Safe Haven in a Global Crisis of Trust

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.

The Brightest Stars in the Commodities Boom Part Two

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Brightest Stars in the Commodity Boom Part One

Thursday sees the market's knee jerk reaction of oil dropping of $4 a barrel, in response to China's announcement of gasoline and diesel price boost of 16%. Most traders perceived higher price will supress Chinese demand on oil. They know nothing about what's going on in China. After the price boost, gasoline still costs only US$3 a gallon, far cheaper than prices in the US and Europe. It will not supress demand at all, consider that only wealthest 3% of households in China own a vehicle. The Chinese transportation fuel market is in severe short supply. Refineries are unwilling to increase production because the crude prices are high, while the refinery product must be sold at government controled low prices, well below cost. The government hopes the price boost will encourage refineries to INCREASE fuel supply to ease the shortage. It actually will boost oil demand. Consider buying USO for a quick rebounce once the market realize they got it totally wrong!

Commodity guru Jim Rogers is my hero not only because he correctly predicted the commodity boom as early as 1999, but because the way he does market research and due diligence study is very inspiring to me. His millenium adventure around the world, which I recommend every one to read in his bestseller books, was not a safari, but a real adventure with real danger to his life. I do not think I can be as brave. I wish I knew him and read his books earlier. Commodity investments provided some of the most spectacular returns in recent years. You look at the spectacular chart below. Don't you wish you have bought some rhodium in early 2004? Me? I wish I had studied about CD-RW and bought tellurium in earth 2004 for $10. I want to talk about rhodium in more details in a later article since this is a very interesting case study on how to find commodity super stars, before they shine.


Jim said the commodity boom is far from over, which I agree. Although the current commodity bull cycle started in 2000, many of the raw materials did not start the earnest rally until pretty recently. Copper did not take off until late 2003/2004. Food grains and fertilizers did not take off until early 2007. As for coal, it doesn't make much movement until early 2008 when it all of a sudden rallied spectacularly, running from $45 a ton to well over $160 per ton in a few short months, surprising every one including me. I had the vision to load up heavily the coal mining stock JRCC at $4 last year, but did not have the foresight to see that it could reach almost $60 today, in just a few short months.

JRCC gained 15 fold in 10 months, or more than 12.5 fold in exactly 7 months. How often do you see such an incredible rally. How you wish you have grabbed that opportunity. I did catch it at the start but did not hold it through the whole course. I remember on Nov. 19, 2007 I was watching JRCC and I really wanted to buy it back but I had no dry powder. I knew I was giving up an opportunity but never knew how big an opportunity I had gave up. I wish had paid closer attention to the coal market and discovered this article last year.

Of course, JRCC is not the only coal stock that see spectacular rallies lately. There are a dozen others, PCX, BTU, ACI, CNX, FCL, FDG, MEE, ANR all gained tremendously.

How do you discover such bullish commodity players, before they take off, and how can you hold on to them for the whole course? And even more importantly, how do you decide your exit strategy? One word, due diligence research. If you know the market fundamentals and supply/demand trends, you can spot a bullish commodity player before it takes off, and you will have the conviction to hold through the highs and lows to rip full profit potential, and you will also know when it becomes over-valued and it is time to move on.

Coal's recent rally far exceeded my original expectation. I believed coal was bullish but I thought it's a long term play, at least 2 or 3 years out in the future. It is worth going back and re-example my original assessment of the coal market, and see if I missed anything.

As I discussed before, for any commodity play you need to exam the supply/demand relationship to see how bullish it is. You concentrate on several things:

• Is the natural source of the raw material scarce or abundant?
• What's the supply/demand numbers. How bad is the shortage?
• How price elastic is the supply. How high does the price need to go to boost supply, and how soon will it happen?
• How price elastic is the demand. Can demand be reduced or replaced if the cost is too high. How high the price need to go to cause that to happen?

I looked at all four criterias for coal and could not find a very solid bullish case. Global coal reserve is still abundant, worth a few hundred years of production. The global coal supply and demand figures in 2007 were 3135.6MT and 3177.5MT respectively. The shortage was 41.9MT, about 1.3% of annual demand. A very small percentage of shortage worth about 5 days of global consumption. Coal is mostly used as fuel in power stations, which often stock up to 3 or 4 weeks worth of coal. That should be plenty of buffering to absorb 1% or 2% of shortage in any given year. From the price elasticity point of view, the high coal price can not last long. China's coal production in 2007 was up 7% year-over-year. Recent news indicate that due to higher prices, the largest coal producer in China is boosting coal production at an annual pace of 13.3% or more. The global coal shortage may end soon right when every one is talking about higher coal prices.

So why did coal price double or triple in just a few months? I guess several reasons.

1. Global coal market is huge. But most coal supplies are already tied up in multi-year long term supply contracts netween producers and power stations. So the amount of coal available on the spot market is pretty limited and so is very sensitive to any temporary supply disruptions.
2. Mid to long term, both the coal supply and demand is quite price elastic. But in very short term, both supply and demand could be completely price inelastic. If a power station is running low on coal reserve and face the danger of shutting down electricity, they pay any price to ensure uninterrupted electricity supply. Mean while disruption at Australia's Newcastle Port forces many dry bulk ships, up to 30 at a time, waiting for weeks to be loaded with export coal. Can't load faster no matter what price you pay.
3. A few global events caused short term supply shortage. Those include the disruption in Australia's NewCastle Port, a major coal export port. By the end of last year, the Chinese government launched a crackdown which shut down a whole batch of small scale private coal mines operated under unsafe conditions, removing a significant portion of the production. As the coal shortage becomes evident, the government is now urging those small coal mines to resume production as soon as possible, when safety has improved.
4. It can not be ruled out that international hedge funds may be speculating on the coal market and bid up the price on the futures market.

Currently most coal mining stocks are prices so high that their prices are justified on the basis that coal price will continue to climb, and will stay high for the foreseeable future. If you look at the history of coal prices there have been periods of quick booms and bursts. JRCC itself emerged from a bankruptcy just a few years ago, and it is still heavily in debt today. So my advice to all the folks holding coal stocks is to sell now and move to something else. I am not calling a top, few people can recognize a top right when it occurs. I am definitely not calling for shorting coals. In all likelihood, the coal fever may well continue for some time and make new highs, but the big crowd has arrived. When big crowds arrive it is often time to move on to something else. There is always a bigger opportunity some where else where the big crowds have not gathered yet.

The biggest crowds in commodity investment probably concentrate on oil, coal, alternative energy, and gold. The gold crowd is too crowded. Today you can not visit an investment site or even tune to a radio or TV station, without hearing some one pitching gold. The most famous gold bug operate a free web site which I read daily. I appreciate the education on fiat currency, the credit crisis and the need of individuals to protect themselves from inflation. But why should gold be pitched as the only good hedge against inflation, and no mentioning of other precious metals, like platinum, palladium, even rhodium? I don't buy gold! You have nothing to gain in gold, in real term, comparing with other physical commodity investments. The only way you can make profit from gold is when you sell it to another gold investor, who just like you, hopes to be able to sell gold for yet higher price to the next gold investor in the line. Pretty much sounds like the bigger fool theory? The world has accumulated 320,000 tons of gold. There is never shortage of gold.

Relatively, the palladium investment crowd is far smaller and far quiet. Lots of gold bugs and silver bugs on the internet. But I have yet to find a palladium bug. Even the respected metals analysts don't understand the palladium market. Year after year they made bearish predictions based on the notion that Russian stockpile palladium flooded the market, each year they were proven wrong as palladium moved up and they scratch their heads wondring why they were wrong. Does it really stretch the mind to understand that Russian stockpile HAS to run out one day, and that will result in an industrial shortage, sending the metal price flying? Look at the sudden boom of investmenet interest since late 2003. Some one must had a Eureka Moment at that time and had been quietly loading up on this unprecedent investment opportunity ever since, driving the price up.

And now, on Nov 11th, 2008 the Russians themselves admitted they are running out of palladium stockpile. Is there any wonder that palladium price surged 12% in one week time since then? People are getting it and jumping on the wagen but unfortunately even a highly respected and award winning metals analyst, Rhona O'Donnell, didn't get it at all! She believed there was still some palladium stockpile some where "available to the market".

Hello! Whoever hoarded palladium since 2003 do NOT do it for a global charity. It's for making money! If the price is not right, it is NOT "available" to any one at all. On such notion of "large stockpile available", then shouldn't some one argue then that gold price should fall just because there are huge stockpiles in the world? No one ever made such a ridiculous argument. Whoever hoarded palladium waited exactly for such a Russian checkmate moment, and now the Checkmate Time in palladium is coming rapidly. The data contained in the Rhona O'Donnell article confirms that without Russian stockpile palladium, the market is in a pretty big gap of supply shortage. Do you notice that the palladium lease market may be halted?

Could palladium be the next rhodium? It could be possible. At least it's a way much better physical metal investment than gold. So you can never go wrong buying some palladium coins or metal bars. Of course, buying the stocks of the only two primary palladium producers in the world, SWC and PAL, may provide higher leveraged investment gains.

PGM metals are unique. Unlike gold, whose largest demand is investment demand, which is unpredictable and can not be counted on. PGM metals are critical to many important industrial applications whose demand can not be supressed even at very high price levels. But at the same time, the physical metals can also be hoarded away by investors, increasing the physical demand and adding to the shortage, driving up price. The global PGM market is so narrow and so tight that minimal investment demand can send the price to very high levels.

That is quite different from other commodity investments. I buy SWC and PAL stocks but I also buy physical palladium metal bars. All your folks who buy coal or oil stocks, do you also stack up a ton of black coal or a couple hundred barrels of crude oil in your backyard. If I visit Goldman Sachs office, do I expect to find a truckload of coal just delivered? No, there can never be any real physical demand from speculative investors, not even in the futures market. All trades are done on paper and when the contracts is about to expire they roll it to the next month. No delivery is ever taken so there is no physical investment demand in coal, oil, food grain etc.

I think I would rather invest in something that can be physically hold in my hands. But maybe I will just buy enough USO to hedge the gasoline price I pay at the pump, UNG to hedge my monthly natural gas bill. Finally read an interesting speech by Kevin Crisp which explains why PGM metals are critically important to the industries.

P.S. The author is heavily invested in SWC and PAL.