If I were to tell you that there are two commodities that have essentially the same in-ground supply, similar quantities of annual production, similar use-values and demand fundamentals, you would expect that they would be priced roughly the same. Further, if they were priced radically differently, you would see an arbitrage opportunity whereby a profit could be made by shorting the more expensive of the two assets against a long position in the less expensive asset.
In this article, I suggest that such a situation exists with platinum (NYSEARCA:PPLT) and palladium (NYSEARCA:PALL). The former trades at nearly $1,500 per ounce while the latter trades at just under $700 per ounce. Furthermore, the relative price action of the two metals has been unreasonably volatile, as the following long-term chart illustrates:
Despite this, we have two metals that are practically identical in their fundamentals. Rather than blindly opining as to why this is the case, I suggest that investors exploit this situation by purchasing palladium and shorting platinum against it.
Before executing such a trade, investors may also consider the following:
- First, it is possible that both metals are overvalued or undervalued. I will not discuss this here, however, if one believes the former, then rather than following my advice directly one might consider simply shorting platinum. If one believes that the latter is true then one should simply buy palladium.
- Second, while the two metals are very similar in their fundamentals, as I will make clear, throughout this discussion I will point out a couple of subtle, yet crucial differences that investors should be aware of: in most cases these differences justify a small premium in the platinum price over the palladium price, however they do not justify the 100%+ premium that platinum currently carries over palladium.
1: Global Annual Mine Supply
Despite the fact that platinum costs more than twice what palladium costs, the annual global mine production for the two metals is roughly the same for each, with platinum being only slightly rarer than palladium. The following chart illustrates the global annual mine supply for the two metals over the past six years:
The following chart is a ratio of the production of palladium versus the production of platinum over the same time frame:
Palladium production exceeds platinum production, although not by much, and the amount by which this is the case has been increasing over the past few years.
Despite this, the ratio between the platinum price and the palladium price has been in favor of the latter over the period from 2010 to the present, which likely reflects a much needed mean reversion.
Still, despite the fact that the global mine supply of platinum exceeds that of palladium by only 12%, I suspect that there might be a reason that the price of the former should exceed the price of the latter by a larger percentage (although still not 100%+ ), namely platinum and palladium are mined in different geographies, as the following charts illustrate:
For both metals, the vast majority of 2012 mine supply came from either South Africa or from Russia. However, for platinum this was heavily skewed toward South Africa, whereas for palladium it was heavily skewed toward Russia. While investors are often skeptical of investing in Russia, in this particular situation, investors have expressed greater skepticism towards mining conditions in South Africa than in Russia, and rightly so. South Africa is not a friendly place for platinum miners, as recent deadly violence at Lonmin's (OTCPK:LNMIY) mine in Marikana evidenced. This is not an isolated incident: earlier in 2012, Impala Platinum Holdings Limited (OTCQX:IMPUY) saw workers go on strike in South Africa, and this too was accompanied by violence. Given that the vast majority of platinum is mined in South Africa where mining is perpetually interrupted, it is no wonder that platinum production has decreased. Consequently, platinum commands a premium over palladium that exceeds that, which one would expect given the purely quantitative supply data, as there is a constant threat that the mine supply of platinum can be severely reduced. Nevertheless a premium exceeding 100% is not justified.
1A: A Brief Remark on In-Ground Reserves
Before I discuss platinum and palladium demand, I should remark that the in-ground reserves of platinum and palladium are very similar: according to U.S. Debt Clock, platinum reserves stand at 985 million ounces, while palladium reserves stand at 1.13 billion ounces, or just 14.7% higher. Again, while my aforementioned remarks regarding platinum's high concentration in South Africa suggest that platinum deserves to trade at a higher premium to palladium than this 14.7% figure suggests, the similarities in supply fundamentals for the two metals suggest that the current premium is unjustifiable.
2: Global Demand
For both platinum and palladium global demand is greater than global mine supply. This deficit must be made up for through either recycled metals or by drawing down inventories. According to Resource Investor, demand for platinum in 2012 was 8,070,000 ounces, or 229,000 kilograms. For palladium, 2012 demand was 9,725,000 ounces, or 276,000 kilograms. Demand outpaced mine supply for platinum and palladium by 28% and 38% respectively. These figures suggest that there is a greater shortage in palladium, and that consequently the two metals should be more equally valued.
In fact such a claim is further corroborated by the fact that the two metals have essentially the same industrial usages. The primary use for both metals is in catalytic converters in automobiles, or autocatalysts: these are devices used in car engines that reduce the emissions of poisonous gases such as carbon monoxide and nitrogen-based oxides. Both metals have other minor uses such as in electrical devices and dentistry. Investment demand for both metals is not insignificant, but somewhat minimal. The one crucial difference that would suggest that platinum should command a premium over palladium is that a significant amount of the former is used in jewelry, while this is not the case with the latter. Nevertheless, there is no physical difference between the metals that necessitates this. One minor difference between the two metals that would make platinum the superior material for jewelry (and investment/wealth storage for that matter) is the fact that it is denser: platinum has a density of 21.45 grams per cubic centimeter, while palladium has a density of 12.03 grams per cubic centimeter.
The following two graphs illustrate the breakdown in demand applications for the two metals.
(Source: High Tower Report)
(Source: Platinum Today)
As these charts show, the one crucial difference between platinum demand and palladium demand is that a significant amount of platinum is used to make jewelry, while this is not the case for palladium. Given the enormous difference in price between the two metals, and their physical similarities, it would not surprise me if the demand for palladium for jewelry were to increase at the expense of platinum over the next several years, and this would be consistent with my overall thesis that the prices of these two metals should be closer than they currently are.
Platinum and palladium are very similar metals.
- They are produced at similar rates.
- They occur in the Earth's crust in similar amounts.
- They have similar physical properties.
- They have similar industrial uses.
Nevertheless there are crucial differences between the two that entail that identical pricing of the two assets is inappropriate:
- They occur in different parts of the Earth's surface, and given geo-political realities palladium is more easily attainable than platinum.
- Palladium is slightly more abundant than platinum.
- Most likely for cultural and historical reasons, platinum is more desirable as jewelry than palladium.
That being said platinum deserves to trade at a premium to palladium. The latter is roughly 15% more abundant in the ground given known reserves of each metal, and on an annual basis 12% more palladium is produced than platinum. These two figures understate an appropriate premium because geo-political risks threaten the platinum supply more than they threaten the palladium supply. While it is impossible to precisely quantify this risk, it is extremely unlikely that the risk is so great as to justify platinum costing more than twice what palladium costs.
Ultimately with platinum trading at just under $1,500 per ounce, and palladium trading at just under $700 per ounce palladium should be purchased in lieu of platinum, or for those who have a bearish bias, platinum should be shorted in lieu of palladium; a long palladium/short platinum pair trade would be an appropriate market-neutral position.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own physical palladium bullion.