Caution in order despite palladium’s rise

(The following is a second instalment from The Commodity Refiner, a monthly publication of Barclays Capital Research.)

Palladium prices recently rose from 6-year lows below US$150 per oz. to more than US$200. This was the largest monthly rise since November 2001. Clearly, given palladium’s still-almost-total reliance on autocatalyst demand, car production must be turning around. In reality, however, production has continued to fall. Ford has announced that North American vehicle production fell 17% in the second quarter. Similarly, Japanese domestic vehicle production fell 2.1% in May. The production cutbacks are clearly in response to weak demand — sales of new autos in the European Union were down 5.2% in May. It is difficult, therefore, to identify any significant rise in palladium demand. Indeed, although palladium appears “cheap” at current levels, anecdotal evidence suggests that several automakers continue to run down stocks and that there has not been significant buying at current levels. Although there remains the likelihood of a switch from platinum into palladium, given the significant price differentials, discussions with European carmakers suggest that this process has not yet begun.

So what is behind the sharp move in palladium? The answer is that it appears to have suddenly reappeared on speculators’ radar screens. At over 25% of open interest, speculative positions on Comex are now at their highest levels since January 2000.

What is behind this move in speculative perception? Aside from a belief that “palladium is cheap,” an answer is difficult to ascertain. While it is true that a significant price differential will gradually lead to a switch out of platinum and into palladium, the move will be gradual. Moreover, until such time as diesel autocatalysts can be manufactured out of palladium, a significant (and growing) share of European car sales will not consume palladium — regardless of the price differential. Therefore, while it is true that there are arguments for being bullish about palladium in the medium term, the short-term omens are far from positive. One would suggest, therefore, that any buyer at current levels must be prepared to wait (and potentially suffer) before palladium ultimately begins to recover.

Platinum prices have also benefited from a surge in speculative interest. NYMEX positions have risen to their highest levels since 2000, though the rise in TOCOM has not been as dramatic.

Again, it is difficult to rationalize this sudden surge in speculative interest in platinum. Clearly, part of this rally must be based on “SARS relief.” As SARS cases have declined, it is natural to expect a recovery in retail sales, as data from Singapore suggest. Clearly, platinum jewelry sales should recover in line with retail sales in Asia. However, the fall in demand means that significant unsold stocks remain. These will, of course, take time to erode before imports begin again. Moreover, although value-added-tax exemption on platinum purchases on the Shanghai Gold Exchange should boost demand, introduction of trading has been delayed by SARS. Obviously, platinum suffers from the same autocatalyst issues as palladium, though platinum demand should suffer less as diesel continues to gain market share.

Part of the surge in platinum interest is clearly related to gold’s surge, though this is somewhat difficult to justify, given the fact that the platinum-gold spread is already close to all-time highs.

Lastly, there is an interesting “knock-on” effect from surging natural gas prices. As a result of the fact that it has historically been cheap, natural gas is used as a feedstock in chemical manufacturing in the U.S. Platinum is used as a catalyst in several of these processes — total platinum chemical demand is estimated to be 325,000 oz. in 2002 (Johnson Matthey). Although the impact is muted by the fact that production has largely shifted overseas (instead of being destroyed), it is likely that some platinum used in chemical processes could return to the market should production shift overseas.

Although the strength of the South African rand could affect South African expansion plans, it is unlikely to be a factor in the short term. Moreover, although the bullish fundamentals identified in previous reports remain (growing jewelry demand), they are likely to continue to be overwhelmed by weak retail spending. Platinum, unlike palladium, is not cheap at current levels, and the surge in speculative interest is difficult to reconcile with deteriorating fundamentals.

MARKET SUMMARY

Platinum

Platinum prices have recently retreated from their multi-decade highs of more than US$700 per oz. (early March 2003) towards US$600 per oz. While there are various reasons behind the rally that took platinum to its high, continued strong growth in platinum jewelry demand in China stands out. Short-term factors, such as an increase in autocatalyst demand (31% of end use demand) in response to palladium’s price expansion in 2000, “backloading” of South African production expansion plans, and an explosion at Lonmin’s smelter in South Africa, all exacerbated trends that are likely to continue to provide support to the platinum price.

Jewelry accounts for 40% of platinum end-use, and Chinese jewelry now represents more than half of total platinum jewelry demand. While it is obvious that jewelry spending will rely on global growth and, more specifically, on the ability of the Chinese government to deliver the 8% growth rates that have become common, demand growth is likely to remain strong (barring a global economic collapse).

Palladium

Palladium prices have fallen by 24% since the start of 2003 and, while they have gained some US$34 per oz. from their lows of the year, they remain at levels not seen since 1997. Although the fall is precipitous (down 84% from their all-time high of US$1,085 reached in February 2001), it is worth bearing in mind that palladium has averaged only US$260 per oz. since 1991. Indeed, excluding the 1999-2001 period, the price has averaged only US$167 per oz.

Some 66% of palladium demand is accounted for by autocatalysts. The most important factor is not the absolute level of the palladium price but its spread to platinum — its major competitor in autocatalysts. For chemical reasons associated with emission regulations, palladium demand grew in the early 1990s. At the same time, large-scale Russian stockpile sales in the first half of the 1990s depressed palladium prices, encouraging a switch out of platinum and into palladium.

As palladium demand grew, the large-scale Russian shipments of the early 1990s began to falter, with export contracts delayed during 1998 and 1999, and this created problems with the metal, which continue to tarnish its reputation among consumers today. Russia still accounts for almost 60% of global supply.

With palladium trading at a US$500-per-oz. discount to platinum, there have been suggestions that auto manufacturers will shift some of their production back to palladium. GM announced earlier this month that it is switching from platinum to palladium in some of its autocatalyst models. But while supply remains abundant (supported by ample scrap availability) and demand remains subdued, the short-term outlook for palladium remains uninspiring.

Rhodium and iridium

The most recent demand figures show that some 84% of rhodium demand is accounted for by autocatalysts. Total demand for rhodium rose by just under 3% to 596,000 oz. in 2002, while the use of rhodium in autocatalysts grew strongly. However, automakers in the U.S. satisfied a portion of their rhodium requirements by further drawing down inventories. Demand for rhodium from the chemical catalyst and glass manufacturing industries weakened slightly. South Africa remains by far the most important rhodium supplier, producing more than 79% of the global total.

Iridium’s principal use in the electronics industry is in the form of crucibles used to grow high-purity crystals. Significant overcapacity has persisted in this sector following the strong sales of crucibles in 2
000. Crystal manufacturers had ample capacity in 2002 to accommodate demand, which did not meet previous expectations following the downturn in the mobile telecommunications industry.

The effect of this on iridium demand, however, was lessened somewhat by growth in demand for high-purity crystals from medical equipment manufacturers. Materials manufactured in iridium crucibles are used in lasers and sophisticated medical scanners, and sales of these products increased. Overall, demand for iridium in electronics applications slipped by 5,000 oz. to 22,000 oz. in 2002.

— Kevin Norrish is head of commodities research/energy and Ingrid Sternby is the base metals analyst for Barclays Capital Research. The opinions presented are the authors’ and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the authors at kevin.norrish@barcap.com and ingrid.sternby@barcap.com