Palladium continues to defy underlying market fundamentals, suggesting it remains sorely undervalued relative to platinum. At less than half the cost of platinum, palladium’s absurdly low price is putting more pressure than ever on total global supply. Although nearly as much platinum is mined annually as palladium (only a 7.5% differential, according to USGS data), palladium is in its fifth consecutive year of supply deficit, which widened 500% last year alone, and platinum is expected to enter a seventh consecutive year of surplus.

The recurring supply deficits are partially attributable to substantial declines in annual sales of Russia’s state stockpiles, which have long been used to help meet total global demand (and/or suppress market prices). GFMS data suggests that such sales dropped 27% last year, lending some credence to Russian mining giant, Norilsk Nickel’s claims that the government stockpiles have been nearly depleted. Russia’s state palladium sales will continue through 2012, according to a finance minister, but it’s highly doubtful the total will exceed last year’s and even more unlikely there will be any sales at all in subsequent years.

Russia’s diminishing state stockpiles aren’t only to blame. Norilsk, which contributes about 40% of all the world’s palladium mine supply, reported a 5% decline in 1H 2011 production to 1.425 M oz. This indicates a possibility that output will be lower for the full year and beyond, as the company has no apparent plans to dramatically increase production in the near future.

Fortunately, other major palladium-producing countries will pick up the slack. South Africa, which also mines roughly 40% of the world’s total palladium, is mostly on track to increase total output despite a series of labor disputes and safety stoppages. The third and fourth largest producers, the U.S. (Stillwater Mining Company) and Canada (North American Palladium), have both reported higher output year-to-date.

So, supply should be stable this year; however, it’s physical demand that’s the real concern. Since both palladium and platinum are used interchangeably in many industrial applications (particularly in the automotive sector), global physical palladium demand is now growing more than twice as fast–and even faster in the world’s largest automobile markets. Chinese palladium demand, for instance, increased nearly 46% last year alone, compared to an 8% drop in platinum demand. The country’s burgeoning automotive sector may have slowed somewhat in the first half, but recently published figures for June and July show a significant turnaround following the Chinese government’s launch of a “Cash for Clunkers” type of program. Auto manufacturing in China is up about 2.5% so far and it’s quite likely the country’s palladium imports will surpass last year’s total.

Indian auto sales surged 30% in 2010, albeit at a slightly slower pace, and production (yr/yr) has grown by double digit percentages every month this year. Similarly, auto sales in Brazil climbed 10% during the first half to a record high. Production seems to be keeping pace and could continue as China’s JAC motors, Japan’s Suzuki and S. Korea’s Hyundai are all planning to launch new manufacturing operations in Brazil. These trends suggest it’s likely palladium imports to both India and Brazil will be higher by year’s end.

The U.S.’ auto industry may have been severely impacted by the Japanese earthquake in March, but palladium imports were still up during the first half with a noticeable 60% yr/yr increase in June, according to preliminary U.S. Dept. of Commerce statistics.

After a surprising 7.3% drop in output last year, Peru, now only the world’s second largest silver producer, continues producing less. Even though official 2011 projections were optimistic, so far the numbers just aren’t stacking up:

Consistent with the past 4 years, #5 Chile will likely report lower figures again in 2011. Nearly all Chile’s silver is mined as a by-product of copper producers, none of which is expected to ramp up production until 2012 according to Chile’s National Copper Commission (Cochilco).

The 6th largest silver producer, Bolivia, suffered a major
blow when miners went on strike earlier this year at two of world’s largest primary silver mines, San Cristobal and Coeur D’Alene’s (CDE) San Bartolome. You may recall that a major strike in 2010 contributed to the country’s 9.4% slump in total output.

Production in the U.S., the world’s 7th largest producer, is perhaps falling hardest, according to the USGS’ preliminary 2011 figures:

The 10th biggest producer, Argentina, may also produce less as many of its top silver mines continue to struggle. For one, Pan American Silver (PAAS) estimated that 2011 output at its Manantial Espejo mine would be 3% lower and Q1 figures showed a 12% decline. Secondly, Coeur d’Alene’s Martha mine produced half as much in Q1 2011 than it did in the same quarter last year. Lastly, Silver Standard’s (SSRI) Pirquitas mine produced substantially less silver in Q1 2011 than the previous 2 quarters.

#3 China will likely mine more silver, however, analysts should not count its projected increase in production towards total global mine supply due to its 3405 ton export quota. Silver investment demand in China is booming, as in India where silver imports climbed 222% in May 2011 over 2010 and 200% in Q2.

Demand is also growing rather briskly in the West where record silver coin sales have become the norm. The US Mint, for instance, reported that sales of its 1 oz. silver American Eagle coins are thus far 19% higher than last year. To keep up with growing demand, the San Francisco Mint had to begin minting these coins for the first time in nearly a decade.

Although yet to report any 2011 figures, we assume that demand is still high in Canada where the Royal Canadian Mint recently reported record Silver Maple Leaf coin sales which jumped 74% over 2009. Australia’s Perth Mint says its silver 1-oz. coin sales are at record highs as well. Sales from July 2010 to July 2011 are up 66% from total FY 2010 sales.

In Europe, the UK’s Royal Mint announced that 1H 2011 silver coin sales doubled and the Austrian Mint said that demand is so high that it plans to increase silver coin production by 36%.

Should these trends persist, government mints could further delay delivery and raise premiums for coins. Once investors truly realize how severe the circumstances have become, it’s only a matter of time before market prices catch up with what investors are actually paying to purchase the physical metal.