Materials Risk

Palladium has been the stand out performer in commodity markets over the past three years – up 160%. Palladium, mainly used in catalytic converters to control emissions from gasoline engines has been supported by a switch away from diesel vehicles and by the introduction of tighter vehicle emissions standards in China and elsewhere in the world.

Investors look to play the price differential

Investors reluctant to follow the bull market in palladium have been looking at alternative ways to bet on increasing emissions standards. The other main metal used in catalytic converters is platinum. Platinum demand has been under pressure since 2015 following the Volkswagen diesel-engine emissions cheating scandal in the US.

Platinum is extremely cheap  compared with palladium. Platinum prices have declined by 17% over the past three years while the platinum/palladium ratio has declined to its lowest level since 2001.

Chart 1: Platinum/palladium ratio

However, that of course doesn’t mean the ratio has to correct through higher platinum prices. Lower palladium prices and/or a combination of the two works just as well.

Switch to platinum will take time

Some investors it seems are backing the former. Holdings in platinum-backed ETFs have surged by 15% this year to reach a 4 year high as investors bet that carmakers will start to use the metal in petrol car catalysts.

But according to the car industry a substitution towards diesel is far from being a done deal. Rahul Mital, global technical specialist at General Motors suggested at a London Bullion Market Association meeting late last year that it would take some time to switch and even then the price benefits don’t necessarily warrant it:

“Any time you want to make a substitution like that, it is at least 18 months to a two-year cycle if we’re going to switch. We have to be careful that by the time we do all that.”

According to the World Platinum Investment Council (WPIC) a 5% substitution would mean a 14% increase in platinum demand from the automotive demand segment. However, given that catalyst demand is roughly half as important to platinum demand as it is for palladium (40% vs 79%) it may take a large switch to have a material impact on overall platinum demand.

Chart 2: End market demand

Fog of uncertainty

The car industry is battling declining sales in China and other markets. If auto-sales growth really does fall off a cliff (perhaps if a global recession hits) then demand for both palladium and platinum decline.

Chart 3: Annual growth in car sales in China

The car industry is facing increasing demands to invest in electric vehicle capability to head off the perceived threat from Tesla and others who have a head start. Is now really the time that they will be tinkering with the amount of metal in their catalytic converters?

History is also not on the side of price booms in metals thought essential continuing indefinitely. Just look at the price of cobalt over the past year and rhodium a decade ago.

Related article: What lessons does rhodium have for commodity investors?

Constrained supply after one-off boost

A new report by the WPIC predicts that platinum mine-level output will rise by 6% increase in 2019 to 6.46 million ounces on top of a 3% boost to recycling. The WPIC said supply growth would come mainly from the release of material stockpiled by mines and smelters in South Africa (responsible for 70% of global mined output) during upgrades and maintenance over 2017 and 2018. If this occurs it will clearly be a one-off boost to supply.

More generally platinum output from South Africa is frequently disrupted by power cuts, strikes and unrest. There seems little chance of that changing. More than 60% of South Africa’s platinum mining industry is loss-making or marginal according to Minerals Council South Africa. Labour costs have been increasing faster than inflation, whilst revenue from metal sales has been declining due to low platinum prices.

Chart 4: Forecast change in platinum supply

An industrial metal but a precious one too

Both platinum and palladium have their uses in applications other than catalytic converters. Jewellery for one but they are also held by investors as a ‘beta’ version of more commonly held precious metals like gold and silver. If gold prices come under pressure (perhaps because of reduced geopolitical tensions, lower inflation expectations and / or higher bond yields) then investor demand for palladium and platinum will also suffer.

Unlike gold and to a lesser extent silver, the PGMs suffer from poor liquidity and an opaque market. The PGM group of metals (palladium, platinum, rhodium and others) are very small markets relative to gold or indeed even silver. This means that prices can go from being an investors best friend to their worst enemy in the blink of an eye.

Related article: Platinum prices: The top 10 most important drivers

Platinum prices have been on a downward trend since 2011 frequently coming up against trend line resistance along the way. Since August prices have attempted to push up towards the trend line again (rising $100 per oz to reach $875 per oz) before failing to push past in in late February and then retracing half of that run-up in just a few days.

Chart 5: Platinum prices

Although speculators have recently turned net long it is going to take a break of this trend-line combined with confirmation of car-makers intent to seriously switch towards platinum for investors to run platinum higher.

Chart 6: Managed money positioning

On 25th January 2019 it happened again. Just three years and two months after Samarco’s tailings dam failed, the world’s largest iron ore producer, Vale, saw one of its tailings dams collapse in Brazil. The death toll is expected to exceed 300.

Aside from the obvious human tragedy the episode holds import lessons for commodity investments and by implication the outlook for commodity prices.

Just as climate concerns and safety failings (e.g. Deepwater Horizon) have arguably deterred investment in the oil industry, the same may happen for the mining industry as poor safety and community relations take centre stage. As Clyde Russel outlines in a recent article for Reuters the recent disaster risks a cascade of negative outcomes for the mining industry:

“If investors don’t want to commit funds to the industry because of fear over damage to their own image from poor mining practices, then the industry will be starved of capital. Lack of capital means it becomes harder and harder to get new mines built or exploration drilling undertaken.”

As international investors scale back funding (perhaps indiscriminately in the short term) then the share price of mining companies will fall while also pushing up the cost of funding for new ventures. Note that the share price of Vale’s competitors are only rallying right now because of the potential iron ore supply deficit that Vale’s difficulties leaves behind.

Governments that have long outsourced the provision of social services to the mining companies, especially in remote regions not easily accessible may be under pressure to take over where the mining companies have failed. Indeed, there may be renewed pressure for the state to have a bigger say in the mining sector and a bigger share of the spoils – a return to resource nationalism. That being said mining accounts for about 5% of Brazil’s GDP and Vale’s biggest shareholders are some of Brazil’s largest pension funds, so in Brazil at least they will be careful not to kill the golden goose. The attitude elsewhere in the world may be different.

According to Amsterdam-based Responsible Mining Foundation many of the world’s largest mining companies are not able to ‘know and show’ how effectively they are addressing the risks of tailings dam failure and seepage. The foundation’s research shows that failure risks are greatest for large, steep and old tailings dams in tropical zones where seismic activity and extreme weather events can precipitate dam collapses.

Although you could argue that iron ore and coal mining are the dirty heaving lifting of the mining sector there is a risk that all mining activities get tarnished with the same brush – that safety isn’t as high up the priority list and not quite as good as the mining companies say it is. The risk of future disasters remains high.

Resource companies are trying to position themselves as the suppliers of the ingredients necessary for an electric future – whether that is cobalt, vanadium or copper. Many people are not aware that commodities like cobalt and vanadium are typically by-products of much larger activities involving the extraction of more conventional commodities. Any negative impact to production of the latter will ultimately affect the former.

There are some parallels between this latest disaster and the BP Deepwater Horizon accident in 2010. Just as with that corporate disaster, rivals are quick to twist the knife but at least then tighter regulations and a long and arduous approval process were  introduced. Although activity dropped sharply in the aftermath, oil production in the US Gulf has since rebounded to hit record levels.

There is no sign of a similar response in the mining industry following this latest disaster. But that is arguably what it must get unless it wants to face the cascade of negative outcomes outlined in this post.

Related article: Shining a light on extractive industries: An interview with Åsa Borssén from Raw Talks

While history never repeats, so the saying goes it often rhymes. Recent developments in the oil market may hark back to an earlier time – the period from 1999 to 2002. According to a recent report from Goehring & Rozencwajg highlighting the similarity between the two periods oil prices and oil related equities in particular are seriously undervalued.

But before looking at where we are today first a recap.

Oil prices fell to a low of $10.72 per barrel in December 1998, in a spasm of near panic selling. The Economist magazine published an edition titled ‘Drowning in oil’ in March 2009 argued that given productivity gains and the poor outlook for the economy that, “$10 might actually be too optimistic. We may be heading for $5.”

A month later OPEC agreed to cut production and oil prices rallied strongly to $37 per barrel by September 2000; the rise in prices that year prompting OPEC to agree to two production increases. Oil prices gradually pulled back to $25-$30 per barrel range over the next 12 months on higher OPEC and non-OPEC supply combined with fears of a slowdown in growth.

After the 9/11 terrorist attacks oil prices dropped over 40% driven by fears of collapsing global demand. Oil prices eventually bottomed at $17 per barrel in November 2001. This then set the stage for the boom that followed with oil prices rising almost 8 fold over the next 7 years.

So how does the past few years compare? Here’s what Goehring & Rozencwajg have to say:

Oil prices bottomed in panic selling back in the first quarter of 2016, just as they did back in 1999…And just like the pullback of 2001, the pullback in oil in the second half of 2018 created a huge surge of bearish market sentiment. In 2001, the underlying fundamentals in global oil markets had improved dramatically from 1999. Oil demand, led by the non-OECD world, was about to surge and non-OPEC oil supply was about to hugely disappoint. Few energy analysts anticipated these huge changes about to take place.

In many ways we are again in the same position as 2002. Because of the temporary imbalance in global oil markets, prices pulled back, and have now stabilized some 60-65% above their 2016 cycle-lows, (just as they did in 2001). Because of the US Federal Reserve quantitative tightening, Trump trade wars, and worries over potential debt problems in China, investors and energy market [commentators] believe we will to see significant downward revisions in 2019 and 2020 global oil demand (also similar to 2001). Finally, we believe we’re going to see a significant overestimate of future non-OPEC oil supply, just as we did back in 2001.

IF history does rhyme then the potential for an asymmetric setup looks very promising. Especially since energy stocks as a proportion of the overall S&P 500 are lower now than they were in 2002/03!

So where could the unanticipated demand growth come from to propel the next bull market in oil? In previous notes we’ve highlighted the strong oil demand growth potential in countries like India (see below) as energy infrastructure and road networks are rolled out. Meanwhile, the growth in electric vehicles may also prove to be much slower than forecast. Up until now demand has been supported by generous subsidies, which in many cases are being gradually removed. Finally, although the risk of a recession or at least a slowdown is much higher that it was a year ago the experience of the early 2000’s may point towards a much quicker rebound in activity and so growth in oil demand.

And what about non-OPEC supply growth? Why might that continue to underwhelm? Most oil companies are still budgeting on a lower-for-longer basis and so the oil majors’ overriding focus is on cost containment rather than engaging in ambitious projects. Big energy companies are focusing on US shale and other short-term efforts over the long-term mega-projects seen in years past, all of which spells bad news for longer term non-OPEC supply stability.

Related article: How electric cars may end up supporting the next bull market in oil

Related article: Curve ball: How the ‘S’curve can help investors focus on the long term

Related article: Drowning in oil? In defence of The Economist’s oil price articles