The Split Personalities of Platinum and Palladium ETFs

Aug.20.10 | About: ETFS Physical (PPLT)

By Abraham Bailin

Among commodities, precious metals like gold have been widely adopted as inflationary hedges and "safe-haven" assets because of their traditional store of value. To the layperson, platinum and palladium are merely pricier alternatives to white-gold engagement rings. Fittingly, those interested in commodities exposure may associate the metals with their "precious metals" group cousins. While both platinum and palladium can be used for beautiful and durable jewelry, well-informed investors should be aware that these metals are primarily used in industrial applications and are thus likely to fluctuate with economic ups and downs.

Headlining their uses in industrial applications, autocatalyst activities accounted for 43% and 52% of the total demand of platinum and palladium over the last three years, respectively. Other large shares of platinum demand come from its use in the jewelry industry, while palladium is also used to make ceramic capacitors for consumer electronics manufacturing. It should come as no surprise then that the pricing of these two metals is tied to production in related industries. That said, the general population's association of platinum and palladium with the value-storing characteristics of precious metals like gold may still tend to augment their demand while markets are falling.

Platinum vs. Palladium

Platinum and palladium have very similar chemical and physical properties, and because platinum has remained roughly 3 to 4 times more expensive since 2004, palladium is being used increasingly often as a substitute. Over the past three years, 76.5% of platinum supplies were provided by South African mines (nearly all of that comes from the enormous Bushveld Complex). In the same time frame, 84.4% of palladium supplies came from Russia and South Africa alone. Accordingly, sociopolitical and economic circumstances of both nations have drastic effects on platinum and palladium markets. While these metals tend to maintain high-price correlation given stable supplies, a supply shock can cause decoupling. A Russian supply crisis during the late 1990s, for instance, caused palladium prices to climb nearly 50% higher than platinum and exhibit a negative 0.80 correlation from 2002-03.

On the demand side, a disturbance in automotive production could have similarly dramatic consequences. Those committed to exposure to either metal for their auto-industry applications may find platinum the safer bet. Though palladium is a cheaper substitute, manufacturers have not cut platinum use outright. To a great extent, palladium, and even silver, is being used alongside platinum in catalyst mixes. The dilution of the mixtures is part of an ongoing effort to curb costs while meeting increasingly stringent emissions requirements. In addition, jewelry's share of platinum's total demand is comparable to its autocatalytic demand. Thus, if an investment in platinum is driven into the red by falling auto production, cheaper platinum prices will encourage discretionary spending on platinum jewelry and curb losses to an extent.

Speculation in Small Markets

The launch of ETF Securities Physical Platinum Shares ETF (NYSEARCA:PPLT) and ETF Securities Physical Palladium Shares ETF (NYSEARCA:PALL) last January raised fears that the dynamics of these small markets would be inadvertently affected. These funds aim to deliver the performance of the spot market for each metal, and to achieve this, they issue shares backed by physical bullion held in London and Zurich vaults. The fear was that by ridding investors of the inefficiencies and inconveniences associated with transporting and storing these commodities, a wave of speculative investment would ensue, causing investment demand to become large enough to offset or impede traditional economic drivers.

From a practical perspective, it is easy to see the foundation of these fears. First, all the platinum ever mined would not fill up a modestly sized basement. There is nearly 17 times more gold mined per year than platinum, and most of that is put back underground again after it is refined. My point is that the platinum market is relatively small compared with other commodities, and thus, its price could be affected by new investment activity. At roughly 130 tons of annual production and a price of $1,500 per ounce, the annual value of production is roughly $6.2 billion. Considering that PPLT was able to attract $455 million in less than six months, it is quite obvious that the ETF has been a major "consumer" of platinum this year.

It appears that the launches of these ETFs did in fact cause a change in the platinum and palladium markets. Back in December 2009, platinum and palladium prices were fluctuating on purely macroeconomic factors. Dire credit ratings for both Greece and Spain caused a shift out of euro-denominated assets and into the dollar, creating stiff downward pressure on the prices of platinum and palladium. Despite the downward trend, announced SEC approval for ETFS' two American physical shares ETFs were highly correlated with a runup in the prices of both metals. The trend continued through launch and into mid-January, ignoring economically relevant news regarding Russian projections of supply increases and continued dollar strength. To this end, the influx of investment demand directly affected the dynamics of these small markets, but the size of these impacts may be less than expected going forward.

While physical shares platinum and palladium ETFs have just recently appeared in the U.S., similar products have been trading in Europe since 2007. The European launches saw very similar upward price trends as barriers to demand were loosed. Shortly thereafter, however, spot prices drastically responded to projected supply expansion data, negative auto-production projections, and a strengthening dollar, indicating that traditional drivers for the platinum and palladium markets remained well intact. Investment demand for platinum and palladium has accounted for 5.9% and 5.3% of total demand over the last three years, respectively. While changes in investment demand will affect the platinum and palladium markets, it is likely that at current levels, automotive and industrial demands, which are not nearly as speculative in nature, will remain primary drivers.

Which Investment Vehicle Works Best?

Individuals with strong fundamental theses about related industries may consider investing, but why invest in physical shares? There are three general methods that funds can use to provide exposure to a commodities space, yet that exposure is not necessarily equal.

The first method of gaining exposure to commodities spaces is by holding equity securities of firms that deal with the production and use of a particular commodity. First Trust ISE Global Platinum Index (NASDAQ:PLTM) takes this approach by holding positions in companies involved with the mining, refining, and production of platinum. This route provides investors coverage of related companies but will also deliver a fund's concentration risks (regional, equity-specific, industry-specific, and so on), possible liquidity issues, and exposure to activity outside the platinum space. But that may still affect a held company's operations--Johnson Matthey, for instance, makes up 7.55% of the fund, but also involves itself in gold and silver refining.

The second method is to invest in a fund that tracks the futures prices of the commodity. IPath DJ-UBS Platinum TR Sub-Index ETN (NYSEARCA:PGM) and UBS E-TRACS Long Platinum TR ETN (NYSEARCA:PTM) are structured as exchange-traded notes that track platinum futures contracts. But aside from the fact that this poses investors with the providers' credit default risk, their performances will be subject to fluctuations in the futures market. Both the platinum and palladium markets operate as normal carry markets and are thus contangoed. That is to say that futures contracts are more expensive at later expirations. Approaching expiry, contracts will lose value and purchasing the next month out will garner a loss.

By taking the third route, a position in physically backed commodities funds such as PPLT and PALL, investors receive direct exposure via the spot market. Shares actually represent a small amount of the physical commodity, and all price fluctuations will be entirely representative of the market demand and supply.

While the aforementioned options are all strictly involved in the platinum space, PALL is currently the only palladium exchange-traded vehicle in the United States. Before investors get involved in either market, however, they should understand how closely tied to one another they are.

Platinum and palladium will, due to widespread association with "precious metals," hold some of their value against a falling dollar, though less so than gold. They also tend to make beautiful rings. But the bottom line is that before taking a position in either metal, one must understand the substantial effects that industrial demand renders upon both.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.