Russian Metals and Mining - Trade Idea: Short Pd/Long Polyus

We are opening a trade idea to buy Polyus and short palladium, expecting the former to continue outperforming, thanks to extensive global stimulus, and palladium prices to decline on expanding oversupply as car production and sales slump globally amid limited disruptions to palladium production.> Palladium supply disruption is limited. We think that the impact of the South African lockdown (started March 23, scheduled to end today) on global palladium production has been limited. Some of the smelters were able to continue production using ore inventories, while limited mining operations were allowed to restart on April 8. Starting April 17, South Africa allowed PGM miners to restart mining at 50% capacity. Amplats, the second largest palladium producer globally, operating primarily in South Africa, already updated its full-year guidance to take into account the lockdowns, lowering it by only 50-100 koz (4-9% of its guidance pre-virus). Last week, Nornickel updated its global supply forecast, decreasing it by 12% from 10.6 moz to 9.3 moz. We think that further downside to palladium supply is limited, because Nornickel's full-year 2020 production was reiterated and the incentive for scrap recycling (which accounted for 30-33% of global pre-virus supply) at the spot palladium price is high. Therefore, the question of market balance comes down primarily to demand. > Consensus estimates car sales down 15-20% y-o-y in 2020, implies optimistic V-shaped recovery. Auto catalyst production accounts for around 84% of global palladium demand. We estimate the market consensus for the 2020 decline in global car sales ranges from 15% to 20-22% y-o-y (IHS expects a 22% drop, Nornickel 21% based on LCMA data). Meanwhile, CRU projects global car production down 16% y-o-y. Global car sales were down 24% y-o-y in January-March according to LMCA with big differences across regions due to the quarantine measures being introduced at different times. April sales and production numbers are likely to be disastrous as key economies (US and EU) were locked down and produced almost no cars. Judging by the post-lockdown numbers in China (where car sales improved but remained well below pre-virus levels), May-June sales in the US and EU (accounting for 40% of global sales) could also be slow on weak consumer confidence and weak purchasing power amid high unemployment rates (see the monthly sales statistics chart below). > Therefore, assuming around 31-32 mln car global sales in 1H20 (down 30% y-o-y), the consensus implies around 39-41 mln cars sold in 2H20, up 27% H-o-H, with 4Q20 monthly sales going almost back up to pre-crisis level. We believe that this corresponds to a V-shaped recovery, which in our view is not that certain, given the poor visibility on how post-quarantine life will shape up and the possibility of a second wave of infections or a spike in countries that have so far been less affected. > No 2020 Pd deficit even in bull case. Importantly, the consensus decline in global car sales implies a slight oversupply in palladium in 2020. Therefore, any decline in car sales bigger than 20% suggests that the market may see a buildup in palladium inventories, which will reduce the risk of the initially expected metal deficit for 2021. Below we outline a sensitivity of the palladium deficit in 2020-21 to car sales in 2020, assuming 9.3 moz of production in 2020 and normalized palladium output and car sales in 2021, in line with 2019.> Lack of cost support makes palladium price vulnerable. According to Johnson Matthey estimates, the palladium market was in balance in 2018. Back then, the metal traded at around $1,000/oz, while the cost of production was likely higher. In 2018, oil was $70-75/bbl versus around the $30/bbl Brent September futures price now, and the South African rand versus the dollar was 13.3 versus 18.2 now. We thus believe that there are high risks of the palladium price drifting from the current $1,950/oz to $1,500/oz (last year's average) or even lower. This would be especially likely if the drop in car sales this year goes closer to 30%, hence implying a balanced market next year. The next reporting of car sales in the US is next week, while data from China and the EU will come in mid-May. > Opening pair trade idea long Polyus/short palladium. We are negative on car sales and we think that governments across the world will continue to stimulate the economy via monetary stimulus, which supports gold stocks. We open pair trade short palladium and go long Polyus. (see our report). We open a pair trade idea to go long Polyus and short palladium. Given recent market movements, we will update our model and long-term view on the stock shortly.> Risks to our trade idea. We see the main risks as a V-shaped recovery in the global economy starting in 3Q20, a strong rally in risk assets on monetary and fiscal stimulus and prolonged quarantines in South Africa resulting in a higher than expected drop in the palladium supply.