Tuesday, October 21, 2008

Safe Haven Investments: Survival of the Fittest

Important update [Oct. 23, 08]: The story of Norilsk selling SWC stake might NOT be true. Please my latest comment on my suspicion and do your own due diligence.

This is part 4 of my series articles discussing the true valuation of physical assets, paper assets and currencies, vital knowledge needed to survive the unfolding global financial crisis. This is a sequel to part1, part 2, part 3. Read previous articles if you have not.

I wanted to discuss the valuation of US dollar; why it rallied so strongly; why we will see a sudden and abrupt reversal of the dollar rally; and why such a reversal will come imminently. I wanted to spend more time giving it more thoughts. But some big breaking news happened yesterday, forcing me to discuss the new developments immediately.

In previous articles, I emphasized that physical commodities can serve as reliable safe haven assets because their intrinsic values are decided by the marginal production cost. When something is sold BELOW production cost, the low price can not last long as no business can operate at loss indefinitely. SUPPLY DESTRUCTION will happen, tilting the supply/demand relationship to a shortage. Price will then be restored to profitable level to allow producers to resume profitable operation. Therefore when you see a commodity traded far below its production cost, it is the best investment you can buy. You can just sit back and wait for it to appreciate soon, in inflation adjusted term, knowing for certain that the price just has to recover regardless of the demand side.

Looks like the supply destruction is indeed happening at neck-breaking pace, in all commodity sectors, and many analysts have noticed the phenomena and openly discussed the idea of supply destruction. As I am a precious metal investor with particular interest in palladium, two news happened yesterday caught my attention and made me very happy, as things that I predicted are happening far sooner than I expected. The news involves two of my favorite stocks, North American Palladium (PAL) and Stillwater Mining (SWC).

PAL announced today that they are temporarily suspending the production at the Lac Des Illes mine, and suspending metal sales due to current low metal prices. I am pleasantly surprised that the new CEO, Mr. Bigger, could act so quickly. I openly called for PAL to suspend operation due to current low palladium price. It's not an easy decision to let 350 hard working mining workers go, through no fault of their own, but the company must preserve precious mineral reserves and liquid assets, and ultimately it is also good for the workers themselves.

I believe that PAL, as the only palladium producer who sells to the spot market, has enough leverage power on its own to turn the palladium market around, and major stake holder George Kaiser also has a capacity on his own to move palladium price. Now PAL is not selling, who will sell in the palladium spot market? Who has the metal to sell? Are they going to sell paper palladium now? The market must realize that it must pay a fair price to get the physical metal. Unfair prices can only buy you paper, as producers simply can not operate at heavy loss to produce metals like a charity organization.

But the next piece of news shocked me so much that I jumped up, could not believe what I just read!!! Russia's Norilsk Nickel (NILSY.PK), the world's largest nickel and palladium producer, 55.4% stake holder of America's Stillwater Mining (SWC), is now offering to sell their SWC stake!

This is incredible! This says the Russian Checkmate in palladium, which I discussed before, is playing out right today, right in front of our eyes. This is incredibly bullish for the price of palladium. Let me explain.

Norilsk Nickel produces 45% of the world's palladium. In 2004, they acquired a majority stake in SWC, America's ONLY mine of palladium and platinum, two strategic metals of critical importance to the security and survival of the United States, through quite some political maneuvers that involved direct negotiations between President Bush and President Putin. Norilsk's strategic acquisition obviously was aimed at achieving a 50% dominance of global palladium supply in order to assert monopoly power. Norilsk never sold a single share of SWC. Such a strategic asset is never to be sold for some cheap money.

Not for sale, UNLESS Norilsk is in a desperate need of cash urgently. Norilsk is huge, producing 20% of the world's nickel, 45% of palladium and 12% of platinum. Last year, Norilsk was on a buying spree, spent US$6.3B in CASH to acquire a small nickel player, LionOre, among other purchases. And today Norilsk needs to sell its strategic SWC stake for maybe a meager $230M cash for lunch money?

They are in a terrible liquidity squeeze if they are so desperate they need $230M in cash now. Current low nickel price really hurts them. My estimate is they probably lose $1B to $2B per quarter. So $230M is probably good to last them another 2 or 3 weeks. I see that shutting down the Norilsk Mine, is an inevitable decision they are forced to make urgently, regardless what they say publicly. They either shut down, or go broken then shut down. Not to mention Norilsk Mine is an environmental catastrophe that needs urgent cleanup.

That would be fantastic news to SWC and PAL, the only primary palladium producers in the world. Shutting down Norilsk would remove 45% of the world's palladium supply. When it comes to PGM metals, look at rhodium! A mere 4% shortage was enough to drive rhodium price from $300 to $10000 per ounce!!! What will a 45% shortage do to palladium? Would the Russians boost palladium price so they can get a better deal on SWC?

It is outrageous Norilsk is suggesting another foreign buyers to take over its SWC stake. It was heart breaking to see our precious national treasure sold out to the Russians, by our president. Do we want to sell SWC to a foreign country again? If an American billionaire investor reads this, please consider seizing this opportunity to buy up the SWC stake, not just because of patriotism, but because of the huge profit opportunity. The nation needs our treasure back! Senator McCain: You can demonstrate you are not Bush No. 2. You can take SWC back from the hands of the Russians.

South Africa is another catastrophe waiting to happen, benefiting the two North America based producers. Current platinum and rhodium price is simply too low for any South African PGM mine to make ends meet, not to mention the on going electricity crisis in the country and ongoing limit of only 90% power supply to the mining industry. SA's PGM industry has entered a Survival Dimension, facing a choice of either cut production to boost metal prices, or a certainty of bleeding to death. Many analysts and shareholders have openly called for production cutback. PAL has already made the right move; South Africa should move soon to cut.

That, of course, is a great incentive for investors to buy and hoard physical palladium and platinum. The investment buying will boost prices so buying begets more buying. History has proven in 1980 that when people need to buy safe haven assets during financial crises, they buy every precious metal, not just gold and silver. When there is strong investment buying, weak industry demand becomes irrelevant.

I am not totally dismissing the factor of industry demand of PGM metals, especially in the auto sector. But the weaker auto sale has been exaggerated. Owning a car is a necessity, not a luxury. How you can walk 30 miles to work or 10 miles to shop? Tight family budget may postpone buying a new car for a while, but only till the old car breaks. You may turn down a customer's request for a car loan but you can not remove the need for a car. Gasoline consumption in the USA hardly reduced, year over year. From the fundamental point of view of the mobility needs, suppression of auto demand is only temporary, not permanent.

More over, history has shown when the industry demand of PGM metals weaken, the extra supply has always been absorbed by jewelry demand as the metals become more affordable.

Out of all precious metals, gold is the least I like. I have not purchased any GLD so far. The current gold price is still well above profitability of most gold mines. Humanity has been digging this almost useless yellow metal for thousands of years till today. There's too much gold sitting there just to collect dusts. If we do need more gold, maybe we can all quit our day time job and go to the beaches panning for gold, like the folks at Jamestown.

Silver is a different story. 70% of silver today is produced as a by-product from base metal mining. Even for the 30% silver that's produced as main product, base metal by-products are also important part of the revenue. The whole silver industry is suffering not only from current low silver price, but also low base metal prices as well. Production cut is expected, reducing supply, at a time when physical silver investment products are in high demand. I believe physical silver price will go up much more than gold. I own SLV and recently increased my SLV stake on the dip to the low $9 area. The silver industry has continuously announced news of mine shut downs recently. Even mentor of the most famous silver bug, Israel Friedman, has openly called for CDE to suspend silver sales.

Silver mining companies are different stories. I have purchased a few silver stocks like SIL, PAAS, SSRI, HL, CDE. But after carefully examine them one by one, I find that all of them are hurt from low base metal prices, not just low silver price. None of they are pure silver play. So instead of providing a leveraged gain over silver, these mining companies provided a leveraged loss over silver. If I am already invested in silver itself, why do I need to buy any silver mining share? I wish there are pure silver players around.

Silver Wheaton (SLW) claims to be a pure silver play. I bought SLW a couple of years ago before I knew better. But once I figured out SLW's business model I never touched it again. It's a holdings company basing its value purely on some contracts. Basically they borrow a ton of money from banks to pay to the mining companies in exchange for the mining companies to sell the by-product silver to SLW for only $3.90 per ounce. SLW will pocket the difference. Sounds good? But I don't see how physical fortune can be made in playing paper contracts, instead of digging real mines. Now the danger of SLW, a danger not unlike sub-prime loans, has been exposed: What prevents these contracted mining companies from shutting down their un-profitable base metal operations, hence cut off SLW's silver supply?

In current turbulent commodity market, the mining world is a world of survival of the fittest. Who has the richest mineral reserves, the most cash and the least debt, will survive and prosper. The long term bullish cycle of commodities will continue, as Jim Rogers pointed out, due to the damage of producers thanks to the credit crunch. A whole bunch of unfit commodity producers will probably be eliminated. But the survivors will get to enjoy the next wave of commodities rally, which I believe is not too far away, despite of a weakening global economy, because the damage to supply is much worse than the damage to demand.

The fundamental bullishness of commodities attribute in large part to the fundamental bearishness of the world's fiat currencies, notably the US dollar, but not just the US dollar.

The dollar staged the strongest rally in recent years, just as the global credit crisis deepens, and the Fed is printing money like crazy to inject huge liquidity into the market. Every bit of liquidity the Fed injects simply disappeared once it's absorbed by the market. It totally defies logic and stunned many market observers. Is it manipulation? Conspiracy theory is always an easy answer. But we must look for the real reason behind the logic-defying dollar rally, to make correct investment decision.

The real reason is that the global credit crunch creates such panic that most people retreat to the basic instinct of "Cash Is King". Liquidity is being hoarded away, instead of circulating in the market. The velocity of money approaches zero, making the dollar seem more valuable relative to surplus goods squeezed out of supply chains. This is a temporary aberration and can NOT be allowed to last. When the velocity of money approaches zero, so does the velocity of goods movement. If goods are not moving, then the society will collapse. The money printing will get both money and goods to move again. Once that happens, the dollars will suddenly flood the market while the supply of goods will dry up, leading to the sudden collapse of the US dollar.

Let me use an analogy. We are riding on a car rushing up a high cliff overseeing the ocean underneath. You will panic and your intuitive response is buckle up your safety belt to strip yourself in. You think you are safe in your safety belt. Well at impact point, you go from no liquidity to hitting an ocean of liquidity in a split second. There is absolutely no time for you to untie your safety belt before you are drowned. The safety belt is the US treasury bonds. Warren Buffet recently sees danger in treasury bonds and he is all out spending cash to load up equities. Follow the Oracle of Omaha as he is the one with market wisdom!

Full Disclosure: The author is fully invested in SWC, PAL, and OMG. I am also loaded in SLV and traded in and out in a few selected silver stocks like SSRI, HL, PAAS and SIL.

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