they are selling at are so low, that you could buy into companies like North American Palladium and Stillwater Mining and sit on them for ten years and if at any time demand shot back up, you'd still make a fairly reasonable return so long as you played your cards right. We'll see, though.

I've only been following the palladium market for about six months now, so I could definitely be wrong on all of this. 

1 Comments – Post Your Own

#1) On December 12, 2008 at 8:58 AM, JakilaTheHun (99.93) wrote:

I forgot to put this in the blog itself, but as a disclosure, I should say I am long on PAL and SWC.

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