The Russian Metal

I presented my global macro overview at the Citigroup commodities conference here in London today. I’ll lay down the highlights from my presentation over the next couple of posts. But today I thought I’d cover my strongest carry-out from the conference.

And that was the contrast between the massively bearish consensus on palladium, and the massively bullish fundamentals.

You might not want to invest in Russian equities. George Soros won’t. But you should invest in Russian metal. And the most Russian of metals is palladium.

The central problem with the palladium market is that the Russians have been selling. They’ve been selling from stockpiles. And they’ve been selling a lot. These stockpile sales added close to 30% to global supply last year.

Johnson Matthey – the platinum group metals specialist – has a part to play in the general negative sentiment on palladium. It has an idiosyncratic way of describing palladium supply; it includes these Russian inventory drawdowns in the supply number. And then it says that the results of its calculations are ‘fundamentals’.

That’s a dangerous way to do it. Because it lulls you into a sense of security – that the market’s easy – and that it will be for years. But if Russian stock sales slow, or even stop, the market fundamentals change overnight. They become very bullish.

Why? Because demand growth is massively outstripping the growth in mine supply.

On the demand side we are seeing substitution of palladium into diesel cars for the first time. In 2005, palladium accounted for less than of 1% of PGMs (platinum group metals) used in diesel catalysts. In 2007, this had risen to 10%. The current leading formulation is 30% palladium, and this will likely rise. This means that palladium demand in diesel auto cats could treble over the next three years or so – after rising tenfold in the last three years – from a tiny base. By that time, it will be significant.

The next issue is jewellery. Palladium is stealing a march over platinum, due to the fact that its qualities are similar, but it trades at a quarter to a fifth of the price. We’re seeing that substitution locally – down in Hatton Gardens – the London jewellery centre. And we’re seeing it in China. But the interesting thing is that the rise in intensity has been completely hidden by some major destocking at the Chinese jewellers over the last two years. That destocking is winding down – and we will likely see a big pop in demand over the next year.

Last year demand rose 3.5% - including the destocking. This year – I’m betting on 5-6%.

Then there’s supply. On the supply side, there is no growth. The ongoing disruptions in South Africa, the trickiness of the Stillwater ore body, and flat Russian production are all contributing to the moribund production picture.

And there is investment. The new palladium ETFs have had a powerful effect – adding a quarter of a million ounces to demand last year. There’s no reason I can see for this to stop. Especially as further platinum ETFs are likely to be delayed due to the dearth of physical material.

So the big issue is the Russian stockpile. The size of the stockpile is a state secret. For decades the Siberian mines, now under Norilsk’s control, produced palladium as a bi-product of their nickel and platinum supply. The problem was – they didn’t have any use for it. So it went into inventory, waiting for a purpose.

Since the wall came down, the Russian’s have promoted palladium use heavily. First for gasoline auto catalysts. Then for jewellery. And now for diesel cats. They’ve done this by ensuring an ample and easy supply (in the mid-late ‘90s, and again over the last few years)– through selling stockpiles and maintaining production and sales out of Norilsk. They’ve also subsidised technological research in auto-catalysts, and for industrial uses. And they have provided cash to promote palladium jewellery use.

But the Russian sales out of inventory are by no means assured. The work I did when I was a full time analyst suggested that there was not an infinite supply of inventory – and that Russian inventory would run thin towards the end of this decade.

And then there is the issue of foreign financial reserves. Clearly, Russian reserves are rising sharply, as oil prices power higher. The Russian state does not need to sell any more palladium.

And I’ve heard on the grapevine that Russian sales out of inventory have fallen off sharply of late – that they wouldn’t sell a chunk to some modern day Hunt brothers due to a lack of availability – and Swiss and US trade data suggest that information may be true. Those slower sales came before oil hit $100bl.

All in all, palladium looks like a nice risk/reward trade on a 1-2 year view. I’ve bought some for the fund, and I’ll look at buying some physical for the family. And I’m not George Soros; I am invested in Norilsk.

A quick bit of housekeeping. Over the past month I’ve got cautious on the market – but every time I’ve put in a short – on banks with Eastern European exposure, or on an index – I’ve been stopped out.

Yesterday that changed, and the shorts I’d put on in previous days started earning fast. I’ve been looking for a break for a little while, and as soon as I saw the Asian price action yesterday I moved aggressively – I put on large FTSE, CAC-40 and Dow shorts during the morning, to take me significantly short overall. I also put on some dollar shorts. That partially protected the portfolio from the vicious sell off in resources and engineering names yesterday. It’s making money outright today.