Important update [Oct. 23, 08]: The story of Norilsk selling its SWC stake might NOT be true. Please see my latest post that deals with these suspicions, and do your own due diligence.
This is the fourth part of my series articles discussing the true valuation of physical assets, paper assets and currencies, vital knowledge needed to survive the unfolding global financial crisis. If you haven't read the previous articles, you can read them here: part 1, part 2, and part 3.
I wanted to discuss the valuation of U.S. dollar. Some of the things I wanted to discuss include why it rallied so strongly, why we will see a sudden and abrupt reversal of the dollar rally, and why such a reversal is imminent. I wanted to spend more time giving it more thought. However, some big breaking news happened on Monday, forcing me to discuss the new developments immediately.
In previous articles, I emphasized that physical commodities can serve as reliable safe haven assets because their intrinsic values are decided by the marginal production cost. When something is sold BELOW production cost, the low price cannot last long as no business can operate at loss indefinitely. SUPPLY DESTRUCTION will happen, tilting the supply/demand relationship to a shortage. Price will then be restored to a profitable level to allow producers to resume profitable operation. Therefore, when you see a commodity traded far below its production cost, it is the best investment you can buy. You can just sit back and wait for it to appreciate soon, in inflation-adjusted terms, knowing for certain that the price just has to recover regardless of the demand side.
Looks like the supply destruction is indeed happening at neck-breaking pace, in all commodity sectors, and many analysts have noticed the phenomena and openly discussed the idea of supply destruction. As I am a precious metal investor with particular interest in palladium, there were two news events that happened on Monday caught my attention and made me very happy, as things that I predicted are happening far sooner than I expected. The news involves two of my favorite stocks, North American Palladium (PAL) and Stillwater Mining (SWC).
On Tuesday, PAL announced that it was temporarily suspending the production at the Lac Des Illes mine, and suspending metal sales due to current low metal prices. I am pleasantly surprised that the new CEO, Mr. Bigger, could act so quickly. I openly called for PAL to suspend operation due to current low palladium price. It's not an easy decision to let 350 hard working mining workers go, through no fault of their own, but the company must preserve precious mineral reserves and liquid assets, and ultimately it is also good for the workers themselves.
I believe that PAL, as the only palladium producer who sells to the spot market, has enough leverage power on its own to turn the palladium market around, and major stakeholder George Kaiser has a capacity on his own to move palladium price. Now PAL is not selling, who will sell in the palladium spot market? Who has the metal to sell? Are they going to sell paper palladium now? The market must realize that it must pay a fair price to get the physical metal. Unfair prices can only buy you paper, as producers simply cannot operate at heavy loss to produce metals like a charity organization.
However, the next piece of news shocked me so much that I jumped up, could not believe what I just read!
This is incredible! This says the Russian Checkmate in palladium, which I discussed before, is playing out, right in front of our eyes. This is incredibly bullish for the price of palladium. Let me explain.
Norilsk Nickel produces 45% of the world's palladium. In 2004, they acquired a majority stake in SWC, America's ONLY mine of palladium and platinum, two strategic metals of critical importance to the security and survival of the United States, through quite some political maneuvers that involved direct negotiations between President Bush and President Putin.
Not for sale, UNLESS Norilsk is in a desperate need of cash urgently.
The company is in a terrible liquidity squeeze if it is so desperate that it needs $230M in cash - now. The currently low nickel price it what really hurts it. My estimate is the company probably loses $1B to $2B per quarter. Therefore, $230M is probably good to last them another two or three weeks. I see that shutting down the Norilsk Mine, is an inevitable decision the company is forced to make urgently, regardless what it says publicly. The company either shuts down, or goes broke and then shuts down. Not to mention the fact that Norilsk Mine is also an environmental catastrophe that needs urgent cleanup.
That would be fantastic news to SWC and PAL, the only primary palladium producers in the world. Shutting down
It is outrageous
That, of course, is a great incentive for investors to buy and hoard physical palladium and platinum. The investment buying will boost prices so buying begets more buying. History has proven in 1980 that when people need to buy safe haven assets during financial crises, they buy every precious metal, not just gold and silver. When there is strong investment buying, weak industry demand becomes irrelevant.
I am not totally dismissing the factor of industry demand of PGM metals, especially in the auto sector. However, the weaker auto sale has been exaggerated. Owning a car is a necessity, not a luxury. How you can walk 30 miles to work or 10 miles to shop? Tight family budget may postpone buying a new car for a while, but only until the old car breaks. You may turn down a customer's request for a car loan but you cannot remove the need for a car. Gasoline consumption in the
More over, history has shown when the industry demand of PGM metals weaken, the extra supply has always been absorbed by jewelry demand as the metals become more affordable.
Out of all precious metals, gold is the least I like. I have not purchased any Spider Gold Shares (GLD) so far. The current gold price is still well above profitability of most gold mines. Humanity has been digging this almost useless yellow metal for thousands of years until today. There's too much gold sitting there just to collect dusts. If we do need more gold, maybe we can all quit our daytime job and go to the beaches panning for gold, like the people at Jamestown.
Silver is a different story. Today, 70% of silver is produced as a by-product from base metal mining. Even for the 30% silver that's produced as main product, base metal by-products are also important part of the revenue. The whole silver industry is suffering not only from current low silver price, but also from low base metal prices as well. A production cut is expected, reducing supply, at a time when physical silver investment products are in high demand. I believe physical silver price will go up much more than gold. I own iShares Silver Trust (SLV) and recently increased my SLV stake on the dip to the low $9 area. The silver industry has continuously announced news of mine shut downs recently. Even mentor of the most famous silver bug, Israel Friedman, has openly called for Coeur d'Alene Mines Corp. (CDE) to suspend silver sales.
Silver mining companies are different stories. I have purchased a few silver stocks like Apex Silver Mines Inc. (SIL), Pan American Silver Corp. (PAAS), Silver Standard Resources Inc. (SSRI), Hecla Mining Co. (HL), and CDE. However, after carefully examining them, one by one, I find that all of them are hurt by low base metal prices, and not just the low silver price. None of them is a pure silver play. Therefore, instead of providing a leveraged gain over silver, these mining companies provided a leveraged loss over silver. If I am already invested in silver itself, why do I need to buy any silver mining share? I wish there were pure silver players around.
In current turbulent commodity market, the mining world is a world of survival of the fittest. Who has the richest mineral reserves, the most cash and the least debt, will survive and prosper. The long-term bullish cycle of commodities will continue, as Jim Rogers pointed out, due to the damage of producers thanks to the credit crunch. A whole bunch of unfit commodity producers will probably be eliminated. However, the survivors will get to enjoy the next wave of commodities rally, which I believe is not too far away, despite of a weakening global economy, because the damage to supply is much worse than the damage to demand.
The fundamental bullishness of commodities attribute in large part to the fundamental bearishness of the world's fiat currencies, notably the U.S. dollar, but not just the U.S. dollar.
The dollar staged the strongest rally in recent years, just as the global credit crisis deepens, and the Fed is printing money like crazy to inject huge liquidity into the market. Every bit of liquidity the Fed injects simply disappeared once it's absorbed by the market. It totally defies logic and stunned many market observers. Is it manipulation? Conspiracy theory is always an easy answer. However, we must look for the real reason behind the logic-defying dollar rally, to make correct investment decision.
The real reason is that the global credit crunch creates such panic that most people retreat to the basic instinct of "Cash Is King." Liquidity is being hoarded away, instead of circulating in the market. The velocity of money approaches zero, making the dollar seem more valuable relative to surplus goods squeezed out of supply chains. This is a temporary aberration and cannot be allowed to last. When the velocity of money approaches zero, so does the velocity of the goods’ movement. If goods are not moving, then the society will collapse. The money printed will get both money and goods to move again. Once that happens, the dollars will suddenly flood the market while the supply of goods will dry up, leading to the sudden collapse of the U.S. dollar.
Let me use an analogy. We are riding on a car rushing up a high cliff overseeing the ocean underneath. You will panic and your intuitive response is buckle up your safety belt to strip yourself in. You think you are safe in your safety belt. Well at impact point, you go from no liquidity to hitting an ocean of liquidity in a split second. There is absolutely no time for you to untie your safety belt before you are drowned. The safety belt is the
Full Disclosure: The author is fully invested in SWC, PAL, and OMG. I am also loaded in SLV and traded in and out in a few selected silver stocks like SSRI, HL, PAAS and SIL.