Monday, June 30, 2008

The Brightest Stars in the Commodities Boom Part Two

Wow, what a slaughter in the coal sector on Wednesday, July 2nd, 08, as coal spot price plummeted nearly 10% in one day! I have warned on June 20 that there was something not right in the coal sector. The coal rally has gone too far too fast. The basic numbers of supply and demand does not warrant such a strong coal rally. I warned folks invested in coal stocks to take profit now, and move to other, more bullish commodity sectors. It's been proven correct and timely. Coal stocks peaked on June 23, right after I issued the warning.

Let's survey the damage: JRCC closed at $62.14 on June 23rd, and at $44.15 on July 3rd, a drop of 28.95%; NCOC went from $10.55 to $6.39, a drop of 39.43%; PCX went from $145.99 to $126.73, a 13.19% drop; MEE went from $93.38 to $75.46, a 19.19% plummet. In one day July 2nd, BTU dropped 9.3%; ACI saw a 17.2% haircut; ANR slashed 16%; CNX -14.6%; FCL - 11.7%; FDG - 12.7%; ICO - 19.7%. What a catastrophe in this whole sector. I believe coal is bullish long term. But there is no fundamental justification for coal price to triple in just 6 months.

Almost all traders focused their attention to NYMEX coal future trade, or Australian Newcastle Port coal spot price, which continues to climb up at scary pace to this day! But on a typical day about 20 contracts for any particular month are traded on NYMEX, with each contract worth 1550 tons. In a typical week about 2 million tons of coal is loaded to ships docked at the Newcastle Port. Those numbers are a drop in the bucket comparing with the scale of global coal supply and demand, which according to BP is over 3 billion tons a year, or nearly 6 billion tons according to other sources.

What people don't understand is that the global coal market is largely a LOCAL market. Shipping coal half an earth away is too expensive and getting ever more so with skyrocketing oil price and extremely tight global dry bulk shipping capacity. Good luck for any major US coal producers to sell thousands of future contracts on NYMEX when the daily trade volume is only 20, or find enough ships to shop the bulk of their production to Europe. They really can't rip profit from current high spot price either buy selling futures contracts, or by shipping a considerable portion of their coal production overseas. If they do, they merely collapse the NYMEX futures market, or simply drive up the dry bulk shipping rate to sky high levels that force international coal buyers to stay back. Good fortune to the Aussies, though. Producing only 6.9% of the world's coal, they are nevertheless the world's Saudi in coal, with 75% of their coal production exported in the first place.

Global coal exports can NOT expand significantly due to the bottleneck of global dry bulk shipping capacity. The Europeans might be so desperate that they are willing to buy coal at $200 a ton and want to import more. But they will not pay $200 a ton at Virginia harbors. Instead they probably pay $60/ton to Americans and then pay $140/ton to the Panamans (the ships). So if you really believe the global coal export market is tight, sell your coal stocks and buy dry bulk shipping stocks like DRYS, DSX. The bottleneck of coal market is NOT coal production, but coal shipment across the oceans. Don't be misled by the coal spot price at shipping ports!

I insist on looking at commodities at their basic supply and demand numbers, and future trend, and how elastic or inelastic the supply and demand responds to price changes. I don't think coal is the best long term commodity play judging from all I see.

In last article I mentioned the spectacular price rally of the PGM metal, rhodium, on a mere 4% shortage. Let's look behind reasons for rhodium's its stellar performance as it gives us a perfect example what makes a superstar in the commodities boom. I will then talk about prospect of PGM demand in the auto industry in light of the auto sales drop recently. Finally I will talk about another spectacular minor metal called cobalt.

According to Johnson Matthey's Platinum 2008 Yearbook, annual rhodium supply in 2007 was 822,000 ounces, while demand, net scrap recycling, was 856,000 ounces. The net shortage was only 34,000 ounces, or 4% of the demand. Such an insignificant shortage was enough to drive rhodium price to $10000 per ounce in 5 short years! So what is rhodium used for, and why it's so price inelastic?

Rhodium has two unique characters among the PGM metals. First, it's the most rigid and has the highest melting point among PGM metals. Second it is the only one that facilitates chemical reactions involving nitrogen, while being the only one strong enough to resist even the nitric acid. These two characters make rhodium virtually indispensible in all its applications.

Biggest demand of rhodium, over 81%, is usage in auto catalyst converters to neutralize the harmful nitrogen oxides (which are responsible for the acid rains) into harmless nitrogen, a role neither platinum nor palladium can play. There is no replacement possible and there is only so much auto makers can do to reduce the rhodium loading. If sub-standard catalyst converter is used, the vehicle may fail to meet the emission control standard after a few years of usage, so replacement will be required and it actually ends up increasing the rhodium demand.

Rhodium is also used as catalyst in a number of very important chemical processes, including the Ostwald Process to produce nitric acid, and the Monsanto Process that produces acetic acid. Nitric acid is the basis of the nitrogen fertilizer industry and a whole family of many chemical products. Acetic acid is the basis for a whole family of chemical products we see in our daily life, including wood glue that holds our furniture together, and plastic soft drink bottles.

Rhodium alloyed with platinum is also used in making high quality glass, including glass used in LCD displays, like computer monitors and big screen LCD TVs. High purity rhodium is made into the crucibles used in the production the high quality optical fibers used in high speed computer networks. The crucible is essentially just a container for the fused glass. So why must it made of pure rhodium and not any other metals? Because the fused silica material in the optical fiber used in long distance computer networks are extremely pure and extremely transparent. It's more transparent than even the air. This allows light to travel many kilograms in the optical fiber without much attenuation, enabling long distance communication using the light signal. In making such material of extreme purity, crucibles made of almost any thing would dissolve just a tiny bit into the fused silica, hence induces impurity and renders the material useless. Only rhodium, the toughest of all PGM metals, is perfectly rigid and inert, with very high melting point, and does not induce impurity into the material.

Without rhodium, computer fiber optics networks would not be possible, production of nitrogen fertilizers would not be possible, a lot of synthetic materials would not be possible to make. You look around yourself, 60% of all the stuffs we use everyday have something to do with rhodium in one way or another. Don't you think then such a magical, indispensible noble metal really should be worth more than ten times the price of gold?

Without gold, life on earth goes on and nothing much has been missed, without rhodium, half of the world's population would not survive because there will be no nitrogen fertilizers to boost food production to feed the hungry population. Without rhodium, companies like Monsanto (MON), Agrium Inc. (AGU), Potash Corp (POT), DOW Chemical (DOW) will have to shut down a major portion of their businesses. That's the whole reason why rhodium, at a mere 4% supply shortage, can reach such astronomical price level, US$10000 for one troy ounce.

The lesson from rhodium: A commodity that is in shortage, and that increased production is unlikely, and that is absolutely essential and indispensible in critical applications, will likely be one of the brightest stars in the commodities boom.

Most rhodium is produced in South Africa and Russia. But one of my two favorite palladium producers, Stillwater Mining Inc. (SWC) in Montana does produce 4,000 ounces of rhodium a year, and recycles about 28,000 ounces from spent catalyst converters. These are not trivial numbers consider that each 100 ounces of rhodium is worth one million dollars!

I have talked in the past that due to the ongoing South African electricity crisis disruption the supply of PGM metals, platinum and palladium; imminent depletion of the Russian government stockpile of palladium; increasing requirement of these metals in auto catalytic converters; emerging new applications of these metals; more over, due to strong investment demand, platinum and palladium will be extremely bullish in the next few years. The best way of leverage the platinum and palladium bull will be to buy the stocks of PAL, North American Palladium, and SWC, Stillwater Mining.

But first I need to address many people's concern that slowing US auto sales and slowing jewelry demand may hurt PGM metals demand. My viewpoints are that you need to study the details to get the accurate picture:

1. Auto sales in China, India, Russia and other emerging countries are booming and the increase more than offset the shortfall in the US market. China's passenger car sale increased 17% year over year. Combined with commercial vehicle sales China's auto sale now exceeds 10 million unions per year. The foreign auto sales in Russia are growing at 54% annual rate. GM reported record Q1,08 auto sales in Europe. Looking globally, the demand on automobiles is very strong. You only need to check out recent gasoline price raise to realize the fact that the world has an insatiable demand on automobiles.

2. Customers are increasingly looking to buy small fuel efficient cars, but auto makers do not produce enough of the small cars to meet demand. They over-supplied the market with oil guzzlers but do not have enough small cars for offering. As auto makers adjust their production plans accordingly to meet customer demand, I actually see a booming new car market in the next few years. The reality of high oil price is forcing many people to retire their oil guzzlers well ahead of time. They need to buy smaller, more fuel efficient cars as replacements to continue to meet their daily commute needs. Simple math! Assuming you drive 12,000 miles a year, keeping a SUV that gives you 15 MPG for the next 5 years costs you way much more money than buying a brand new Prius that gives you 60 MPG, consider that gasoline will go to $5, $10 or even $20 a gallon.

3. There is a myth that higher platinum or palladium price may suppress jewelry demand. Annually the amount of PGM metals used in jewelries is a couple million ounces, or roughly 0.01 grams per person in the world. Clearly platinum and palladium jewelries are NOT for every one. There is only enough metal for the wealthiest 0.08% of the world's population. Platinum and palladium jewelries are mostly for high end jewelries, like bridal jewelries. A typical diamond wedding band set probably cost $5000 or more, and contains maybe 6 grams of platinum. The metal cost is worth about $400, far less than the diamond itself. Platinum price goes up from $1500 to $2000 only increase the cost of a $5000 diamond ring by $100. A typical American wedding costs US$50K to US$100K. A typical Chinese wedding costs US$10K to US$50K. No one will cancel a platinum diamond wedding ring just for $100 extra cost!!!

4. John Reade did not know that year 2008 is a big Chinese wedding year. As the number of weddings will double, so will the purchase of bridal jewelries. He probably observed how jewelry dealers responded to PGM price changes and concluded that demand in this sector was pretty price elastic. It's absolutely wrong. Jewelry dealers, like any trader, always seek to reduce their cost, so they tend to double their purchases when the price drops a few dollars, and slash their purchases or even sell some, when the price rally a few dollars. But at the consumer end, the demand is not price elastic at all. At the end of day jewelry dealers will have to buy at any price to meet that consumer demand.

But most analysts missed two big issues on PGM metals fundamentals. One is investment demand on the physical metals. The other is the demand of industrial users to hoard stockpiles to secure their supply, especially in light of tight supply, and that investment demand may squeeze the already tight supply, and even worse, the possibility that some investors might intend to corner the PGM market.

The investment demand on physical PGM metals is very real. One only needs to look at the rapid increase of the physical metal holdings at the ETF Securities. Based on the dollar value of latest holdings of ETF Securities, the percentage of investment interests are respectively: Gold 54.90%, silver 7.78%, platinum 32.54%, palladium 4.78%. Such percentages reflect a very strong investment demand on platinum and palladium, if you consider how narrow the PGM market is in relative comparison to the gold and silver market.

Many gold bugs pitch gold as the best hedge against inflation. My opinion is any physical asset probably can be used as hedge against inflation, and contrary to common myth, gold is the WORST of all inflation hedges. Just ask the people who bought gold neat the $800 peak in 1980, or people who bought before the peak, but held right through the peak and eventually sold at a loss. In the next wave of gold maniac, it's quite possible gold may actually reach $2000, $3000 or even higher. But do you actually gain in real term of purchase power?

Gold might be useful to people who has too much money to be invested in anything else but gold, because everything else has a market capital way much less than the gold market.

But even Warren Buffett doesn't like gold. He had this to say:

[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it
down, dig another hole, bury it again and pay people to stand around guarding
it. It has no utility. Anyone watching from Mars would be scratching their

Almost every one laughed at Warren Buffett's gold comment. I did at one point. But after giving it some thought, I found that he actually said something in wisdom.

Why humanity continues all the efforts to dig gold out of the ground, when the world has already accumulated enough gold to last a thousand year? Why do we spend all the energy, resources and human efforts to mine something that we already have plenty? It doesn't make sense especially at a time when we are fast depleting our limited fossil fuels and other natural resources. Our efforts could be better spent on producing something that is useful, and that is in short supply.

I would rather buy SLV and PGM metals than GLD. But now I have found something way much better than silver: the metal cobalt. It is rare, in short supply, and the demand is surging due to increased production of batteries used in hybrid electric vehicles, and increased demand on special alloys containing cobalt. I believe this metal will do way much better than silver in the next few years. If you know a place where folks can buy small quantities of cobalt metal, please share the information with me. I will talk about this magic metal in greater details in my next article. For now if you are interested in cobalt play, have a look at a stock called OMG, "Oh-My-God", which I first noticed during its run up from $35 to $60. I think now it's cheap to buy.

P.S. The author is heavily invested in SWC and PAL, and holds shares in OMG.

1 comment:

Anonymous said...


If SWC is such a good investment, why has it retraced almost its entire move from when the South African power crisis blew up in late January?

Second, do you have any estimates on automotive demand? I see four forces at work in that sector of Pt demand:

A. Slower economy, high gasoline prices and restrictive lending means fewer miles driven, fewer new cars, therefore lower demand for platinum in catalytic converters.

B. But a lot of the Pt supply comes from recycled converters. If people drive their cars for longer, then less recycled supply is available. So which is more important: lower demand or lower supply?

C. Political pressure for less polluting engines starting in 2009. I'm no scientist, but I assume that means more Pt used in autos.

D. Many fuel-cell vehicle technologies use Pt. Do you know if they use more Pt than a conventional auto?