Palladium’s catalyst

Since the start of the year palladium has been by far the best performing commodity, up almost 16% to almost $790 per oz. In contrast to the stellar performance from palladium, its precious metal kin platinum (+8%), silver (+7%) and gold (+5%) lag well behind. Palladium typically performs well at this time of year. Since 2000 the median increase in January versus the month earlier has been 3.4% with prices increasing over 80% of the time. But what has been behind the increase this year?

Much of the gain has just been due to a rebound in sentiment towards precious metals in general since the start of the year. A decline in yields on US Treasury bonds in the US has encouraged investors to move funds towards other perceived safe havens, gold in particular but also by extension silver and other precious metals. There were also signs, going into late 2016 that precious metals were also very much oversold compared, and that based on historical trends were likely to rise in the months ahead.

Meanwhile, renewed scandal involving diesel vehicles, in which platinum is more commonly used as a catalytic converter, this time from Fiat Chrysler has dampened sentiment for platinum and optimism that increased petrol fueled vehicles will increase demand for palladium.

However, the main driver behind palladium price sentiment has been a tax break on Chinese car purchases. Buyers typically pay a vehicle-purchase tax, which is applied to vehicle prices before the 17% value-added tax. The tax was cut from 10% to 5% on purchases of small vehicles from October 2015. The tax break helped stimulate sales in China during 2016 by 14% during the first 11 months of 2016, according to the China Association of Automobile Manufacturers.

The tax break was due to expire at the end of 2016. But in mid-December authorities announced that it would be extended into the end of 2017. While Chinese consumers are likely to have sought to taken particular advantage of the tax break in December, because of the expectation that the tax break would expire, demand for new cars and by extension palladium catalysts could still be high in 2017.

Roughly 75% of palladium demand is from the autocatalyst sector. Palladium finds application in gasoline engines and 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.

Indeed, the Chinese government has form in doing last minute tax break extensions. The government previously cut the vehicle-purchase tax to 5% between 20 January 2009 and 31 December 2009. It later extended the tax-relief period to the end of 2010, but raised the rate to 7.5%. The 2009 tax cut stimulated year-over-year auto sales growth to 45.5% in 2009 and to 32.5% in 2010 from 6.6% in 2008, according to the China Association of Automobile Manufacturers.

Where do we go from here?

Palladium price strength comes on the back of declining output from top producer South Africa, which together with Russia is responsible for more than 80% of global supply of the metals. Data released this week showed South African output fell 2.1% in the period Jan-Nov 2016 versus the same period in 2015. Under investment in one of the main palladium producers could start to become more evident in 2017 and beyond.

Investment demand in the form of funds moving into ETF’s could help prices move higher. Set against this is that palladium is an industrial metal – higher prices, when compared with its close substitute platinum tend to result in users (vehicle manufacturers in general) looking to reduce its use or substitute it with platinum.

Strength in palladium prices has typically not been long lived as abundant above ground stocks can be brought into the market relatively quickly to take advantage of any price strength. Finally, higher prices are likely to incentivise the recycling of palladium catalytic converters (a source that typically accounts for around 30% of total supply).

Related article: Fools platinum?

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Rising fuel prices: The not so obvious political risk in energy markets

Oil and gas markets may be underestimating the level of political uncertainty among some of the biggest energy producers. And the risk stems from the very thing that many governments in these countries are trying to engineer, higher prices. Except that now, higher energy prices, far from just helping to fill the government coffers are now starting to hurt the ordinary people that have come to rely on the goodwill of their governments.

The reason? Well, previously, authoritarian governments had attempted to placate their citizens through subsidies on everything from energy, food and many other daily staples. The decline in oil prices starting in mid-2014 prompted many oil producing nations to reform their subsidy systems, reasoning that in a ‘lower for longer’ world they had no choice to reduce or eliminate the payments and that the fall in prices presented a golden opportunity for them to do so without their citizens noticing.

One of the countries that is currently flying under the radar at the moment is Algeria. But that might not be the case for long.

The IMF warned Algeria in May that it needed to reform its generous subsidy system and shake up its bureaucracy. The country’s oil stabilization fund – a rainy-day account – had shrunk sixfold in three years to 740 billion dinars, about $7 billion.

Since the start of 2017 there have been several street riots in some northern cities, as local citizens protest against increased taxes, imposed at the start of the year to compensate for lower oil revenues.

Algeria is the leading natural gas producer in Africa, the second-largest natural gas supplier to Europe outside of the region, and is one of the top three oil producers in Africa. Algeria gets about 95% of its export revenue from oil and gas sales and needs prices as high as $87 a barrel to cover government spending. The OPEC nation currently produces some 1.2 million barrels per day.

Oil money has been the driving force behind vast national spending on social programs here. President Abdelaziz Bouteflika has long directed subsidies to fuel costs, food and cheap housing, helping him maintain his 17-year, military-backed grip on power.

The sharp rise in violence seen over the past week is similar to that in Algiers at the start of 2011. At that time the uprising was described as the “bread and sugar” riots (two products subsidised by the state) in protest against the increase in the price of basic products.

In other countries in the region, similar challenges led to the fall of regime after regime during the tumultuous Arab Spring in 2011. That the Algerian government was able to escape a similar fate was due largely to widespread fears that a major political and economic upheaval would trigger a civil war similar to the one that ravaged the country during the so called “Black Decade” of the 1990s. The government was also able to placate its restive population with subsidies, government jobs, and public sector pay increases – all financed, of course, by oil.

Even if oil prices stay around current levels, the Algerian government will, at some point, no longer have the resources to support even its scaled back patronage schemes. This could lead to even more instability, potentially ending in an Arab Spring-type uprising.

Algeria only has to look across to its eastern doorstep to see what could happen if the country collapses. Libya has been beset by political uncertainty since 2011 and despite recent improvements in the amount of oil produced still remains a high political risk.

Algeria is no stranger to disruption to its energy infrastructure. A deadly hostage-taking at a gas plant in 2013 left 40 people killed during a four-day siege at the Tiguentourine gas plant in In Amenas, near the Libyan border. Just as lower oil revenues means lower subsidies it also means that governments like Algeria that are dependent on oil revenues have less money for security to protect energy facilities.

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

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Oil prices: The top 10 most important drivers

Demand

Economic growth has a strong impact on oil consumption. Increased demand for transportation (e.g. more car miles traveled), higher power generation and increased road building (uses bitumen, a derivative of oil) and other products such as plastic result in higher demand for crude oil. Expectations of stronger economic growth can result in higher oil prices as speculators anticipate higher demand for crude oil.

OPEC supply

Announcements by oil ministers from the most important oil producing countries within OPEC can also influence oil prices. Recognising that they can’t always adjust output rapidly in order to influence the price of oil, a strong statement of intent can often be enough to influence sentiment and result in higher prices during a period of seasonal weakness. Despite their influence OPEC have a poor record of sticking with their agreements. The conflict between members and non-OPEC producers means that there is an incentive for individual members to overproduce.

The degree of spare capacity, particularly from swing producer Saudi Arabia is a much watched indicator as to the degree to which the oil market can respond to unanticipated shocks. A smaller level of spare capacity is often a sign pointing towards higher oil prices.

Cartels can only influence the spot price and the shape of the forward curve however. Long dated prices (beyond two years to an extent, but certainly beyond five years) are generally out of the cartel’s control, as long as the cartel is not the marginal producer.

Non-OPEC supply

Non-OPEC members are not (typically) subject to any agreements on the amount of oil they produce. Oil companies produce the amount of oil they can do technically and economically at the price in the market for a given cost. Whether it be the rise of North Sea oil production or shale crude oil output in the US often non-OPEC oil producers can surprise on the upside, a perennial thorn in the side of OPEC.

Weather

If the weather is too windy (a hurricane, for example), then oil rigs and transport facilities operating in the US Gulf are likely to need to shut down or may even suffer damage. If there is a loss of oil production, this may lead to higher oil prices because the region’s refineries, which depend on the Gulf’s output, are forced to seek crude oil elsewhere. Meanwhile, very cold temperatures can mean that pipelines cannot be switched off – one of the reasons why it is difficult for Russia to support OPEC in cutting production during its winter.

Very warm and very cold temperatures, especially for prolonged periods, can dramatically increase the demand for crude and heating oil for cooling and heating, respectively, as opposed to the softening effect of more moderate temperatures. Saudi Arabia for example relies on oil to generate electricity. If the summer is particularly hot then more crude oil is used in power generation, resulting in less available to be exported.

US dollar

Like most internationally traded commodities oil is priced in US dollars. At its most basic a decrease in the value of the US dollar relative to a commodity buyer’s currency means that the purchaser will need to spend less of their own currency to buy a given amount of the commodity. As the commodity becomes less expensive demand for the commodity rises, resulting in an increase in the price and vice versa.

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 can reduce profit margins for oil companies in Russia. All of the oil producers revenues 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). Therefore, the prospect of a lower profit margin acts as an incentive to decrease the supply of oil.

The relationship between oil prices and the US dollar works both ways. For example, a decline in oil revenues from oil producing countries could result in them pulling money back that they have invested elsewhere in the world (the US, in particular) in order to help prop up their budgets. The repatriation of these so-called “Petrodollars” may then lead to a decline in the value of the US dollar.

War and conflict

A cursory look at a simple oil price chart dating back to the 1970s reveals a series of bumps. Each of these can be pinpointed to wars and conflicts, whether it was the Iranian revolution, the Iraqi invasion of Kuwait or the US-led invasion of Iraq in the second Gulf War. More recently, Arab Spring-related uprisings in Libya or Egypt have also affected the oil price.

The price chart for the first Gulf War is a good case study. The Iraqi invasion of Kuwait caused prices to spike higher, but then as soon as the US led ground invasion started oil prices fell back on speculation that the conflict would be brought to a swift conclusion and that the military would secure oil producing facilities.

Speculation

Oil and oil products tend to play a major role in commodity index funds that invest in a broad basket of commodities. Although the evidence is mixed some commentators have suggested that these funds have pushed oil prices higher than they would otherwise be.

Although the physical fundamentals of supply and demand prevail eventually, the physical market may not always be able to anchor futures prices for days, months or even years. It takes time for the market to divert and accumulate sufficient physical supplies from normal business channels to meet a rise in futures prices driven by speculative rather than fundamental factors.

Inventories

Stocks (otherwise known as inventories) act as form of buffer for both producers and consumers of a commodity. Typically, falling stock levels occur if demand increases faster than supply, resulting in a higher commodity price. Falling stock levels may, however, make a particular commodity market more vulnerable to an unanticipated disruption to supply or a sudden increase in demand.

Typically, there is an inverse correlation between stock levels and the price of oil. However, at different times in the market the fear among market participants may place a lower or higher premium on the overall level of crude stock levels. Other factors (listed in this article) may trump concerns over stock levels. In addition, although relatively robust data exists in the US and many other OECD countries, other parts of the world are much more opaque.

Strategic Petroleum Reserves

One of the most well known strategic reserves is the US’ Strategic Petroleum Reserve (SPR), the largest emergency supply in the world with the capacity to hold up to 727 million barrels of oil. Most recently, it was used to offset disruptions to oil supply in the US Gulf following Hurricane Katrina in 2005 and following the political upheaval and loss of oil production in Libya in 2011. Just the threat of a release from the SPR has often been enough to temper an increase in the oil price, particularly when there has not been any actual cut to output.

More recently, other countries such as China have sought to establish their own SPR’s, often entering the market when oil prices are relatively low to build up their reserves.

Unplanned outages

Unplanned outages can result in higher prices. Possible reasons include the weather, maintenance, war or civil unrest etc. For example Nigerian crude output has been frequently disrupted due to armed gangs that blow up pipelines.

Previous episodes

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Natural gas prices: The top 10 most important drivers

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Gold prices: The top 10 most important drivers

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