Are Safe Haven Investments Really Immune From Current Crisis?

Is it deflation, stagflation, or hyperinflation, that we're seeing 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 my previous, serial articles talking about valuations of physical and non-physical assets as well as currencies. Please read the first two 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 unfolded, we saw the worst commodity price plummet in history, while the U.S. 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. They reason that due to the credit squeeze, people cut back on spending, because they could not borrow any more.

This 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 on TOTAL spending. Actually, people are squeezed to spend every dollar of their monthly income, just to keep their heads above water. More and more people are living from paycheck to paycheck, meaning they have to spend every dollar they take in, and have nothing to save. They might be forced to cut spending on some specific items while spending more money on other things. Their 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 things have changed 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 momentary. 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 material. 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 capital. Oftentimes therefore, money tied up in inventories is derived from credit provided by banks, in the form of so-called commercial paper. 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 they must sell off inventories and cut spending on purchases of raw materials and equipment. When producers cut spending on productive activities, the supply destruction occurs in the pipeline!

Not only do corporations end up selling, but hedge funds that are invested in commodities also end up selling like there is no tomorrow. Everyone is liquidating everything to raise cash and stick the money somewhere safe. That is absolutely foolish!

When businesses at all levels suddenly sell off their inventories and at the same time halt purchasing of new feedstock materials, prices become 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 celebrates cheaper prices, without realizing that the supply chains have been squeezed empty.

My wife told me the best sales 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 Economics 101 - all businesses are for profit. No one can operate at a loss--that's just not 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. Therefore, the price will rally in an extreme volatile way. That is what I predict will happen with all commodities in the coming weeks, including oil, food grains, and metals.

The market for platinum and palladium metals [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, automakers normally maintain a stockpile of PGM metals equivalent to about 6 month 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 reactions 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 headlines about South Africa's electricity crisis in early January caused the platinum and palladium prices to shoot up, they stayed at those relatively high levels until the end of June. And then, at the onset of the global financial crisis, they plummeted in a free fall, all while South Africa's PGM production continued 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 U.S. automakers, General Motors (GM), Ford (F) and Chrysler (DCX) 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 assets 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 automakers were sold out, a lot of downward pressure was created. 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 an explanation that hedge funds have to sell their precious metal hoardings due to a liquidity squeeze.

I agree with most of what Nathan Becker has to say, 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 heavy sustainable losses. Businesses must scale back production or shut down, if they cannot make a profit. Anglo Platinum (AAUK) is currently producing at an average cost of $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 $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 levels.

Last week's market plummet creates one of the rarest buying opportunities in our time for savvy investors with cash on hand who are 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. They may not be there tomorrow.

Do you think mining companies and farmers can continue to sell nickel at $5.00 a pound, wheat at $5.53 per bushel, corn at $3.84 per bushel, and expect to be able to sustain  the business while selling things well below cost? It's the same as the out of business sale my wife told me about!

The absolute best out of business sale is palladium, metal of the 21st century, currently at $185/ounce bid. Gold mines are everywhere, silver is mined everywhere. But only four places in the world produce significant amounts of platinum and palladium: Norilsk Nickel (NILSY.PK) in Russia; the Bushweld Complex in South Africa; Stillwater Mining (SWC) in the USA; and North American Palladium (PAL) in Canada.

Not one of the four palladium producers is operating at a profit at current  nickel, platinum and palladium prices. 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 the current price, as there is a virtual guarantee the price must go up to reflect real cost, regardless of industry demand. A good historic example, from 1980, occurred when auto production demand for PGM metals collapsed, but investment demand still pushed the metals to all time highs, together with gold and silver.

Out of the four platinum and palladium producers, Norilsk is in bad shape and is most likely to slash production, due to low nickel price. It 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 and clean up the environmental catastrophe it has caused.

But South Africa is in a much worse shape as the Rand dropped nearly 20% in one day versus the U.S. dollar. When a country's currency drops 20% in a day, it's pretty much a broken and bankrupt country. The light of South Africa will go out, as 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 the lowest quality trash possible to keep operations going. Now the global credit crunch means they have lost the ability to borrow. It's not going to be long before it all blows up.

South Africa blowing up means the disappearance of 85% of the world's platinum and 35% of palladium supply! You cannot have a more bullish story than that, on any other commodities. Stillwater Mining, with its palladium sale protected by a hedge floor price well above current market, is the best bet to weather current markets and most likely to leverage the coming bull market in palladium and platinum.

The only other metal that is even close to the having the bullish possibilities of palladium/platinum is cobalt. There are strong and rapidly increasing industrial demands due to alternative energy applications, and due to the need formore drilling equipment in the oil/gas industry, and due to the metal's strategic importance in military applications. I intend to dedicate one article just to 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, the Congo, which has been involved in a civil war for years. And the conflict looks it's going to be flaring up again. So, the supply is vulnerable while the demand is strong and growing. That's a perfect set-up for a bull market.

The best cobalt play I found is a stock called OM Group (OMG) [Oh-My-God]. It is currently a very decent buy at a ridiculously low valuation. If you know any other cobalt play, or know places other than BHP Billiton (BHP)'s Cobalt Open Sale where I can buy physical cobalt, tell me!

Now, back to the U.S. dollar. We are creating trillions of dollars out of a vacuum and throwing them into a black hole. Make no mistake; this is inherently hyper-inflational.

The whole planet is facing a big dilemma today. In the short term it is about liquidity preservation or die. A little longer term it will be about valuation preservation or die. Hoarding fiat currency while new money is created out of thin air preserves liquidity but erodes value. Hoarding physical assets preserves value but reduces your liquidity.

I think we will see a very sudden and abrupt switch from a false U.S. dollar rally caused by everyone hoarding cash, to a hyperinflation scenario where everyone wants to spend their 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 Arch Coal Inc. (ACI), Alpha Natural Resources Inc. (ANR), Peabody Energy Corp. (BTU), CONSOL Energy Inc. (CNX), Foundation Coal Holdings Inc. (FCL), Fording Canadian Coal Trust (FDG), and James River Coal Company (JRCC) repeatedly since June 20 and I continue to make such calls as I see the U.S. coal market is now bearish. I can see JRCC dropping to near $10 or even below. Continue to watch DryShips Inc. (DRYS), as it is a good indicator of the global economy.

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, and SIL.

Comments

[John Lounsbury:]

Very interesting article.

The only question I have is timing. It may be that the unwinding of the credit paper pyramid will take some time (years, not months). As long as this deleveraging is going on, credit will remain tight. The re-inflation of the economy may be very sudden, but it also may be years away. Alternatively, effects of the credit bubble may linger and demand may remain supressed and return only gradually. Then the supply side stresses you anticipate may develop slowly, not with a sudden surge.

2008 Oct 16 10:24 AM

[Goalchie:]

Why atre you long SLV? The cost of pruduction is around 5-6 and current bid is around 10.

2008 Oct 16 10:32 AM

[Wefwef:]

I believe we're going to deflate for a significant amount of time. Can be anything from 9 months to 5 years (some authors forecast even 10 years).

2008 Oct 16 10:37 AM

[Carl Spackler:]

Nice cowboy hat there!

2008 Oct 16 10:39 AM

[Mark Anthony:]

Goalchie:

Some quarters ago some silver company have listed cost of silver production as low as $5 to $6 per ounce. That is the cost AFTER deducting revenue from the base metals produced together. Now since base metal prices have collapsed, reducing such deduction, the cost of silver is probably now something like $20 per ounce or more. Many silver companies start to report quarterly losses.
A bigger reason for silver bull is investment demand will drive silver price up. Retail quantity of silver investment products, the one or ten ounce silver pieces, are now hard to find and sold at very high premiums.
To answer the question of how long the temporary deflation phase will last, you need to watch how fast the supply destruction happens and how fast governments are printing money. The current credit market is virtually freeze up and all economic activities come to a grinding halt. This situation will NOT last six months or years, or we will all die. Give it at most weeks, no more than a month, and things should change dramatically almost in an over-night fashion.

2008 Oct 16 10:59 AM

[DaveW:]

Mark,
You've been hailing PGMs since Pd was $450/oz, it's now $170/oz. Yes, now is a better time to get in than $450 was, but the market proves you are wrong over state the supply side dynamics and under state the demand side. Forwarding looking 'consumer destruction, thus demand destruction' is killing the PGMs. My PAL purchase at $5 looks stupid now. My PAL purchase at $3 looks stupid now. My PAL purchase at $1.25 looks horizontal now. I suppose I'll consider buying *when* it reaches $0.80 as well (and it will). However, and here is the HUGE question. How in danger is PAL of going out of business when it just doesn't pay the mining bills to unearth the PGMs? They've recently given up land rights to a competitor and ousted their CEO. I'm guessing we'll see PAL share price above $6.00 not for another 5 years or more. Convice me I'm wrong.
-Dave

2008 Oct 16 12:48 PM

[H.J. Huneycutt:]

DaveW,

I think you're basically right that Mark does not analyze demand side destruction fully and PAL was definitely a bad buy at $5 (I bought in to). However, at $1.20 or so, the company's equity in their assets is significantly greater than the stock price. Plus, they don't actually have much debt so they don't seem to be in any imminent danger of bankruptcy for the moment. If the stock did indeed go up to $6 in 5 years, you would be making a 400% return, or roughly 80% for each year you held onto it.

2008 Oct 16 12:56 PM

[Mark Anthony:]

DaveW:

I admit I made some wrong judgement at the start of March. I kept monitoring South Africa's electricity crisis and I know supply is continuously restrained and the global market should continue to be tight. That, plus investment demand of precious metals, are bigger over-riding factors than the lower demand in auto sectors.

The thing I miss is I did not pay attention to the short term impact of the credit crunch. It causes investment firms to sell their PGM metal holdings to raise cash liquidity, when they should be buying. It also causes auto makers to sell off their PGM inventory, at a time they really need to hoard more, knowing the ongoing long term electricity crisis in South Africa. I should have paid more attention to GM's balance sheet and know how bad a shape they are in, and I should have known they MUST be forced to sell their PGM inventory, even though rationally they should be buying and hoarding. But at the end of day, they still have to buy the metals when their inventory runs out.

Now is the time to talk about supply destruction as suppliers are all hurt by low prices. It's unsustainable. Palladium is unique that it is mostly a BY-PRODUCT, not a main product. So it is less price elastic moving in both ways.

Low nickel price will kill Norilsk Nickel. Low platinum price will kill South Africa. If that scenario plays out, it leaves SWC and PAL the only one in the world supplying palladium and they are not any where close to being able to supply enough to the world. It will lead to a situation where you could have palladium price several times higher than platinum, instead of current palladium being 5 times cheaper than platinum.

Your worry about PAL is legitimate. For the same reason I have put more in SWC than PAL now. I have repeatedly urge PAL to suspend sale at current low palladium price. They don't seem to be anxious at this time. If they are anxious about the fate of their business there are many things they can do to turn the market around. Nearly major stake holder George Kaiser does not seem anxious either. If he is anxious he could do many things to corner palladium market and turn his investment around just as well. Knowing these I will continue to hold PAL.

2008 Oct 16 01:46 PM

[phdinsuntan...:]

cobalt must be recycled from medical equipments and these sort of uses,
have a look to scrap traders and you will fin what you need, good luck

2008 Oct 16 03:50 PM

[DaveW:]

Mark,
Thank you for the reply.....and thank you for your research. btw, you couldn't have seen the credit freeze coming, it caught most everyone off guard. In time this investment will pay up.

Jake-thanks for the reminder on the return for patience.

SmartStops-NOW you tell me :) yes, I do employ stop limits now, PAL taught me something at least.

2008 Oct 16 06:35 PM

[Cesato:]

Mark you finally started to get it, good point!! took a while for you to understand what was going to happen with Gold, didn't it?

2008 Oct 16 07:03 PM

[Poltrader:]

Mark, you may want to check Geovic Mining - GMC (on TSE).

2008 Oct 16 07:25 PM

[rayt:]

Money is Debt. Less than 5% of money created is by the government. The vast majority is done via banks.

Fractional-reserve banking has fueled economic 'growth' for years and years beyond actual what the economy can actually support. Now this system is on the verge of collapse - the catalyst being the bursting of the housing bubble. Suddenly, banks are no longer lending, credit has tightened right up - why? Cause they are extremely over extended. When banks are able to lend out x100 the amount of money they have on hand (and charge interest on it) this is great (for them) during good times but during bad? Its proves to be disastrous as we are seeing now.

Less money in the system (cause banks are no longer giving out loans/debt/creating money) means the USD will go up - and we are seeing that right now. The only thing the government, Federal Reserve or anyone else can do is to print more money (out of thin air). At the moment, the amount they are printing has not offset the lack of lending by the banks, but eventually it will and at that moment, we should see a huge rise in EVERYTHING valued in USD. Why? Increase the supply of USD means lessening of its value and ultimately inflation, maybe even hyperinflation.

This is my interpretation of what is going on and I thought I add it to this discussion. I could be wrong, so input is welcome.

2008 Oct 16 09:46 PM

[31October:]

I quit insisting that the US financial debt system could collapse and decided that the international currency and commodity flows must be balancing the sytems out. So I bought PTM, PAL, and SWC. Then the house of cards did erode, only to be supported by $750B, [not including Iceland, France, Korea, or Belgium] which will later erode the western economies.

De facto deflation will arise, despite inflationary pressure from devalued currencies and overprinted fiat money. Why? Banks will be gun-shy and leave it in the FED to collect interest. US homeowners can no longer buy Wii's and cars on HELOC cards, so demand drops further, then the sheeple hear on Entertainment Tonight (sorry, the nightly news) that it's time to hoard cash and not buy.

PGM metals in items such as catalytic converters will have less demand [query-are car sales up or down?]. Electronic toys will see less demand: Less dollars flowing to China will cause local dollar buildup and thus inflation, causing a lower point on the supply/demand curve; i.e. production falls. As demand for PGM metals falls, the market price falls below the cost of production. But industries never cut production until AFTER prices fall, so there is an upcoming drop in demand, followed by an oversupply. Therefore, PGM metals & miners will get a double-hit.

To sum, PGM miners are screwed, as is my portfolio.
I expect Cramer to be screaming !BUYBUYBUY! as he shorts like hell.
The only thing that could save PGM prices would be war.

Now... Which candidate owns more metals?

2008 Oct 19 04:28 PM

[Mark Anthony:]

Absolutely shocking development today in the palladum market:
www.themoscowtimes.com...

Russia's Norilsk Nickel, supplier of 45% of the world's palladium and holder of 55% stake in SWC, America's ONLY mine of the strategically important palladium and platinum, is now so desperate for some cash that it needs to sell its strategically critical asset for a mere $230M cash?

Just last year Norilsk spent $6B in CASH to acquire a much smaller potato, Lion Ores. They now much be in a very bad shape in terms of cash liquidity if they need to sell SWC for a mere $200M cash. They are hurt by current low nickel price, as nickel is their main product and palladium is only 5%. Heavy loss could force them to shut down the mine at any time. If that happens it cuts off 45% of the world's palladium, and could send the metal to the moon instantaneously.

On another thought, the Russians are not dumb. If they want to sell SWC they will want to fetch a better price. They have the power to jack up palladium price, hence jack up SWC share price, so they can fetch a better cash deal. Jump on board if you think that is a reasonable conclusion!!!

2008 Oct 21 11:31 PM

[String:]

On Oct 19 04:28 PM 31October wrote:

>
> The only thing that could save PGM prices would be war.
>
> Now... Which candidate owns more metals?

A new and improved US Nuclear Command...Very Interesting!

2008 Nov 02 03:41 PM

[Greg1:]

The reduction for the need for platinum group metals is going to happen alot faster than what people might believe. I have been watching the development of an exciting new enterprise in Latin America. The company is manufacturing electric cars and some alternative fuels that is already starting to affect the purchase of platinum group metals. Even though the general car market is sluggish and auto sales are dropping this Latin American company is one of the fastest growing car manufactures in the world.
The cars are built without the need for a catalyst, the replica Tesla electric car by Super Replicas is selling like hot cakes. In a recent video on their website Super Replicas demonstrated that their car sales have hit the roof since the credit crunch, because people are looking for physical investments that have a high profit return. The bottom line is many investors are looking into the future which is turning to new high tech alternative energy sources. The price of their electric cars are also the main attraction for new investors. Super Replicas Tesla electric car sells for only US$29,000 whereas the original Tesla version is around the US$100,000 mark.
Even though the typical wage in Latin America is US$6.00 for a 12 hour day, the NAFTA program has made it more profitable to invest in the Latin American auto industry, because the currency is with US dollars. Panama and El Salvador use only the US dollar so its no problem with worring about exchange rates.

2008 Dec 07 09:51 AM

[Mark Anthony:]

Greg1:

Annual global auto sales is about 70 million units. Electric cars are currently an extremely tiny portion and totally negligible. There are several big problems with electric cars:

1. The batteries have a very low energy density, limited by the battery chemistry. So electric cars are bulky, expensive due to the big battery pack, and they have an extremely limited driving range unsuitable for the daily commuting routine for most people.

2. There is not an infrastructure of power grid big enough to allow massive adaptation of electric cars to replace gasoline engine cars. The electricity supply will have to go up many many times from current level. It's simply infeasible.

3. There is not enough raw material to make enough batteries for electric cars to replace even a tiny portion of current population of automobiles. The batteries use lithium, cobalt, nickel, all are metals of limited supply.

The future of the auto industry is fuel cell vehicles. Fuel cell cars are electric cars in a broad sense as fuel cells generate electricity to drive the car. Fuel cells use much more PGM metals as catalyst. It has driving range even better than a gasoline engine car, but is much more energy efficient.

Feb 18 01:27 PM