Gold has been blogged and bandied to death

(Futures Magazine) -- Boris Schmitz-Thiersen’s family has been selling jewellery in the same location in Cologne, Germany, for more than 100 years, with a brief sabbatical during World War II. Only in the past year, however, has he begun offering bracelets made of a peculiar white metal mined in South Africa. “It’s pure palladium,” he explained. “Pretty, isn’t it?”

Yes – and relatively cheap, trading around $450 per troy ounce at press time, compared to just under $2,000 for the same amount of platinum, and about $1,000 for gold. Silver, by contrast, is trading at between $17 and $18 per ounce.

Schmitz-Thiersen’s decision to peddle palladium instead of platinum is one of those quirky little flips of the mind that, if multiplied by all the jewellery stores in the planet, could have major ramifications for the price of these two most precious of metals, and a quick perusal of Cologne’s jewellery shops indicates the minds are, in fact, turning over.

Samantha Trickey, precious metals consultant at the Commodities Research Unit (CRU) in London, points out that jewellery currently accounts for about 20% of total platinum demand, but that, unlike gold, platinum and palladium are primarily industrial metals and not stores of value.

“If prices of platinum get too high, you could see a substitution on the industrial side to palladium,” she said (see “Precious industrials”). “This is why I’m more bullish on palladium than I am on platinum.” Yet it is platinum’s secondary function as a precious metal that is driving prices to the stratosphere, along with a rickety South African electricity grid.

Most coverage of gold’s rise focuses on two factors: the plunge in the U.S. dollar and a general fear of exposure to paper assets. Less attention has focused on the supply side of gold and silver, but more of platinum, palladium and plain old copper.

“In South Africa, the main power supplier, Eskom, has run out of reserve capacity, and this has caused rolling power cuts,” Trickey said. “Many platinum and palladium mines had to close temporarily at the end of January, since power could not be guaranteed, and this posed a safety risk, especially for the underground mines.”

As a result, mines are operating at just 95% capacity, at a time when industrial demand, primarily in China, remains at full throttle. “They’re able to operate on that, but companies are looking at ways to find individual power sources of their own,” she said.

Palladium, thanks to these and other factors, rose from less than $200 per ounce in March 2003, to nearly $580 in February this year (after a one-month surge of about 40%), before settling down to its current mid-$400 range.

Supply concerns also are dominating the copper market. “The supply side seems to perennially shoot itself in the foot, and so far in 2008 it seems to have shot itself in both feet,” said Trickey’s colleague, Allan Trench, who is CRU’s research manager for copper. He said many of the bullets hitting those feet left their chambers in the 1990s.

“You had a lack of investment then due to low prices. But when that changed, you had all the usual quick fixes being implemented, like expanding leach tanks and debottlenecking the crushing circuit, or putting an extra shovel in the pit in cases where an operation was pit-constrained,” Trench said. What didn’t happen was significant re-tooling.

“As a result, everyone is doing the same thing at the same time, meaning maj or expansions and new projects and suppliers are swamped.” He cites a litany of statistics: tires that could have been delivered in four months three years ago now sometimes need almost two years to arrive. Trucks that would show up in three months now need two years. “You know how they’re dealing with this?” he asked. “They’re driving slower to maintain tire life.”

Analysts seem at odds over the short-term prognosis for platinum, which recently traded up to $2,276 per ounce before settling down to its current range just below $2,000.

The consensus on its poor cousin, palladium, however, is strong — largely because of the paradox that, as with platinum, most of the factors that can make demand for the metal go down actually make it go up. In other words, the factors that hurt demand for palladium as an industrial metal actually help it as a precious metal, and vice versa — at least, that’s the perception. A global deflationary trend would, in reality, drag down the price of both precious and industrial metals.

But in reality, South Africa’s electricity problems and strong industrial demand are only half of the palladium story. The other half is gold and platinum. “Economic news from the U.S.A. seems to be pushing gold around, and that’s also having an effect on platinum on a day-to-day basis,” Trickey said. “Given platinum’s stellar performance so far this year and the risk to the supply side, this should continue to be supportive for palladium.”

This quarter, she sees platinum averaging between $2,000 and $1,900, with palladium remaining in the mid-$400s. In the second half of the year, she sees prices dipping for both.

“I’m expecting platinum to be around $1,800 in the second half of the year, and for palladium to be below $450,” she said. “This is actually higher than we previously projected, because our earlier figures included a number of uncommitted South African mining projects that were scheduled to come online towards the end of this year and in 2009. Now many of these projects are rethinking their strategy based on the energy situation.”

Gold has, of course, been the headline-grabber over these past few months, and what can you say about the yellow metal that hasn’t already been blogged and bandied to death? It’s risen 55% over the past year, topping out above $1,000 per troy ounce before settling back to $900 at press time.

Gold bugs — those ‘end-of-the-worlders’ who seem to materialize by the thousands whenever the global economy shudders — are justifiably happy. But are their doomsday scenarios justified?

Bob McKee, chief economist at Independent Strategy, doesn’t think so. He started getting long gold between $330 and $350 in 2003 (see “Golden opportunity”), citing three drivers that, in hindsight, are clear to all: the current account deficit’s pressure on the dollar, growing political uncertainty and an impending reversal of the liquidity boom.

All three remain in effect today, and the same counter-arguments are being offered now as then, at least as far as the dollar is concerned. “Some people argued then that money flowing into Asian economies would be recycled into dollars,” McKee said. “There’s some truth to this, but there is also a growing pressure to diversify.”

One counter-argument petered out three years back: namely, that the world’s central banks would dump tonnes of the yellow metal on the market if it ever began to overheat. “Up until three or four years ago, that was a real concern because the central banks still saw gold as a dead thing,” he said. “But they have done their dumping, and have no more left to sell.”

The other drivers have only gotten stronger, and the question now is whether they have become so strong that the market has already discounted them. McKee doesn’t think so.

“We still have some room to go in all three drivers,” he said. “Assuming that the U.S. economy went into recession this last quarter, and knowing that recessions tend to last nine to 12 months, we can expect dollar weakness to continue for at least the next two quarters.”

Then, he said, just when the United States begins to pick up steam, the other OECD countries could be slipping into recession with low interest rates sparking fears of inflation. His recommendation: hold your gold for now, but don’t expect the vertical trend of the last year to continue.

HSBC analyst James Steel is also gingerly bullish but warns the end could be near.

The bullish argument comes from the safe haven argument. “There are no reliable estimates of how much “toxic debt” remains in the (mortgage) market and how that debt is distributed,” he wrote in a mid-March newsletter.

“Regarding precious metals prices, there is also the separate but related question of whether a commodities bubble is in the process of bursting,” he added. “Although the commodity rally is in part related to the credit crisis, in that the crisis has undoubtedly encouraged substantial purchase of hard assets, commodity prices, including precious metals prices, are also subject to a slew of other factors.”

Specifically, he warns of a divergence between commodity prices and economic growth: prices can’t keep going up if the economies of the world are slowing down. “We believe the slump in commodity prices is evidence that investors are reassessing likely commodity demand levels, and therefore also prices, after the recent run-up,” he said.

With copper hovering above $8,000 per tonne ($4 per pound) and metals like gold and nickel breaking long-respected milestones, the question on copper traders’ minds is whether the metal can breach the once unheard-of price of $10,000 per tonne. In the most recent edition of his “Copper Monitor,” titled “High Prices: Market Flavour or Fundamentals?,” CRU’s Trench identified 10 events that would have to happen for that level to be breached.

The five that are necessary (condensed to four for brevity) to stay above $8,000 are: Chinese consumption maintains double-digit growth, U.S. consumption holds steady, Chilean and Central African supply remains clogged and ‘non-fundamentals’ like market sentiment remain strong.

Five events that are necessary to get above $10,000 (also condensed here) are: some sort of nationwide supply catastrophe like the one that has impacted South Africa, a flurry of ‘micro’ supply disruptions, developing world demand growth outpacing developed world contraction and hedge fund lemmings going bonkers over the stuff and buying it like mad.

“The first five are already over the line, which is why we’re at these levels,” Trench said. “It’s like we’ve completed the pentathlon and now want to see if they can do the decathlon.”

Of the questionable five, he said number six, a nationwide catastrophe like the one that has befallen South Africa’s mining industry, is the least likely to take place. “That’s something you get once every few decades,” he said. “The others have a fair chance of coming through.”

And, he might add, “once every few decades” isn’t as much of a long shot as it may seem.