Some True Safe Havens Are Still (Surprisingly) Undervalued

by: Mark Anthony

All investments are about buying something at a lower cost to get a higher return later. Therefore, investors should try to understand the value of things they buy and sell. Warren Buffett said you should never buy something that you do not understand. At a time of crisis such as the one we face now, in order to survive and prosper, investors must have a profound understanding of values not just of things physical, but of non-physical things as well.

In my last article, I discussed why physical things have intrinsic value and how they are determined. This article is meant to be a sequel, so I shall continue by discussing the values of non-physical assets. Such discussion is urgently needed, and is made even more relevant today due to the unfolding global financial crisis and the Bailout Fiasco.

Our current financial and credit crisis is like the black hole that Albert Einstein predicted. A black hole is formed when a huge mass is packed within a very small volume. A black hole's gravitational pull is so strong that it sucks everything and not even light can escape.

A black hole will keep growing bigger as it keeps sucking in more matter. When the Large Hadron Collider was recently turned on to search for a ghost particle called Higgs, some feared it could generate a black hole which could swallow the earth. But instead of swallowing the earth, the LHC merely spit out a ton of helium before it was shut down, possibly for good, as nations throughout the world can no longer afford giant science projects like LHC.

But the real black hole that threatens our survival is in the global financial system. The hole in this case is something that Warren Buffett called "Financial Weapons of Mass Destruction", the so called OTC Derivatives, a thing that no one really understands.

It's such an enormous monster that by some estimates there's $1.14 quadrillion worth of them. That's a ONE followed by FIFTEEN(15) ZEROs.

US$1,140,000,000,000,000 in OTC Derivatives! Where exactly is this huge amount of fortune physically located? This huge amount is actually nothing but some digits stored on some 3.5 inch hard drives within some computers somewhere on Wall Street. That, my friend, is the precise definition of a black hole, a giant mass stored within a tiny space.

This black hole is swallowing everything around it, starting small and growing exponentially bigger. First it was New Century Financial (OTC:NEWC), then Countrywide Mortgages (CFC), then Bear Sterns (NYSE:BSC), Lehman Brothers(LEH), Merrill Lynch (MER), Fannie Mae (FNM), Freddie Mac (FRE), IndyMac Bank (IMB), Washington Mutual (NYSE:WM), Wachovia Bank (NASDAQ:WB). Who knows what's next! Now the US Congress wants to toss in trillions of dollars in a Bailout? Do they understand that you CANNOT feed a black hole?

The ongoing financial crisis is not a housing bubble or sub-prime mortgage crisis. It is not even a liquidity or credit crisis. Mr. Karl Denninger sums it up best in a 10 minute long video which all Americans need to watch and think about carefully: IT IS A CRISIS OF TRUST.

Let me emphasize the keyword TRUST, because TRUST is the very reason any non-physical asset has value at all. It is also the reason why people must seek physical assets as the only trustworthy safe haven assets during times of crisis.

It's easier to understand that physical things have intrinsic values because it costs something to produce physical things. When demand is high and supply cannot catch up, people go to extra lengths to produce more at higher cost in order to meet the demand, and so the intrinsic value, as well as price, goes up in response.

Do non-physical things have value? They do. If you lend some money to your neighbor, you want to make sure your neighbor will pay you back. There is a promise that you will be paid back. You trust that promise, so it has value. The promise could be in any form: a notarized contract on paper, or just an oral promise, or merely mutual trust. As long as there is trust, the lending relationship has an intrinsic value based on that trust. But when there is no trust, a legal document is just a piece of worthless paper.

Lots of things in the economic cycles rely on trust and retain their value based on trust: loans, business contracts, agreements between nations. Without trust, the contracts written on paper are worth less than the ink and paper they are written with. Without trust, relationships cannot exist. Without trust, marriages may break apart; organizations may disintegrate; financial systems may collapse and great nations may fall.

TRUST is THE single most precious thing in human society, bar none!

The US dollar is just a piece of colored paper. Does it have intrinsic value? I say it does have intrinsic value.

The dollar's intrinsic value is not in the physical ink and paper, but in the trust that it represents. The value of the dollar is backed by the "full faith and credibility" of the US government.

In the past, our government did have pretty good faith and credibility. It was so trusted that the US dollar is the world's reserve currency and central banks felt more comfortable holding dollars instead of actual gold as their reserves.

But we have destroyed that trust and credibility by our chronic reckless fiscal policy of debts and spending, from the top level leadership all the way down to average Americans. We spend way beyond our means, accumulate debts way beyond our ability to pay them back.

That destroyed our credibility and trust. That is the root cause of today's crisis, the systematic destruction of TRUST in the system, at all levels.

The US dollar is doomed. The only thing that can salvage the dollar is restoring the trust that the dollar is based on, by paying off our foreign debts using honest money, and then living within our means. I don't see anyone discussing that solution, and I don't see how it can be done, physically, without breaking the back of our nation.

The US dollar is doomed, with or without the $700B bailout. Even restoring the gold standard is not going to help the restoration of the dollar. The world simply does not have enough gold to back the amount of dollars in circulation, and our gold may not even be in Fort Knox any more.

The dollar's reputation can only be based on TRUST, something infinitely more valuable than gold, but something that has been systematically destroyed over a long period of time.

When there is no longer trust in the system, you must get rid of any and all paper assets whose value is based on trust, and that means the only assets that are safe are those whose values are not based on trust: physical assets under your full control. Their values are derived from the mere fact that it costs something to produce them in the first place.

But when it comes to safe haven investments, I must reject the misconception and hype some gold or silver bugs are attempting to inject into people's mindset. Notions that portray gold and silver as money and hence the only good safe haven investment. Folks who bought gold at the $800+ peak in 1980 lost heavily instead of found safety.

To avoid mistakes like the 1980 gold and silver mania, one must be able to correctly judge a physical asset's true intrinsic value, with all sentiment and hype removed. Read my previous article on that discussion. A physical asset's intrinsic value is its replacement cost, no more, and no less, and no sentiment or opinion attached here.

Some clarification is needed to the principle of intrinsic value as cited in my last article. Let me revise it as follows: A Commodity's Intrinsic Value is Equal to its Marginal Production Cost.

The cost varies when different producers produce the same thing. Marginal production cost is the cost of the most expensive supply source needed to meet demand. For example, the world consumes and produces 85M barrels of oil a day. 60M barrels come from oil fields at a cost of only $5 a barrel; 20M barrels come from oil fields where the cost of extraction is $50 per barrel; the last 5M barrels come from marginally producing fields where the cost of extraction is $100 per barrel.

What do you think the intrinsic value of oil is, then? We have to pay $100 or more to make it incentive enough for the marginal, 5M barrel fields to keep producing in order to meet the world's 85M barrels a day demand. So the fair value of any commodity is always priced at the higher cost of marginal producers that's needed to balance the supply and demand.

All physical assets more or less serve as safe haven assets, where trust based paper assets cannot be trusted. The only consideration is their current price relative to their replacement cost, and the difficulties and costs in guarding, moving, storing and preserving those assets.

All precious metals have excellent properties in that regard due to their durability and high density value in compact sizes. They are preferred choices as safe haven assets. So which one is the best buy boils down to the question of current price relative to their intrinsic value.

Based on what I know, gold's current price is enough to keep most of the world's gold producers happily profitable. So gold is currently priced fairly. There is not much room for gold to gain in terms of real purchase power. Not to mention the world has a huge stockpile of above ground gold, enough to last the world for hundreds of years.

I expect the majority of people will continue to run towards gold. But I insist that gold is definitely NOT the best safe haven assets to buy today and I feel comfortable holding that minority opinion, as the majority in the market place is always wrong. For this reason I never bought GLD.

Silver is a bit different. 70% of the global silver supply is produced as a byproduct from base metal mining. Only 30% of silver is produced as a main product. Primary silver producers I monitor include Pan American Silver (NASDAQ:PAAS), Silver Standard (NASDAQ:SSRI), and Hecla Mining (NYSE:HL).

Based on current silver prices, I hardly see these primary silver companies making profits. Some silver companies have already started shutting down unprofitable mines. Moreover, even those mining companies that produce silver as a byproduct are now unprofitable, due to rising costs and weaker pricing of their main base metal products.

As these companies are forced to reduce or shut down their base metal operations, it will also reduce the silver supply. So silver is definitely under-priced now and it is a better buy than gold.

But platinum, especially palladium, is extremely under-priced now, if you understand who produce these metals and what their cost bases are, and particularly if you understand the continuing South African electricity crisis. South Africa produces 85% of the world's platinum, and 35% of its palladium.

According to a recent survey, SA's PGM industry average cash cost is about US$1000 per ounce basket PGM metal (60% platinum, 35% palladium and 5% rhodium). That was based on one year old data.

Today, due to the high inflation rate in SA and US dollar depreciation, the cash cost is probably close to $1200 per ounce basket metal. Adding administrative overhead costs, the total operating cost is probably somewhere in the neighborhood of US$1350 per ounce basket metal.

Today's market price of the basket PGM metal price is $870 (=$1000*60% + $200*35% + $4000*5%). That's way below the $1350 needed for profitability of the SA's PGM mining industry.

No business can operate with heavy losses indefinitely. The market must soon start to pay better prices, or SA will be forced to reduce production or shut down mines. I am wondering why they have not already done this. It would help ESKOM to reduce its electricity load and boost its profits! But I think it is only a matter of time before they will do something.

When it comes to palladium, the world's largest producer is a nickel mine in Russia, Norilsk Nickel (OTCPK:NILSY); its main products are nickel and copper. Let's look at their cost basis. In 2007, the Norilsk mine's total operating cost was US$8.5B while metal sales revenue was US$14B.

Using today's depressed metal prices, the metals would sell for only US$7.7B, while inflation would bring the cost higher to US$10B, making Norilsk totally unprofitable today. Norilsk's share price plummet reflects the reality of heavy operational loss at current metal prices.

Not to mention the incalculable cost of environmental destruction, as Norilsk is ranked No. 7 on the list of the TOP TEN most polluted places on earth, contributing 1% of the world's sulfur dioxide emission. The pollution is so bad that there is not a single live tree or fish within a 20 kilometer radius from the mine.

Why should such a heavy polluter continue to produce, if it can not at least turn a profit? Mr. Alexander Bulygin, RUSAL CEO, after visiting the site recently, issued an open letter referring to the environmental situation there as on the "brink of catastrophe".

According to information that Jack Lifton discussed in his article, shutting down the now unprofitable Norilsk mine, and thus eliminating 45% of global palladium production, is now quite a strong possibility.

A news story that appeared on Sep. 30, mentions that Mr. Anton Berlin strongly hinted at Norilsk's intention to cut production soon in response to weak nickel prices, further enhances such a possibility.

I first mentioned Mr. Anton Berlin on June 12. At that time his comments caused a knee-jerk reaction in the global palladium market.

If Mr. Oleg Deripaska, who currently owns 25% of Norilsk, gets his way and shuts down the Norilsk mine to clean up the pollution and wait for nickel prices to recover, it will be the ultimate Russian Checkmate to the global palladium market.

Could such a Russian Checkmate happen? Could it not happen?! Why should the Russians continue to produce this environmental catastrophe, at a heavy operational loss, and for how long?

We are talking about a narrow market where industrial demand already exceeds supply, and now 45% of that supply is further removed. I can't even imagine how high palladium prices would go.  Remember, it took less than a 4% shortage to jack up rhodium prices from $300 to $10,000!

In 2004, Norilsk acquired a 54% stake of Stillwater Mining (SWC), America's ONLY producer of platinum group metals, strategic materials of extremely critical importance to the nation's security, especially at war time, after some highly political negotiations involving Bush and Putin.

Norilsk promised it was a purely non-political business deal. There is no Russian face on the board of SWC. But Norilsk's strategic aim of dominating over 50% of the global palladium supply is crystal clear.

Are the Russians going to use their monopoly power for profit, or would they rather act like a Santa Claus, operating a global charity organization, polluting their own fatherland and providing the world with cheap palladium at a price far below cost? The answer is clear.

In light of the recent plummet of platinum and palladium prices, I have never seen a commodity market so completely rigged to the opposite of fundamentals, defying every logic and rational. Palladium is now so under-valued that if you look around the world, there is not a single palladium producer who can produce the metal and make a profit: not Norilsk, not any South African PGM mine, not SWC and certainly not North American Palladium, (PAL). They are all producing at potentially heavy losses now. This is not the normal affair within any market.

Can you name another commodity that is being produced as a significant loss by every single one of its producers in the world ? Have you seen another commodity price chart like this one, or this one, where prices shot up in a straight line and then fell down at a perpendicular?

The excuse is lack of recent ESKOM news, so people assume South Africa's electricity crisis has been fixed. I know better.

Another excuse is the slow economy and high gasoline prices which have suppressed auto sales and reduced PGM metal demands in the auto catalytic converter sector.

However, globally, auto sales are still growing due to strong demand in emerging economies offsetting any fallback in Western markets. According to General Motors's (NYSE:GM) own data, in the US market, at the retail level, even though GM delivered fewer vehicles to dealers in September compared with a year ago, retail sales were 303,300 in September, up from 255,744 last September. That is 18.8% up y-o-y.

The credit crisis forced auto makers and dealers to massively reduce inventory, but people still require vehicles for their daily needs. Higher gasoline prices increase demand for new, fuel efficient cars as people decide to junk their oil guzzlers. Even for those people who decide to hang on to their old vehicles longer, the catalytic converter in their vehicles will be unavailable for recycling, so it wouldn't change the PGM supply/demand balance.

Moreover, the lesson from 1980 is that although auto demand collapsed that year, platinum and palladium prices nevertheless ran to a peak alongside gold and silver, as investors at that time hoarded all precious metals as safe haven assets. When there is significant investment demand for the physical metals, the industry demand becomes a moot argument.

Absurdity is now the norm of the marketplace. Take, for instance, the global coal market which I discussed on June 20th; the global coal supply and demand is largely balanced, and there is abundant coal reserve. Yet, the coal price managed to triple in just a few months, and called for people invested in coal stocks, like ACI, ANR, BTU, CNX, FCL, FDG, JRCC, to take profit.

The call was proven to be timely. The plummeting dry shipper stocks, like DryShips (NASDAQ:DRYS), suggests there is not a lot of coal being shipped across the oceans, so the US coal market remains a local market.

Amid a looming US economic depression, I see the US coal market as bearish in short to mid-term. Get out of any coal stock at the next rally. I am seeing JRCC dropping to the low $10-ish, for example.

Natural gas is a different story and remains bullish due to fast depletion of conventional natural gas sources, and the drop of imported LNG volume. I own some NGAS (NASDAQ:NGAS) and UNG (NYSEARCA:UNG) by the way.

Needless to say I am still heavily invested in SWC and PAL, two of my favorite palladium stocks, and I suffer heavy losses in them. I have repeatedly checked my original thesis of a palladium super bull market, but cannot find anything wrong with my assumptions.

I still believe this is one of the best investments I can find in the short term, so I am sticking to my convictions. Isn't it strange that today, logic and rational thinking have been replaced by manipulation, distortion and absurdity? Otherwise we would not have a global financial crisis such as what we are seeing today.

In the end, things will have to return to the laws of nature as it meant them to be. As billionaire Mr. George Kaiser is still patiently holding nearly a majority stake in PAL, I think I have the patience to wait for nature to return to its normal course as well.

Disclosure: The author is heavily invested in SWC and PAL, and also owns OMG, SLV, PAAS, HL, SIL, NGAS and UNG.