Platinum: A Fundamental Analysis

| About: ETFS Physical (PPLT)

Summary

Platinum has been in a supply deficit for nine of the last 12 years, with 2016 expecting another deficit.

Cost of production per ounce of platinum exceeds price per ounce.

Above-ground stocks of platinum rapidly depleting.

The platinum/gold ratio suggests platinum is cheap relative to gold and should correct in the near term.

In our current global economic environment, there has been sufficient distraction from the opportunity that platinum presents. With all the focus on Brexit, the woes of the EU, China's real estate bubble, gold, and the Fed's rate decisions (or indecisions), it is easy to understand how one could overlook the potential that platinum provides. In fact, according to the World Platinum Investment Council (WPIC), Platinum ETF holdings have been reduced over the last three quarters; paradoxically, these ETF outflows have been contrasted by sizable coin and bar purchases begging the question: who is right - physical or paper investors?

I believe there is persuasive evidence provided by fundamental and technical analysis that supports my assertion that platinum is set to rise in price in the area of 40% in the next four years. Leveraged miners should see gains far in excess of platinum's potential price move.

Overview of Platinum

Platinum is fifteen times rarer than gold and is costlier to produce. As a result, it has historically traded at a premium to gold. In the last 40 years, platinum has only been priced at a discount to gold four times, each time lasting less than two years.

Global platinum mining supply is 70% sourced from South Africa, 13% from Russia, 8% from Zimbabwe, and the rest from various other countries. Platinum recycling also accounts for 23% of total global supply. Major sources of demand include 40% automotive (catalytic converters in exhaust systems), 35% jewelry, 20% industrial, and 5% for investment.

Platinum is, as of Oct. 18, trading at US$938.80/ounce, a $322.50 discount to gold which is trading at US$1,261.30/ounce. In other words, platinum is trading at a 26% discount to gold when it has historically traded at a 50% premium.

Demand

Demand for platinum has been stagnant for the last six years. A retreat in investment was made up by an advance in industrial use. The major source of demand for platinum is in the automotive industry as an anti-pollutant in catalytic converters. China is the largest fuel combustion vehicle market and shows little sign of stopping its growth in this industry. The China Association of Automobile Manufacturers reports this year's August sales, and production, to be up, year over year, 23% and 28.9%, respectively. Global car production growth is expected to slow, but 2016 is still anticipated to produce 89 million cars, up from 88 million in 2015.

Jewelry demand is up 3% in Q2 of 2016 from the prior quarter, indicating momentum. India, after a brief strike, has seen an astounding 25% year-over-year increase in Q2 2016 in platinum jewelry sales. A drop in the number of Chinese wedding registrations resulted in a 4% year-over-year decrease in platinum jewelry demand from this Q2.

Industrial demand has been making slow advances in recent years, increasing by 1% each quarter since Q3 2014. Industrial demand, in order from greatest to least, is sourced from chemical, medical, electrical, glass, petroleum, and others.

Platinum investment has seen three quarters of ETF outflows but these have recently tapered and are dwarfed by the increase in physical investment demand. In 2015, bars and coins increased by 525koz, while ETF holdings decreased by 240koz. Japanese coin and bar investors led demand in the first two quarters of 2016, recording an increase of 140koz and 110koz in Q1 and Q2, respectively. Interestingly, in the U.S., 10,000 American Eagle platinum-proof coins were made available this past June and sold out in under an hour. There seems to be a disconnect between investors who prefer physical platinum and those who prefer ETF holdings; the former being bullish and the latter bearish.

Given these figures, I believe platinum demand will grow slowly and modestly over the next few years as more motor vehicles are produced, jewelry-consuming Chinese and Indian middle classes grow, and significant investor interest returns, particularly from the ETF segment.

Demand (koz)

2013

2014

2015

2016* estimate

Automotive

3,165

3,300

3,405

3,390

Jewelry

2,945

3,000

2,880

2,885

Industrial

1,480

1,535

1,650

1,625

Investment

935

150

305

350

Total Demand

8,525

7,985

8,240

8,250

Click to enlarge

Source: World Platinum Investment Council

Supply

Global platinum supply has been fairly even for the last four years, with a dip in 2014 due to a five-month strike in South Africa. The strike, due to union wage demands, resulted in 1,200koz of lost production, equating to US$2.25 billion. Modest wage increases were agreed upon and are to be implemented over three years; normal operations and production have since resumed.

Total global platinum supply for 2016 is expected to be 3% less than in 2015. This is partly attributable to safety stoppages due to an increase in work fatalities in South Africa's major platinum region, Western Limb. In addition, the spot price of platinum is well below the cost of producing an ounce, which discourages producers to produce, reducing the supply (more on this later).

Platinum recycling provides 25% of the total global supply and seems to correlate with the price of platinum. Interestingly, the last two and a half years have seen jewelry recycling subdued to only 500koz, down from its average of 794koz for the prior four years. This could indicate that holders of platinum jewelry are of the belief that a price rise is due and are in wait. Steel is also seeing a price recovery, which lends incentive to scrap vehicles increasing platinum recycling in the short-term; however, the World Platinum Investment Council estimates platinum recycling to increase by a modest 2% in 2016.

I believe global supply will continue to decrease at a modest pace because the price of platinum per ounce is below the average cost of production per ounce: producers prefer to produce at a profit and slow down production and deleverage when their wares are in cyclical lows. Moreover, South Africa, supplying 70% of global mining supply, continues to harbor political, union, and economic risks posing a threat to future supply.

Supply (Koz)

2013

2014

2015

2016* estimate

Total Mining Supply (Total refined production net of producer inventories)

5,855

5,230

6,195

5,985

Recycling

1,980

2,035

1,710

1,745

Total Supply

7,835

7,265

7,905

7,730

Click to enlarge

Source: World Platinum Investment Council

The Deficit and Depletion of Above-Ground Stocks

As mentioned, platinum has been in a physical deficit for nine of the past twelve years, with 2016 expected to post another deficit. The last four years have seen deficits on average of 521koz, 6.8% of average total demand for the same period. Demand-supply imbalances affect pricing, which in turn corrects the imbalance: simple economics.

In platinum's case, large physical above-ground stocks have been delaying this self-correcting imbalance. Using 2016's expected deficit from the World Platinum Investment Council, the deficits have averaged 6.75% of total demand in 2013-16. This is a significant amount of demand not being met for numerous years. As a consequence, above-ground stocks are being depleted each year by the amount of that year's deficit. The depletion rate is starting to accelerate as deficits remain steady but stocks diminish, with full depletion in early 2020, by my calculations.

Once demand can no longer be met by these above-ground stocks, the price of platinum will be forced upward by the market. Due to the foresight of market participants, I believe this price increase will occur well before the above-ground stocks fully deplete as the market wakes up to the imbalance. This view is supported by the belief that platinum supply and demand is set to remain stagnant over the next year, maintaining the deficit. Have a look at the table below for an eye-opener.

Year

2013

2014

2015

2016

2017

2018

2019

2020

Total Demand

8525

7985

8240

8250*

8300*

8350*

8400*

8450*

Deficit

690

720

335

520*

566**

566**

566**

566**

Above-Ground Stocks

3450

2730

2395

1825*

1259*

693*

127

0

Depletion Rate

21%

12%

22%

30%*

45%

82%

100%

* Estimates using data from 2013-16

**The deficit of 566koz was derived from the average of 2013 through 2016

Click to enlarge

(All platinum figures in Koz.) Source: WPIC and personal calculations on estimates from 2017-20.

Costs of Production in Excess of Price

Another factor that will put upward pressure on the price of platinum is the current price of platinum being lower than its average cost to produce. Producers operate for a profit, as corporations are legally required to do. Therefore, if platinum is currently trading at US$938.80 and the cost to produce an ounce is around $1,209, producers are losing $270.20 each ounce they sell, a 22% loss.

This is unsustainable for any business and is forcing producers to deleverage and eventually reduce output. In fact, a brief glance at some top platinum producers' balance sheets shows severe deleveraging, retained earnings capitalization, and borrowing. Anglo American Platinum LTD, the largest producer, has seen its 2015 total assets fall below 2014's. Lonmin PLC has seen its 2014 total assets shrink from (in millions) 4,365 to 2,429 in 2015.

In any case, it is unsustainable and inadvisable to sell for less than what it costs to produce. Cheap debt, retained earnings capitalizing, and deleveraging can only keep the boat afloat for so long. Investors can expect a reduction in output, and thus, supply, leading to higher platinum prices, given a stable demand.

The Platinum/Gold Ratio

Historically, platinum has traded at a premium to gold due to it being rarer, having a larger industrial demand, and having a higher cost of production. There is a reason why it has been termed "rich man's gold."

Currently, the platinum/gold ratio is hovering around 0.76. Platinum hasn't traded at this deep of a discount since 1982. The lowest the ratio has been in recent history was 0.73 in 1985. Moreover, platinum has only traded at a discount to gold four times in the past thirty-five years, each time lasting less than two years.

Past performance can't tell us future performance, but trends do exist and can complement fundamental analysis. Platinum and gold's relationship does tell us that either gold is overpriced, platinum underpriced, or a new norm has begun. Gold could be overpriced, but it does serve as a hedge against equities and fiat currencies. Uncertainty isn't about to leave the markets, so I believe gold has found a strong resistance around $1,200/oz, but this is speculation. A new norm of platinum being priced below gold seems unlikely due to its rarity compared to gold, cost of production exceeding gold's, and historical trends. Therefore, it is likely that platinum is underpriced and a reversal of the discount-to-premium is likely in the near term.

The platinum/gold ratio hit its peak in January, 2001, at 2.34 and another sub-peak in May, 2008, at 2.31. I wouldn't expect to quite see these numbers, but even halfway of 1.17 would take platinum to $1,474/oz (gold at $1,260/oz x 1.17). This is a 53% increase from today's prices. According to PMTREND, the platinum/gold ratio has averaged 1.4 for the past 25 years. If gold remained at $1,260/oz, then platinum -- should it revert to its 25-year mean -- would be priced at $1,764/oz, an 83% increase from today's prices.

Words of Caution

I should make myself clear that I believe platinum has great potential in the short to medium term. In the long run, platinum does have some headwinds that should be considered.

Electric vehicles (EVs) don't need platinum and are gaining market share. Some believe EVs to rise to 35% of global car sales by 2040; however, in the next decade, the conventional car will still be a cheaper alternative to EVs and still dominate global sales.

Interestingly, Anglo American Platinum, Lonmin PLC, and Impala Platinum are investing in fuel cell tech, which, by combining oxygen and hydrogen over a platinum catalyst, generates electricity. Critics of this technology raise the issue of hydrogen refilling stations costing more than EV charging stations.

Platinum has a substitute for automotive applications: palladium. Palladium is currently trading at US$653.50/ounce. Therefore, it is a cheaper substitute but it has a higher sensitivity to poisons that renders it less effective than platinum in this regard. Moreover, palladium, also largely sourced from South Africa, has seen recent supply deficits that could see upward price action. Also, diesel vehicle catalysts can't use palladium and so provide a protective moat on platinum's automotive demand. Western Europe still has sales of diesel vehicles making 58% of the market.

In any case, I believe the use of platinum in the automotive industry won't subside in the medium term.

Conclusion

An analysis of platinum presents a strong case for a price increase in the near-term. The rapid depletion of above-ground reserves that are expected to run out in early 2020 will put upward pressure on platinum's price at a much earlier date. The average cost of production per ounce exceeding the price of platinum per ounce has been causing producers to deleverage and will force them to reduce supply; given a stable demand, this will put upward pressure on the price. Lastly. the platinum/gold ratio is near all-time lows at 0.76 and has never lasted below 1 for more than two years in the last forty years.

Investing in a platinum producer will magnify returns in a rising-price environment. I will be writing an article on prospective platinum producers in the coming weeks. If you found my article informative, I encourage you to follow me.

Disclosure: I/we 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.