Yesterday, barely one week after the fall of Fannie Mae (FNM) and Freddie Mac (FRE), we saw the fall of the third and fourth largest financial institutions at the same time. Lehman Brothers (LEH) filed for bankruptcy, and Merrill Lynch (MER) sold itself to Bank of America (BAC) in a hurry.
The Dow plummeted more than 500 points. We are now looking at an unprecedented financial tsunami and it is at times like this that people MUST preserve their wealth through safe haven investments, or risk losing everything.
When it comes to safe haven investing, people immediately think about physical assets such as gold, silver, oil, land, real estate. There is a reason for this: Physical things have intrinsic value. The value of a paper fiat currency, or a stock, can fall to zero. But the value of any physical asset can never fall to zero. The intrinsic values of physical assets are the reasons why they preserve wealth during times of financial and economic crises.
It is important to understand why physical assets like commodities have intrinsic values and how these values are determined. Without this knowledge you might end up over-paying for something and losing your wealth. Those folks buying gold at the $800+ high in 1980 ended up losing big time and they may never be able to recoup their losses, because they chased the gold mania and overpaid well above the intrinsic value of gold. Knowing how to measure intrinsic value is more important as the value of the US dollar is changing dramatically, so the dollar price no longer provides an objective comparison.
To understand how intrinsic values of commodities like gold are determined, a few common misconceptions must be addressed. Those common misunderstandings include:
- A commodity's value is determined by its usefulness, or how much people are willing to pay for it.
- A commodity's value is determined by supply and demand, the more scarce the supply the more valuable the commodity. The more abundant the commodity, the cheaper it should be.
Both notions are considered common sense by most people. But both notions are actually wrong if you think them through. Why are both notions wrong? Let's use water as an example, potable, drinkable water.
Water, is extremely useful not to mention important. We need it to sustain life.Yet water is cheaply available. So even if something is useful, it doesn't necessarily have to be expensive.
Water is also abundant. Coca Cola (KO) can produce as many soft-drinks as people on earth would like to drink, and more, but there is always going to be competition from Pepsi (PEP) and others. The Saudis can buy as much sea water as they need, but someone has to filter the sea water to produce any amount of fresh water, which will be done as long as the Saudis pay the right price.
But this abundant water is not exactly as cheap as dirt. Conversely, something being scarce doesn't necessarily make it expensive, either. Remember KO and PEP for a potential short? I believe both companies will survive a severe economic recession or depression. But profits for both are going to plummet as consumers cut back on discretionary spending on such things as soft drinks.
Water also provides a good example of the intrinsic value of a commodity. A one-gallon bottle of water is sold roughly at about the cost to produce and ship it, plus a bit of marginal profit. The reason is very simple: If the price of bottled water is too low to be profitable, no one would be willing to produce bottled water and the supply would immediately fall, driving the price back up.
But if the price is a bit too high, competitors could increase production, driven by the potential for profit, which would, of course, bring prices down again. This leads to the important principle I want to talk about: A commodity's intrinsic value is the cost of replacement.
In my past articles, I have emphasized the basic economic principle that supply and demand drive the price. Now I am suggesting that commodities should be valued by the cost of producing them. Have I changed my mind? Am I contradicting myself? No! There is no contradiction. Both principles are valid and are consistent with one another. The reason these two principles are compatible is that the replacement cost, the cost of producing the commodity, is NOT a constant. The production cost itself is driven by supply and demand.
That's because when the demand weakens and the price falls, businesses that produce at higher cost will fail, reducing the supply and leaving only the lower cost suppliers in play, hence the replacement cost is reduced until things reach some sort of equilibrium.
Likewise, when demand exceeds the supply, prices must go up, and new sources of supply, sources that previously found it too costly to produce the currently scarce item can now come into play profitably. So this is a case where strong demand drives up price as well as the production cost.
Let's use natural gas as an example. Some predicted that natural gas prices should fall and they point to recent US production increases. What they failed to mention is that due to international market competition, LNG (Liquefied Natural Gas) importation into the USA has ceased so that increased domestic production can barely make up for the drop in imports.
The weekly NG storage number is significantly lower than the level last year, meaning the market has consumed more than the available supply for the past year. Further, almost 100% of the domestic production increase comes from so called shale gas, a resource impossible to produce in the past that is still prohibitively expensive to produce today. The horizontal wells are difficult to drill and production from each well is very slow. Some estimate that shale gas is unprofitable to produce unless the natural gas price remains at $10 or more per MM BTU. Current spot price is at $7.39.
Moreover, from an energy equivalence point of view, one MM BTU of natural gas is equivalent to 6.5 barrels of petroleum. So the current price of natural gas is equivalent to only $48 per barrel oil, even though it is a cleaner fuel.
Compared with petroleum, natural gas is now extremely oversold. Using the principle that commodities should be priced at the production cost, which is at least $10, I am seeing United States Natural Gas Fund (UNG), as an excellent buy here and I see it less affected by turbulence in the general market. I bought UNG at around $33 myself. I also suggest buying NGAS (NGAS) as it is an unconventional natural gas play, with a nice ticker name others are jealous for.
Let me come back to the topic of safe haven investments. The most important feature of a safe haven investment is not to make money, although that would be nice. The main goal, however, is to protect and safeguard your wealth. So a safe haven investment must be something physical, with intrinsic value that does not fall, and is under your control and disposal.
Safe haven assets are something you accumulate which you are not supposed to sell at any price, unless times are really bad. That's when those hard assets you own will protect you and your family.
It's like buying a gun for self-defense; do you buy it one day and sell it the following week, thinking that since you were not in danger for the week that you owned it you won't be needing it any more? You buy and own a gun indefinitely if you want protection. So it is with safe haven assets.
Trading paper futures contracts, buying one day and selling another day and gambling on daily charts, like hedge funds are doing, is NOT safe haven investment. Safe haven assets are physical asset you acquire while they are still cheap, and hold on to for rainy days, as such, suitable physical assets to acquire must not only preserve and grow in value, but they must be easy to store, transport and safeguard as well.
This leaves very few suitable options. You can not store coal, oil, natural gas or even helium in your backyard. The only practical things to consider are gold, silver, platinum and palladium. Even silver is considered too bulky in comparison with other precious metals. But for average Joes who do not have a large net worth, silver is perfect as a safe haven asset.
In the near term, I am bullish on precious metal producers; I am bullish on natural gas and crude oil. But I am now bearish in coal. I called for the coal producer, James River Coal Company (JRCC), at $4, and then called for taking profit on JRCC at $60+. My calls were perfect. I called for JRCC to reach low $20-ish levels, and here we are today.
The bullish sentiment in the coal sector is still too strong. But the fundamentals of the US economy do not support a bullish US coal market. If a large amount of US coal is shipped to Europe, we might continue to see a bull market in coal. But the dry bulk shipping rate is collapsing, as reflected in the stock price of DryShips (DRYS). The falling dry bulk shipping rate shows there really isn't a lot of coal being shipping around the world. If investors are hoarding coal in their backyards, it might provide additional demand. However, I have not heard of any one hoarding coal at home.
I am seeing JRCC continuing to fall to low double digits, in the $10 to $12 range. If you are in JRCC, or into other US coal players such as Arch Coal (ACI), Alpha Natural Resources (ANR), Peabody Energy (BTU), Consol Energy (CNX), Foundation Coal Holdings (FCL), International Coal Group, (ICO), Massey Energy (MEE) or Patriot Coal (PCX), dump them on the next rally up. It's no longer time for a coal bull market. There are better bullish investments somewhere else.
The best commodity bull plays right now are precious metal producers. This is especially true since many precious metal players are now at ridiculously low prices. It's a basic supply and demand thing, and a big part of the demand now comes from investment demand.
So which precious metals provide the best value protection as well as the best potential for gain? That depends on current price relative to replacement cost.
Gold, I think, is currently the worst investment. Gold's current price allows most gold producers to be comfortably profitable. The huge above-ground gold stockpile means there is no lack of gold even if many producers go out of business. So gold does not provide very good bottom price protection here. On the up side, there is currently enough incentive for new gold projects to be developed, bringing extra supply to the market. But that limits the up side potential as well.
Silver is better than gold because the current silver price is unprofitable for many primary silver producers. The current silver price just does not provide incentive for new silver supply to come online. Further, according to USGS, the world's remaining silver resources will be depleted in about 13 years at current production rates. So silver has very limited down side here and much greater up side than gold. I have recently purchased silver players like Pan American Silver (PAAS), Hecla Mining (HL) and Apex Silver Mines (SIL).
But I think PGM metals, platinum and palladium, provide the best of all worlds. PGM source is pretty much limited to South Africa, Russia and two North American producers, Stillwater Mining (SWC) and North American Palladium (PAL). South Africa, by far the dominant supplier, produces 85% of the world's platinum and 35% of its palladium, saw PGM production collapsed due to the country's electricity supply crisis, which is a long term problem with no solution in sight. In August alone, their PGM production fell by 32.8% from a year ago, while 2007 production was also down significantly from 2006 levels.
The investment community has completely ignored South Africa's electricity woes and production decline, while totally exaggerating the demand setback in the auto catalytic converter sector and in the jewelry sector. In my last article, I pointed out that diamond demand is actually booming. That alone points to a higher jewelry-related demand for platinum and palladium. A loose diamond cannot be worn. It must be set in a precious metal setting, such as platinum and palladium.
Investors also forget that their own purchasing of the physical PGM metal constitutes a physical demand, on top of any industry demand. At current prices of $1,120 per ounce platinum and $230 per ounce palladium, this is pretty much a bottom price which is already below the replacement cost. None of the South African PGM mines can make a profit producing platinum at $1120 per ounce. Indeed, it takes 20 tons of hard rock ores and 5 months of total processing time to produce just one ounce of platinum?
Regardless of the precise industry demand figure, if the market does not begin to pay a better price, South African PGM producers will have to cut back production so the price will boost. That alone is a strong argument for investors to purchase platinum at the current price.
Platinum's sister metal, palladium, should be a better buy than platinum because it is currently only 1/5 of the price of platinum. Historically the prices of the two were close to each other, as these two metals are interchangeable in many applications.
Industry users tend to use more of the less expensive metal, reducing the price gap over time. Palladium-- which is mostly a byproduct metal though SWC and PAL produce it as their main product -- is way less price elastic, hence it has more explosive price rally potential. Palladium coins are now rare and hard to find. You should certainly buy any palladium coins you can find with a decent premium. Of course the better buy would be the producers themselves, SWC and PAL.
How do you decide on the valuation of these two palladium producers? Look at historical price figures. The performance of the two track each other at roughly a 3:2 ratio, with SWC being about 1.5 times the price of PAL. The price of PAL collapsed in November, 2007 after a catastrophic secondary offer dilutied the shares and provided an excellent short target to the naked shorter. Same story as what happened to Hecla Mining recently.
Consider that SWC still has lots of proven and probable mineral reserves, 23 million ounces worth of PGM metals, and the largely untouched potential of the gigantic stillwater igneous complex. Plus, they also have the opportunity to expand into the bullish chromium sector, while PAL's current mine is nearly depleted and they have yet to develop the rich Offset High Grade Zone. I think I would put a fair price ratio between SWC and PAL at roughly 5:2.
Nevertheless, both companies are a strong buy on the palladium play. Both stocks have been heavily shorted and heavily manipulated. The high outstanding short interests can not be safely unwounded, even at current low prices. Both companies have a very strong and patient majority or near majority stake holder behind them.
Behind PAL is billionaire investor George Kaiser, who has owned nearly a 50% stake for many years, presumably because he believe palladium has an extremely bullish future. If Mr. Kaiser wishes, he can easily lift up global palladium prices single handedly.
Behind SWC there's an even stronger player, a 54% stake holder, Russia's Norilsk Nickel (NILSY.PK), the largest palladium producer in the world. They took the trouble to acquire SWC in order to control over 50% of the world's palladium supply in the first place.
Their strategic aim is clear: dominance of the global palladium supply. If they wish, the Russians can name palladium's price. They have not, however, taken any action to boost palladium's price so far. But I believe a Russian checkmate is just a matter of time. They did not acquire SWC just to supply the world with cheap palladium at a price far below cost.
and I really cannot envision a market more bullish than that! Time to buy some SWC and PAL. They will be the investment of a lifetime. Mr. George Kaiser has been waiting patiently for nearly 10 years so I think I can wait for a few more months. I am hoping that SWC or PAL will suspend palladium sales at the spot market because it makes no sense for any company to sell products at a heavy loss.
They could even buy back palladium at spot price! Even Gold Corp (GG) has suspended an unprofitable mine due to current gold price. If either SWC or PAL suspend sales or buy back palladium from the spot market, things could get really fun really fast. The global palladium market is so narrow that anyone might squeeze the supply and pump up prices.
Disclosure: The author is heavily invested in SWC and PAL, and holds long positions in HL, UNG, NGAS, PAAS and SIL.