Palladium's Perfect Storm for the Automakers

c. 2011, Sean Daly

We continue to expect both platinum and palladium to outperform gold over the course of this year.

--Edel Tully, UBS, January 14,2011[1]

The better exposure should be to “anything and everything” that trades inside the PGM market, but not linked to South Africa.

--Leon Esterhuizen, RBC Capital Markets[2]

Palladium enjoys a certain mystique these days.

It’s not just that lustrous white sheen. It’s a fascination that comes from the exquisite delicacy of its supply and demand equation - the result of ever widening car use, general scarcity and stacked odds. Yes, 30 million new car owners a year can’t be wrong; yes, it’s tough to mine; yes, its price is just one South African blackout from a moon shot.

Palladium’s thin supply line is now at the nexus of an expanding constellation of macro forces. Computing the metal’s fair value requires assessments from virtually every corner of the world – from Chinese car purchases, Russian stockpile estimates, Brazilian auto-loan growth, Eskom coal procurement, and of course the American recovery story.

Will the center hold on this widening gyre? Will synchronized global growth (a la 2006) and bad palladium supply numbers (a la 2000) finally pop this metal toward its historic high, a price not seen since March 2001? Or do the emerging markets overheat so significantly that, despite real strength in Germany and the U.S., demand for the metal dips?

With palladium having pulled back this past week on China inflation concerns, I thought I’d take up these questions. First, let’s list out the demand issues.

1. U.S. Auto Demand Accelerating

U.S. new car and light-truck sales are headed for double-digit percentage gains in 2011. With the average age of cars and trucks on the road today at more than 10-years-old, Americans will need to replace their aging vehicles. This fact, combined with low financing rates and wider credit availability, will drive sales.

Ashvin Chotai, managing director of auto consultant Intelligence Asia Automotive, believes light-vehicle sales in the United States should reach 12.8 million units in 2011.[3] Paul Taylor, chief economist of the National Automobile Dealers Association, places sales slightly higher. He sees growth of more than 10%, reaching 12.9 million new cars and trucks in 2011, up from 11.6 million in 2010.[4]  New models, credit availability, and more job security will finally get Americans back into the showrooms. Expect to see impressive escalations into the summer months.

People will likely fear that a rise in interest rates is coming and pull the trigger early to capitalize on the lower rates. "Credit availability at a time of very low interest rates will drive new vehicle sales this year," Taylor says.

And these cars will not be electric. They will continue to need their dollop of palladium. As I see it, the “chicken and the egg” problem of electric cars will keep them from meaningfully participating in this spring/summer rally.

2. U.S. Investment Demand Expanding

In addition to the burst of automotive demand, President Barack Obama recently signed the American Eagle Palladium Bullion Coin Act of 2010 into law. This bill, the love-child of Montana Rep. Dennis Rehberg, authorizes "the production of palladium bullion coins to provide affordable opportunities for investments in precious metals, and for other purposes."

This new U.S. coin will essentially democratize palladium buying. Now grandma can buy it for the kids. As former U.S. Mint director Philip Diehl suggests, "It gives the blessing of the U.S. government that palladium is not just industrial metal but an investment metal." The coins will expand demand the same way that the two ETFs - ETFS Physical Palladium Shares (PALL) and ETFS White Metals Basket Trust (WITE) - have done over the past year.

Why now for a new coin? Well, I needn’t mention that Stillwater (SWC) mines all its palladium in Dennis Rehberg’s home state of Montana, but there may be a less provincial explanation.

It may suggest the U.S. government - sponsor of the dollar - would prefer to offer precious metal vehicles beyond gold, particularly ones that link back to native mining sources. It may also suggest that there is fear in elite circles that demand is outstripping supply for palladium and that the government assurance allows SWC to ramp up production, confident that in later years - after the near term imbalance of 2011-2012 has been righted - that it can offload to the government.

More immediately, the result of the new investment buying is that it will scare automotive producers, who rightfully feel that more of the physical metal will be pulled out of the industrial marketplace. Reflect on the chronology of the following two news events:

According to Kitco, "By the first week of December holdings PALL reached 2.05 million ounces. Comparatively, annual global mine supply of palladium is just 6 million ounces, prompting analysts to suggest that investment demand is looking increasingly likely to push the metal's supply into deficit in 2011."[5]

This followed in late December: General Motors Company (GM) announced that it would be re-engaging Stillwater as a supplier, securing a conduit of local supply regardless of price. This alliance reminds me of W.R. Grace’s November agreement with Molycorp (MCP) for native lanthanum, a deal which now looks brilliant in light of recent catalyst pricing run-ups.[6]

In two months, this GM effort could likewise look prescient. It will be interesting to see if other car makers take a similar course, with a metal off-take agreement with North American Palladium (PAL) to secure supplies.

As you may remember, back in 2001, Ford (F) was badly bruised by Russian supply disruptions and the Tokyo Commodities Exchange freeze, writing off one billion in losses.[7]

3. Brazil and Chinese Car Sales Growth Will Still Be Impressive

Yes, auto sales growth in both countries are estimated to be lowr than 2010, but they will still be growing robustly by any normative standard.

Brazil continues to have one of the best demographic profiles of any country regarding mass consumption. Like the U.S. in the 1960s, its young workforce is seeing real wage increases, family formation and the best lending environment the nation ever enjoyed in its history. Vehicle financing surged 45% in Brazil last year, helping to propel the country’s fastest economic growth in nearly three decades. Yes, there are efforts to raise reserve and capital requirements for local banks, in an effort to head off a credit bubble, but overall consumer loan growth is expected to be 10% in 2011. FENABRAVE still sees vehicle sales growing at 5.2%,[8] expecting about 3.5 million light vehicles to be sold in Brazil in 2011.

Don’t get too caught up in the inflation scares. Brazil’s gains in purchasing power are translating into real sales for cars and consumer durables. Brazil last year overtook Germany as the fourth-biggest car market in the world. And with a population of 193 million, the country has approximately one vehicle per seven residents, leaving ample room for growth. European car makers like Fiat are doubling down with factories throughout the country.

Moving on to China: Much fretting has been made that China sales growth will be lower in 2011 than 2010 due to a tax incentive phase-out and traffic-related vehicle registration curtailments in the capital.[9] First, Beijing’s registration drawdown will likely have a limited impact, as the city accounts for only 5% of national car sales.

Keep the “big picture” in mind. Only 30 out of every 1,000 people own cars in China. Growth is still expected to top in at 15% for China's automobile market, according to GM's China President Kevin Wale. And data compiled by Booz & Co. suggests that total auto sales in China may hit 20 million in 2011.[10] That’s a lot of cars. Instead of fretting over regulatory issues like city registration constraints, keep in mind that China is upgrading national emissions standards that will take the amount of palladium used per vehicle from 2 grams up to the developed world Tier 1 levels of 4 grams per vehicle. Carbon reduction is an important platform of the coming CCP five year plan, meted out back in October 2010. Pollution reduction - like energy intensity reduction - is of central importance to the Party.
Car ownership growth and these higher emissions reductions will likely drive Chinese demand for palladium by 4-5% per annum, i.e. every year for the foreseeable future. That translates to at least an extra 120,000 - 150,000 ounces of palladium per year needed just for China.

Expect this fact to hit our tenuous global palladium supply like a ton of “brics” when Chinese firms start the kind of proactive stockpiling they are known to do.
The following graph from Johnson Matthey is suggestive of China’s impact on the market over the past decade, as it overtook both Europe and Japan in demand.

So with those demand trends in mind, let’s list out the supply issues.

1. A “Double Reset” May Crimp Russian Supply in 2011 Russia currently supplies about 45% of the world’s supply of palladium, with a third of that coming from its strategic stockpile.

For most of a decade, the Russian stockpile of palladium slaked 15% of total world demand. With an annual  .9 – 1 million ounces sold, it was the third largest contributor after direct mine output from South Africa and Russia.[11]  Though the official level of the Russian stockpile is a state secret, an off-the-cuff disclosure by a Finance Ministry official back in November suggested that the Russians may not have any more stockpile to sell into the market.[12] If Russia has indeed exhausted state inventories of the metal, the world market will be in deficit in 2011. They may have run out, or they simply see keeping the remaining metal on as a good idea.

A second “reset” in Russian supply may also alter demand. This year Norilisk Nickel struggles with new processes and exploration issues. According to Bloomberg, the Russian firm will spend $45 million on mineral exploration projects in an effort to just maintain 2010 levels of primary metal production.[13] At present, Norilisk Nickel (NILSY.PK) supplies 84 tons of palladium per year, primarily because the mining of certain ores for nickel leaves palladium as a major byproduct. But in order to reduce pollution, the company is changing its nickel extraction process, using a chemical process that greatly cuts both pollution and production costs. Nickel and copper can be extracted at much higher efficiency, but the “by-product” platinum and palladium are not extracted.[14]

2. South Africa’s Power Supply: A Threatening, Multi-Year Problem

The world depends on South Africa for a full 80% of its platinum and 40% of its palladium. The danger of such intense dependence made clear by another statistic: 95% of South Africa’s electricity supply is produced by one utility, Eskom. It is a company that has struggled for years with higher demand expectations, cavalier domestic coal producers, distracted government, and its own bad management practices.

In many ways, the stability of entire PGM supply this year now rests on whether South Africa can cope with the strains on its aging power plants. The country has struggled with the issue for years, suffering a series of rolling blackouts and suspended mining in early 2008 that deeply embittered the business community.

Though a national emergency was declared after that crisis, the issue has not been resolved. In February 2008, in his State of the Nation address, President Mbeki publicly apologized for his government’s mismanagement of the issue, admitting that Eskom reports from 1998 and 2004 that warned of a future crisis were not taken seriously at the time.

The investment community has become more strident in its view. Southern Africa analyst Anne Fruehauf called South Africa’s power infrastructure “a material constraint to investment.” In a 2010 profile report, she stated: "The consequent lack of spare capacity to support an economic upturn will once again impose an unbreachable ceiling on growth and expansion prospects."[15]
Last week’s successful bond sale and

lans for new power plants point in the right direction, but South Africa’s power infrastructure crisis is a problem that will plague the country for years.
Earlier this month, Eskom’s chief executive, Brian Dames, warned of an energy gap in 2012 equivalent to about 1,000 megawatts of baseload capacity in South Africa, and called for a range of cross-cutting interventions.[16]

Just this past week, on January 18, TEX reported that the supply situation of electric power in South Africa is anticipated to worsen due to heavy rainfall, a short supply of coal, and facility troubles.[17] In addition to the exogenous weather and coal issues, Eskom officials have reported that, if this equipment deterioration issues continue, the country can expect a short supply in the coming months, particularly March.
To cope with this looming deficit, Eskom has planned to import 43,000 MW of electric power from such neighboring countries as Namibia, Botswana and Zimbabwe. In conclusion, I believe that, as described, palladium’s demand profile will have a constructive effect on prices over the next 12 months.

The metal's popularity looks assured. Back in November, UBS declared in a report: “We forecast that palladium will likely see one of the strongest increases in intensity of use of any commodity to 2015.”[18] Of course, less euphoric phrases come up describing the other side of the equation, the precious metal’s precarious supply.

The fact that the world remains so complacent - sailing “too close to the wind” by relying on Soviet-era stockpiles and a power-challenged South Africa - is worrisome. As in 2001, carmakers may get caught in one metal's “perfect storm.”

[1] Precious Metals Investing: Palladium Soars on Supply Squeeze and Auto Market Growth
[2] PGMS set to surge over next 3 years - Leon Esterhuizen
[3] China Car Market to Extend Gains Over U.S., Automakers Say
[4] NADA: Top 5 Factors That Will Boost Auto Sales in 2011
[5] OUTLOOK 2011: Palladium's Strength To Endure For Another Year
[6] Molycorp Makes Deal to Supply Rare Earths
[7] Pricing History
[8] Brazil car sales up record 11% in 2010
[9] China car sales may skid on ownership curbs
[10] Financial Times
[11] Strength in Palladium Continues in 2011
[12] Palladium Keeps Climbing; Gold Soft
[13] Norilsk to Boost Capital Spending Up to 54% Next Year
[14] Among White-Hot Commodities, Demand for the White Metals
[15] SA Energy Shortage
[16] Mines brace for new outages
[17] SA may face serious shortage of electricity supply in March
[18] UBS Report