I have been a long-term bear on palladium prices and the abrdn Physical Palladium Shares ETF (NYSEARCA:PALL). In my opinion, the long-term decline in palladium prices is inevitable as its main industrial use is in gasoline catalytic converters, and gasoline internal combustion engine ("ICE") vehicles are increasingly being replaced with electric vehicles.

Since I initiated on PALL, its shares have declined by over 24%, by far the worst performance amongst the precious metals compared to gold, as represented by the SPDR Gold Shares ETF (GLD), silver, as represented by the iShares Silver Trust (SLV), and platinum, as represented by the abrdn Physical Platinum Shares ETF (PPLT) (Figure 1).

However, in recent weeks, palladium markets have shown signs of life, briefly popping back above $1,000/oz. Is the recent rally in palladium prices sustainable, and are the fundamentals of the palladium market turning more positive?

In my opinion, the long-term picture remains unfavorable for palladium, as gasoline vehicles are increasingly being displaced with electric ones. However, in the short-run, a potential shuttering of Sibanye's U.S. operations could take ~5% of the global palladium production off the market, which could spark a short-squeeze in the futures market, as speculators are heavily short palladium futures. I am raising my rating on the PALL ETF to a hold, and will revisit if Sibanye follows through on their threat.

Brief Fund Overview

First, before we delve into discussions on the Palladium markets, it may be useful to remind users of the structure of the abrdn Physical Palladium Shares ETF. The PALL ETF is an investment trust that holds physical palladium bars in vaults in Zurich and London. The PALL ETF has $292 million in AUM and charges a 0.60% expense ratio (Figure 2).

Shiny Rock With Dwindling End Uses

As I have written previously, palladium is a precious metal with few industrial uses. According to research from Sprott Asset Management, the biggest end-use of palladium is in automotive applications as a catalyst in gasoline catalytic converters (Figure 3).

However, as is well known by most investors, gasoline automobile production has been in terminal decline with the introduction of electric vehicles ("EV"). According to data from Bloomberg, the global economy reached 'peak' gas-powered vehicle sales in 2017 and has been in terminal decline ever since (Figure 4).

This inevitable fact is the main reason why I have been so bearish on palladium and the PALL ETF. As demand from the automotive industry declines, there is no alternative market large enough to absorb the excess palladium production.

Surprising Supply Response Coming Due To Low Prices

In my most recent article, I also discussed the dynamics of the palladium market and why I do not foresee any significant supply response, unlike other commodities.

Historically, palladium production is dominated by a few mines and producers, with Russia and South Africa controlling 46% and 39% of global reserves respectively (Figure 5).

Furthermore, since palladium is typically produced as a byproduct from mining other precious and semi-precious metals like silver and copper, supply-side response is virtually non-existent. When palladium prices surged in the 2010s, copper and silver miners did not increase primary production to garner more palladium credits (Figure 6).

Similarly, even as prices plunged in the past few years due to lower demand, copper and silver miners did not curtail their primary production because palladium credits were reduced.

However, in recent days, we have received some surprising news that Sibanye Stillwater (SBSW) is considering shuttering its palladium mine in Montana if prices do not improve. This is a major development that is underappreciated by the market.

As a reminder, Sibanye is one of the few primary Platinum Group Metal ("PGM") producers with a substantial share of the global mining reserves of PGM metals (Figure 7).

If Sibanye shutters its US production, that could potentially take 0.5Moz of production out of the ~10 Moz market, or ~5% (Figure 8).

Futures Positioning Primed For A Squeeze

If Sibanye follows through with its threat, we could see a substantial squeeze in palladium prices, as commodity speculators are very short palladium futures currently (Figure 9).

Who are these futures speculators net short palladium? In recent years, we have seen a rise in the assets under management ("AUM") of Commodity Trading Advisors ("CTAs") that take large bets on commodity futures. The rise of CTA AUM has led to increased volatility in commodity markets, culminating in the epic rally in cocoa and coffee futures earlier this year and the largest short position on record in palladium futures.

The problem with CTAs is that they are momentum traders; i.e. they buy assets that are rising and short assets that are declining. Readers are advised not to stand in front of the potential CTA freight train. If/when palladium prices start to gain traction due to short covering, the reversal in CTA positioning could quickly overwhelm any bearish fundamental story like the decrease in demand due to EVs.

Reduced Substitution Also A Net Positive

Another net positive for palladium prices is that with palladium trading at less than $1,000/oz, the substitution of palladium for platinum in catalytic converters may go into reverse, providing some support to palladium prices (Figure 10).

Of course, substitution is a slow process, as it is primarily a decision made during the production of new vehicles. However, over the long run, price parity between platinum and palladium should be a modest net positive for palladium prices.

Conclusion

While the long-term demand picture for palladium remains negative due to waning auto demand, a supply response from one of the largest PGM miners globally could spark a short-covering rally in palladium prices, with COT futures short-positioning at a historical level. I am raising my rating on PALL to hold, and may revisit the PALL ETF if Sibanye follows through on its threat to shutter production in its U.S. operations.