- Emission standards are getting tougher in some of the key auto markets around the world and palladium’s role as an autocatalytic is key.
- 2021 is expected to be a much better year for the auto market with China leading the way.
- Risks include potentially increased supply from SA and Australia, weakness in the eurozone, the rise of alternative catalytic agents, and the growing penetration of electric, battery, and hybrid vehicles.
Earlier this month, in The Lead-Lag Report, I had flagged silver’s relative underperformance in September. At the other end of the return spectrum, you had palladium, the only other precious metal to deliver positive returns. In light of these developments, I thought it would be a good time to explore and reassess conditions across the palladium landscape.
Long-term investment case
Over the last 5 years, palladium has caught the imagination of the investment world delivering triple-digit returns, well above the returns delivered by the other precious metal cohort.
For the uninitiated, much of this surge has been on account of developments in the automobile sector which accounts for 75-85% of total palladium demand (the electronics and the jewelry segments are the other key consumers). Palladium is in effect used as a key component of pollution-control devices in vehicles (through its catalytic qualities it helps convert dangerous environmental pollutants such as carbon monoxide, and hydrocarbons into less harmful substances). Until the 2015 Volkswagen (OTCPK:VWAGY) diesel emission scandal, in Europe, gasoline-powered vehicles were not as popular as diesel-powered vehicles. But since then, there has been a shift, and palladium’s virtue as a catalytic converter for gasoline vehicles has come to the fore. Other contributing factors driving this demand are increased emission standards in a key auto market such as China (which thereby necessitated higher palladium loadings per car) and the growing share of large American SUVs and trucks that need more palladium coating.
Conversely, on the supply side of things, the situation has been quite challenging. There are very limited palladium-dominated deposits in the world (mostly in Russia and South Africa who produce around 160+ metric tonnes in aggregate) and the metal usually crops up as a byproduct to nickel or platinum mining operations around the world.
On account of limited supply and strong demand, the metal has seen a deficit situation for the last 7 years. This has translated to a strong price performance over the last few years.
Situation in 2020
2020’s health pandemic has made some alterations to the dynamic here, and for the first time, in 8 years, we could see these deficits ebb as the market comes into balance. While palladium mining supply was impacted by lockdowns and the slow pickup in South Africa (global supply of palladium is expected to fall by -14% annually in 2020), global demand, predominantly on account of weakness in the auto sector, is expected to fall by a greater margin of 16% YoY (Source: Norilsk Nickel).
In H1-20, global auto sales were down -28% annually, and Moody’s thinks global auto sales could decline by 20% for the whole year whilst S&P Global think global light vehicle sales could be down by -22%. On expectations of a weak supply-demand picture in 2020, palladium had seen a brutal fall in March, declining by c.47% since hitting $2,875/ounce in late Feb.
Since the dark days of early and mid-March, palladium prices have crept up slowly and are currently c.20% away from the previous highs. There are some encouraging demand-side drivers behind the momentum in palladium prices. Firstly, global light motor vehicle sales should improve in H2 and, in 2021, will benefit from the low base effect which should see it grow by c.16% next year.
As global sales come back, I also expect palladium’s role as a catalytic agent to deepen. Norilsk Nickel (OTCPK:NILSY), the largest palladium producer believes there are a few drivers that will continue to drive more palladium loadings within the average car. Firstly, a growing component of auto sales in the U.S is in the SUV space, and these types of vehicles require more palladium coatings. Secondly, Europe has become the first region to introduce RDE tests (Real Driving Emissions) which measures pollutants emitted by cars while driven on-road (potentially over the next few years, we may also see this test being embraced in other parts of the world). Car-makers will be scrambling to ensure that their cars comply with these norms, thereby increasing the demand for palladium.
Crucially, there’s also what’s happening in China – the largest auto market in the world. The country was all set to transition from the 6a emission standard to 6b emission standard for light-duty vehicles in Q3-2020, but on account of COVID-19, this has been postponed to Jan 1, 2021. The advent of the 6a emission standard could likely see palladium loadings per car, go up by c.5-7%.
Risks to the Palladium story
Having written about the investment case for palladium I want to now touch upon certain short-term and long-term risks that could disrupt the palladium story.
Much of palladium’s prospects will be driven by how some of the key auto markets fare. After China, the eurozone is the next largest auto market in the world and after seeing sequential improvements since April, sales seem to have slowed down in August declining by 31% m-o-m. Recent virus outbreaks across the eurozone are another cause of worry, and as I mentioned in the global section of The Lead-Lag Report, developed markets appear to be in a more vulnerable state than the emerging markets.
SA mining regulation
As mentioned previously, South Africa is the second-biggest producer of palladium after Russia, so any significant mining regulatory developments here could be key to the prospects of palladium prices. Last month, it was proposed that the South African government would be looking to simplify and modernize mining regulation to help drive through greater exploration and productivity. The country is looking to target 3% of global exploration and also reduce the time taken to secure various licenses related to mining and the environment. Developments such as this could potentially stimulate the supply side bottlenecks of palladium and this could weigh on prices.
Australia joins the palladium bandwagon
Until recently, Australia was not known to have any palladium deposits but recent reports suggest that a small gold explorer – Chalice Gold (OTCQB:CGMLF) – had found high grades of palladium from its Julimar Project near Perth. The company is looking to now pursue drilling activities in this project and hopes to come out with a reserve estimate by the middle of next year. If successful, you could see further drilling activities in and around Western Australia and this could potentially assuage the supply-side issues ever further.
Risk of other catalytic alternatives such as platinum
Before the Volkswagen scandal, platinum had quite a hold as a catalytic agent for diesel-based cars. Since this broad shift to gasoline, platinum’s allure has dimmed. But such is the price difference between these two precious metals (palladium trades at c.$2353/Oz vs platinum at c.$850-900/Oz) that carmakers have started exploring options to bring back platinum as a competitive catalytic agent. In fact, BASF recently reported that they had developed a platinum-based technology that could potentially be used in cars from 2023 onwards. Currently, it is believed that platinum’s catalytic qualities are not on par with palladium but if BASF’s technology can gain scale and other makers follow suit, this could disrupt palladium’s investment case.
The effects of this disruption may not be immediate and may come about gradually but as I said recently in The Lead-Lag Report, the world is moving away from fossil fuel-based vehicles, and by the next decade electric or battery-operated vehicles could take a dominant share. This could significantly impact palladium’s fuel as the electric cars don’t burn fuel and don’t need palladium. Even if we don’t see a shift to pure electric and maybe just largely hybrid versions, this does not bode well as hybrid vehicles use much smaller gasoline engines where palladium loadings per car will be much lower.
Palladium is up c.53% since its March lows and is only c.20% away from its all-time high, so the risk-reward is not ideal; perhaps there is more value to be found in other avenues. Yet still, the long-term demand-supply mismatch is a rather alluring facet that not many commodities can throw up. There are some mixed precious metal ETFs but if you’re looking for pure palladium exposure you should be looking at the Aberdeen Standard Physical Palladium Shares ETF (PALL) which is the only ETF that will offer you pure palladium exposure; that said this exposure won’t be too cheap with an expense ratio of 0.6%. PALL physically holds palladium in vaults based in London and Zurich.
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