Principles of Wealth Preservation Through Physical Assets

Yesterday, barely one week after the fall of Fannie Mae (FNM) and Freddie Mac (FRE), we saw the fall of the third and fourth largest financial institution at the same time. Lehman Brothers (LEH) filed for bankruptcy. Merrill Lynch (MER) sold to Bank of America (BAC) in a hurry. Dow plummeted more than 500 points. We are looking at an un-precedent financial tsunami and it is at times like now that people MUST preserve their wealthy through safe haven investments, or risk losing everything.

When it comes to safe haven investment, people immediate think about physical assets like gold, silver, oil, land, real estate. There is a reason for it. Physical things have intrinsic values. Value of a paper fiat currency, or a stock, can fall to zero. But value of any physical assets can not fall to zero. The intrinsic values of physical assets are the reasons why they preserve wealth during times of financial and economic crises.

It is important to understand why physical assets like commodities have intrinsic values and how are they determined. Without this knowledge you might end up over-paying for something and losing your wealth. Those folks buying gold at the $800+ high in 1980 ended up losing big time and they may never be able to recoup their losses, because they chased the gold maniac and over-paid well above the intrinsic value of gold. Knowing how to measure the intrinsic values is more important as the value of the US dollar is changing dramatically, so the dollar price no longer provides an objective comparison.

To understand how intrinsic values of commodities like gold are determined, a few common misunderstandings must be demystified. Those common misunderstandings include:

A commodity's value is determined by its usefulness, or how much people are willing to pay.

A commodity's value is determined by supply and demand, the more scarce the more valuable it is. The more abundant the cheaper it should be.

Both notions are considered common sense by most people. But both notions are actually wrong if you think them through. Why are both notions wrong? Let me use one example to illustrate why these two notions are wrong. Let's talk about water, potable, drinkable water.

Water, of course is extremely useful and important. Water is needed to sustain life. But yet water is cheaply available. So something useful doesn't necessarily make it expensive.

Water is also abundant. Coca Cola (KO) can produce as much soft-drink as people of the whole earth needs to drink, and much more, there is even competition from Pepsi (PEP) and others. The Saudis can buy as much water as they need. Some one can filter the sea water to produce any amount of fresh water as long as the Saudis pay the right price. But the abundant water is not exactly cheap as dirt. Vise versa, something scarce doesn't necessarily make it expensive, either. Remember I mentioned KO and PEP for a potential short? I believe both companies will survive a severe economic recession or depression. But profits are going to plummet as consumers cut back on discretional spending on soft drinks.

The case of water provides a good example of the intrinsic value of a commodity. A one-gallon bottled water is sold roughly at about the cost to produce and ship it, plus a bit of marginal profit. The reason is very simple: If price of bottled water is too low to be profitable, then no one is willing to produce bottled water and so supply immediately falls, bringing the price back up. But if price is a bit too high, then driven by good profit, competitions will bring in extra production, which brings price down again. This leads to the important principle I want to talk about:

A Commodity's Intrinsic Value Is the Cost of Replacement

In my past articles, I have emphasized the basic economic principle that

Supply and Demand Drives the Price

And now I am talking about that commodities should be valued at the cost of producing them. Have I changed my mind? Am I contradicting myself? No! There is no contradiction. Both principles are valid and they are consistent with each other. The reason these two principles are compatible between them is that the replacement cost, the cost of producing the commodity, is NOT a constant. The production cost itself is driven by supply and demand.

That's because when the demand weakens and the price fall, businesses that produce at higher cost will fail, reducing the supply and leaving only the lower cost suppliers in play, hence the replacement cost is reduced until things reach equilibrium.

Likewise, when demand exceeds the supply, price must go up, and new source of supply where it previous was too costly to produce can now come into play profitably. So this is the case where strong demand drives up price as well as the production cost.

Let's use natural gas as one example. Some predicted that natural gas price should fall and they point out recent US production increase. What they failed to mention is that due to international market competition, LNG (Liquefied Natural Gas) import into USA has collapsed so the increased domestic production can barely make up for the drop of importation. The weekly NG storage number is significantly lower than the level last year, meaning the market has consumed more than the available supply for the past year. Further, almost 100% of the domestic production increase comes from the so called shale gas, a resource impossible to produce in the past and is still prohibitively expensive to produce today. The horizontal wells are very hard to drill and production from each well is very slow. Some estimate that shale gas is unprofitable to produce unless the natural gas price remains at $10 or more per MM BTU. Current spot price is at $7.39.

More over, from an energy equivalence point of view, one MM BTU natural gas is equivalent to 6.5 barrels of petroleum. So current price of natural gas is equivalent to only $48 per barrel oil, even though it is a cleaner fuel. Comparing with petroleum, natural gas is now in an extremely oversold condition. Using the principle that commodities should be priced at the production cost, which is at least $10, I am seeing United States Natural Gas Fund (UNG), is an excellent buy here and I see it less affected by turbulence in the general market. I bought UNG at around $33 myself. I also call for buying NGAS as it is an unconventional natural gas play, with a nice ticker name others are jealous for.

Let me come back to the topic of safe haven investments. The most important feature of a safe haven investment is not to make money, although that will be nice, but the main goal is to protect and safeguard your wealth. It must be something physical, with intrinsic value that does not fall, and is under your control and disposal. Safe haven assets are something you accumulate and you are not supposed to sell at any price, until time is getting real bad. And then these hard assets you own will protect you and your family. It's like buying a gun for your self-defense, do you buy it one day and then sell the gun next week, thinking that as you were not in danger that you do not need it any more? No! You buy and just own a gun indefinitely if you want protection. It's the same principle for safe haven assets.

Trading paper futures contracts, buying one day and selling another day and gambling on daily charts, like hedge funds are doing, is NOT safe haven investment. Safe haven assets are physical asset you just acquire while they are still cheap, and hold on for rainy days, as such, suitable physical assets to acquire must not only preserve and grow in value, but they must be easy to store, transport and safeguard as well. This leaves very few suitable options. You can not store coal, oil, natural gas or even helium in your backyard. The only practical things to consider are gold, silver, platinum and palladium. Even silver is considered too bulky in comparison with other precious metals. But for average Joes who do not have a lot of net worth, silver is perfect as a safe haven asset.

In near term, I am bullish in precious metal producers; I am bullish in natural gas and in crude oil. But I am now bearish in coal. I called for the coal producer, JRCC, at $4, and then called for taking profit in JRCC at $60+. My calls were perfect. I called for JRCC to reach low $20-ish and it is here today. The bullish sentiment in the coal sector is still too strong. But the fundamentals of the US economy does not support a bullish US coal market. If a large amount of US coal is shipped to Europe we might continue to see a coal bull market. But the dry bulk shipping rate is collapsing, as reflected in the stock price of DryShips (DRYS). The falling dry bulk shipping rate show there really isn't a lot of coal being shipping around the world. If investors are hoarding coal in their backyard, it might provide additional demand. I have not heard any one hoarding coal at home, though.

I am seeing JRCC to continue to fall to low double digits, in the $10 to $12 range. If you are in JRCC, or in other US coal players like ACI, ANR, BTU, CNX, FCL, ICO, MEE, PCX, dump them on the next rally up. It's no longer time for a coal bull market. There are better bullish investments some where else.

The best commodity bull plays right now, are precious metal producers. This is especially true as many precious metal players are now at ridiculously low prices. It's a basic supply and demand thing. A big part of the demand now comes from investment demand. If you look at the big picture, that investors large or small must now purchase physical precious metals as safe haven assets to protect themselves. The argument of investment demand now supercede any argument regarding the industry demand, because the investment demand can be orders of magnitude larger than industry demand.

Once again, physical commodities provide protection of value because their intrinsic value is the replacement cost. They can not fall below that replacement cost for extended period of time, because when it happens, it quickly kills off the supply, and then the price is brought back up. The intrinsic value also goes up as production cost goes up due to inflation and high material cost.

So which precious metals provides the best value protection as well as the best potential for gain, depends on its current price relative to its replacement cost. Gold I think is the worst. Gold's current price allows most of gold producers to be comfortably profitable. The huge above ground gold stockpile means there is no lack of gold even if many producers go out of business. So gold does not provide very good bottom price protection here. On the up size, there is currently enough incentive for new gold project to be developed, bringing extra supply to the market. So that limits the up side potential as well.

Silver is better than gold because current silver price is unprofitable for many primary silver producers. Current silver price just does not provide incentive for new silver supply to come online. Further, according to USGS, the world's remaining silver resource will be depleted in about 13 years at current production rate. So silver has very limited down side here and much greater up side than gold. I have recently purchased silver players like PAAS, HL, and SIL.

But I think PGM metals, platinum and palladium, provide best of all worlds. PGM source is pretty much limited to South Africa, Russia and two North American producers, Stillwater Mining (SWC) and North American Palladium (PAL). South Africa, by far the dominant supplier, producing 85% of the world's platinum and 35% of palladium, saw PGM production collapsed due to the country's electricity supply crisis, which is a long term problem with no solution in sight. In August alone, their PGM production falls by 32.8% from a year ago, while the 2007 production was also down significantly from 2006 level.

The investment community has completely ignored South Africa's electricity woe and production fall, while totally exaggerated the demand set back in the auto catalytic converter sector, and in the jewelry sector. In my last article, I point out that diamond demand is actually booming. That alone point to a higher jewelry demand of platinum and palladium. A loose diamond can not be worn. It must be set in a precious metal setting, platinum and palladium.

Investors also forget that their own purchasing of the physical PGM metal constitute a physical demand, on top of any industry demand. At current prices of $1120 per ounce platinum and $230 per ounce palladium, this is pretty much a bottom price which is already below the replacement cost. None of the South African PGM mines can make a profit producing platinum at $1120 per ounce. Do you know it takes 20 tons of hard rock ores and 5 months of total processing time to produce just one ounce of platinum?

Regardless of the precise industry demand figure, if the market does not begin to pay a better price, South African PGM producers will have to cut back production so the price will boost. That alone is a strong argument for investors to purchase platinum at current price. I wonder why the South African PGM industry would not shut half of their mines down to help alleviate the country's electricity crisis, and make much greater profit from half of the production. It seems they are not worried about weak demand or over-supply at all as they see the purchases are strong. They would rather worry about potential demand destruction if they do not strive to produce as much as possible to supply the market. Nothing can be more bullish when the main suppliers tell you that they worry about not having enough supply, instead of not having enough demand, when the platinum price is already so low.

Platinum's sister metal, palladium, should be a better buy than platinum because it is currently only 1/5 of the price of platinum. Historically the prices of the two were close to each other, as these two metals are inter-changeable in many applications. Industry users tend to use more of the less expensive metal, reducing the price gap over time. Palladium, being mostly a byproduct metal, except for that only SWC and PAL produce the metal as main product, is way much less price elastic in the supply, hence it has more explosive price rally potential. Palladium coins are now rare and hard to find. You should buy any palladium coin you can find with a decent premium. Of course the better buy would be the producers themselves, stocks of SWC and PAL.

How do you decide on the valuation of these two palladium producers, SWC and PAL? Look at historical price figure. The performance of the two tracks each other at roughly a 3:2 ratio, with SWC being about 1.5 times the price of PAL. The price of PAL collapsed in November, 2007 after a catastrophic secondary offer diluting the shares and provided an excellent short target to the naked shorter. Same story as what happened to Hecla Mining (HL) recently.

Consider that SWC still has lots of proven and probably mineral reserves, 23 million ounces worth of PGM metals, and they have hardly touched the tip of the iceberg of the gigantic stillwater igneous complex, and that there is opportunity to expand into the bullish chromium sector, while PAL's current mine is near depleted and they have yet to develop the rich Offset High Grade Zone. I think I would put a fair price ration between SWC and PAL at roughly 5:2.

Nevertheless, both companies are strong buy on the palladium play. Both stocks have been heavily shorted and heavily manipulated. The high outstanding short interests can not be safely unwounded, even at current low prices. Both companies have a very strong and patient majority or near majority stake holder behind them.

Behind PAL is billionaire investor George Kaiser, who own nearly 50% stake for many years, presumably because he believe palladium has an extremely bullish future. If Mr. George Kaiser wants, he can easily lift up global palladium price single handedly.

Behind SWC is an even stronger player, a 54% stake holder, Russia's Norilsk Nickel (NILSY.PK), the largest palladium producer in the world. They took all the trouble to acquired SWC to control over 50% of the world's palladium supply in the first place. Their strategic aim is clear: dominance of the global palladium supply, not for charity to the humanity, but for maximum profit. The Russia can name the palladium price any way they see fit if they want to. They have not taken any action to boost palladium price so far. But I guess a Russian checkmate is just a matter of time. They do not acquire SWC just to supply the world with dirt cheap palladium at a price far below cost.

I really can not see a market more bullish than that! And I really can not comprehend why so few investors can see what the Russians are up to. Time to buy some SWC and PAL. This will be an investment of a lifetime. Mr. George Kaiser has been waiting patiently for nearly 10 years so I think I can wait for a few more months. I am hoping that SWC or PAL suspend palladium sale at the spot market because it makes no sense for any company to sell products at a heavy loss. They could even buy back palladium at spot price! Even Gold Corp (GG) has suspended an unprofitable mine due to current gold price. If either SWC or PAL suspend sales or buy back palladium from the spot market, a lot of fun could happen fast. The global palladium market is so narrow that any one might squeeze the supply and pump up price.

P.S. The author is heavily invested in SWC and PAL, and hold long positions in HL, UNG, NGAS, PAAS and SIL.