April 15, 2011 - 2:43pm EST by
2011 2012
Price: 6.15 EPS NA NA
Shares Out. (in M): 162 P/E NA NA
Market Cap (in $M): 999 P/FCF NA NA
Net Debt (in $M): -76 EBIT -31 59

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Following up on a post by bode314 regarding Stillwater Mining Co. (NYSE:SWC), I wanted to expand on the bullish thesis on palladium (and platinum group metals in general) and introduce North American Palladium (AMEX:PAL or TSX:PDL), another underfollowed mining asset with a very interesting value proposition. In short, I believe the global supply/demand imbalance that has recently resulted in sharp price acceleration of palladium will intensify in the coming years due to a number of both supply and demand-side factors.

Looking at supply first, palladium is mined in only four regions of the world:  Russia (46%), South Africa (41%), North America (10%), and Zimbabwe (3%).  Historically, South Africa was the low-cost supplier, and it was difficult for the North American mining companies to maintain a competitive cost structure.  However, South African miners currently face numerous operating constraints, including electricity (while electricity costs are increasing ~10% per year, a much bigger concern is obtaining a consistent source of power, since the threat of electricity shortages is growing throughout the entire region), labor (also growing ~10% per year), and lower grade, higher cost ore (mining companies have to dig deeper and deeper, which is more expensive and resulting in ore with less precious metal content).  Because of these issues, a 10% further increase in costs is estimated to make 40% of the South African supply negative free cash flow at current palladium prices.  Any supply disruption in this region would put severely upward pressure on the palladium price.

Russia, in addition to contributing a large percentage of total production, has for years had a large stockpile of palladium that it sold into the global market.  It is widely believed that the country had nearly 30 million ounces of palladium in storage at the time the Soviet Union collapsed in the late 80's (palladium is produced in Russia by Norilsk Nickel as a byproduct to nickel).  Since that time, Russia has on average sold nearly 1.5 million ounces of its stockpile annually. This compares to an average annual palladium market of 5.5 million ounces over that time, thus implying that in addition to primary production, over 25% more palladium was supplied to the market as an exhaustion of the Russian stockpile.  Data suggests the Russian stockpile is now exhausted, and this was confirmed recently by a Russian Finance Ministry official who stated the Russian state palladium stock is "practically nill" and the State Precious Metals and Gemstones Repository is unlikely to sell palladium on the world market.  The palladium market will become materially tighter if Russia has indeed exhausted its store of palladium.  It should be noted though, that in 2001, palladium prices soared to nearly $1,100 (compared to ~$775 currently) due to a premature worry that the Russian inventory would either no longer be accessed (it was believed the state could not obtain export permits) or that it was gone altogether.  As you can see in the table below (data supplied by the industry's leading authority on platinum group metals, Johnson Matthey,, the surplus has fallen to virtually zero even with Russia supplying over 1 million ounces of palladium into the market.  Without the supply from the Russian stockpile, the market will be severely undersupplied in coming years, especially given the robust projected growth in autocatalyst demand, which I will outline later.

These trends in the two largest production regions create a very favorable environment for the North American palladium miners, who do not have all of the same regional or operating risks as miners elsewhere.  This opportunity is enhanced by the fact that the North American mines currently have or are on a path to have the lowest cost structures in the world.  Once PAL's new zones are fully developed, it is expected to have cash costs of under $150 / ounce (compared to $700+ for some South African mines).  Finally, because palladium is only found in select regions of the world and significant lead time is necessary to build a new mine even if more palladium is found, it is extremely unlikely that significant new supply will come online in the next 5-7 years.

On the demand side, the largest use for palladium is catalytic converters for emissions control in automobiles (~54% of total demand).  In addition to projected car build growth in the US and emerging markets, new emission requirements in emerging markets (China) are increasing the metal loading requirements in catalytic converters.  Although both platinum and palladium are used for this purpose, gasoline engines predominately use a palladium filter (versus platinum-filtered diesel engines).  Because emerging markets favor smaller, gasoline-powered engines, demand growth should be more robust for palladium over the coming years.  In addition to this, more efficient technology and cleaner fuels have allowed palladium's functionality to move closer in line to that of platinum.  While historically 2-3x as much palladium would be needed to equal the efficiency of platinum, a 1:1 relationship now exists for some uses.  Although platinum is currently 2.3x as expensive as palladium, I believe any ratio greater than ~1.5x to 1 will continue to drive conversion from platinum to palladium.  This auto demand is highly inelastic, as the total palladium content of a catalytic converter in an automobile is insignificant (~$80-$150) compared to the total cost of the vehicle.  Even if palladium prices were to double, I believe there would not be a material change to metal demand for catalytic converters.

A relatively new source of demand is the purchase of palladium by ETFs, or exchange-traded funds.  These funds purchase the metal and allow individuals to invest in palladium through a security or financial instrument without having to hold the physical commodity itself.  ETFs only started purchasing palladium in the past few years, and all palladium ETFs combined only hold about $2 billion of the metal, suggesting there could be incremental demand in the future.  Stable to robust demand continues for palladium's other uses - electronics, dental, chemical, and to a smaller extent, jewelry.

I believe that bode314's original Stillwater thesis is still valid.  While Stillwater offers a great way to capitalize on the global palladium imbalance with little development risk, I believe North American Palladium (AMEX:PAL or TSX:PDL) is even more misunderstood by the market.  Current Street estimates give little-to-no value to several potentially large zones under development.  After conversations with management, I am confident these are on track and will add meaningful metal production starting in the next 3-5 years.  Historically, mining at the Lac des Iles Mine focused on the Open Pit and, starting in 2006, the Roby Zone (an underground zone beneath the Open Pit that is mined via ramp access).  After being put on care and maintenance in late 2008 due to low palladium prices, the mine reopened in 2010 with plans to mine the Roby Zone and develop a new zone to the side known as the Offset Zone.  In 2011, PAL will primarily mine the Roby Zone via ramp access at a rate of 2,700 tonnes of ore per day, resulting in 165,000-175,000 ounces of palladium.  Starting in 2012, commercial production will shift to the Offset Zone (still via ramp access) at a rate of 3,200 tonnes of ore per day.  PAL is currently developing shaft access to this zone which will augment the capacity through the ramp.  The first half of the shaft will be completed in the fourth quarter of 2012 and will have an initial capacity of 3,500 tonnes per day.  Assuming the company uses the full initial capacity of the shaft and slows down ramp access from its current levels, it will still be able to mine up to 230,000 ounces of palladium annually by 2014.  Beginning the first quarter of 2015, the entire shaft will be completed with a total capacity of 7,000 tonnes of ore per day.  Even using the company's conservative guidance of 5,500 tonnes per day of use, PAL will produce well over 250,000 ounces of palladium per year at a cash cost of under $150/ounce.  Using the full capacity of the shaft, as well as 2,300 tonnes per day of ramp capacity, the ultimate capacity of this development could be as high as 450,000 ounces of palladium annually. 

Assuming the company uses only its shaft capacity once it is complete (zero ramp capacity) and using very conservative gold production estimates (the company has recently purchased a gold mine, and while the company has plans to eventually mine 250,000 ounces of gold per year, I assume they reach maximum production of ~75,000 ounces), earnings per share would be ~$0.80 at spot palladium prices of $775/ounce (platinum at $1,790/ounce), ~$1.00 at a palladium price of $1,000/ounce (platinum at $2,000/ounce), and upwards of $1.40 at a palladium price of $1,320/ounce (platinum at $2,400/ounce).  With gold miners, silver miners, and worse-positioned South African platinum/palladium miners trading at forward P/E multiples averaging north of 20x (versus PAL, who will be the low cost producer of palladium in the world with a growing mineral base), even the most conservative estimates yield a share price that is multiples of PAL's current $6.20.  Additionally, the quantity of known mining reserves is continuously expanding at Roby Zone and Offset Zone as the Company is generously funding exploration (the company stated its reserve estimates will increase, and the data will be released in Q2 2011).  In order to mitigate the risk once these zones are exhausted, the Company is already planning its development of three additional zones (Cowboy, Outlaw, and Sheriff) that will be accessed through the shaft and ramp being developed at Offset and will start production as early as 2013.  Because of these developments, I am very comfortable the company will have adequate, high-grade reserves for a long time.  Thinking about valuation differently, even assuming the conservative Street estimates (which give virtually no credit to any of the Cowboy, Outlaw, and Sheriff zones and minimal credit to the company's gold operations and expansions of the Offset zone), PAL is trading at a discount to Net Asset Value (0.7-0.9x).  This compares to gold miners trading at 1.1-2.0+x NAV and South African platinum/palladium miners of 1.0-1.2x NAV.

While I believe the above supply / demand dynamics are very likely to emerge over the coming months, risks do exist.  With timing relatively tight, any further delays in Offset Zone development may lead to a production gap when transitioning mining from the Roby to Offset Zone.  If this occurs, however, it would simply push back production for the length of the delay and not impact the ultimate amount of palladium reserves.  PAL management is intensely focused on growing total reserves and setting up the mine for future production expansion, so it is possible near-term production could be limited/delayed while PAL sets itself up for significantly stronger palladium output in the future.  I do not see this as a huge risk; Offset Zone development is coming along nicely, and even if there are delays, PAL is much more of a development story than one about 2011 or 2012 production (although 2012 mining estimates do not leave much room for further delays).  At a broader level, the global supply / demand picture would get murkier if Russia has more stockpiles than I anticipate.  I believe this is very unlikely, but we cannot forget what happened in 2001 when many believed the stockpiles were gone then.  Based on the above palladium supply / demand data, I still believe demand would outstrip supply in the event Russian stockpile sales continued, albeit we would not reach the deficit levels I envision.

PAL is aggressively focused on growth, and I believe production could be materially in excess of conservative guidance given to date.  With cash costs so low in the new developments, the company is materially levered to palladium prices and will significantly benefit from the current shortage of supply and growth in demand.

Paladium Supply / Demand Data (Source: Johnson Matthey

Palladium Supply / Demand Data

















South Africa Mine Supply








Russian Mine Supply








Russian State Stock Sales








North American Mine Supply








Other Mine Supply









Total Supply









  % Growth



















Autocatalyst Demand, net of recycling







Investment Demand









Other Demand, net of recycling







Total Demand









  % Growth



















Surplus / (Deficit)









Surplus / (Deficit) ex-Russian Stockpile

















Source:  Johnson Matthey (





- Palladium supply squeeze due to energy / other difficulties in South Africa, exhaustion of Russian stockpile, and/or robust end-market demand growth

- Q2 2011 - updated resource estimates for LDI mine and gold properties

- Shaft production continues as planned

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