Note: This trade is a little different than most of the others we publish. Although we like the idea, there is a lot of risk in a trade like this, so it should be handled appropriately in your portfolio if you choose to take on a position like this. Trading global risk events, like the ones occurring Ukraine, can be lucrative but you have to be sure that you can handle the likely volatility before you jump in. Whatever you decide, hopefully this article will explain a little more about how commodity markets are affected by events around the world.
As everyone knows, the Russians are involved in a conflict in Ukraine. The Europeans and the United States are on one side with Russia and many Ukrainian-Russians on the other. The fighting has worsened this week, which means Russia is more likely to escalate its intervention. Besides the obvious tragedy of war, this could also lead to further and longer sanctions for Russia.
Despite the escalation this week, the market seems to be pricing in a short-term resolution. For example, the Market Vectors Russia ETF (RSX) has continued to base near its March lows and was largely unaffected by the news this week. We think the market is probably right on this score. The Russians have chips to bargain with (oil, natural gas supplies, etc.) but their position is weak from an economic perspective.
Keep in mind that Putin took power from Yeltsin after an economic crash. Flirting with recession is not something that his regime is likely to take lightly. The bottom line is that it still seems likely that a short-term resolution can be achieved in May. There are planned elections, and the Kiev government seems to be making progress at putting down the rebels.
It is reasonable to expect that a short-term resolution in Ukraine would relieve the Russians of some of the sanctions, and Russian stocks will rally. However, we have found that in a crisis, betting against the asset that is artificially inflated is more likely to provide returns than betting on the one that is artificially deflated. It takes a while to rally, but a crash is fast.
Rather than betting on a recovery in Russian stocks (the damage may be somewhat irreversible at this point) we like the idea of trading against an inflated asset class before it crashes. In this case, that means palladium – one of the ‘white’ metals in the commodity markets. Among other things, palladium is used to make semiconductors and catalytic converters. Demand is high for the metal’s industrial applications and Russia controls about half of the world’s supply.
The risk of economic countermeasures from Russia has sent palladium prices skyrocketing. As you can see in the next chart, palladium futures are hovering near their 2011 highs and this last leg up was triggered by the crisis in Ukraine.
Fears about Russia restricting supply of this critical industrial metal are not unfounded. It happened in 2000 and Palladium jumped above $1,100 an ounce. Ford (F) tried to hedge the risk of higher prices at that point and lost a billion dollars when it plummeted again in 2001.
Could the Russians do it again? Yes, but it’s a case of cutting off your nose to spite your face. We don’t think they will but the market has left that premium in palladium prices anyway. In fact, palladium prices have disconnected from Russian stocks and we think this divergence is more evidence of a fragile trend in the metal.
A short position in palladium futures may be the most direct route for exposure to a decline. However, as we discussed in last week’s Trade of the Day on coffee prices, most individuals probably don’t have access to that market but they probably don’t need it for a short term play like this.
The ETFS Physical Palladium Shares ETF (PALL), which invests in physical palladium provides very good exposure to the market. If you are familiar with the SPDR Gold Trust (GLD), then the concept of a physical-backed ETF should be familiar to you. PALL is managed differently than many physical gold ETFs but it’s similar enough for a comparison. If palladium drops in value, PALL should follow because there is very little indexing error between PALL and palladium futures prices.
It’s important to remember that palladium could continue to rise. If the situation in Ukraine escalates, the Russians could retaliate and prices would shoot up again. However, we think the Russians will blink first and move to deescalate the situation out of a sense of self-preservation. When we compare the potential risk to the upside with the downside reward if things cool down, the trade seems very attractive.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.