Standard Bank recently reported that market participants seem more confident about palladium’s prospects compared to other precious metals. They are not alone. Analysts are also expressing optimism about palladium. Barron’s quoted Rohit Savant, senior commodity analyst for CPM Group, as saying “we are most bullish on palladium among all of the precious metals.” Three factors that appear to be driving positive sentiments are auto sales, South Africa, and a potential supply deficit.

The latest Commodity Futures Trading Commission report shows that investors are continuing to buy into palladium ETFs, and that open interest on the NYMEX has surpassed last year’s average.

HSBC also recently reiterated a forecast of $785/ounce as the average price for palladium in 2012, adding that it anticipates a range of $600 to $900 this year.

Palladium demand

Bullish analysts have expressed expectations for positive palladium demand this year.

Savant projects 5.05 million ounces going into catalysts and 1.3 million ounces going into electronics.

HSBC is projecting automotive demand at 6.022 million ounces, though an estimated 1.6 million ounces will come from recovery. The bank expects electrical, electronic, and chemical demand to consume 1.52 million ounces. Jewelry is expected to consume 425,000 ounces and ETF demand another 400,000 ounces.

Auto demand

Palladium’s positive performance largely hinges on demand from the automotive sector, where the metal is used to produce catalytic converters. Thus far in 2012, there has been some reason for optimism in this regard.

Scotiabank reported that stronger than expected vehicle sales in North America have prompted automakers to schedule a further increase in vehicle assemblies.

In the US, the world’s second largest auto market, February’s sales numbers beat analysts’ expectations, following strong sales in January. It’s seen as a positive sign that this strength is occurring in the absence of a stimulus program. With an aging fleet and pent-up demand, the trend is expected to continue as long as the economy holds up.

Sales were strong in neighboring Canada in January, which Scotiabank estimates was the best month in that market since May 2008. Business purchases appear to have lent a helping hand to auto sales in that nation.

Impressive figures are also coming out of Japan, where a fuel-efficient subsidy program is expected to drive demand this year. Based on January sales, Japan claimed its highest market share since last March.

However, according to Johnson Matthey, in China, the largest auto market, passenger car sales for the first two months of 2012 saw the biggest decline since 2005.

Falling Chinese auto sales are not a negligible matter with regards to palladium, but Scotiabank pointed out that China’s performance was excluded from its January assessment because sales were impacted by the early lunar new year.

While palladium investors will also likely want to take the recent festive period into account, it should be noted that China’s palladium imports for February fell 40 percent month-on-month.

South African production problems

When considering strong demand, the sources of supply must also be taken into account. The second-largest supplier of palladium is South Africa, where the metal is mined along with platinum. The palladium market has found support this year rooted in concerns about production losses among that nation’s miners.

Impala Platinum (OTC Pink:IMPUY,LSE:IPLA) is a prime example of one issue: labor disputes. The company is trying to get its Rustenburg mine back online after weeks of strike action halted operations and resulted in 100,000 ounces of lost platinum production, equivalent to R2 billion in losses.

Similarly, a strike on March 15 stopped production at the Modikwa mine, a joint venture between African Rainbow Minerals (OTC Pink:AFRBY) and Anglo American (LSE:AAL,OTC Pink:AAUKY), where some 3,000 workers downed their tools in connection with demands for a twelve percent wage increase.

The production of South African miners is being hammered by labor disputes, and if disgruntled workers aren’t presenting enough of a challenge, regulators are aggravating matters with safety stoppages that can shut down a mine for hours or days.

Sharps Pixley said that platinum group metals (PGM) production dropped 36 percent in October due to safety inspections.

Russian stockpiles

Russia, the leading producer of palladium, is also suspected to be a source of diminishing supply.

Last year, Anton Berlin, Marketing Director at Norilsk Nickel (OTC Pink:NILSY), said that the palladium market could see a deficit as early as 2012.

Both HSBC and Barclays are now saying that they too are expecting a palladium deficit this year. They expect the shortage to result from declining palladium sales from Russian government stockpiles

While there is much focus on when Russia’s government stockpiles will be depleted, Berlin pointed out that even a reduction from Russia could change the market.

It is believed that the supply from Russian government stockpiles has largely been responsible for keeping the palladium supply in positive territory.

HSBC said its forecast for a deficit, and thus its bullishness, is largely based on reduced sales from this source.

The bank estimates that about 500,000 ounces were sold from the stockpiles in 2011, but predicts that the Russian government will only sell 300,000 ounces this year.

Suki Cooper, precious metals analyst for Barclays, says expectations are very much based on the fact that the supply from Russian state stocks is expected to be much lower than they has been in previous years.

Last year, Berlin said information leaked from a government source warned of a reduction this year, though no figures were provided.

Palladium investors

A softening of prices was witnessed after it appeared that Impala Platinum had ironed out its issues, eliminating supply concerns upon which some appear to have built their palladium positions.

Still, investors may not want to read too much into that, as analysts at both Standard Bank and Barclays expressed expectations that palladium will put up its best performance later this year. That positive showing is expected to continue in the long term, with prices rising over the next several years.

Investors should also exercise caution about making investment decisions based on expectations for a palladium deficit connected to the Russian stockpiles. For years theories have been afloat about the longevity of that supply and they have often been disappointing.

Developments that palladium investors should keep their eyes on include South Africa’s production issues and the auto market, with a special focus on China.

Securities Disclosure: I, Michelle Smith, hold no direct investment interest in any company mentioned in this article.