Palladium prices: The top 10 most important drivers

1) Vehicle demand

Roughly 75% of palladium demand is from the autocatalyst sector. Unlike diesel cars that use platinum, petrol fueled cars use palladium as a catalyst to reduce noxious vehicle emissions. Tighter vehicle emission standards is likely to increase demand for palladium.

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Palladium is more exposed to the Chinese and US markets where diesel hardly features in the passenger vehicle segment. Chinese demand is particularly important in that almost one-third of net palladium demand (accounting for recycling) comes from the Asian economy.

Apart from catalytic converters, palladium sees usage in a wide range of industrial applications, including fuel cells, dentistry, and medicine.

2) Russia

Norilsk Nickel is the largest producer of the precious metal, accounting for about 40% of global supply. Any disruption to exports from Russia perhaps in the form of sanctions could be expected to reduce the supply of the metal onto the global market.

3) South Africa

Around 40% of all mined palladium comes from South Africa. Supply constraints in the form of intermittent electricity supply, rising fuel and construction costs and industrial action have all curtailed output from South Africa in the past.

4) Investment

The launch of a number of Exchange Traded Funds have helped support investor demand, opening up the possibility of investing in palladium to a wider group of investors. Investors should be cautious though. Unlike gold and to a lesser extent silver, the palladium market is a lot more opaque while swings in investment fund flows can have a disproportionate affect on prices.

5) Substitution 

High prices incentivise vehicle manufacturers to look for alternatives or reduce the amount of metal used in their catalytic converters. This could involve substituting palladium with other metals such as platinum or rhodium.

6) Recycling

Higher prices typically incentivise the recycling of palladium catalytic converters, a source that typically accounts for up to 30% of total supply. But since palladium forms a very small proportion of the value of a vehicle high palladium prices only have a marginal impact on the incentive to recycle. High steel prices encourage dismantlers to recycle vehicles and take palladium and other materials as byproducts.

7) US monetary policy

Although not just a fiat commodity in the same way as gold, palladium shares some of the properties of gold. Higher interest rates, reflected in higher bond yields reduce the attractiveness of holding non-interest bearing assets like palladium. However, it is not the nominal interest rate that affects the price of palladium but the real interest rate, i.e. after inflation.

When real yields are low the opportunity cost of owning palladium drops. Investors are then likely to be willing to pay a higher price relative to palladium’s long-run estimated real value.

8) US dollar

A weaker dollar can also act as a disincentive to producers to increase output. For example, a depreciation of the US dollar against the Russian ruble will (all other things being equal) reduce profit margins for Norilsk Nickel, the largest producer of palladium. All of its revenue will be received in US dollars, which will now buy less rubles, but some proportion of the costs will be denominated in rubles and will remain constant (at least in the short term). The prospect of a lower profit margin acts as an incentive to decrease the supply of palladium on to the global market.

9) Stockpiles

Stockpiles of palladium in Russia have been an important source of supply in recent years. However, the amount of metal held in the form of stockpiles is a secret so there is uncertainty over the exact amount of metal held.

10) Seasonality

Of all the precious metals palladium exhibits the strongest degree of price seasonality. Palladium prices tend to show the strongest gains during the first quarter of the year.

Previous episodes

Gold prices: The top 10 most important drivers

Silver prices: The top 10 most important drivers

Natural gas prices: The top 10 most important drivers

Copper prices: The top 10 most important drivers

Livestock prices: The top 10 most important drivers

Sugar prices: The top 10 most important drivers

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Materials Risk explains: How El Niño affects commodity prices

A deadly mudslide that killed hundreds of people in Colombia earlier this month may portend the spread of more extreme weather conditions. Local weather forecasters have blamed the wet weather that has hit the region on the weather phenomenon known as El Niño.

First observed in the 19th century by Peruvian fishermen, the recurring weather phenomenon is known to affect Australasia as well South America. Its climatic effects can reach as far as West Africa triggering downpours or droughts. Previous episodes have had a significant impact on crop yields and the price of agricultural commodities as well as metal and energy prices.

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According to the Australian Bureau of Meteorology six of the eight models that it tracks suggest that an El Niño may develop in July. South Africa’s weather service and global forecasters agree, predicting that El Nino will form again in the southern hemisphere winter or spring, which falls between July and September. El Niño events tend to develop between April and June and reach their maximum strength during December and February. According to Columbia University conditions usually persist for 9-12 months, but can occasionally last for up to two years.

Should El Niño return, it will be the first time the Pacific has swung from warm to cool and back again over a three-year span since the early 1960s. The reason weather forecasters are so concerned is that sea temperatures off the coast of Peru have warmed significantly in recent weeks. This has brought heavy rain to the region, but also means that as the sea currents spread west it will result in a warming of the Pacific Ocean, increasing the risk of an El Niño developing.

Two factors, in addition to its severity, will influence the impact that El Niño will have on crop yields and prices. The first is the timing of El Niño event. The impact of which will vary depending on what stage of a crop’s lifecycle (e.g. sowing, growing, harvesting) it occurs at. As the two maps below illustrate the impact of El Niño varies considerably depending on whether it occurs during the summer or winter months (see maps below). The current outlook suggests that if it does occur El Niño will reach its maximum strength towards the end of 2017 – figure 2 below.

The second factor that determines the degree to which commodity prices are affected by El Niño is the degree of geographic production concentration. Some crops, like palm oil, are grown in one specific region whereas others are grown globally. The main commodities to be affected by El Niño are typically those ‘softs’ that are located around the tropical regions.

Coffee – The warm weather that El Niño brings in June to August aids the Arabica coffee harvest as the crop solidifies and warmer weather protects against the spread of the roya fungus (which thrives in wetter conditions). However, drier El Niño weather in December to February may have negative impacts on the next Arabica crop, helping to support coffee prices as the event continues.

Cocoa – Cocoa output has been volatile regardless of El Niño due to the majority of its production occurring in west Africa which has geopolitical, funding and energy issues.

Palm oil / soybeans – This is perhaps the crop with the biggest exposure to El Niño on account of 90% of production occurring in Indonesia and Malaysia. Whilst palm oil plants are fairly resilient during an event, dry weather tends to impact production growth and yield trends in the following 12 months. Though any increase in palm oil prices tends to be capped by increased soybean production, as palm oil is substituted by soy oil.

Sugar – El Niño’s impacts on sugar production are greatest when it brings too much rain to Brazil and drought to India (which, together, produce 38% of the world’s sugar). India’s sugar production is for its domestic market as it has the highest per capita sugar consumption in the world (consuming 15% of the world’s sugar). In Brazil, El Niño means fewer days for crushing and causes lower sugar content in the cane as the wet conditions cause the plant to store less sugar.

Perhaps surprisingly though the commodity that has typically seen the biggest impact on price during the 20 year period to 2015 has been nickel. This has been because dry weather in Indonesia (up until recently one of the main exporters of nickel ore) lowered the water levels in canals, preventing the metal from being exported.

Other metals may also be impacted by the arrival of adverse weather. In Peru for example heavy rains have flooded zinc mines in the past triggering price spikes. Gold demand may also be hit if a weak monsoon results in a poor harvest. Indian farmers are large buyers of gold and so any fall in their incomes could hit purchases of the precious metal.

Globalisation of markets and trade should, all else being equal, diminish the impact of any region-specific decline in output. For this reason grains such as wheat and corn tend not to see a significant weather related impact on yields from El Niño. That being said, regional weather conditions may still result in prices responding violently to a perceived or actual threat to output.

 

Finally, El Niño also reduces the risk of hurricanes in the US Gulf. El Niño increases wind shear in the Atlantic, acting as a block to tropical storms from forming. As hurricane activity has subsided in recent years the typical seasonal bounce in crude prices in late September/October has been much less pronounced.

Historically El Niño creates a risk premium for many commodities that tends to be reflected in prices and volatility. But crucially for investors and physical commodity traders this tends to happen only once an event is underway.

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Demand and supply: Rewriting history

“No other industry begins to offer the data problems that are presented by petroleum,” – John Blair

The production of basic statistics and forecasts about oil reserves, production, consumption and stocks ought to be a matter of routine. You just stick a gauge at the end of a pipe and measure the amount of liquid flowing through (in the case of oil) right? Unfortunately, it’s not that simple, and the problem isn’t limited to just oil, but all commodities.

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Doubts about the reliability of energy statistics were a major part of the “energy crisis” that erupted during the 1970s. As late as 1968, the United States had an estimated 4 million barrels per day of spare crude production capacity and thousands of wells across Texas and Louisiana were being operated for fewer than 10 days per month. But just four years later spare capacity had suddenly dropped to zero, every well was at maximum production, domestic output was falling, and politicians began to speak of an energy crisis.

The OPEC oil embargo, announced in October 1973, intensified the sense that something had gone badly awry, leaving the USA unprepared. Politicians and the media blamed a conspiracy between domestic producers and OPEC for engineering the crisis to drive up prices and profits.

Congress held hearings amid a sense that the statistics and forecasts prepared by oil and gas producers and the U.S. Department of the Interior had been either inaccurate or deliberately manipulated. One outcome of the crisis was the creation of a new U.S. Department of Energy and within it a new Energy Information Administration (EIA) in 1977 to produce more accurate and independent data. Another was the creation of the International Energy Agency (IEA) in 1974 to gather better statistics and bring greater transparency to the international energy markets.

Prior to the energy crisis, most data and forecasts were confidential and under the control of oil and gas producers themselves. After the energy crisis, data collection and forecasting would be led by impartial civil servants at national and international levels.

Improvements in data collection and forecasting in the United States, led by the EIA, have largely quelled controversy about domestic US oil production, consumption and stocks. But that doesn’t mean they are free from error or revision. Indeed, information on international markets remains much less comprehensive and accurate, mostly as a result of data collection problems in emerging markets and the deliberate secrecy of the major oil producing countries, particularly those who are members of OPEC.

According to a recent study by the Wall Street Journal, annual estimates of global crude demand by the IEA have been revised up for the past seven years (up until 2016) by an average of 880,000 barrels per day. And there is little evidence that demand estimates from other institutions are any more accurate. The EIA have also underestimated consumption over the past seven years, with the annual figures being revised up by an average of 2.3 million barrels a day.

Revisions to oil supply estimates are typically much smaller than for demand and are often about correcting overestimates for crude production. The IEA’s supply data has been revised down 60,000 barrels a day on average over the last seven years, according to the Journal analysis. That means the oversupply usually ends up being smaller than initially thought.

Demand is much harder to estimate than supply. Unlike supply which can be estimated from the pre-announced expansion plans of a relatively small number of companies, estimating demand involves billions of consumers worldwide and many millions of companies of all shapes and sizes.

The history of discrepancies underscores how commodity markets often trade based on, and pundits provide price forecasts using incomplete and often significantly revised data. And remember, the oil market is by far the largest, most liquid, most important commodity market in the world. If such big revisions are made in the oil market, then imagine how difficult it becomes to estimate demand and supply and then forecast prices in much smaller markets like lead, live cattle or lithium.

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