Palladium is set to generate strong investment returns during 2010, driven both by its use as a precious metal and as a replacement for platinum in automobile manufacturing.

Palladium spot prices dropped by almost 3.7% on Jan. 21, from as high of $468.7 per ounce on just the previous day for spot delivery on the Nymex, following the recall of 2.3 million vehicles by Toyota Motor ( TM). The metal remained under pressure as Honda Motor ( HMC) joined the recall parade.

Nonetheless, the ongoing recovery in overall auto sales in the U.S. bodes well for the metal. During February, Ford Motor ( F) reported a 43% jump in sales, while General Motors, Honda, and Hyundaireported double-digit growth in sales on a year-over-year basis.

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Currently, palladium is trading at $456 per ounce for spot delivery, while platinum trades at $1,576 per ounce for spot delivery on the Nymex.

Citing tightening supply and increasing demand, analysts at JPMorgan chase forecast palladium prices at $700 per ounce in the long-term. Derek Engelbrecht, Impala Platinum, estimates a palladium deficit of 800,000 ounces during 2010 itself.

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In tandem with the current recovery in the automobile sector, stocks of palladium producers Stillwater Mining ( SWC) and North American Palladium ( PAL) are likely to see good times ahead. The two stocks have already appreciated 268% and 264%, respectively, compared with their 52-week lows on March 12, 2009, in tandem with a 112% run-up in the price of the commodity.

While palladium production is dominated by South African and Russian companies, Stillwater Mining is the only U.S. producer of this precious metal. Having similar physical and chemical properties, palladium and platinum often occur together in the same mineral deposits.

Stillwater Mining's palladium production is three times that of platinum, whereas its South African peers produce twice as much of platinum as palladium. In addition to the increase in prices, the company stands to benefit from the use of palladium in auto catalysts, which is likely to increase further as manufacturers substitute platinum.

During the fourth-quarter earnings call last week, Stillwater's CEO Frank McAllister said management will continue strengthening cost performance and improving mining efficiency this year, instead of seeking to maximize mine production alone. McAllister told analysts and investors that he has no expectations for parity between the two metals, but suggested that the price of palladium could potentially increase to half that of platinum.

Stillwater is a key supplier to Ford and is likely to benefit, as the latter is on the verge of grabbing the highest market share in U.S. automobile sales. The stock has one buy, no hold and no sell ratings, according to TheStreet's Analyst ratings guide.

North American Palladium

A Canadian precious metals company, North American Palladium owns Lac des lles (one of North America's two primary palladium producing sites) and the Sleeping Giant mine. According to President and CEO William J. Biggar, the acquisition of the Sleeping Giant mine in May 2009 reduced the operating risk and provided an additional source of cash flow for the company. The Lac des lles mine, which was closed for maintenance during 2009, will resume full-scale operations during the second quarter of 2010, in time for the company to benefit from the uptrend in palladium prices.

According to analysts polled by Bloomberg, the company, which reported a loss of 0.188 per share during 2009, is projected to report earnings of 0.075 per share for 2010 and 0.244 per share for 2011, reflecting expectations of a significant turnaround in its profitability. The stock has two buy, one hold and no sell ratings, according to TheStreet's Analyst ratings guide.

Investing in Palladium

On Jan. 5, the U.K. officially recognized palladium as a precious metal, mandating the use of a hallmark on products made out of the metal. Palladium has witnessed strong demand, especially from the automobile industry, which accounts for nearly half of the total consumption. Palladium prices are closely tied to the automotive industry, as reflected in the correlation of 0.946 between spot delivery prices on Nymex and the DJ US Automobile Index since 2009.

Investors can gain exposure to palladium through one of several ways:

a) physical palladium: ETFs and palladium maple coins;

b) palladium derivatives: futures on Nymex; and

c) palladium mining stocks.

Furthermore, ETFS Physical Palladium Shares ETF ( PALL), which commenced trading on Jan. 8, provides a new opportunity for U.S. investors to gain exposure to this precious metal.

The automotive sector drives around half of the global demand for palladium, while investments, electronics, dental products and jewelry account for the other half.

The revival in automobile demand and tightening environmental regulations around the world have led to increased use of platinum group metals in general and palladium in particular. Automobile production is estimated to grow at an annual rate of between 2% and 3%. In tandem, worldwide car ownership is expected to increase to 840 million in 2010 and 1,070 million in 2020, according to OPEC.

China, as the world's largest automobile producer and consumer, will play a dominant role in shaping the demand for palladium. In addition, the increasing automobile production in India and Brazil will support the robust demand scenario during 2010.

Moreover, palladium is likely to substitute platinum in automobile manufacturing. For most catalytic converter applications in automobiles, there is hardly a compelling product difference between platinum and palladium, whereas the spread between costs is fairly huge. Palladium spot prices averaged around $429 per ounce this year, almost one-third the $1,542 per ounce commanded by platinum. Experts believe that palladium can even replace the scarce Rhodium, another platinum group metal, for converting NOx emissions.

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