Oct 19/15 – Time to buy palladium?

2015-10-19 2pm EDT  |  #Ford #palladium #platinum #Volkwagen

If you believe we are a scant few years away from a Elon Musk/Sergey Brin inspired world where self driving electric cars ferry us all around in some sort of Utopian Uber ride sharing environment, then stop reading. Actually you can keep reading because maybe you want to take the other side of my trade.

Although I think electric cars are nifty, I am not sure they are about to displace gas cars anytime soon. In my hometown of Toronto, I see plenty of Tesla’s. But they are more of a status symbol than a logical cost saving economic decision. Given their lack of range, pure electric cars will remain a niche for some time to come.

That doesn’t mean that hybrid cars will not gain in popularity. But hybrid cars still have gas engines, and they still produce noxious emissions. And those emissions need to be dealt with. Which brings me to today’s topic – catalytic converters. I know, pretty fantastic topic, huh?

But bear with me. I will tie this all in with the recent Volkswagen diesel scandal, and lay out some trades ideas to think about, but first we need to understand the evolution of the modern day catalytic converter.

Let’s start with what exactly is a catalytic converter. According to Wikipedia (and we all know there is no way Wikipedia is ever wrong):

A catalytic converter is an emissions control device that converts toxic pollutants in exhaust gas to less toxic pollutants by catalyzing a redox reaction (oxidation or reduction). Catalytic converters are used with internal combustion engines fueled by either petrol (gasoline) or dieselincluding lean-burn engines as well as kerosene heaters and stoves.

The first widespread introduction of catalytic converters was in the United States automobile market. To comply with the U.S. Environmental Protection Agency’s stricter regulation of exhaust emissions, gasoline-powered vehicles starting with the 1975 model year must be equipped with catalytic converters. These “two-way” converters combined oxygen with carbon monoxide (CO) and unburned hydrocarbons (HC) to produce carbon dioxide (CO2) and water (H2O). In 1981, two-way catalytic converters were rendered obsolete by “three-way” converters that also reduce oxides of nitrogen (NOx) however, two-way converters are still used for lean-burn engines.

Got that? Basically it is a scrubber for your car’s exhaust. Initially both gasoline and diesel catalytic converters were composed of platinum. In the late 1980’s scientists found ways to substitute cheaper palladium for platinum in the gasoline engine catalytic converters (due to diesels’ lower combustion temperature, the diesel catalytic converter still needs platinum). Ford was the first company to use palladium in their catalytic converter for their 1989 model lineup. At the time, palladium was trading for approximately 20% to 25% of the price of platinum, so this was a big coup that helped reduce the cost of creating these emission reducing devices. Unfortunately as the auto companies gradually switched to palladium, the arb disappeared. Not only did palladium rally to the same price as platinum, at the turn of the century, palladium eclipsed the price of platinum. Ford, which had been so instrumental in creating the demand for palladium, did what too many companies do in the face of a run away market – they panicked and made it even worse. Again according to Wikipedia:

In the run up to 2000, Russian supply of palladium to the global market was repeatedly delayed and disrupted because the export quota was not granted on time, for political reasons. The ensuing market panic drove the palladium price to an all-time high of $1,100 per troy ounce in January 2001. Around this time, the Ford Motor Company, fearing auto vehicle production disruption due to a possible palladium shortage, stockpiled large amounts of the metal purchased near the price high. When prices fell in early 2001, Ford lost nearly US$1 billion.

For the next decade, the price of palladium drifted lower as platinum went on a tear higher with the other precious metals. Although technically palladium is a precious metal, I have never heard anyone heading to the bank to withdraw their palladium in a financial crisis. In the depths of the 2008 crisis, between the worries about the economy and the lack of “preciousness,” palladium was once again $175.

There was also another factor affecting the demand for palladium. Although during the 2000s, Japan and the US were working on hybrid technology, European car makers cast their hopes in the diesel bucket. There was an aggressive push that “clean” diesel could provide the fuel savings that environmentalists were hoping for.

Have a look at how much the European diesel fleet gained share during this period:

There was a seismic push by the Europeans into diesel. The trouble for the price of palladium is diesel catalytic converters need platinum. So at the margin, the relative demand for palladium was falling.

Recently this has been balanced by the terrific US auto sales as the so called “sub prime auto boom” has exploded.

Yet the commodity collapse eventually brought down platinum and with it, palladium. In 2014 platinum went from $1,500 an ounce to $950. Palladium was over $900 at the high, but fell to $542 in the midst of the commodity carnage this summer.

You might look at this chart and say to yourself, it looks like palladium has more room to fall. The price of palladium has not fallen as much as platinum. But step back and look at the long term trend of the ratio of palladium to platinum.

This sure looks like a ratio that is making a long term base. I wouldn’t want to short this ratio, and the recent breakout looks like it might be the start of something bigger.

I promised I would talk about the Volkswagen scandal, so now that we know a little bit about catalytic converters and the different compositional elements, let’s figure out what this means in light of the recent cheating developments by our German friends.

Sunday night, I was listening to one of my tin foil hat podcasts and the hosts read a letter from someone in the car industry who claimed the Volkswagen cheating was a well known industry secret. Maybe I am too cynical, but after watching large banks bend the tax code with blatant derivatives that have no economic benefit except to arbitrage tax, I believe there are often cases where insiders across an entire industry know about abuses, but the public is ignorantly unaware. I think the Volkswagen case was one of these times, and there is a good chance they are not the sole car marker to cheat. Either way, it doesn’t matter. The hammer of public outrage will reign down on the industry. The first casualty will be the European diesel initiative. I don’t see how they can continue with this technology. The scrutiny will be intense, and it was already falling behind the hybrid option. So although there will be an initial spike in platinum for fixing of the existing Volkswagen diesel fleet, the long run demand for platinum (which is needed for diesel catalytic converters) will fall as diesel cars grow out of favour.

Then think about the other long run consequences. This scandal will increase demands for even greater stringency and more emission reductions, even among gas engines. The end result will be a greater need for even better catalytic converters. Unless you think gasoline powered cars are going away, the coming years will see much more demand for palladium.

We all know the terrible problem with pollution in China. Some of this is the result of much more lenient rules about emissions from cars. As China makes the transition from an emerging nation to a developed one, there will be increasing standards for their cars, and that will once again mean more demand for palladium.

Now, if you think solely electric cars will be the majority in the coming decade, then you should probably just go ahead and short palladium. However, given the recent collapse in oil prices, I think this reality has been put off even further into the future. In the mean time, the Volkswagen scandal has decimated the diesel solution, and the hybrid electric gas has become the clear winner. But don’t forget – these hybrids still need catalytic converters. And those catalytic converters need palladium. I am bullish on the Chinese car industry. I expect their wealth has hit a point we will get exponentially growing demand for automobiles. All of this adds up to increased palladium demand in my books.

Thanks for reading,

Kevin Muir

the MacroTourist