Prices of platinum-group metals have seen better days. Both platinum (NYSEARCA:PPLT) and palladium (NYSEARCA:PALL) have declined by roughly a third since the start of the second half in 2014. While platinum has fallen from around $1500 per troy ounce to $936, palladium has gone from about $900 to $608. The charts below for platinum and palladium show how prices have behaved the last two years.
Looking at the charts it's worth noting that while both palladium and platinum have declined, they have done so differently. The latter seems to be on a downward slope with persistent declines. On the other hand, palladium has held up better in comparison. A big chunk of its decline has actually come in the last three months. Prior to that, palladium prices stayed within a narrow range.
Why palladium and platinum have declined in price
There are several reasons why commodities, including platinum and palladium, have declined in value. An important factor is the appreciation of the U.S. dollar relative to other currencies. This pushes down prices because commodities are usually priced in dollars. The chart below reveals how the dollar has strengthened over the last two years.
Another factor contributing to weakness in the commodity sector is the perception that the Chinese economy is getting weaker. This is seen as bad news for commodities because China is a major consumer of commodities. Both platinum and palladium count China as their leading consumer. The concern is that a weak Chinese economy may lead to reduced demand for commodities.
Also playing a role is the fact that demand and supply for platinum and palladium is now pretty much in balance. While demand still exceeds supply for both metals, the deficit is not as large as before and is being taken care of by using existing reserves of metals above ground after recycling. The table below shows the supply and demand equation for platinum and palladium.
|(Unit: 1000 troy ounces)||2014||2015|
Source: Johnson Matthey
Although both platinum and palladium belong to the same family of precious metals and can be found in jewelry and so on, they're primarily used in industry. The two metals are used to reduce harmful emissions as an autocatalyst in vehicles. However, while platinum and palladium share some similarities, there are also a few differences between the two of them.
One difference is that palladium is preferred in engines using gasoline and platinum is preferred in diesel engines. The latter can be more fuel efficient than gasoline engines assuming they're properly designed. The drawback is that vehicles using diesel engines will generally cause more pollution than their gasoline counterparts.
This efficiency of diesel engines has helped make them popular in Europe in contrast to North America and China where gasoline is more common. Europe is actually the number one user of platinum if we only look at autocatalyst use in diesel engines. It's the popularity in China of jewelry using platinum which puts it ahead of Europe as the leading consumer of platinum.
Behind China, the second largest market for platinum and palladium is Europe and the United States respectively. This means that palladium is more tied to the U.S. market while platinum relies on the European market. The relative strength of the U.S. economy in comparison to Europe is therefore a current advantage of palladium over platinum.
Short platinum and long palladium
Recent allegations that Volkswagen (OTCQX:VLKAY) has been tampering with emission tests of their diesel engines is a negative for platinum. It's a reminder to everyone that diesel engines tend to generate more pollution than gasoline, a headwind for the use of diesel engines in cars and platinum by extension.
On top of that, gasoline engines are becoming increasingly more efficient in fuel use. Newer cars generally get more mileage per gallon than older ones, negating some of the traditional advantage of diesel engines. Hence, there's less reason to opt for diesel, at least when it comes to cars.
Furthermore, pricing of platinum is not likely to recover as long as the economies of Europe and China are perceived to be weak or getting weaker. If anything, platinum could decline even more along with the rest of the commodity sector due to several factors such as the elevated strength of the U.S. dollar.
Shorting platinum may seem appropriate under these circumstances. At the same time, commodity prices are volatile. Initiating a new short position can be risky when prices have already declined a great deal. Metals such as platinum could easily rally if only because they're oversold.
A short position alone is therefore not recommended. A more prudent approach would be to trade in pairs, a short position in platinum offset by a long position in palladium. In the event that commodities rally, a hedge should provide protection for a short position.
The underlying reasoning here is that palladium is likely to outperform platinum at this point. Gasoline engines should be preferred over diesel engines due to worldwide developments in environmental standards with a trend towards tighter restrictions on vehicle emissions. That's bullish for palladium at the expense of platinum.
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.