When people see danger in the market, their animal instinct response is to liquidate everything and go fully in cash to ride out the storms. The conventional wisdom is "Cash is King". But conventional wisdom doesn't work anymore, as this is unconventional time. If you are fully loaded in cash or US Treasury Bonds, this news first noted by Karl Denninger should completely shock you out of your shell:
$2.29 Trillion Dollars US Treasury Bonds Failed To Deliver!
Note it is $2.29 TRILLION, with a T for Trillion! I never heard one can short US Treasury Bonds, let alone naked shorting US T-Bonds! The T-Bonds are considered some of the safest investments, with the full faith and credit of the US government guaranteeing the principal, and you get an interest payment. So shorting US T-Bonds is virtually guaranteed to lose money. You will have to payback the principal plus the interest. You do NOT short the US T-Bonds, let alone naked shorting, let alone as much as $2.29 Trillion.
That is UNLESS you are a really BIG player and you clearly see imminent danger of the collapse of the US T-Bonds, and of the US dollar itself. I wrote before that Warren Buffet saw extreme danger in the US Treasury Bonds and he was completely out of the bonds and fully into the equities market now. Of course people should respect and follow this guy's wisdom. But small potatoes like Warren Buffet could not have naked shorted $2.3 Trillion US T-Bonds. Some one much bigger and knows better did it. I will not speculate. Please read Karl Benninger's comment.
Money created out of thin air is NOT King! The Kings now are precious metals. Never mind the fact that the dollar staged a shocking rally and precious metals plummeted. The dollar rally is nothing but a bubble, while current precious metal prices, especially platinum and palladium, is nothing but absurdity. Physical commodities MUST be priced above their production cost, or the supply will simply dry out, as no one can continue produce metals at a loss. So if I am sitting on my precious metals, I pretty much have the guarantee that they will soon appreciate in real purchase power term. On the other hand, if you are sitting on trillion of dollars of the fiat currency, and the currency falls, the only guarantee you will have is they will continue to fall further down, until eventually they reach zero.
The general market always manages to fool most people most of time, and causes more people to lose more money in unexpected way, and rewards only the selected few who has the wisdom and who has the determination to stick to their wisdom. The current global crisis necessarily means an astronomical amount of fortune must be totally wiped out. What could be a better, cleaner and quicker way of wiping out trillions of dollars of fortune instantly, than to first herd the sheeples into holding nothing but cash, and then the currency suddenly collapses? Of course the US dollar rallies big time if every one is herded into buying dollars. A bubble is something pumped up to a valuation much higher than where it should be.
Fiat money is completely at odd with the economy basics of supply and demand. For anything physical, equilibrium can be reached as the price impact positively on supply and negatively on demand. Higher price encourages more production while low price suppresses the supply. When the price falls below cost, supply dries up as no one can continue to produce and sell something at loss. On the demand side, the price has exactly the opposite effect. High price suppresses demand while low price encourages consumption.
Fiat money acts in exactly the opposite way. The less valuable a currency becomes, the more is being produced out of thin air. The cheaper the currency becomes, the less people desire to own and keep them, and the faster people want to get rid of them. When people want to get rid of their paper money as fast as possible, it speed up the velocity of money, and cause the value of the currency to plummet even more, forcing the government to print more money. The vicious cycle continues until the currency is totally destroyed. Throughout civilized history of mankind, every single experiment of fiat currency has failed. No exceptions.
In Chinese the word CRISIS contains two characters, DANGER and OPPORTUNITY. We are in extreme danger but also with extremely good investment opportunities. The opportunities are made even better because every one runs away from them and run towards a gigantic death trap with a sign "Cash Is King". Remember one thing, safe havens must be small, with narrow spaces that accomodate only a few refugees.
It reminds me of the Bible story of Noah's Ark. People ridiculed Noah as he was building his ark, thought it had never rained a single drop for a year, how could the flood come? The flood did come as Noah expected. Had these people listened to Noah and seek refuge in his Ark, would it make a difference? No! The Noah's Ark was still only big enough to contain just one pair of each kind of animals. It wouldn't be a Noah's Ark if it was made any bigger. Likewise, today's financial safe haven wouldn't be a safe haven, but a death trap if it was big enough to allow every one in!
Although we do not see a drop of rain yet, trillion dollars of wealth will soon be flushed away by the coming financial flood of hyperinflation. Have you built your Noah's Ark yet? There is definitely NOT enough material to build a big enough Noah's Ark to save every one.
I can't understand it! There are tons of investment opportunities in commodities right now. You can buy a few metric tons of nickel or copper or cobalt or a number of other things. You know they are priced far below their production cost right now. So it is absolutely a guarantee they must appreciate to at least the fair price of their cost. Can you find any better investment, with such absolute certainty of making double, triple and quadruple the money in the next few months, regardless of the demand? How could people be so blind and not seeing the opportunities? They all rush to cash and T-Bonds waiting to be slaughtered, and they actually thought it was safe to be with the biggest group of mobs?
Nickel is now less than 1/6 its price of May, 2007? Hello?!
ENOUGH IS ENOUGH! When enough is enough, the eruption is fierce!
On Monday, third largest nickel producer in Russia, Ufaleynickel, responsible for slightly less than 1% of global supply, announced that they are shutting down production, as the nickel price is simply too low. They need to see at least $26,000 per metric ton to break even.
Instantly nickel shot up to touch $5.00 a pound, from Friday's $4.00. That's a one day rally of 25%. It's probably the biggest one day rally of any commodity in history. Removing 1% of global supply doesn't really change supply/demand that much. But the price was suppressed too much so the bounce had to be fierce. Had you bought nickel at $4, you have made 25% profit in just a day. And yet people rush away to buy US T-Bonds to earn 3% annual interest while waiting to be slaughtered in the looming implosion of the bonds market?
Want to make a 10 fold return in two months, and maybe two weeks? Go buy some palladium metal. Any palladium metal you can find. Palladium price can go from $170 per ounce to $1700 per ounce in no time, once the Russian Checkmate plays out.
The Russian Checkmate event will be Norilsk Nickel (NILSY.PK) shut down production. They are the No. 1 nickel producer in Russia. No. 3 has shut down already. Would No. 1 be far away? Norilsk shut down, and 45% of global palladium supply is gone. I can't even start to predict where palladium price could go up to, with 45% of supply removed instantly. In 2000/2001, one false rumor from Russia was enough to send palladium up to $1100. It would be fun to watch the effect of 45% of palladium supply removed.
Of course, you can get better leveraged gain investing in the palladium stock Stillwater Mining (SWC) and North American Palladium (PAL).
Will Norilsk shut down? They are facing a severe liquidity squeeze. In first half of 2008, Norilsk group reported a profit of $2.682B, at 32% profit margin. If you look up metal prices as of Oct. 24, 08, and re-run the numbers, they would have to write down -$4.594B of sales revenue for the whole group, or $3.634B for the main Norilsk Mine, resulting in heavy losses. The cash drain will be nearly $2B per half year.
Norilsk group had $4.8B cash as of end of June, 08. The main Norilsk mine probably had $4B in cash. They spent $2B in a recent stock buyback, a senseless decision which Mr. Mikhail Prokhorov denounced as "capable of putting the company on the verge of bankruptcy". Operation loss since June probably costs them another $1B. They have a debt payment of $400M due in November. Do they have any cash left? Can they continue to operate the mine at heavy loss? Why would they continue to operate with heavy loss until bankruptcy?
The bullish case for palladium can not be disputed if you understand how bad a shape Norilsk Nickel is in today.
Yesterday's news of Ufaleynickel shut down mentioned OM Group (OMG) and reminded me that OMG is the best cobalt play, because it dominates the chemical sector involving cobalt. I consider cobalt as a better metal to buy than silver, with the potential of 10 fold appreciation in a short period of time. Check out news on Minor Metals. If the speculation of Katanga Mining shut down plays out, cobalt price should fly soon. You can buy cobalt from BHP Billiton (BHP).
There are so many beaten down silver and gold mining shares now. All are very good buys: PAAS, SSRI, SIL, HL, NEM, AUY, NAK, IVN, NG. There are so many to name. Even Southern Copper (PCU), my very first commodity play, is now back below where I first bought in late 2005. Anything in mining is good nowadays. I would not touch Silver Wheaton (SLW)though, because of counter party risks. Also forget about any coal player now. I continue to call for selling JRCC, ACI, ANR, BTU, CNX, at any rally. The US coal market is a local market and is now bearish. Again watch Dry Ships (DRYS) share movement as it is an important indicator of the health of the global economy. I might even consider buying some DRYS as the valuation has become so attractive. But I first need to get a conformation that cross ocean shipping activity is recovering.
I will keep a portion of my portfolio in iShares Silver Trust (SLV). I will not buy gold or SPDR Gold Shares (GLD). I believe gold is adequately priced at current level. The money spent on gold is better spent on something else. Even buying a ton of nickel or copper is better than gold.
But the best of all is still palladium, and the only two pure palladium plays, SWC and PAL. We are witnessing a singularity event unfolding in the palladium market as Norilsk Nickel will inevitably shut down, to protect its own best interest. What is singularity? A singularity is the kind of extremes like what you get when you try to divide a number by zero!
Full Disclosures: The author is heavily invested in SWC, PAL, has considerable stake in OMG and SLV, and will continue to buy some select silver shares including SSRI, HL, PAAS and SIL. I am also looking for opportunity to buy DRYS soon.
Monday, October 27, 2008
When people see danger in the market, their animal instinct response is to liquidate everything and go fully in cash to ride out the storms. The conventional wisdom is "Cash is King". But conventional wisdom doesn't work anymore, as this is unconventional time. If you are fully loaded in cash or US Treasury Bonds, this news first noted by Karl Denninger should completely shock you out of your shell:
Thursday, October 23, 2008
My article on Oct. 22, 2008 discussed the breaking news that Norilsk Nickel (NILSY.PK) is open to offers to buy its majority stake in Stillwater Mining (SWC), America's only PGM mine. The share price of SWC plummeted 25% on yesterday while the news spreads, as investors probably fear that Norilsk dumping its shares could depress the share price.
However, upon further research, I am growing more and more suspicious about the credibility of the news story. It could well be a false rumor after all. I still do not have a definite confirmation or denial of the authenticity of the original news story, but I will discuss why I now suspect the story could be a false rumor.
1. SWC is Norilsk Nickel's very important strategic asset. They have not sold a single share. They would never sell, unless Norilsk is extremely desperate for some cash and they can't get a loan from a bank. I believe they still have credit lines to pull. If they need to sell asset, there are plenty of other less important overseas assets to sell, for much more cash, before they would sell SWC for a meager US$230M. Not long ago, Norilsk was still spending billions of dollars in a stock buyback trying to support its share price. It seems unlikely its cash liquidity drained so fast.
2. Source of the news story is suspicious. The news story was first carried by The Moscow Times and immediately mentioned on Yahoo by a misterious cjlu4585, at 21-Oct-08 09:18 pm EDT, which is 04:18am Oct. 22, 08 Moscow Time. The original news story was dated Oct. 22. How would the story be published so early during the day, at 4:18am, and promptly catched?
3. Anonymity of the original citation. CJLU4585 used a curious URL to refer to the original article. When you go there, there is no mention of author near the title of the story:
However, notice the number 600 in the URL link? Replace it with other numbers, like 599 or 601, it still link to the same story, but with the author name shows up. Only when you use 600 does the author name NOT show up. Very strange.
4. No confirmation. The hometown newspaper of SWC also carried the story from Moscow Times but said that SWC was never informed by any one from Norilsk. Every one got this news from the original Moscow Times piece. There is no press release from Norilsk and no direct confirmation from any official in any of the companies involved. No other media confirmed the information independent from Moscow Times.
5. The writting of the original news story was non-professional and contained many obvious errors. It refered to Mr. Oleg Lobanov as Chief Financial Officer (CFO). That's a term commonly used in western corporations, but not in Norilsk. Mr. Lobanov's official title is Deputy General Director for Economy and Finance, very different from a CFO.
The story said Mr. Lobanov made the comment during a conference of finance executives. It did not say what conference it was and where it was held. Why would Moscow Times be the only media invited, as no other media carried the story? Why would Norilsk reveal it through such a casual comment by Mr. Lobanov, instead of in a more formal way? Why no party involved was informed about it?
The cited percentage, 55.4% stake in SWC, was incorrect. It's more like 53.5%. Would Mr. Lobanov get the percentage wrong?
The story twice mentioned the South African company "Empala Palladium". A very strange name. It should be Impala Platinum (IMPUY.PK). Mr. Lobanov, an industrial insider, would never make such a mistake. The rumor maker probably did not get the name right. Since the name was referenced twice, it was not a typo. Further the author said he/she called "Empala Palladium" and left a phone message which was not returned. If he/she called the correct phone number, he/she would not have gotten the company's name so wrong.
In all, until we get further confirmation from Norilsk or Stillwater, I am now highly suspicious of the originality of the original story, and persuade readers to do their due diligence to find out the truth. It can not be ruled out that some one deliberately spread the rumor in a deliberate effort to manipulate SWC share price. If this is confirmed to be a rumor, I shall take actions to report criminal act of involved parties to the SEC and other authorities.
I am a value-based investor and strive to get all my information and facts correct and tell readers what I truely believe is correct information. I am always fully responsible for everything I say. If I inadvertedly helped spread a rumor, my appologize to all who might have been mislead. I still do not know whether the orignal story is true or false and will provide update as soon as I find out from related parties.
P.S. The author is heavily invested in SWC and PAL, the world's only primary palladium producers. The author does not currently own shares in Norilsk Nickel.
Tuesday, October 21, 2008
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.
Thursday, October 16, 2008
Is it deflation, stagflation, or hyperinflation, in the current global economic crisis? That's the quadrillion dollar question investors must get right. This article will answer that big question but it is also meant to be a sequel to part one and part two of the serial articles talking about valuations of physical and non-physical assets as well as currencies. Please read the first two parts of the articles if you have not. It's critical to understand valuation of commodities and currencies first, before the big question of inflation versus deflation.
Recently, as the credit crisis unfolds, we saw the worst commodity price plummet in history, while the US dollar index rallied amid the unfolding financial crisis. Many people wonder that the commodity bull market has ended as the global economy enters a recession. Their reasoning is that due to credit squeeze, people cut back on spending as they could not borrow any more.
Such notion is wrong. While people looked at the weaker demand side, they failed to notice the destruction on the supply side! On the consumer spending side, people are NOT cutting back in TOTAL spending. Actually people are squeezed to spend every dollar from their monthly income, just to keep heads above water. More and more people are living from paycheck to paycheck, meaning they have to spend every dollar of they take in, and have nothing to save. They might be forced to cut spending on some specific items and spending more money on other things. The total spending in dollar terms is up.
Recent commodity price plummet is NOT a fundamental change in the supply/demand relationship. Fundamentals do not change abruptly in just three months.
The real reason is that the global credit crunch squeezes out inventories in the supply chains, causing a temporary and false supply surge, depressing the price. Such price depressing effect is only momentarily. It will be corrected violently to the bullish side once the false surge of supply is exhausted and the effect of supply destruction becomes evident.
In any commodity market, besides the supply side and the demand side, there is a long supply chain connecting the supply and the demand. In different parts of the supply chain, there are sizeable stockpiles of the materials. Under normal supply, the stockpiles at different parts of the supply chain will buffer out supply disruptions and ease out price shocks. That's why when a commodity is in adequate and abundant supply, the price will be flat.
However, stockpiling materials requires operational capitals. Often time money tied up in inventories is credit provided by banks, in the form of so called commercial papers. Things work fine if the credit market is healthy and adequately funded.
Unfortunately in a credit crunch, borrowing money is expensive or virtually impossible even for good businesses. Faced with a liquidity squeeze, businesses must raise cash for operational needs or to merely service debts. That means selling off inventories and cut spending in purchase of raw materials and equipments. When producers cut spending in productive activities, the supply destruction is in the pipelines!
Not only corporations are selling, hedge funds invested in commodities are also selling like there is no tomorrow. Every one is liquidating everything to raise cash and stuck the money in safes. That is absolutely foolish! While governments around the world are printing astronomical amount of money out of thing air, people are hoarding the funny papers in their pillows? We are in the making of a Weimar Republic on a planetary scale, and you hoard the fiat money?
When businesses at all levels suddenly sell off the inventories and at the same time halted purchase of new feedstock materials, prices are depressed prompting more sell offs. This leads to the false illusion of supply surplus, while hiding the fact that production of further supply is being suffocated. It's an extremely dangerous situation, as it could lead to a sudden onset of supply disruptions just as every one cheer at cheaper prices, without realizing that the supply chains have been squeezed empty.
My wife told me the best sell always happen right before a store goes out of business! When you go shopping this weekend and enjoy the lowest prices you haven't seen in a long while, you'd better ask the manager when will the next delivery truck arrive, or will it arrive at all! It's economic 101, all businesses are for profit. No one can operate at loss sustainable.
What do you expect when the supply chain stockpiles are depleted? There is no longer a buffer to absorb supply disruption and price shock. The market will suddenly discover that the supply has dried up. So the price will rally violently, in an extreme volatile way. That is what I predict will happen in all commodities in the coming weeks, including oil, food grains, and metals.
The market of platinum and palladium metal (PGM) is probably a good case study. About half of these metals are used in making the catalytic converters on vehicles. To reduce the risk of price volatility and supply disruptions, auto makers normally maintain a stockpile of PGM metals worth about 6 months to one year's consumption. Jack Lifton from Resource Investors described a very interesting case when one man's attempt to modify that inventory level caused dramatic reaction in the tightly traded rhodium and platinum market.
I am a big fan of palladium and platinum investment due to these metals bullish prospects. After the headline news of South African electricity crisis in early January caused the platinum and palladium prices to shot up, they stayed at the relative high level till the end of June. And then, at the onset of global financial crisis, they plummeted in a free fall fashion, all the while South Africa's PGM production continue to suffer from tight electricity supply. What gives? Who is selling? Every metals analyst is puzzled by the mind boggling fall of platinum and palladium.
The Big Three US auto makers, General Motors (GM), Ford (F) and Chrysler are facing a severe liquidity squeeze. They have been aggressively reducing inventory levels for months. When you are in a liquidity crisis, you sell whatever asset you can sell quickly to raise cash. The most liquid asset, of course, is the platinum and palladium precious metal stockpile.
In the narrow platinum and palladium spot market, when inventories from auto makers were sold out, it creates a lot of downward pressure. If industry users are selling, speculative hedge funds will be selling as well. The only buyers therefore must be the value-based long term investors. A recent Resource Investor article by Nathan Becker also provided explanation that hedge funds have to sell their precious metal hoardings due to liquidity squeeze.
I agree with Nathan Becker mostly but I must point out that he only considered the demand side and failed to recognize the damage that low metal prices may inflict on the supply side. No one can produce metals at heavy loss sustainable. Businesses must scale back production or shut down, if they can not make a profit. Anglo Platinum (AAUK) is currently producing at an average cost of US$1250 per ounce basket PGM metal (60% of Pt, 33% of Pd and 7% Rh) while the current market price of the PGM basket is only US$778 per ounce. It's only a matter of time before South African producers must start to reduce production if the prices do not improve to profitable level soon.
Last week's market plummet creates one of the rarest buying opportunities in our times for savvy investors with cash at hands ready to buy. How often do you get to go to an out of business sale and pick up things at prices far below their cost? Nickel is on out of business sale, copper is on out of business sale, grains like wheat, corn and rice are all suddenly on nose bleeding out of business sales. Grab them while you can. It may not be there tomorrow.
Do you think mining companies and farmers can continue to sell you nickel at $5.00 a pound, wheat at $5.53 per bushel, corn at $3.84 per bushel, and expect to continue the business at all selling things well below cost? It's the same out of business sale like what your wife told you!
The absolute best out of business sale is the palladium, metal of the 21st century, currently at $185/ounce bid. Gold mines are every where, silver is mined everywhere. But only four places in the world produce significant amount of platinum and palladium: Norilsk Nickel (NILSY.PK) in Russia; the Bushweld Complex in South Africa; Stillwater Mining (SWC) in USA; and North American Palladium (PAL) in Canada.
None of the four palladium producers are operating at a profit at current prices of nickel, platinum and palladium. They must each or together decide to slash production to boost metal prices, or face eventual bankruptcy. Any of these four have enough leverage power to boost metal prices on their own, and I believe there will be strong will to do that, as no business wishes to operate at a loss if they have a choice.
That is reason enough for investors to purchase physical palladium at current price, as there is a virtual guarantee the price must go up to reflect real cost, regardless of industry demand. 1980 was a good historic example when auto industrial demand of PGM metals collapsed, but investment demand still pushed the metals to all time high, together with gold and silver.
Out of the four, Norilsk is in bad shape and is most likely to slash production, due to low nickel price, now stands at $4.93 per pound versus the high of $25 per pound last year. There are also huge political pressures to shut the mine down to clean up the environmental catastrophe.
But South Africa is in a much worse shape as Rand dropped nearly 20% in one day versus US dollar. When a country's currency can drops 20% in a day, it's pretty much a broken and bankrupt country. The light of South African will go out, so will the light for that country's PGM mining industry. I previously pointed out that ESKOM, SA's electricity company, has to keep borrowing money and burn lowest quality trash to keep operation going. Now the global credit crunch means they have lost the ability to borrow. It's soon before it all blows up.
South Africa blowing up, as hinted imminent by the Rand's 20% one day drop, means removal of 85% of world's platinum and 35% of palladium supply! You can not have a more bullish story than that, on any other commodities. Stillwater Mining (SWC), with their palladium sale protected by a hedge floor price well above current market, is the best to weather out current market and best to leverage the coming bull market in palladium and platinum.
The only other metal that is even close to the bullishness of palladium/platinum, is the metal cobalt. There are strong and rapidly increasing industrial demands due to alternative energy applications, and due to the need of more drilling equipments in the oil/gas industry, and due to the metal's strategic importance in military applications. I wish to dedicate one article just to talk about cobalt. But suffice to say for now I consider cobalt a better physical metal to buy than silver and it should appreciate at least 10 fold relative to silver. Like PGM metals, 90% of the world's cobalt supply is concentrated in one country, Congo, which has been in years of civil wars and the conflict looks like flaring up again. So the supply is vulnerable while the demand is strong and growing. That's a perfect making of a bull market.
The best cobalt play I found is a stock called OM Group (OMG) (Oh-My-God). It is current a very decent buy at ridiculous low valuation. If you know any other cobalt play, or know places other than BHP Billiton (BHP)'s Cobalt Open Sale that I can buy physical cobalt, tell me!
Now, back to the US dollar. We are creating trillions of dollars out of vacuum and throw them into a blackhole. Make no mistake; it is inherently hyper-inflational. It's a big dilemma the whole planet is facing today. Short term it is about liquidity preservation or die. A little bit longer term it is about valuation preservation or die. Hoarding fiat currency while new money is created out of thin air preserves liquidity but loses value. Hoarding physical assets preserves value but reduces your liquidity.
I think we will see a very sudden and abrupt switch from a false US dollar rally caused by every one hoarding the cash, to a hyper inflation scenario where every one wants to spend out the cash as fast as possible. In physics it's like a high pressure and high temperature phase transition. The credit will go straight from solid ice to rapidly expanding vapor, skipping the liquid phase altogether, blowing everything out. The phase change will come imminently and suddenly, so be prepared for it!
A few side notes: I called for shorting Coca Cola (KO) and Pepsi (PEP), now it looks like I was right. I called for selling coal stocks like ACI, ANR, BTU, CNX, FCL, FDG, JRCC repeatedly since June 20th and I continue to make such call as I see the US coal market is now bearish. I can see JRCC drops to near $10 or even below. Continue to watch DRYS as it is a good indicator of the global economy.
Full Disclosure: The Author is fully invested in SWC and PAL, and is also heavily loading OMG recently. I am also buying SLV, GLD, SSRI, PAAS, SIL.
Thursday, October 2, 2008
All investments are about buying something at lower cost to get higher return later. Investors must try to understand the values of things they buy and sell. Warren Buffett said you should never buy something that you do not understand. At a crisis time like today, investors must have a profound understanding of values not just of physical things, but of none-physical things as well, to survive and prosper.
In my last article, I discussed why physical things have intrinsic values and how are they determined. The article I am writing now is meant to be a sequel, so I shall continue on to discuss values of non-physical assets. Such discussion is urgently needed, and is made even more relevant today due to the unfolding global financial crisis and the Bailout Fiasco.
Our current financial and credit crisis is like a blackhole that Albert Einstein predicted. A blackhole is formed when a huge mass is packed within a very small volume. A blackhole's gravity pull is so strong that everything is sucked in and not even light can escape. So a blackhole will keep growing bigger as it keeps sucking in more matter. When the Large Hadron Collider was recently turned on to search for a ghost particle called Higgs, some feared it could generate a blackhole which could swallow the earth. But instead of swallowing the earth, the LHC merely spitted out a ton of helium before it was shut down, maybe for good, as nations in the world can no longer afford giant science projects like LHC.
But the real blackhole that threatens our survival is in the global financial system. Something that Warren Buffett called "Financial Weapons of Mass Destruction", the so called OTC Derivatives, a thing that no one really understands. It's such an enormous monster that by some estimate there's $1.14 quadrillion of them! That's a ONE followed by FIFTEEN(15) ZEROs. US$1,140,000,000,000,000 in OTC Derivatives! Where exactly is this huge amount of fortune physically located? This huge amount of fortune is actually nothing but merely some digits stored on some 3.5 inch hard drives within some computers in the Wall Street. That, my friend, is the definition of a blackhole, a giant mass stored within a tiny space.
The blackhole is swallowing everything around it, starting small and growing exponentially bigger. First it was New Century Financial (NEWC.PK), then Countrywide Mortgages (CFC), then Bear Sterns (BSC), Lehman Brothers(LEH), Merrill Lynch (MER), Fannie Mae (FNM), Freddie Mac (FRE), IndyMac Bank (IMB), Washington Mutual (WM), Wachovia Bank (WB). Who knows what's next! Now the US Congress wants to toss in trillions of dollars in a Bailout? Do they understand that you CAN NOT feed a blackhole?
The ongoing financial crisis is not a housing bubble or sub-prime mortgage crisis. It is not even a liquidity or credit crisis. Mr. Karl Denninger sums it up best in a 10 minutes video which all Americans need to watch and think carefully:
IT IS A CRISIS OF TRUST
Let me emphasize the keyword TRUST, because TRUST is the very reason any none-physical asset has value at all. It is also the reason why people must seek physical assets as the only trustable safe haven assets during times of crisis. It's easier to understand that physical things have intrinsic values because it costs something to produce physical things. When demand is high and supply can not catch up, people go to extra length to produce more at higher cost in order to meet the demand, and so the intrinsic value, as well as price, goes up in response.
Do non-physical things have value? They do. If you lend some money to your neighbor, you want to make sure your neighbor will pay back. There is a promise that you will be paid back. You trust that promise so it has value. The promise could be in any form: a notarized contract on paper, or just an oral promise, or merely mutual trust. As long as there is trust, the lending relationship has an intrinsic value based on the trust. And when there is no trust, a legal document is just a piece of worthless paper.
Lots of things in the economic cycles rely on trust and retain their values based on trust: loans, business contracts, agreements between nations. Without trust, the contracts written on paper are worth less than the ink and paper they are written with. Without trust, relationships can not exist. Without trust, marriages may break apart; organizations may disintegrate; financial systems may collapse and great nations may fall.
TRUST is THE single most precious thing in human society, bar none!
The US dollar is just a piece of colored paper. Does it have intrinsic value? I say it does have intrinsic value. The dollar's intrinsic value is not in the physical ink and paper, but in the trust that it represents. The value of the dollar is backed by the "full faith and credibility" of the US government. In the past our government did have pretty good faith and credibility. It was so trusted that the US dollar is the world's reserve currency and central banks felt more comfortable holding dollars instead of physical gold as their reserves.
But we have destroyed that trust and credibility by our chronicle reckless fiscal policy of debts and spending, from the top level leadership all the way down to average Americans. We spend way beyond our means, accumulate debts way beyond our ability to pay back. That destroyed our credibility and trust. That is the root cause of today's crisis, the systematic destruction of TRUST in the system, at all levels.
The US dollar is doomed! The only thing that can salvage the dollar is restoring the trust that the dollar is based on, by paying off our foreign debts using honest money, and then living within our means. I don't see any one discussing that solution, and I don't see how it can be done, physically, without breaking the back of our nation!
The US dollar is doomed, with or without the $700B bailout. Even restoring the gold standard is not going to help the dollar. The world simply do not have enough gold to back the amount of dollar in circulation, and our gold may not even be in Fort Knox any more. The dollar can only be based on TRUST, something infinitely more valuable than gold, but something that has been systematically destroyed in the whole system over a long period of time.
When there is no more trust in the system, you must get rid of any and all paper assets whose value is based on trust, and that means the only assets that are safe are those whose values are not based on trust: physical assets under your full control. Their values are derived from the mere fact that it costs something to produce them in the first place.
But when it comes to safe haven investments, I must reject the misconceptions and hypes some gold or silver bugs are attempting to inject into people's mind set. Notions that portrait gold and silver as money and hence the only good safe haven investment, and that anything not labeled as money is therefore not good. Of course gold and silver is money. That's a piece of 7000 years old news so it does not constitute a good reason why you need to buy or sell gold for a particular price, at a particular time. Folks who bought gold at the $800+ peak in 1980 lost heavily instead of found safety.
To avoid mistakes like in the 1980 gold and silver maniac, one must be able to correctly judge a physical asset's true intrinsic value, with all sentiments and hypes removed. Read my previous article on the discussion. A physical assets intrinsic value is its replacement cost, no more, and no less, and no sentiment or opinion attached here.
Some clarification is needed to the principle of intrinsic value as cited in my last article. Let me revise it as following:
A Commodity's Intrinsic Value Equals to the Marginal Production Cost
The cost varies when different producers produce the same thing. Marginal production cost is the cost of the most expensive supply source needed to meet demand. For example, the world consumes and produces 85M barrels of oil a day. 60M barrel come from easily oil fields at a cost of only $5 a barrel; 20M barrels come from oil fields that costs $50 per barrel; the last 5M barrels come from difficult marginal producing fields that cost $100 per barrel. What do you think the intrinsic value of oil is, then? We have to pay $100 or more to make it incentive enough for the marginal 5M barrels fields to keep producing to meet the 85M barrels a day demand. So the fair value of any commodity is always priced at the higher cost of marginal producers that's needed to balance the supply and demand.
All physical assets more or less serve as safe haven assets, where trust based paper assets can not be trusted. The only considerations to be given are their current price relative to their replacement cost, and the difficulties and costs in guarding, moving, storing and preserving those assets. All precious metals have excellent properties in those aspects due to their durability and high density of value in compact sizes. They are preferred choices as safe haven assets. So which one is best buy boils down to the question of current price relative to their intrinsic values.
Based on what I know, gold's current price is enough to keep most of the world's gold producers happily profitable. So gold is currently priced fairly. There is not much room for gold to gain in terms of real purchase power. Not to mention the world has a huge stockpile of above ground gold enough to last the world for hundreds of years. I expect the majority of people will continue to run towards gold. But I insist that gold is definitely NOT the best safe haven assets to buy today and I feel comfortable holding that minority opinion, as the majority in the market place is always wrong. For this reason I never bought GLD.
Silver is a bit different. 70% of the global silver supply is produced as a byproduct from base metal mining. Only 30% of silver is produced as a main product. Primary silver producers I monitor include Pan American Silver (PAAS), Silver Standard (SSRI), Hecla Mining (HL). Based on current silver price, I hardly see these primary silver companies make profits. Some silver companies have already started shutting down unprofitable mines. More over, even those mining companies that produce silver as byproduct, are now unprofitable, due to raising costs and weaker pricing of their main base metal products. As these companies are forced to reduce or shut down their base metal operations, it will also reduce the silver supply. So silver is definitely under-priced now and it is a better buy than gold.
But platinum, especially palladium, is extremely under-priced now, if you understand who produce these metals and what their cost basis are, and particularly if you understand the continuing South African electricity crisis. South Africa produces 85% of the world's platinum, and 35% of palladium. According to a recent survey, SA's PGM industry average cash cost is about US$1000 per ounce basket PGM metal (60% platinum, 35% palladium and 5% rhodium). That was based on one year old data. Today, due to high inflation rate in SA and US dollar depreciation, the cash cost is probably close to $1200 per ounce basket metal. Adding administrative overhead cost, the total operating cost is probably some where in the neighborhood of US$1350 per ounce basket metal.
Today's market price of the basket PGM metal price is $870 (=$1000*60% + $200*35% + $4000*5%). That's way below the $1350 needed for profitability of the SA's PGM mining industry. No business can operate at heavy loss indefinitely. The market must soon start to pay better prices, or SA will be forced to reduce production or shut down mines. I am wondering why they have not already done this. It would help ESKOM to reduce electricity load and help they profit! But I think it is only a matter of time they will do something.
When it comes to palladium, the world's largest producer is a nickel mine in Russia, Norilsk Nickel (NILSY.PK), with main product nickel and copper. Let's look at their cost basis. In 2007, the Norilsk mine's total operating cost was US$8.5B while metal sales revenue was US$14B. Using today's depressed metal prices, the metals would sell for only US$7.7B, while inflation will bring the cost higher to US$10B, making Norilsk totally unprofitable today. Norilsk's share price plummet reflect the reality of heavy operational loss at current metal prices.
Not to mention the incalculable cost of environmental destruction, as Norilsk is ranked No. 7 on the list of the TOP TEN most polluted places on earth, contributing a whole 1% of the world's sulfur dioxide emission. The pollution is so bad that there is not a single live tree or fish within a 48 kilometers radius from the mine! Why should such a heavy polluter continue to produce, if it can not at least turn a profit? Mr. Alexander Bulygin, RUSAL CEO, after visiting the site recently, issued an open letter calling the environmental situation as on the "brink of catastrophe".
According to an information bit that Jack Lifton discussed in his article, shutting down the now unprofitable Norilsk mine, and hence removing 45% of global palladium production, is now quite a strong possibility. A news story on Sep. 30, 08, where Mr. Anton Berlin strongly hinted at Norilsk's intention to cut production soon in response to weak nickel price, further enhances such a possibility. Remember I first mentioned Mr. Anton Berlin on June 12. At the time his comments caused a knee-jerk reaction in the global palladium market.
If Mr. Oleg Deripaska, who currently own 25% of Norilsk, gets his way and shut down Norilsk mine to clean up the pollution and wait for nickel price to recover, it will be the ultimate Russian Checkmate in the global palladium market!
Could such a Russian Checkmate happen? Could it not happen?! Why the Russians should continue to produce this environmental catastrophe, at a heavy operational loss, and for how long?
We are talking about a narrow market where industrial demand already exceed supply, and now 45% of that supply is further removed! I can't even imagine how high palladium price can go! Remember it took less than 4% shortage to jack up rhodium price from $300 to $10000!
In 2004, Norilsk acquired a 54% stake of Stillwater Mining (SWC), America's ONLY producer of platinum group metals, strategic materials of extremely critical importance to the nation's security, especially at war time, after some highly political negotiations involving Bush and Putin. Norilsk promised it was a purely non-political business deal. There is no Russian face on the board of SWC. But Norilsk's strategic aim of dominating over 50% of the global palladium supply is crystal clear.
Are the Russians going to use their monopoly power for profit, or would they rather act like a Santa Clause, operating a global charity organization, polluting their own fatherland and providing the world with cheap palladium at a price far below cost? The answer is clear.
In light of recent plummet of platinum and palladium prices, I have never seen a commodity market so completely rigged to the opposite of fundamentals, defying every logic and rationality. Palladium is now so under-valued that you look around the world, there is not a single palladium producer who can produce the metal and make a profit: Not Norilsk; not any South African PGM mine, not SWC and certainly not PAL. They all produce at potentially heavy loss now. This is not the normal affair of any market.
Can you name another commodity which every single one of the producers in the world is producing at a heavy loss? Have you seen another commodity price chart like this one, or this one, where price shot up on a straight line and then fall perpendicular down?
The excuse is lack of recent ESKOM news so people assume they have fixed South Africa's electricity crisis. I know better. Another excuse is slow economy and high gasoline price suppressed auto sales and reduced PGM metal demands in the auto catalytic converter sector. I know it's not true. Globally auto sales is still growing due to strong demand in emerging economies offsetting any fall back in western markets. According to General Motors (GM)'s own data, in the US market, even though GM delivered fewer vehicles to dealers in September comparing with a year ago, at the retail level, the retail sales were 303,300 in September, up from 255,744 in last September. That is 18.8% up y-o-y.
The credit crisis forced auto makers and dealers to massively reduce inventory, but people still need vehicles for their daily needs. Higher gasoline pushes up demand from people to junk their oil guzzlers in favor of a new fuel efficient car. Even for those people who decide to keep their old vehicle longer, the catalytic converter in their old vehicle will be unavailable for recycling, so it doesn't change the PGM supply/demand balance.
More over, the lesson from the year 1980 is that although auto demand did collapse that year, platinum and palladium price nevertheless run to a peak together with gold and silver, as investors hoard all precious metals as safe haven assets at that time. When there is significant investment demand of the physical metal, the industry demand becomes a moot argument.
Absurdity is now the norm of the marketplace. Like in the global coal market, I discussed on June 20th, 08 that the global coal supply and demand is largely balanced, with abundant coal reserve. I did not know how the coal price managed to triple in a few months, and called for folks invested in coal stocks, like ACI, ANR, BTU, CNX, FCL, FDG, JRCC, to take profit. The call was proven to be timely. The plummeting dry shipper stocks, like DryShips (DRYS), suggests there is not a lot of coal shipped across the oceans, so US coal market remains a local market. Amid a looming US economic depression, I see the US coal market as bearish in short to mid-term. Get out of any coal stock at the next rally! I am seeing JRCC dropping to the low $10-ish, for example.
Natural gas is a different story and remains bullish due to fast depletion of conventional natural gas sources, and drop of imported LNG volume. I own some NGAS and UNG by the way.
Needless to say I am still heavily invested in SWC and PAL, two of my favorite palladium stocks, and I suffer heavy losses in them. I have repeatedly checked my original thesis of a palladium super bull market but could not find anything wrong. I still believe this is one of the best investments I can find in short term, so I am sticking to my convictions. Is it any strange that today logic and rational thinking has been replaced by manipulation, distortion and absurdity? Otherwise we would not have a global financial crisis like we see today. At the end of day things will have to return to the way natural laws mean them to be. As billionaire Mr. George Kaiser is still patiently holding nearly a majority stake in PAL, I think I have patience to wait for natural things to happen as well.
Full Disclosure: The author is heavily invested in SWC and PAL, and also owns OMG, SLV, PAAS, HL, SIL, NGAS and UNG.