The price of the precious metal palladium, a close relative of platinum, which soared as recently as May before a 20% correction, could continue to drop as new supply outstrips demand, a new report argues.

Although such a scenario doesn't bode well for miners of palladium, such as North American Palladium ( PAL) and Stillwater Mining ( SWC), investors looking to make a quick buck shorting the stocks would do well to be wary: Not all palladium miners are vulnerable to metal price weakness.

The report, published Tuesday by CPM Group, a New York-based specialty commodity consulting firm, says 2006 could see the market awash with a massive 1.3 million-ounce surplus of the metal. Palladium, like its cousin platinum, is used primarily in the manufacture of pollution-preventing catalytic converters, but is also found in electronics, jewelry and the dental industry.

"...given that it is on the high side, it might suggest that the palladium price may need to subside" in order to absorb the extra metal, the report notes.

The findings won't make for fun reading at Stillwater Mining or North American Palladium (NAP), both large producers of palladium, especially after recent dramatic declines in futures prices on the New York Mercantile Exchange.

The price of palladium reached a recent high of just over $400 an ounce on May 14 before pulling back to its current level of $314, having reached an all time high of $1,082 in 2001. Total world supply of palladium is expected to reach 8.47 million ounces in 2006, while demand is set to touch only 7.14 million ounces, the report says. While some of the balance could be absorbed by investors, increased stocks look likely to put a damper on any price rallies.

The CPM outlook for platinum is similarly bearish and comes just weeks after prices hit a record high of $1,340 an ounce in May, then fell to about $1,190 now. Those high prices are part of the problem because, where possible, manufacturers are scrambling to substitute cheaper palladium in the development of catalysts and jewelry. Prices remain high enough to warrant switching. NAP and Stillwater both produce platinum also.

NAP and Stillwater are the only pure-play stocks for platinum-group metals listed on the NYSE. But they present totally different risk profiles to investors, warns Kevin Walkush, a stock analyst with Morningstar.

Although he gives both stocks a one-star rating, the lowest possible out of five, he prefers Stillwater. That's because the company has contractual price collars for both platinum and palladium through 2010, which should protect earnings from swings in the metal's price, especially those on the downside.

Collars are derivative contracts that limit the firm's exposure to both upward and downward movements in commodity prices. Currently, the spot prices of palladium are below the 2006 floor of $339, and platinum is significantly above the $856 cap, although only 16% of 2006 production is subject to the maximum.

The story over at NAP is completely different, and although in the past NAP has entered fixed-price contracts, it currently doesn't hedge palladium. The metal accounted for over half of the first-quarter revenue. It doesn't hedge its small platinum output, but it does occasionally use derivatives to fix the price of by-product metals, such as nickel, gold and copper.

"Shareholders like those of North American Palladium have a philosophy to buy the stock for its exposure to the metal," says Ian MacNeily, NAP's CFO.

Company management remains bullish on palladium going forward, noting the strong and increasing demand for palladium jewelry, which appears to be gaining in popularity as a substitute for platinum where prices are now sky high.

MacNeily also says that future earnings should benefit from a new underground mine starting operations with higher-grade ore. That will likely bring down the unit costs of production, thus helping earnings.

All of which means that Stillwater will be less subject to the vagaries of price movements when compared to those of NAP, but it's his overall analysis of value that has Morningstar's Walkush most concerned.

He says that both stocks got run up in the general metals madness and believes they still are significantly overvalued. His analysis shows a fair value for Stillwater of $7 a share vs. its current price of $11.80. For NAP, the fair value would be $3.50 vs. a current price of $8.50. And he doesn't see much upside in palladium to help earnings bring his value estimate up enough to warrant today's prices.

If he's right about the values, short sellers could do well, but when commodities are involved, even seasoned pros say the market can diverge from any underlying economics.

"One would think that given supply/demand balance that sees a surplus, you would see some downward pressure on prices," says Victor Flores, senior mining analyst at HSBC, who has underweight ratings on both stocks. "But to the extent that you have speculative investors in the market, the prices could go the opposite direction."