Physical Platinum Shares ETF: Defensively Preserving Capital

| About: ETFS Physical (PPLT)
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Pt (Platinum) had a high for the week, around 1805 $/toz, sank to 1670, and recovered to 1715 on Friday.

YTD, PPLT is -0.05%.

The reason for my emphasis on Pt, (as the ETF PPLT), in an investment portfolio is that I think it fits the criteria for preservation of capital, while still giving an upside for returns, better than any other investment. This is due to the concept of strategic defense in depth, or multiple redundancy, applied to investments. In this application, I look for investments that have multiple ways to work out, so if any one of them fails, others may play a role in protecting capital or providing a positive return.

The four lines of defense, or offense, for platinum prices to rally around are:

1) Devaluation of the dollar: mathematically certain, timing uncertain.

2) Cost increases of supply: these inevitably must be reflected in prices received by producers or supply will fall to the point where prices balance costs. Many developments on this front, but the basic thesis is that Pt is the first major industrial commodity to reach peak production for the history of the world. That is, the 2006 peak of production will never be surpassed, and it will take constantly rising prices to maintain a plateau of production.

3) Political forces: these will play a role in increasing the required rate of return on long term capital projects or directly affect production. Basically, this is a fight over a diminishing asset base. Peacefully this takes the form of high labor cost increases, higher taxes and royalties, and higher levels of regulation. The more violent forms are nationalization and even wars of an economic type.

4) New demands: New technologies and the ever changing economic landscape create new demands due to to Pt's unique elemental properties and man's creativeness.

Relative to the four lines of defense in depth, above:

1) S&P downgraded US debt from AAA to AA+, in spite of intense lobbying and political pressure. Economies follow a cycle where banks create new money in response to investor interest in borrowing money, the investment of this money creates rising prices, employment, GDP, and good times, which causes more demand for loans, etc. Then the cycle reaches its peak, investments fail, banks stop lending, prices fall, unemployment rises, bad investments are liquidated at prices significantly below bank loans, etc.

At this point in the cycle governments step in with a variety of economic support measures, i.e., support for unemployed people, buying bad assets from banks at full value, and increase in the size of Fed payrolls. This is where we have been since 2008. As a consequence, the Fed has tripled the size of its balance sheet, the US Government is running a 40% budget deficit with debt/GDP going ballistic, and many states are selling huge amounts of debt. The debate on the debt ceiling only shines a spotlight on this process, where the next-in-line-too-big-to-fail entity becomes the US government, since they're bailing everyone else out. As these risks become evident to investors, gold and other precious metals become sought after as monetary assets that are not conditional upon counterparties willingness or ability to pay claims.

2) I just finished reviewing a 150 page document issued by the USGS (US Geologic Survey) in 2004 on platinum and palladium. In this document the forecast level of world production of Pt for 2010 is 10 million oz/yr. Actual production was 6.1 Mtoz. What happened? Peak Platinum in 2006. The compound rate of cost increases over the last 5.5 years for Anglo Plat is 13.6%/yr. According to the rule of 72, this means costs are doubling every 5.3 years. As the resource base is depleted, new mines are going after either lower grade ores near the surface or quadrupling capital expenditures on 1.5km deep mines that take six years just to bore the shafts.

Labor rates have been increasing at inflation + 3% as workers want a bigger piece of the pie. Safety stoppages for deaths are reflecting changing values and work practices, as the lives of laborers are given higher value. Electricity costs have been compounding at 25%/yr. as international demand for coal, the nationalization of SA's electricity industry, and cost pressures for new plants work through the system. In addition, as the productivity of old Pt mines declines, overhead per unit of output increases. And the higher capital or depreciation charges from new deep mines are hitting the income statement as these mines are brought on. None of these factors is expected to change for the foreseable future.

3) The famous quote that "war is politics pursued by other methods" can be applied to the nationalization process and debate taking place in SA and Zimbabwe as "nationalization is politics pursued by other methods". I really think the political bosses of these countries realize that between them they control around 90% of the world's supply of Pt, and intend to nationalize the industries, and use them as a base to extend political power.

The history of all nationalized industries is that output falls as capital efficiency is sacrificed to other goals, such as employment or transfers of money to politically connected parties. Take Venezuela as the role model, first - a populist leader rises to power promising increased social benefits, second - assets are nationalized, third - China is brought in as a new deep pocket investor, and fourth - production steadily falls. This model can be superimposed on the nationalization discussions of Zimbabwe and SA.

4) New demands. Two of note: 1) those positively correlated with crude oil, i.e, diesel engine catalysts and ultimately fuel cells and 2) those positively correlated to gold prices, i.e., Pt demand in China and India for wealth preservation and display. The fuel cell story is 10 years away, and will take another doubling in hydrocarbon fuel prices to become really significant. The US is still pursuing a hybrid/battery strategy for engine efficiency but in many parts of the world mini diesel cars, with their significantly lower cost, are winning consumers over.

Even in the US, VW reports sales of diesels in July are up 24% versus last year. The investment/jewelry demand in China is huge, for 2010 consuming 27% of world mine production of Pt, and that is based on data from when the Pt-Au spread was $300+/oz.. Consumer tastes are regional, and the Far East (Japan + China) regard platinum as a "purer" metal than gold, with higher status. As the differential between gold and platinum has collapsed in the last several months from 300-400 $/oz to only 50 $/oz on Friday, the substitution of platinum for gold in jewelry and retail investment demand could be a huge effect. If 5% of the India + China gold jewelry demand shifted to Pt, it would add 25% to world Pt demand.

So while it has been central banks and large institutions fleeing the Euro, European banks, and US dollars as the West's credit cycle spirals downward that have driven gold demand, it may be small retail buyers in China and India that transfer this to Pt demand. The US consumer and investor is hopelessly linked to faith in the dollar and the current too-big-to-fail institutions, and his wealth will be destroyed as this mouse-click money and its dependent institutions fail, while the China + India segment of the world rises, along with the value of their preferred metallic monies.

Bottom line:

Defense in depth is a comforting thought.

Disclosure: I am long PPLT.