Palladium prices have exploded on the upside with a gain of almost 25 percent since December and over 60 percent in the last year. This is in contrast to gold, silver, and platinum which have had strong gains but nowhere near the price change for palladium. Palladium is a case study on why commodities are different than other financial assets and may have explosive gains and loses with greater likelihood.
Supply and demand shocks can create large price moves because new commodity production cannot be generated in the short-run nor can substitutes be found to satiate demand. In contrast to financial assets, there is no new supply through issuing stocks or cutting supply through buybacks. There is no inelastic demand because there often can be found close substitutes with similar return and risk.
Demand for many commodities can be very inelastic because there are limited substitutes. Palladium is a necessary metal in catalytic converters especially for gasoline engines and the next closest substitute, platinum, is less efficient. 85 percent of palladium usage is tied to the automotive industry, so high auto production with more stringent pollution standards will keep demand high.
Supply is also inelastic given the costs of developing new mines and the fact that there are often decreasing returns to scale with mining. In the case of palladium, it is a by-product metal from nickel and gold mining. New mining is a function of the average or combined cost of the metals to be found. Palladium has been in net deficit for a number of years and the inventory buffer stock has been eroded.
This does not mean speculative bubbles cannot exist in commodity markets. Since it is hard to determine the actual supply necessary to meet demand and small transactions can move the market, there is the potential for excessive feedback loops. In fact, there may be more potential for extreme expectations in these smaller markets. Of course, the old commodity adage is that the solution to high prices is a high price. In those case, substitutes and new supplies will be found. We are now seeing thieves stealing catalytic converters.
When inelastic demand meets inelastic supply, the result is high volatility and the potential for big price moves from any supply or demand dislocation. This is one of the key reasons why these markets are often liked by trend-followers. Given that supply and demand shocks may play-out through time, there may slow change in price. Trends will last longer than expected.
Demand for many commodities can be very inelastic because there are limited substitutes. Palladium is a necessary metal in catalytic converters especially for gasoline engines and the next closest substitute, platinum, is less efficient. 85 percent of palladium usage is tied to the automotive industry, so high auto production with more stringent pollution standards will keep demand high.
Supply is also inelastic given the costs of developing new mines and the fact that there are often decreasing returns to scale with mining. In the case of palladium, it is a by-product metal from nickel and gold mining. New mining is a function of the average or combined cost of the metals to be found. Palladium has been in net deficit for a number of years and the inventory buffer stock has been eroded.
This does not mean speculative bubbles cannot exist in commodity markets. Since it is hard to determine the actual supply necessary to meet demand and small transactions can move the market, there is the potential for excessive feedback loops. In fact, there may be more potential for extreme expectations in these smaller markets. Of course, the old commodity adage is that the solution to high prices is a high price. In those case, substitutes and new supplies will be found. We are now seeing thieves stealing catalytic converters.
When inelastic demand meets inelastic supply, the result is high volatility and the potential for big price moves from any supply or demand dislocation. This is one of the key reasons why these markets are often liked by trend-followers. Given that supply and demand shocks may play-out through time, there may slow change in price. Trends will last longer than expected.
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