Platinum deficit and South Africa: event-driven investing at its best
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South Africa. A country is as remarkable as it is troubling. Discovered by the Portuguese, colonized by the Dutch, and conquered by the British. Achieved its independence from the British Empire in 1931.
The country passed through turbulent years of apartheid, beginning in 1948. With its end, a new era in South African history began. South Africa had a period of economic growth and integration into the global world. The peak of the integration was South Africa's hosting of the World Cup in 2010 and membership of BRICS in 2011.
At the same time, South Africa is torn by deep problems - extreme inequality, economic stagnation, and high crime rates.
Wealth has been concentrated in the hands of the descendants of English and Dutch settlers, while the African National Congress (ANC) has held the levers of power for the past 29 years.
This is Nelson Mandela's party, representing the interests of the country's natives, who make up 80% of the total population. Ethnic and political differences between South Africa's ruling and economic elites deepen the crisis.
The author visited Cape Town several times between 2012 and 2018. Even then, the looming problems were visible. However, they have worsened considerably over the past few years - constant power cuts, an intense racial division, and a shrinking economy.
South Africa remains the most developed country in sub-Saharan Africa and a significant player in diamond, gold, and platinum group metals (PGMs) mining. The latter, in turn, plays a crucial role in the energy transition. And like most commodities, they, too, suffer from a supply-demand imbalance.
The synergy between the growing deficit of PGMs, South Africa's central role in their extraction, and the chronic state crisis brings asymmetric investment opportunities.
The investment approach that finds and exploits such opportunities is called Event Driven Macro (EDM). It is the intersection of macroeconomics, geopolitics, and catalytic events.
Today, I will introduce you to this strategy. We'll review the basics and present you with an investment hypothesis according to EDM rules.
Good enough analysis and appropriate timing always beat brilliant analysis and poor timing.
What are the necessary and sufficient conditions for successful investments?
The answer is simple—the validity of our forecast. Is it?
In 2016, I predicted two things – an oil price of $110 and inflation above 8%. These two events occurred in 2022, 6 years later. What am I, great clairvoyant or ordinary sucker?
Of course, the latter. Six years is too long to wait. That's foregone benefits, i.e., I'm paying opportunity cost. Sooner or later, even the most outlandish predictions come true. Therefore, anyone can be a great prophet if they ignore the timing.
However, this brings no operational value because time costs money. By waiting for our forecast to come true, we miss other opportunities.
Successful investment is based on operational forecasts. The operability of any prediction is a function of time. This statement is one of the few certainties in the market.
The timing is at least as important as our hypothesis. A valid forecast means that the market validates our hypothesis. That is, our assumptions about the future price of the chosen investment are correct.
Successful timing means we are both on time and on time for its implementation. Perfect timing is only possible to achieve. The trick is to be less off, i.e., relatively precise.
Proper timing can turn a mediocre forecast (not wrong) into a winning investment. At the same time, the wrong one turns even the most brilliant forecast into a losing position. A valid prediction and correct timing do not guarantee success, but lacking even one guarantees failure.
Event-driven Macro - when the moment is more than right
A valid forecast and good timing - are the two must-haves for positive final results. Where to look for these ingredients?
A valid forecast depends on the quality of our hypothesis and our analytical process. In today's article, we will divide it into the macro environment, region, industry, and individual company.
The macro-environment looks at the global picture—geopolitical transformations, technological innovations, and demographic changes. These are like the tide—slowly but irreversibly transforming our world.
The next step is to isolate the industries and regions benefiting from ongoing global changes and focus on finding potential winners among them.
Finally, we select companies from the region and industry that we believe will be the big winners from the macro changes.
There are specific cases where the selection of an individual company can be omitted. These are most often related to investments in raw materials. In the second half of the article, I will describe when the big picture and industry analysis are sufficient to make an informed decision.
Timing, in turn, depends on the credibility and significance of the anticipated event—an event whose occurrence will spark significant price movement in the desired direction.
The previous paragraph describes the essence of event-driven strategy. Its application involves seeking and exploiting events that will bring about radical changes. These can occur at the level of a company, a region, an industry, or the whole world.
No matter the magnitude, the anticipated event must be of such importance that it dramatically transforms the market environment and the expectations of market participants. Examples of such events are:
· Business level - bankruptcy, corporate restructurings, court trials
· Region level - change of power, local military conflict, energy crisis
· Industry level – output cuts, worker strikes, technological innovation
· Global level - pandemics, wars, economic collapse
The above list needs to be completed; it gives only the framework.
We must have a profound understanding to best benefit from the expected event. The examples listed serve as a starting point for what circumstances to look for.
To summarize, as an event-driven investor, I follow these steps:
· Start with the macro, looking for changes and their consequences
· Filter the industries and regions that I believe will benefit from these changes;
· Select the companies through which I will test my hypothesis
· Look for the catalytic event that will materialize my forecast
In the following lines, I will introduce you to an investment idea following the event-driven macro framework. We are going on a journey to South Africa.
Crisis in South Africa + platinum deficit = Event-driven macro
Reducing emissions and transitioning to clean energy requires a mind-boggling amount of raw materials. One of them is platinum. And South Africa produces over 70% of the world's output. At the same time, South Africa suffers from chronic problems.
The above paragraph sums up an event-driven macro (EDM) in practice - we have a growing demand for PGMs, and the primary player, South Africa, is in deep crisis. We have all the ingredients for an asymmetric macro trade.
The demand side and the catalyst - the energy transition and the crisis in South Africa- are familiar. In the following lines, we will examine it through the prism of demand, supply, and the accumulating deficit.
The platinum market - supply, demand, and deficit
Platinum is among the critical metals for the transition to clean energy. Like all other commodities, it requires more investments in discovering and developing new deposits.
The imbalance between supply and demand has already started to materialize. For 2023, the deficit is 983 thousand ounces. The following graph illustrates the growing deficit:
The deficit will continue to increase steadily. The question is how much and for how long. So far, the forecasts are diverging from reality.
According to the chart above, prepared in February 2022, a deficit of 650 thousand ounces is expected for 2023. However, the shortfall is 50% more than projected at 983 thousand ounces. It is expected to reach 1900 ounces in 2030, about 30% of annual platinum production.
Platinum demand
The demand for PGMs is linked to emission reductions. Over 60% of the annual production goes to catalyst production:
In recent years, a low-cost alternative to PGMs for catalysts has been sought, and silver has led the way. Time will tell whether it or some other metal will prove a suitable replacement.
At the same time, the production of cars with internal combustion engines is gradually declining, which also affects the demand for PGMs for catalysts.
However, despite the declining demand for catalyst production, demand for PGMs will continue to grow:
Setting zero carbon targets requires measures that go beyond catalysts. Fuel cells powering cars are becoming increasingly relevant. Platinum’s role in the cells is that of a catalyst, which accelerates the chemical processes taking place.
In fuel cells, however, there is (so far) no alternative metal to replace the role of platinum. For fuel cells alone, the market is expected to reach 10% of the total after 2030 and 28% by 2040.
These dates seem very far away in time. However, in the context of supply, they are very close.
Platinum supply
The uranium mining industry is dominated by four countries - Kazakhstan, Australia, Canada, and Russia. In PGMs, however, supply is even more concentrated—the leading player in South Africa and, to some extent, Russia (in palladium only).
Like all other metal mining industries, this one follows the CAPEX cycle flawlessly. Over the past decade, the lack of investment in the discovery and development of new deposits has started to bear fruit.
Supply is steadily declining. The need for new deposits to replenish the declining reserves is squeezing companies. Investments to renew depleted reserves are necessary for every miner.
The basic heuristic in the mining industry is as follows:
The rate of reserves renewal should be higher than their depletion rate.
The following chart illustrates the steady decline in reserves of the major platinum mining companies:
With constant annual production, Impala Platinum reserves will deplete after 2025. The reserves (blue) are part of the resource base (yellow and green). They are proven to be in the ground and can be extracted, but it is still being determined to what extent and at what cost it is viable to extract them. Converting resources into reserves requires time and capital. And in recent years, there has been little investment.
The chart presented is not the exception but the rule for mines producing PGMs. In the coming years, the reserves will reach its peak.
Over the last year, the big players in the industry have increased their investments, but this does not mean that new mines will open tomorrow. For the foreseeable future, the rate of resource depletion will remain higher than the rate of resource renewal.
The location of these deposits is a crucial factor, apart from the time it takes to discover, develop, and build a new mine. For every 100 ounces of platinum reserves, 90 are in South Africa, 6 in Russia, and 2 in Zimbabwe. The remaining two ounces are in North and Latin America.
South Africa is in an acute crisis, and Russia is partially isolated politically and economically. These two factors make discovering new deposits and building mines even more challenging.
One factor that temporarily quells platinum deficiency problems is recycling. Here's what the platinum supply side looks like for 2022:
· Mines - 5511 thousand ounces (76%)
· Recycling - 1682 thousand ounces (24%)
· Total - 7193 thousand ounces
Out of every four ounces of platinum, one is obtained through recycling. But even that cannot make up for the fact that one country dominates the platinum supply. The statistics clearly show it:
· South Africa holds 90% of the world's reserves of platinum, palladium, and rhodium (platinum group metals);
· South Africa produces 73% of the world's platinum and 42% of its palladium.
All platinum mines are located in the northeast of the country. And in this part of South Africa, the electricity grid needs to be updated and maintained. This means an increasingly pressing need for repairs and replacement with new.
The map below shows the location of mineral deposits in South Africa, including platinum:
In the context of the current crisis, the renewal of the electricity grid in the region will not happen. Instead, it will worsen—power cuts and worker strikes will become more frequent. These will significantly threaten the efficiency of operations in South Africa's mines.
ESCOM, South Africa's national power company, has decided to move to a Level 6 power regime. This will disconnect about 6000 megawatts from the grid. There is no prospect of the situation improving. ESCOM has been technically bankrupt for over a year. Traditionally, South African state-owned enterprises are run by corrupt and incompetent officials—a classic combination proved incapable of creating value.
Conclusion
The growing imbalance between supply and demand will affect platinum prices in the long term. However, the looming problems in South Africa have the potential to be the spark that will cause a parabolic rise in PGM prices.
2008, there was increased demand for PGMs to produce catalytic converters and a shock contraction in platinum supply due to the power outages. The price of platinum and palladium reached record levels.
Earlier, I compared the uranium mining and processing industry and PGM miners. Both markets experience deepening deficits.
However, while uranium supply is affected only by the lack of investment in PGMs, in addition to this fact, the crisis in South Africa plays a significant role. Its deepening will affect platinum production, and the question is not if but when and by how badly.
In summary:
· Demand – growing demand despite declining production of cars with internal combustion engines. The new factor compensating for the lost demand is fuel cell production.
· Supply - by 2023, supply is insufficient to meet demand. Reserves are being depleted at a higher rate than they are being renewed due to the CAPEX cycle.
· The spark - an escalation of the crisis in South Africa will affect mine operations and cause panic among market participants.
Even if the turmoil in South Africa does not escalate, the platinum shortage will continue to grow. This will have a long-term impact on the price of platinum. This fact alone motivates me to invest in platinum, but it is not enough for me.
The missing ingredient is timing. Without it, I'll hold positions in platinum for years until my hypothesis (probably) materializes. And that waiting has a high opportunity cost.
The worsening instability in South Africa has offset this danger. It significantly raises the risk of a severe supply contraction over the next 12 months. That is, I have an indicative time horizon for platinum investment.
Having a well-reasoned hypothesis and plausible (not guaranteed) timing is sufficient motivation for me to invest.
Like any forecast about the future, this one has its weaknesses. Two of them carry the most weight:
· South Africa's rulers are finding a resolution to the crisis - a possible but unlikely scenario. Many structural weaknesses in the country's governance have become apparent in recent years. They are symptoms of deep and intractable problems. The latter requires a radical change in the thinking of South Africa's financial and political elite. Such changes are complex and take time. In my view, even if a solution is found, it will be temporary and only quell the symptoms. At most, it will postpone the escalation of the crisis, but it will not reverse it.
· Finding a substitute for platinum - for many years, research has been underway to find cheap alternatives to PGMs. However, this is not an easy task because the properties of these metals are unique and very difficult to replicate at a low cost. Gold and palladium are not a solution because their price is often higher than platinum. Silver is so far shown as the substitute with the highest potential. However, even if it proves to be a workable alternative, it will be several years before its introduction.
Of the two points, the second has the potential to invalidate my hypothesis more. A long-term resolution of the crisis in South Africa is possible but unlikely.
The trend more often keeps its direction than changing it. This fundamental principle in technical analysis applies with full force to all developments, including political-economic crises such as the one currently raging in South Africa.
The introduction of a substitute for platinum is a scenario with higher credibility. However, it will take years, during which the deficit will continue to grow.
The growing platinum deficiency is not an isolated case. It is a fact in all metals to varying degrees.
From an investment point of view, platinum and PGMs generally have an advantage over other metals - their production is concentrated in only one country.
This makes predicting supply problems easier than aluminum or nickel, where a few countries dominate the market. Platinum production is concentrated in South Africa, which faces political-economic turmoil. Constantly decreasing production can be predicted with high confidence, leading to even more significant shortages.
How to play platinum deficit?
One metal, one country, deep crisis - an event-driven macro idea, presented in six words. EDM is among my favorite strategies because it provides asymmetric bets and a time frame.
The platinum shortage and the crisis in South Africa are great examples. However, one more thing needs to be added: how can you take advantage of the situation?
We have various instruments at our disposal - derivatives, equities, ETFs, and everything else. Each of the above has pros and cons. Investments in platinum mining companies have one serious drawback - they are all based in South Africa, as 90% of platinum reserves are located there. This means we cannot mitigate country-specific risk.
Even a concentrated industry like uranium mining offers alternatives - Canada, Australia, Namibia, and Kazakhstan. Depending on our risk preferences, we have a choice.
We do not have options with platinum. Only companies focused on platinum mining exist in South Africa and Russia. Some major mining companies extract platinum as a by-product of polymetallic mines.
Examples of such companies are Vale and Glencore. In their case, platinum mining accounts for less than 3% of total revenues. And as few ounces as that is, much of it again comes from South African mines.
Against the backdrop of the platinum mining industry, the uranium mining industry seems incredibly diversified. If we want to buy shares of platinum mining companies, the only option is to invest in South Africa. This does not mean that the companies in question are not good but that we expose ourselves to high political-economic risk.
I prefer buying futures directly or ETF investing in platinum. I get the upside potential but at a much lower risk. That is, the risk-reward remains highly asymmetric in my favor. At the same time, I am not taking the risks inherent in South Africa. To add leverage, I use LEAPS calls on Sibanye Stillwater. The company has a rock-solid balance sheet, business in the US, and owns DRD Gold.
The world is vast, and Alpha is lurking everywhere. In today's article, I showed you how I put this motto into practice through the Event-driven macro strategy.
It combines two ingredients - top-down analysis and the presence of a catalytic event. I start with an overview of the big picture in search of global change. I then consider how and where these changes will most impact. In doing so, I isolate regions and industries that will benefit from these changes.
The final ingredient is the catalytic event, which will drastically impact the chosen region and industry when it occurs. Furthermore, it sets the time frame of my investment hypothesis, i.e., its timing.
The mining sector offers one of the best EDM opportunities. We can forecast the future supply with relatively high plausibility. This is especially true for raw materials whose extraction is concentrated in a few countries. Platinum and uranium are such examples.
Today, I have introduced you to the platinum market following EDM steps. Here's how they look in summary:
· Profound changes - the transition to clean energy, which needs unimaginable amounts of raw materials, including platinum
· Benefiting industries - mining, and processing of platinum and other PGMs
· Region of focus - South Africa is a significant player in platinum mining
· A catalytic event - escalation of the country's political-economic crisis
The credibility of this hypothesis is plausible and probable. Playing it out requires patience and a strategic approach.
South Africa's general elections will be held on May 29, 2024. These are the most important elections since Nelson Mandela and the ANC’s victory in 1994. I have two plausible scenarios: ANC victory will deepen the crisis further; DA-led coalition electoral victory may signal changes in the country's course. However, even if the second scenario becomes a reality, the issues will only be resolved after a period of time. DA victory could spark civil unrest in regions dominated by ANC and EFF supporters. So, regardless of who wins the elections, the above-discussed issues will persist for a while. This means constrained PGMs supply.
I play the platinum shortage with Platinum ETF for direct exposure, and Sibanye Stillwater OTM calls for leverage.
Everything written represents only my opinion on the subject. It is biased, limited, and incomplete. This does not detract from its informational and predictive value but only serves as a reminder that the future is, by definition, unknowable.