Profiting from the “Commodity Carry Trade”

by Travis Johnson, Stock Gumshoe | June 19, 2009 4:59 am

This article was originally written as a Friday File[1] for the Stock Gumshoe Irregulars two weeks ago, on June 5. It has been slightly edited, but not updated for current prices (the stock teased is down significantly from that date, the commodity in question is also down a little bit).

How about another sexy teaser about a rare commodity that has strategic importance, that China[2] will be buying, and that’s mined in the US? And no, it’s not rare earth minerals or cobalt[3], though we’ve also seen many a teaser for both of those lately, too.

The ad comes in from Andrew Snyder[4] for his TFN Strategic Trader[5] newsletter, and this is how it begins:

“China wants its money back… any way it can!

“— This could be the largest transfer of wealth in modern history —

“This is your chance to rack up 1,389% gains from the ‘COMMODITY CARRY TRADE!'”

So you can already tell that they’re playing off Tim Geithner’s trip to China (and the fact that the Chinese students laughed at his assurances of the safety of their dollar holdings), and the recent moves by China to begin, albeit gradually, diversifying away from the dollar.

They do this in many ways, of course — baskets of currencies and gold[6] are the main reserves they seem to be switching to … but they’re also spending some of their reserves, not just to stimulate their economy at home but to buy up natural resource caches around the world. Not everyone loves this, as seen by Rio Tinto’s turned back to Chinalco just today, but it seems unlikely to stop in the near term.

Here’s how Snyder pitches the scenario:

“China is fed up and rightfully scared it’s going to lose its money.

“This notion has launched the start of the “Commodity Carry Trade”, or CCT for short. It’s one of the largest wealth-exchange mechanisms in history.

“The CCT doesn’t involve gold. The CCT has nothing to do with silver[7]. And forget what you heard about copper[8]. The CCT is about something even bigger, even more economically important.

“The metal that the smart traders are buying is central to China’s long-term wealth. It’s the keystone of the CCT.

“Let me take a minute to fill you in on the details…

“Every time America has a deficit it needs to finance (about twice a week these days), the Treasury picks up the phone and calls China. It knows Beijing has no choice but to buy.

“Due to China’s huge export surplus, it gets stuck with an incredible amount of American dollars. In fact, China needs to lend Americans enough money to buy China-made goods!

“Until recently, China was fine with transferring that money back to the States by purchasing our debt. But then America got carried away…

“This year, Washington printed $2 trillion worth of brand new money.

“And China fired up the CCT ….

“Instead of giving hundreds of billions of dollars to the deadbeat American government, it’s now putting the money into the free market, buying something it can later sell to domestic industry.

“As long as China buys American commodities, it can exchange its surplus greenbacks for something it can actually use. No more I.O.U.s from Uncle Sam.

“As you’ll see, it’s doing it in record numbers.

“Take my word (that’s all a man’s got), the CCT is about to erupt like we’ve never seen before.”

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So … we can quibble with at least one of those connections (the American commodities bit) in just a moment, but let’s first figure out what that metal is, and how Snyder thinks we should profit from it’s rise.

“Eight truckloads a year… that’s it.

“Remember I told you this CCT metal was extremely rare? Well get this…

“This vital metal is so scarce only about 300 tons of it is traded each year. That’s just eight truckloads to be spread across the entire globe.

“No wonder experts are predicting record-shattering prices.

“If just one country (or even a company) gets greedy, its value will soar.

“That’s what happened in 2001 when Russia[9] (one of just three countries with major reserves) played hardball with its stockpile. Prices hit incredible new records.

“Imagine what’s about to happen as China drops the CCT into high gear and buys the metal like it recently did with copper, zinc[10] and lead.

“I’ll tell you what’ll happen…

“One company’s $5 share price will absolutely explode. Its options[11] will follow through with gains of several orders of magnitude.

“I’m predicting gains of 1,389% from today’s prices….

“For over three years, I’ve been studying one tiny American miner that has a virtual lock on this market.”

And this is not just a play on that company, but on the options for its stock …

“The options I’m recommending are far from liquid. Only a handful of investors will be able to get in time to make the kind of money I’m talking about.

“That’s okay, as long as it’s you!

“…shares of this $500 million company are going to be the hottest commodity around.”

And then there’s just a little bit more for your reading pleasure:

“There are just three countries in the world with sizeable reserves of this rare and extremely valuable metal: Russia, South Africa[12], and the United States.

“Fortunately for us, China absolutely has to buy its supply of this metal from the States. If not, the CCT would not work and Beijing would be stuck sitting on an ever-deflating pile of American dollars.

“Its only option is to use the CCT to cash in on commodity profits. It needs an American commodity that’s actually worth something.”

So, ready for your Gumshoe to pull back the curtains? First, I’ll tell you what metal they’re talking about …

This is palladium[13], the poor stephchild of platinum[14] and the most heavily traded platinum group metal (PGM) — demand for palladium has indeed been about 300 tons a year (about twice that of platinum, I think).

And the lone significant US producer? That’s Stillwater Mining (SWC)[15]

Platinum group metals are rare on earth, and most of them are found in South Africa and Russia (I think Norilsk Nickel is still the biggest miner of palladium in the world). Stillwater is one of two North American miners that extracts palladium as a primary product (the other, North American Palladium, mines in Ontario). There are also many mines in North America and elsewhere that produce platinum and palladium as byproducts, though in pretty small quantity, and only profitably when the accompanying copper, gold, zinc and/or nickel[16] are pretty well profitable on their own.

Like platinum, the major industrial use for palladium is in catalytic converters — and the recycling of same is also the biggest non-mining source of the metal. There are many other uses, including for many electronic gadgets, water treatment, jewelry, and dentistry, but the one that gets the most attention as a possible future demand driver is fuel cells — palladium is apparently a key component to hydrogen[17] fuel cells.

Palladium also has produced some interesting tidbits in recent history — Ford, back when it was still an admired and profitable company in 2001, lost a billion dollars by buying up a stockpile of palladium at total panic prices when it feared that Russia might cut off supply.

And yes, that’s the spike Snyder teases in the notes above — Russia did help to drive palladium prices when they cut exports for a while, the price spiked to about $1,100 an ounce early in 2001. It also got a big boost back when the stock market was peaking in late 2007, hitting close to $600 an ounce — other than those big spikes, it has mostly traded in the $200-400 range over the last ten years. Right now it’s right around $250 an ounce … it hit a low of under $200 an ounce back in December and has been climbing pretty steadily in the months since (as have the other precious metals).

And just as an aside, do you remember back a bit further, to 1989 and cold fusion? That experiment that caught the world’s fancy, of a safe room-temperature fusion reaction, also used palladium.

So now we’re left with a metal that is potentially very strategic, but also produced in very small amounts annually, and from a limited number of mines. The argument from this newsletter is that this US mine will be unusually valuable, because China is going to stop cycling their dollars into treasury bonds and start cycling them into US assets, and particularly commodities and commodity producers.

This seems to me like it might be a bit of a stretch — sure, Stillwater may well be a great investment because of future palladium demand — and it is one of a relatively small number of palladium producers, and perhaps the one that’s most vulnerable to takeover because it’s American (or most strategically important, for the same reason) … and the Chinese are certainly buying up a lot of natural resources right now with their extra cash. But if the Chinese want to stockpile commodities, almost all of them — including palladium — are usually priced in dollars. You don’t necessarily have to buy US assets to spend US dollars, you just have to buy commodities that are priced in US dollars … and that’s pretty much all of them. At least for now — there’s certainly the potential for this to change, albeit gradually, if the dollar falls as much as some folks fear.

So I quibble a little bit with that aspect of the argument, but I can’t argue with the fact that this is one of the relatively few palladium ore resources in the world, and palladium is both a noble and precious metal, and a strategic one for many industrial reasons. Of course, as we all know, prices themselves also cause changes in the marketplace — one of the reasons that palladium is in high demand for catalytic converters and other uses where it’s a catalyst is that platinum got so expensive, so industrial users started using palladium instead. There is some possibility that if palladium spikes in price, they might switch away from palladium and work to develop systems that use other less expensive metals, including potentially silver for some of these uses. So the long-term industrial demand is tough to predict, but in some ways the metal is in a bit of a sweet spot — very rare, very useful, not expensive enough to be ridiculous for industrial use. What that means for future prices is anyone’s guess, of course.

The newsletter teaser is further focused on options, and making huge gains from this stock by trading options, and Stillwater is traded in the US and does have a full complement of options available on the stock. The ad was written a month or so ago, I’d guess (though it’s being sent currently), since he says it’s a $500 million company (it’s up to $700 million now, thanks to the commodity price runup and market recovery of April and May). There is a pretty high open interest in the $5 strike price for January 2010, so we can speculate that this one might be the option they like, but that’s just a guess — and for 1,000% returns as they tease you’d probably have to buy out of the money calls to get more leverage[18]. Incidentally, SWC does also have 2011 LEAP[19] options available now, so you could always buy yourself a little more time — at a price — if you think this is a worthwhile investment.

And other than that, if you’re interested in palladium you could always look at one of the international producers — most PGM miners like Norilsk Nickel and Jubilee Platinum are also looking for (or mining) palladium to at least some degree. I don’t think there’s yet an ETF tracking palladium prices in the US, but the sponsor of a palladium fund in the UK has filed to introduce one here[20] (there was huge resistance last time this was proposed, since supply is so limited and industrial users don’t want investors driving the price). I haven’t heard anything about whether this new fund will be approved or not, but it’s certainly possible. You can learn about their existing UK physical palladium fund here[21], but I think you have to trade in London to buy it.

And of course, you could yourself buy palladium bars or coins[22] if you like — there’s not nearly the market for this as there is for gold or silver, or even for platinum, but several mints produce coins. I’ve seen Canadian Maple Leaf coins in palladium available, as well as PAMP Suisse bars, and rounds and bars from the Northwest Territorial Mint and from Stillwater itself (it runs a refinery, too, not just the mines). There are also futures available, and I assume futures options if you want super leverage — I think palladium futures contracts are for 100 ounces.

So what do you think? Will the Chinese come calling for American palladium, or try to corner the market for this metal in general and drive the price up (this is one that they can’t easily to buy on the cheap in underdeveloped African countries, since there are so few big ore resources for palladium). Is Stillwater a good buy today — or would you prefer to look at North American Palladium, which is in a bit more turmoil at the moment? (NAP just made an acquisition, and is planning for a restart and extension of their palladium mine.)

Then again, maybe we’ll see yet another of these metals catch on — I just noticed that Kitco, which I use for all precious metals prices, has started quoting rhodium, too, yet another platinum group metal.

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