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Palladium Rally Is About More Than Just Autos

Palladium has been on a tear this year. Its spot price increased 45 percent year on year in the first half of 2017, and it now trades at a 16-year high. Although the rally has largely been attributed to the strong demand from the automotive industry, there’s a geopolitical risk premium baked into the price.

palladium 30 years price chart
Palladium 30 years price chart

Approximately 67 percent of palladium produced is used in catalytic converters, which convert up to 90 percent of the harmful gases in automobile exhaust to less noxious substances. Global auto sales, up 4 percent for the year, are driven by a global increase in SUV sales, the ongoing shift from diesel to gasoline engines in Europe (diesel engines alternatively use platinum), and tightening emission legislation.

Sales of autos fueled by petroleum have been particularly strong in China and India. According to Jeffrey Christian, managing partner of CPM Group, car sales in China have been “borrowed” from future years through the offering of rebates and tax cuts. In the first half of the year, auto sales in China rose 4.3 percent, to 13.4 million units, from a year earlier.

Palladium’s price has been lifted by the rally in gold due to its status as a haven in the wake of a North Korean missile launch over Japan, and the devastation caused by Hurricane Harvey. The price of gold tends to have an effect on the precious metals complex.

It also helps that semiconductor sales grew 19.4 percent year on year, to $187.91 billion in the first half of the year. About 12 percent of palladium is used in electronics. But the U.S. auto sector isn’t so rosy. July was the seventh consecutive month that U.S. auto sales posted a year-on-year decline, falling 3 percent, to 9.8 million units, from 2016. Nevertheless, palladium has geopolitics on its side, beginning with Russia.

On Aug. 2, Congress passed a bill approving new sanctions on Russia in response to its interference in the 2016 U.S. presidential election, as well as its human rights violations, annexation of Crimea, and military operations in eastern Ukraine. The measure substantially reduces the president’s power to waive or ease certain sanctions without congressional approval.

The bill lists 12 types of sanctions that can be imposed on people and entities that, for example, conduct “significant” transactions with Russian defense and intelligence agencies and invest or facilitate the investment of $10 million or more in the privatization of any state-owned asset that unfairly benefits government officials or their associates.

So far, Russia has been able to maintain stable palladium supplies in the face of international political issues. Yet since 2014, a bloc of nations — including Switzerland, Japan, Australia and Canada, as well as the European Union — has imposed sanctions against Russia.

Norilsk Nickel, a public joint stock company, is the world’s leading producer of palladium and nickel. Its key shareholders are two powerful Russian oligarchs: Vladimir Potanin’s Interros and Oleg Deripaska’s Rusal. Each reportedly owns more than 25 percent of shares.

Interros Group is one of the largest private investment companies in Russia. Deripaska has close ties to President Vladimir Putin and a connection to the American political consultant Paul Manafort, whom Deripaska employed from at least 2005 to 2009.

Norilsk Nickel reported that its palladium production fell 2 percent in the first half of the year from a year earlier, to almost 1.3 million metric tons. CPM’s Christian indicated that Norilsk’s stockpiling in the first quarter likely contributed to the tight market in May and June.

Although markets are fairly balanced, showing a small surplus, Norilsk said palladium consumption is expected to reach an all-time high of 10.8 million ounces, and is forecasting a deficit this year of more than 1 million ounces.

Why should palladium’s price be affected by the threats from North Korea, and potential military escalations in Afghanistan and the Middle East? Palladium plating is often selected over gold due to its high melting point and lower cost, for various types of connector applications used in defense manufacturing processes. Defense plating processes are used to protect military parts including detonators, avionics, missile components and aircraft engine parts, and offer such benefits as corrosion and heat resistance, electrical conductivity, and compliance with military specifications.

Finally, hydrocarbons are increasingly becoming a vital energy source by the military both in the U.S. and elsewhere, and palladium-based nanomaterials play a significant role in hydrogen purification, storage, detection, and fuel cells. While used sparingly in these technologies, it’s enough to still raise concerns about supply.

What could pressure palladium prices? First, a recession in the U.S. would drastically hurt auto sales. This scenario is unlikely as the Federal Reserve, closely monitoring employment and inflation, has moved from a more hawkish stance earlier in the year to a slightly more dovish one in recent weeks. Secondly, auto catalysts and other technologies can substitute palladium with gold or platinum, should palladium’s price exceed either. And both spreads are narrowing.

gold/palladium
Gold/Palladium chart
platinum/palladium
Platinum/Palladium chart

Third, China could end subsidies and tax breaks for auto sales, particularly if sizable defaults come into play. Finally, in the longer run, a move away from petroleum-based fuels in automobiles could reduce demand for palladium. While this transition is emerging, it will have only a marginal negative effect on palladium use in auto catalysts for many years.