Recent Developments in Precious Metals and Shipping

Gold rush 2009 is on! Gold is the front runner in precious metals so far. Gold is now only 10% away from its early 2008 high; silver is 39% off; platinum is still 57% off the high; palladium is still 67% off the 2008 high. Gold is the front runner and palladium is the laggard.

Don't buy the front runner, buy the laggard! Chasing the front runner and big crowds is the fastest way of losing money. Just look at recent bloodshed in DryShips (DRYS), a front runner in shipping stocks. I switched from DRYS to EXM and cautioned about DRYS in mid January, 09. So I was lucky to have avoided the massacre in DRYS. There are inherit problems in DRYS that are now exposed, but big crowd sentiments added to the severity of plummet.

Gold is currently the front runner of precious metal because most people intuitively know what is gold. But few people have heard about palladium. Recent stories from Russia and South Africa indicate that palladium and platinum has the most bullish fundamentals among precious metals, while gold has the weakest fundamentals.

First, palladium. Norilsk Nickel, producer of 45% of the world's palladium, just released the Q4 and full year 2008 production. The palladium production dropped to 2.702M ounces, much lower than the 3.05M ounces in 2007, even though the nickel production is in line with 2007. Norilsk expects another drop of 7% in palladium production in 2009 to bring it down to about 2.5M ounces. The reason cited is lower grade of PGM content in the ores. I explained before that Norilsk has two types of minerals: the one high in nickel and low in palladium content, and the one low in nickel and high in palladium. Due to current low nickel price, they must opt to mine the high nickel ores, hence produce less palladium.

Base on my calculation of their mineral ores grades, if they produce the highest nickel grade while maintaining the nickel production level, the 2009 palladium production could drop to only 2.0M ounces, from 3.05M ounces in 2007. More likely, Norilsk will be forced to cut nickel production to meet weaker global demand. In that case, palladium production could fall significantly below 2.0M ounces.

Adding to the bullish case is news from South Africa of a looming mining worker strike to protest against the job cuts. I think the mining companies there, hurt by low PGM prices, would LOVE to see the strike proceed so as to drive up the metal prices.

The bullish case of palladium can not be better. Look at the supply/demand picture starting with data from Impala Platinum (IMPUY.PK); we will be talking about global demand of roughly 8.215M ounces. On the supply side, South Africa can provide roughly 2.2M ounces if current production cuts are implemented. Russian will provide 2.0M ounces, North America will provide about 0.33M from Stillwater Mining (SWC), other sources count for about 0.3M, and there will be little recycling as low palladium price discourages recycling.

Summing it up; we are looking at about 4.83M in palladium supply, versus 8.215M in industrial demand, not counting any investment demand on the physical metal. The deficit will be 3.385M ounces, or 41% of industrial demand. No other metal has such a large margin of deficit!

Remember, a less than 4% deficit in rhodium was all it took to drive the metal from $300 to $10000 per ounces!!! What would a 41% deficit in palladium do, to the price? What would investors do, when they jump on the palladium shortage wagon and help drive up the price?

Remember, the Russian Government is trying to help Norilsk Nickel with its financial difficulties due to current low metal prices. There have been talks that the government will purchase some of the precious metals from Norilsk Nickel and re-stock the government's depleted strategic stockpile. The Russians can easily drive palladium price up to $2000, $3000 or even $5000 per ounce, if they so choose. I don't see why not! The Polar Bears are not Santa Clause! They want to make money just like every one does.

In 2000/2001, upon one false rumor that Russian government was terminating the annual palladium stockpile sale, the panic buying drove palladium price up from $300 to $1100 per ounce. There was only one investment fund noticed the palladium rally, and profited from it. At the time gold was at the low and there was no interest in precious metals as safe haven assets.

Today, it is a material fact that Russian government stockpile sale ended, and Norilsk's palladium production is down, and Russian government may be buying the metals to help Norilsk as well as replenish its strategic stockpile. And today there is plenty of interest in all precious metals as safe haven assets as the financial crisis unfolds. Rest assured there will be a lot more investment interest in palladium than last time.

It's not too late to buy physical palladium. And time to buy stocks of the world's only primary palladium producers, Stillwater Mining Company (SWC) and North American Palladium (PAL).

I am openly calling these two companies to consider how they can help the average investors to acquire the physical metal easily, and hence be able to participate in and gain from the coming palladium boom. I believe that the precious natural PGM resources are NOT the private properties of mining companies, but belong to the people. These two companies, blessed with the privilege to produce the natural resources, have the social responsibility that they must maximize the value of the metals they produce so as to pay back the community.

Likewise, the Governments of the USA and Canada have the responsibility to ensure any minerals produced from their soil must maximize the values and must not be sold below cost. If the metals are priced below cost, then the governments should purchase and stockpile these precious strategic metals. The Chinese government is already stockpiling strategic metals to protect its domestic mining industry and take advantage of recent low commodity prices. The US and Canadian governments must do the same for their respective national interests.

Now let's talk about gold. Current price of gold is about $900 per ounce. I believe gold is fairly priced as most gold mining companies are making comfortable profits. I believe there is now no good reason for average Joe to buy gold at this price. Joe makes $40K per year, or $28K after tax. He makes $112 per work day after tax. So to buy a one ounce gold coin, he needs to work at least 8 full work days to earn enough money for it.

Joe might as well take 8 days off to go prospecting for gold. Some gold prospecting web sites claim you can collect up to two ounces of gold a day. Sounds like a better deal than earning a salary to buy gold. Maybe California the golden state should have zero unemployment? Lost your job? Go prospecting for gold and you get yourself a job making tax-free real money.

The economic incentive to prospect for gold rather than to buy gold puts a reasonable natural cap on gold price, in terms of purchase power. But silver, platinum and palladium are different as you can NOT prospect for these other precious metals. So these other precious metals should have bigger room for gain. My only advice is stay away from ETFs like GLD and SLV. Instead buy physical metals and precious metal mining shares. I am suspicious of these two ETFs after I browsed through their physical metal bars serial number lists. I will not elaborate here. Spend your time scrutinizing the lists to see if you can find some red flags.

What about shipping and the recent bloodshed in DRYS? The Baltic Dry Index has been going up strongly for TEN consecutive trade days in a row, reaching 1099. The low was 666 on Dec. 4, 08. How often do you see something going up 10 days in a row? That says the shipping is recovering strongly. The plummet of shipping rate last year was largely due to credit crunch freezing up trading activities, NOT due to supply and demand. As the credit now eases up, there will be pent-up demand to clean up the goods previously piled up on harbors.

The short term outlook of dry bulk shipping is bullish, the long term prospect is even better, as governments around the world, particularly China, are ramping up gigantic economic stimulation programs. Governments can print money out of thin air. They print paper money not to hoard their own money, but to spend the money.

When governments spend money, every dollar spent is a demand on physical goods and services, just like average Joe's grocery spending. So it is really a moot point talking about consumers spending less and saving 3% of their incomes, when the governments are racking up deficit spending in the tune of multiple trillion dollars.

China is one big driving force behind growing global demand on commodities, as well as growing demand on global shipping, and will continue to be, for many years to come. It's not just a matter of economic development; it is a matter of China's very survival. That's because China is rich in cheap labor forces, but poor in critical natural resources.

As Jim Rogers correctly pointed out, China's very survival hangs in one thing: WATER. China's biggest engineering projects are all water related. The most famous one is the Three Gorges Dam, the world's largest hydro-electric dam. At its peak of construction, this one project alone consumes 1/4 of the world's cement and steel production.

But Three Gorges Dam is nothing comparing with another mammoth project that's already well underway in China, but little talked about in the western world, China's South to North Water Diversion Project, which is at least TEN TIMES as big as the Three Gorges project. It's been talked about for half a century but was only recently rushed through the approval by the People's Parliament in a hurry without much debate: There is simply not much to debate about: Beijing, with its 14 million populations, is depleted of water resources and desperately needs the water to quench the thirsty! It's a non-negotiable, survival issue!

The South-to-North Water Transfer Project was supposed to take at least half a century to finish due to its gigantic scale, but will be rushed probably in a decade, due to the urgency of the water crisis in Northern China. Just think about how much concrete, steel, construction machineries and materials this one project will demands from the world! The infrastructure projects in China will ensure a global commodity and shipping boom for many years to come.

What do I think about DRYS's recent plummet? The panic was caused by DRYS's disclosure that two banks notified it that it was in breach of the loan covenants, as the fair market value of its ships has fallen below a certain percentage of the debts, and that DRYS was trying to raise $500M cash by selling shares in the open market, hence dilute the share value.

I do NOT think the loan covenant thing is too much a deal. How do you define a ship's fair value? I think any physical property's fair value is its replacement cost. But the convention is use recent market transactions of similar properties to determine the "fair market value". I think such terminology is ironic! The market is never a fair place to begin with so the word "fair" and "market" don't come together. Why would it be a "fair price" when a ship owner is coerced to sell its ship far below inherit value, under financial stress? Such unfair price is then used as "fair price" to undercut the assets of every one else and force many more defaults and stress sells, further escalating the crisis. This unfair "mark to market" rule results in distorted values of physical assets. It is one of the culprits of current crisis in real estates and other sectors. It must be abolished and replaced by a "mark to cost" rule.

In light of the continuous surging BDI index, the value of ships goes up with BDI. Banks know this and they don't want to bring an unnecessary crisis on themselves. They will work with shippers to find acceptable solutions to the loan covenants. It's in their best interest to do so.

My biggest worry about DRYS is the ongoing sell of shares to raise $500M. This will greatly dilute the value of DRYS shares. How much dilution? No one knows. So even though DRYS has become much cheaper, I would advice wait a little bit till the dust settles, just to see how much the share dilution factor is. Mean while I believe other shipping stocks like EXM, EGLE, GNK, DSX, TBSI and NM are better buys than DRYS, until we know more about DRYS's share dilutions. For the same reason, avoid OCNF for now.

Full Disclosure: The author is heavily invested in SWC, EXM and EGLE. I also own shares of PAL, OMG, TBSI, DRYS and USO. I do not own other stocks mentioned but positions may change at any time.