Introduction

The current situation declares that demand for palladiuim is off previous levels, and the price has been coming down. Prospects appear good however as increasing substitution of palladium for platinum in catalytic converters, new government emission standards, and the departure of Russia from the market as a palladium supplier all bode for higher prices to come. The palladium commodities market is relatively thinly traded and subject to manipulation, but a recent crackdown may eliminate some of the trouble. Also, the "thin-ness" is disappearing as more interest in the market has been generated in recent months to allow the establishment of an options market for palladium contracts. Zenith welcomes that addition and offers its first attempt at a palladium optioin recommendation below.

Intermarket Analysis

We fed palladium, platinum, and gold into a neural network to get the following result:

Parabolic Chart

March Palladium:

Nirvana Chart

March Palladium:

News Analysis

The palladium market is one that is largely driven by legislation. Governments have been heavily focused on improving on-road vehicle emission standards to achieve their environmental goals and this has resulted in increasing demands for palladium in catalytic converters. Now, just as governments are turning their focus to improving off-road emissions, investors’ sentiments toward the metal appear to be changing.

Palladium was a stellar performer in 2010 and according to a report released last week by Johnson Matthey (JM), from January to September the metal traded at an average of 61 percent higher than during the same period last year. Yet, the report predicts that 2011 investment demand will be in negative territory, as pronounced periods of liquidation have already been seen.

Investors who have moved out of the market or those thinking about it may want to consider that legislation is likely to become an even stronger driver for palladium demand due to off-road emissions regulations taking effect this year in the US, EU, and Japan.

Though off-road emissions standards are not new, they are changing in efforts to close the gap between them and those imposed on road bound vehicles. Tier 4 Interim as the new legislation is called in the US, and Stage IIIB as it is called in the EU, accompanied by similar measures in Japan aim to put a tighter clamp on pollution from sources such as agricultural and industrial equipment. This will be accomplished over the next few years as limits are phased in according to engine size.

In 2014, North America will be subject to an even stricter bundle of regulations known as Tier 4 Final. The EU will be regulated by Stage IV and Japan will follow with a similar bundle of legislation taking effect in 2015. By this time, nitrogen oxide (NOx) and particulate matter (PM) emissions are supposed to be at near zero levels for off-road machinery regulated by these laws.

David Wilson, Director of Metals Research with Societe General, projects that off road emissions control will affect over 600,000 non-road mobile machinery units per annum.

JM’s report, which describes this application as a promising growth area, says that the stricter emissions limits is likely to involve and result in pgm (platinum group metal) demand of 130,000 ounces this year. But, the report goes on to explain that estimating PGM demand requires more than looking at the size of the market in the terms of engine numbers or displacement. It is necessary to assess the various off-road sectors individually with a number of other factors.

The difficulty in estimating stems in large part from the fact that just as the sectors are diverse, so are the types of off-road engines that will be affected by this legislation. Complying with increasingly strict standards is not as simple as mass production, but will likely require specialized solutions for various types of equipment.

The chosen methods for each type of product will be implemented in phases like the legislation and how the first round attempts will hold up remains to be seen. Given that new technology will be put to work under new conditions, a forecast of the palladium growth stemming from off-road emissions control would be unreliable.

What is known is that of the PGM catalysts that are currently used in emissions systems, palladium is the cheapest. Where other metals in the family have been used, when technology has provided the opportunity, that use has been abandoned and palladium has become the alternative. The palladium market is one that is largely driven by legislation. Governments have been heavily focused on improving on-road vehicle emission standards to achieve their environmental goals and this has resulted in increasing demands for palladium in catalytic converters. Now, just as governments are turning their focus to improving off-road emissions, investors’ sentiments toward the metal appear to be changing.

Given the substitution rates, it is expected this tobe partciularly positive for palladium demand.

Insider trading and predatory lending are apparently not the only focuses for increasingly hawk-eyed US regulators. The cases against Christopher Pia, founder of Pia Capital Management, and his former employer, Moore Capital Management, show that regulators are also watching the palladium and platinum futures markets.

The Commodity Futures Trading Commission (CFTC), an agency responsible for regulating US futures and options markets, alleged that from November 2007 to May 2008, Mr. Pia attempted to manipulate the settlement prices for NYMEX palladium and platinum futures contracts using a strategy called “banging the close.” At the time, Pia was a top portfolio manager for Moore Capital Management, which was trading over $15 billion in assets.

The CFTC’s definition of banging the close is “a manipulative or disruptive trading practice whereby a trader buys or sells a large number of futures contracts during the closing period of a futures contract… in order to benefit an even larger position… .”

Pia’s strategy, according to the CFTC, was to execute a large number of market-on-close buy orders. Either directly or through execution clerks employed by Moore Capital Management, Pia would inform a trader of the need to place anywhere between 20 to 100 buy orders. These orders were given with directions indicating that Pia wanted to push up the settlement prices. To help ensure the desired results, the trader would wait until the last ten seconds of the closing period to relay the orders to the floor clerk in the trading pit.

Settlement prices for palladium and platinum futures contracts are calculated based on the volume-weighted average price of all transactions conducted during the two minute closing period each day, which spans from 12:58 and 1:00 pm for palladium. The CFTC alleges that the last second orders from Pia accounted for a significant portion of the volume during this determining period and the reason why was because he was attempting to manipulate the prices in these two thinly traded, relatively illiquid markets.

A source at the National Futures Association (NFA) said that this type of market manipulation has been going on for a long time, but it is often difficult to catch. Still, he says, the exchanges employ people to monitor the trading pits in attempts to identify this type of behavior. And the strategy employed by Mr. Pia would have certainly been a red flag, he added. In this case it was reportedly complaints from other traders that tipped off the regulators.

Last week, without admitting or denying any of the allegations against him, Pia submitted an offer of settlement and the CFTC accepted. In addition to a $1 million civil penalty, Pia is also subject to a list of regulations. Among them, for five years, he is required to attend training programs annually, he is subject to stricter reporting and record-keeping obligations, and he is obligated to cooperate with a monitor whose services he is responsible to pay for. Pia is also permanently barred from trading during any closing period and from ever trading any CFTC regulated palladium or platinum products.

This follows a settlement last April in which Moore Capital Management, Moore Capital Advisors and Moore Advisors were ordered to pay $25 million for Pia’s trading scheme. The CFTC asserts that the companies attempted to manipulate settlement prices and they failed to have adequate supervisory systems and procedures in place. Like Pia, his former employer settled without admission or denial of guilt and the companies were also subject to other stipulations on future operations.

Attempts to obtain information from the CFTC about the amount of financial harm or gain that resulted from Pia’s manipulative trading were unsuccessful. However, the source at the NFA said it is probably near impossible to put forth that type of information in numerical figures, but any attempts to jeopardize the integrity of the market are harmful, he said.

The Pia settlement comes at a time when the CFTC is applauding the adoption of new anti-manipulation and anti-fraud rules and has reiterated its commitment to impose significant sanctions on violators.

Palladium supply is outpacing demand. Russia’s stockpiles have been a source of about a quarter of the global supply for 20 years, said Francis McAllister, CEO of Stillwater Mining (NYSE:SWC). However, it’s believed that by 2012, Russia will leave the seller’s table, which may widen the deficit and boost prices.

Russia sold about 800,000 ounces of palladium from state reserves in 2010 reported research company GFMS. The amount that will be sold this year is still a matter of speculation.

If there are any palladium deliveries from Russia in 2011, these will be the remains of the stockpiles said Viktor Sprogis, Deputy Chief Executive Officer of Norilsk Nickel (LON:MNOD), the world’s largest palladium producer. Furthermore, he says no supplies are expected in 2012.

“Remains,” generally an unemphatic word, is very significant in Sprogis’ statement because there are widespread beliefs that Russia’s departure from the market is not voluntary. Rather, rumor has it that the nation has depleted its renowned stockpiles.

During the 1970s and 1980s, the Russian government amassed large quantities of palladium. According to the UN, Russia was the only nation to hold significant stocks of the metal. The potential size of those stockpiles has always been the great unknown in the palladium market said Leon Westgate, a metals analyst at Standard Bank.

Although it is still unclear what the Russian government had then or has now, the rumors circulating about depleted stocks are being granted some degree of credibility by comments from those close to the situation.

For example, last year, the Dow Jones Newswires cited a Russian Finance Ministry official as saying the nation’s palladium stock was “practically nil.” In an interview in London, Sprogis said that judging by indirect indicators, the government stockpiles are gone.

If Russia’s palladium is gone, what happened to it is another unanswered question. Considering that the nation has been a major supplier, a person may be quick to assume that sales have simply eroded the supply. However, the UN says it is widely believed that western banks have a substantial portion of Russia’s palladium due to use for collateral on loans.

Over the years, Russia has been a major influence on palladium prices. McAllister said any remaining Russian inventories would probably not have much of an impact on the market if they were sold.

But, impact is expected from Russia’s absence from the palladium supply chain. The nation’s departure could result in a deficit that lasts until 2015… and not a minor deficit. Johnson Matthey reported that in 2010, gross demand for palladium increased 23 percent to hit a record 9.63 million ounces. The total global production was less than 7 million ounces.

Though Russia may withdraw from the sales team, the demand is not expected to subside and the prices are not expected to retreat. Top analysts forecast prices to reach $940 an ounce or higher by the end of the year and to keep rising thereafter. If history is an indicator of what will happen, investors may want to look back to 2001 when uncertainties about Russian supplies caused palladium prices to soar to a record high of $1,125 an ounce.

What will the world do if the Russian government says bye to the palladium market? Some analysts believe stockpiles held by investors and consumers will be sought as pain relievers.

Johnson Matthey, reported that physical investment in palladium rose 74 percent to over a million ounces, due mainly to strong flows into palladium ETFs, such as the new Palladium Trust (NYSE:PALL) and the more seasoned ETFS Physical Palladium.

Point & Figure Chart

Cyclical and Seasonal Factors

We are headed toward a cyclical high and a strong seasonal up period.

Internal Program

Our best-performing internal program is "Volume." It is giving a buy signal.

Results of "Volume" for Palladium (blue lines = successful trades, red, unsuccessful): (Not always in the market.)

Third System Confirmation

Our third system has triggered a sell signal. (Note, disregard the year on the chart. Our regular readers know this is not a Y2K-compliant system, but it still works.)

Margin

The point value is $100. Initial margin on a single contract is $5,775. Use of options is advised.

Historic Range

Scale trade sellers are entering the market for the long term in this price range.

Commitment of Traders

In the chart below, the yellow line is the futures price, read on the right axis. All other colors are read on the left axis. Blue is small speculators. Red is large speculators. Green is commercials. Commercials with the best track record are getting increasingly-short.

Volatility / Probable Range

The average volatility shown below suggests that a current downtrend remains intact from the last volatility low point.

Possible Future Prices

Option Recommendation

In our previous reports on palladium, we have stated, "Options are not available for this contract." The New York Mercantile has decided to establish options for palladium due to increased interest in this contract, and Zenith welcomes the new (although relatively sparse) selection of options to the trading world.

Our option trade recommendation is to Sell the Palladium March 575 Put @ 15.80 or better.

Calendar Spread

What the Mar. - Jun. calendar spread suggests to us is that buying the near contract and selling the far one is at most times not profitable, which we think is a sign that these futures may go down. The best time to enter or leave the above spread is when it is at +2.00 or narrower buying the far as prices are falling and then selling the near, and exiting or entering when it is at -8.70 or wider sellling the far as prices are rising and then buying the near.

Level Table:

Other Factors

Here's an intraday chart for the previous day ( 12/02 ).

Overall Recommendation

Place 2 March Palladium on a Buy Watch with stoploss @ -25.55 below the get-in point.