ETF-izing the Market: Are Producers Getting the Wrong Signal?

Reports this morning that Russian aluminum giant Rusal is looking at launching an exchange-traded fund (ETF) back by physical aluminum.

Rusal said the fund could initially be backed with up to 1 million tonnes of aluminum.

This seems to be the way of the world. Investors are increasingly becoming the go-to buyer for a host of metals.

The most recent success in "ETF-izing" a metal came in the platinum group elements.
Earlier this year, the first platinum- and palladium-backed ETFs were launched in North America and Japan. Both have been a resounding hit with buyers.

Net ETF holdings of platinum jumped by 277,000 ounces in the first quarter of 2010. A 41% rise in total holdings.

In fact, direct investment has become one of the major drivers for the PGM market. ETF buying of platinum in Q1 was equivalent to 16% of overall global demand.

And this investment buying is having a significant impact on prices. In 2010, platinum has jumped from $1500 per ounce to over $1700. Nearly a 15% gain. In the same period, gold prices have been largely flat.

But the biggest winner from the ETF explosion has been palladium. Palladium prices have jumped from $420 per ounce to nearly $550 so far this year. A 30% rise.

In fact, palladium prices have recovered to their pre-financial crash level. Currently trading at a two-year high.

This is great for early investors in the metal and its ETFs. It poses some challenges for mining companies.

Yesterday, Canada's only primary palladium producer, North American Palladium, announced the restart of its Lac des Iles mine in Ontario. This looks like a sensible move given the rebound in palladium prices. You can make good money selling Pd at over $500 per ounce.

But are current prices really reflective of the true state of the market? Or is investment demand sending the wrong price signals to producers? After all, investors can change their minds on a dime. Sending prices down as quickly as they drove them up.

Companies making production decisions (especially on marginal assets) are going to have to make some strategic judgments on metals prices. How much real demand is in the market? And how much of the price can be attributed to potentially temporary factors like investment buying?

No one wants to get caught by a price down-draft that pushes their mine into unprofitability. ETFs are going to make this a growing challenge for managers.

By. Dave Forest of Notela Resources