Here’s a challenge: see how many mainstream finance websites you can visit before coming across a negative story about gold. I bet you won’t get far. These websites will give you a host of reasons to avoid gold and silver, but their chatter—whether bad or good—rarely extends past these two precious metals. It’s time to look at the overlooked precious metal that is up 16% year to date and fresh off a 13-year high. Let’s turn our attention to palladium.
As Jeff Clark detailed in our May issue, palladium is a member of the platinum group metals (PGM). The metal is commonly discussed in tandem with platinum due to its similar chemical properties and industrial end uses.
Like platinum, palladium is used predominantly by the automobile industry for catalytic converters—a component of vehicle exhaust systems that essentially scrubs pollutants. Palladium also finds its way into electronics and is increasingly used in dentistry and chemical applications. Still, the automobile industry remains the driving force for palladium, accounting for 70% of global demand.
Catalytic converters were first commercialized in the mid-1970s, yet the technology is still standard on most gasoline and diesel engines. Environmental regulations support palladium demand in the developed world, but the real opportunity lies in emerging markets. And once again, China is playing a prominent role.
China surpassed North America as the largest automobile producing region in 2009, though it’s only begun to scratch the surface. In the United States, there are about 800 vehicles for every 1,000 people. In China, the vehicle per capita rate isn’t even 100 vehicles per 1,000 people. This spells opportunity for catalytic converters, especially given China’s infamous air pollution problem, which should bring about more stringent environmental regulations.
Electric and other alternative-fuel vehicles don’t pose an immediate threat to catalytic applications. In fact, gasoline and diesel engines are expected to dominate the mass automobile market for at least another decade.
Strong secular demand is just part of palladium’s story. A seemingly incurable supply deficit is the real reason to own palladium.
Economics 101 tells us that supply and demand adjust to shortages and surpluses. Thus, it’s somewhat perplexing that palladium consumption has outpaced mine production for over two decades—that is, until you understand Russia’s role in the palladium market.
Russia is the world’s leading supplier of palladium, accounting for 43% of global output. I say “supplier” because most palladium leaving Russia was amassed during the Cold War. Russia began selling its stockpile following the collapse of the Soviet Union, which coincidentally wasn’t long after the Ford Motor Company introduced the first palladium catalytic converter.
The Russian inventory has always been a closely guarded state secret. In 2001, it was rumored that the Russian stockpile was nearing exhaustion and that the Kremlin was going to limit inventory sales. The gossip was enough to send the price of palladium to an all-time high of $1,097 per ounce.
Reports of an exhausted Russia supply were ultimately proven premature. Nonetheless, global production hasn’t caught up with demand even though this warning sign has been flashing for more than a decade. Today, the consensus opinion among analysts is that Russian inventory holds no more than 3 million ounces and is dwindling rapidly.
The palladium market is embarking upon a post-Russian inventory environment in which the global supply could get even tighter. This is because palladium can only be found in a handful of places on the planet. Where it can be found, operating conditions are less than ideal.
South Africa supplies the most palladium after Russia, though it is technically the largest palladium-producing nation. Earlier this year, the country’s mining industry was rattled by labor strikes that led to a 45% reduction in total PGM mining output. The dispute was resolved in June after five difficult months; however, South African miners continue to face operational challenges due to insufficient electricity capacity and rising electricity costs.
Supply constraints are exacerbated by the fact that palladium plays a supporting role at most mines worldwide. At Russia’s Norilsk mine, palladium is a byproduct of nickel production, while platinum is the primary metal at most South African mines. As such, higher palladium prices won’t necessarily lead to increased production.
Palladium’s supply deficit is widely known across the industry. Stillwater Mining Company (SWC)—the world’s largest palladium producer—estimates that global palladium supply will fall 1.05 million ounces short of demand in 2014. Specialty-chemicals maker Johnson Matthey expects an even more severe shortage, of 1.61 million ounces.
Palladium’s supply shortfall represents a rare instance in which the cure for higher prices isn’t higher prices. In fact, palladium production could very well lag demand even in the face of significant price appreciation.
Supply disruptions in South Africa and Russia have fueled palladium’s strong recent performance. That said, global palladium supply would remain tight even if the Russia-Ukraine crisis disappeared overnight. The same goes for the cost pressures facing South African miners. Palladium’s supply imbalance is simply too severe at this stage.
Investors have more options than ever when it comes to owning palladium. However, as is the case with gold and silver, ETFs and other paper investments simply can’t match the security of owning the real thing.
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