Precious Metals, Commodities and The Innovation Threat

Innovation is the enemy of commodity investor.

OK, that might be exaggeration, but it does point to a bigger truth. Platinum and palladium markets are trading down today on news that engineers at Nissan Corp. have figured out how to design catalytic converters that use only half as much platinum, palladium and rhodium as existing models. That’s a huge breakthrough and a matter of critical important to platinum investors, because catalytic converters consume 54 percent of the platinum sold each year, according to Standard Chartered PLC (via this Bloomberg story. If Nissan’s new system bears out and everyone switches to it, platinum demand could fall precipitously.

(It may seem odd that the same metal that is coveted for wedding rings also helps scrub soot out of auto exhaust systems, but it’s true; they use diamonds in mining tools and X-ray machines, too.)

Of course, it’s not as if demand for platinum will tumble overnight. The system is as-yet unproven and there are huge legacy investments in machining plants based on the old method. But if platinum prices stay high, this and future innovations will find ways to reduce industrial demand for platinum and related metals. Higher prices increase the premium on innovation and make it economical to investigate alternative methods to achieve the same result.

We are seeing similar developments in the energy industry. Sky-high (and persistently high) oil prices have made it attractive to invest in alternative fuels and alternative sources of crude, such as oil sands, shale oil and more. It has also pushed oil engineers to look in more unusual places, including ultra-deep wells and politically challenging countries.

Similarly, folks are investigating ways to conserve energy, which is being borne out in developments like new hybrid-electric vehicles and efforts to ban the use of incandescent bulbs. (The fact that OPEC has allowed oil prices to remain so high that these efforts are profitable is one of the reasons many people believe OPEC is pumping at maximum capacity; in the past, they have periodically flooded the market with oil as a way of discouraging alternative energy research.)

Nearly all commodities are exposed to innovation/conservation risk, although some more than others. Agricultural commodities are less exposed, as it is difficult to fundamentally replace food; nonetheless, innovation can and will make crop-growing more efficient, find new uses for formerly discarded crops, etc.

Gold’s value is more immune, as gold has no real utility, and its value is tied solely to the fact that it’s gold. A narrowly focused market like palladium is the most exposed, functioning like a company with a single large customer, where things can go horribly wrong in a heartbeat if that one customer gets in trouble.

How do you play this theme as an investor? Well, for starters, it opens up an entirely new platform for commodities related investments. Instead of investing in actual agricultural commodities, you can invest in fertilizer plays or companies like Monsanto. Instead of buying oil futures, you buy deep sea rig companies and developers of photo-voltaic cells. PowerShares actually offers an exchange-traded fund (AMEX: PZD) that invests in companies that help other companies operate more efficiently.

Staying within pure play commodities, an alternate approach might be to look for pricing discrepancies between substitutable commodities. For instance, oil is currently much more expensive than natural gas on a per-BTU basis. The reason is that oil is more useful in today’s economy: it’s easier to turn into gas, heating oil and other useful distillates, and it’s easier to transport from one location to another. Assuming oil prices stay high, that pricing gap provides a huge incentive for companies to figure out ways to make natural gas more useful, which could help narrow the BTU spread over time.

Platinum futures were only off marginally in New York trading, but as news of the Nissan innovation spreads, they may face more downward pressure.