Going Outside The Box !
Economics, finance and social comments
people in motion
dimanche 14 avril 2013
More Precious than Silver and Gold
The Best and the Better : Platinum and Palladium
I met Rick Rule last month. Rick is now part of Sprott Asset Management, one of the most respected natural resource investors around. Rick also had a ridiculously good long-term track record in managing money before joining Sprott.
The thesis is simple, as most good ones tend to be.
“What we discovered in about four weeks’ work,” Rick told me, “is that the platinum and palladium mining industry as a whole does not earn its cost of capital. What that means is that either the prices of platinum and palladium go up or there is less and less of it going forward.” PGMs have a high supply risk. In the British Geological Survey's Risk List 2012, the platinum group of metals (PGMs), of which platinum and palladium are widely viewed as the most significant, received a high supply risk index based on the list's seven criteria: scarcity in the Earth's crust; production concentration-location of principal producers and contribution to global supply; reserve distribution-global distribution of reserves; recycling rate; substitutability; governance (top producing nation); and governance (top reserve-hosting nation). Overall global supplies of platinum and palladium are expected to decrease substantially in 2012, resulting in supply deficits. A substantial reduction in primary and secondary supply is expected to move the platinum and palladium market from surplus to deficit in 2012, according to the Johnson Matthey Platinum 2012 Interim Review. Gross demand for platinum is predicted to remain firm, however, severe disruptions to platinum mining are expected to result in a 10% drop in global mine production of platinum. The report also estimates an 11% decline in supplies from recycling. Together, these factors are expected to result in an overall 10% decline in worldwide platinum supplies and a deficit of 400,000 oz. Gross demand for palladium is predicted to increase 15%. However, both mine production and recycling are expected to contract by 4% each, and stock sales by more than two thirds, resulting in a deficit of 915,000 oz.
Another way to say it is that the platinum and palladium business, as is, doesn’t pay investors enough for the risks they take compared with alternatives. So it means people will not invest new dollars in the sector. No new investment in mining means depletion of existing mines with no new sources of supply. Eventually, the price has to go up as rising demand (or flat demand) presses on a diminished supply.
Supply Constraints What’s unique here is that platinum and palladium face particularly challenging supply constraints.
“Gold and silver come from many countries and many geologies and as a byproduct with other metals,” Rick says by way of analogy. “But about 90% of platinum and palladium supplies come from South Africa, Zimbabwe and Russia. And they are enormously constrained.”
How constrained? Well, South Africa is by far the most important producer. Let’s start there.
“First, it doesn’t earn its cost of capital,” Rick says. “And that has manifested itself in a few ways, but the most important is that the industry by its own estimate has deferred between $6-8 billion in capital investment.”
Widespread labour disruption, mine closures and other issues are negatively impacting the supply of platinum and palladium from South Africa, which produced more than half of the supply of the metals in 2011.
Platinum supplies from South Africa, which accounted for 75% of global production in 2011, are projected to fall to an 11-year low in 2012, declining 19% from the peak in 2006. The country is also the second largest producer of palladium but supplies of this metal are projected to drop more than 6% in 2012. A myriad of issues in the country are lowering cash profit margins and resulting in less supply of the metals, including labour disputes, closure of marginal operations, declining ore grades, , and progressively lower depths required for mining operations in some locations.
Additionally, the availability and cost of electrical power continues to be precarious and the uncertain political environment, including increased rhetoric and political pressure regarding possible nationalization and/or ''super'' taxation, could reduce the ability and willingness of industry participants to make the necessary investments to sustain current supply.
Rick took me through the situation in South Africa in some detail. The mining industry there is labor-intensive for reasons both historical and geological. Workers are poorly paid. Labor conditions are truly awful. “Workers are crawling across broken rock on their hands and knees, often carrying 125-150 pounds of hand-operated drills with them,” Rick says. “Worker mortality was always disgusting in South Africa, but it’s becoming frightful now.”
Workers have almost certainly seen a co-worker killed, if not maimed. “The point of all this,” Rule says, “is that workers’ wages have to go up. But because the industry can’t earn its cost of capital, wages can’t go up.”
It’s a hard spot to be in -- but it seems clear that something has to give. Once again, the price of the metals has to go up or production will continue to dwindle as rising costs put these miners out of business.
Mining is, of course, energy intensive. And the power industry has a political mandate to provide cheap power for people who can’t afford it. So the mining industry pays more for power but is also the first one to be interrupted. There have been no capacity upgrades in 12 years, Rick says. Meanwhile, demand keeps rising. Antiquated power plants struggle to keep up with demand.
Not a promising picture for the most important supplier of mine production of platinum and palladium in the world.
Then there is Zimbabwe. “Which I can dismiss very quickly,” Rick said. “Zimbabwe had a viable platinum and palladium industry 10 years ago. Robert Mugabe took care of that.” The only region expected to increase platinum and palladium production in 2012 is Zimbabwe, though it remains a relatively small producer of the metals. However, increasing political tensions and threats over security of tenure in the country has deterred new investment.
The industry “de-capitalized itself,” as Rick put. “It can’t be turned around in any reasonable amount of time with any reasonable amount of money.” Moreover, when Mugabe dies, the struggle to succeed him could well paralyze the country for years.
“I don’t see Zim affecting platinum or palladium supplies for at least a decade,” Rick sums up.
The final alternative is Russia. “I believe it is getting better,” Rick said, “but it is getting better from a low starting point. The problem there isn’t political, it’s geological. The ore bodies of Norilsk, which are the biggest PGM ore bodies in the world, are 80 years old. They are long in the tooth, started by Stalin. And as you get deeper and deeper, the concentration of palladium declines.”
Potentially, there is another deposit, but it is about 400 miles from Norilsk, which itself is in western Siberia and is fairly remote. Rick speculates that it will happen in 10 years and take billions of dollars. Short story: It’s not going to happen anytime soon.
As Rick says, this is not a resource story that’s going to take place in two-three years. It’s a story that’s already taken place over the last five-six years.
The majority of platinum and palladium producers are operating at a loss. The cash costs and capital expenditures required to mine a 3E PGM oz (~60% platinum, ~30% palladium, and ~10% rhodium) have risen to a level such that most mine production is already cash flow negative. Only five companies are slightly cash margin positive after accounting for capital expenditures. A 15-year trend of declining ore grades and anticipated labour settlements with increased wages are expected to further increase cost and stress balance sheets for these producers. What about recycling ?
Rick told me that recycling makes up about 30% of supply. “It is the only source of supply that has been growing,” he says. “It has increased as a percentage of total supply by 50% in the last 10 years.”
What about substitution? “Substitution doesn’t make sense at anything less than a 100% increase in price,” he guesses. And the demand scenario? Compelling. “Platinum and palladium go out a tailpipe, go up a smokestack or get turned into jewelry -- that’s what happens to it,” Rick says.
More stringent vehicle emission standards continue to drive demand growth for platinum/palladium in autocatalysts. Due to their powerful catalytic properties, platinum and palladium are essential components in catalytic converters in automobiles as they form the surface catalyst upon which the critical chemical reaction converting engine exhaust emissions into neutral compounds occurs, resulting in the reduction of the toxic components from combustion. There is no widely used substitute for the metals in autocatalysts and emission standards are becoming increasingly stringent across Asia increasing platinum/palladium loadings per vehicle. Demand for palladium in autocatalysts is expected to grow by 7% to an all-time high of 6.5 million oz in 2012, resulting in a combined 5% increase in autocatalyst demand for the two metals to 9.6 million ounces. For 2013, automotive demand for palladium is anticipated to grow by 24% and for platinum by 13%. China is an increasingly important demand driver for both platinum and palladium. China recently surpassed the U.S. to become the largest auto maker globally and auto sales are projected to grow at 5% per annum over the next three years, according to IHS Global. Palladium loadings per gasoline powered vehicle produced in China have approximately tripled over the past decade and in 2010, China adopted the Euro IV emission standard, which is expected to materially increase the PGM loadings in Chinese-produced vehicles. The country's demand for platinum in jewelry, particularly among the younger generation, comprised close to 70% of the global share in 2011 and is growing. From 2006 to 2011, platinum purchases doubled on the Shanghai Exchange. Strong long-term annualized returns and uncertainty about the global financial system has the potential to take more supply of platinum and palladium off the market. The returns on both platinum and palladium outpaced the S&P 500 Total Return Index in the ten years leading up to November 21, 2012, according to Bloomberg. The Manager of the Trust believes investor demand, through ETFs and funds acquiring the physical bullion, may increase as investors seek to protect their portfolios from inflation, deflation, economic slowdown and currency devaluation. They are incredibly useful metals. “The social trade-off is really platinum versus smog,” Rick says. “I mean that’s really what it’s about. The air quality we enjoy today in Western Europe and North America and Japan is a function of catalytic conversion. It takes only about $200 of PGMs at today’s prices to afford the air quality we all enjoy. And that’s $200 against a median sticker price of $27,400 for a new car in the U.S. If the price doubled, the demand implication would be de minimis.”
“The price has to go up, and can go up,” is the pithy summation Rick offers up.
“It’s a thesis that is really, really difficult to poke holes in.” Unless the Western world goes off an economic cliff and vehicle sales get cut in half, it is hard to imagine anything less than a 50-100% increase in price.
Strong long-term annualized returns and uncertainty about the global financial system has the potential to take more supply of platinum and palladium off the market.
The returns on both platinum and palladium outpaced the S&P 500 Total Return Index in the ten years leading up to November 21, 2012, according to Bloomberg. The Manager of the Trust believes investor demand, through ETFs and funds acquiring the physical bullion, may increase as investors seek to protect their portfolios from inflation, deflation, economic slowdown and currency devaluation.
As you can see, this is a thesis worth investigating further.