Of all the precious metals of interest to investors, palladium may be the one to watch going into the second half of 2012.

Palladium’s supply and demand fundamentals are bullish for the metal’s price, with a widely predicted supply deficit starting this year and deepening by next. Meanwhile, demand is rising.

Still, you would never have guessed that based on its recent performance. Currently, the price isn’t far off its lows. The problem to date is that in a “risk on” environment, palladium, which is used largely in automobile catalytic converters, has been getting shorted aggressively, especially by the hedge funds, says Wiktor Bielski, the London-based global head of commodities research at VTB Capital, the Russian investment bank. To understand why palladium has traded down despite the strength in the auto market, you have to keep an eye on the long versus short statistics released every Friday by the U.S. Commodity Futures Trading Commission, Bielski says, noting that all of the industrial metals are trading like risk assets right now. With palladium, “I have to say that anybody playing the short side has done very well,” he says. But, Bielski insists, “you can’t fight the fundamentals forever.”

After hitting a year-to-date high of 71.51 on February 22, ETFS Physical Palladium Shares (PALL), the only U.S.-listed ETF backed by physical palladium, closed on July 9 at 57.48, a decline of 19.6 percent. At this level, PALL isn’t far from its 52-week low of 52.90, and it’s well off its 52-week high of 83.90.

Is there a lot of mileage left in shorting palladium? “Probably not,” says Bielski. “The risk/reward is clearly skewed more to the upside.” He predicts that as a result of the way palladium has been beaten down by the shorts, “the stronger and more sustained the rally will be when it comes.” Just when that will occur, he says, “is just impossible to predict at this point, unless you have a line into Ms. Merkel and the euro zone leaders.”

One of the leading reasons why a number of fundamental commodity analysts like Bielski are strongly positive on palladium is that Russia has announced that 2012 will be the last year for sales from its Cold War–era stockpiles. Back then, Russia was mining nickel aggressively to build military equipment, and it ended up with lots of palladium as a by-product. Up until now, Russia has been the second-largest producer of palladium (behind South Africa), with over 46 percent of global annual production, according to research from ETF Securities of London, PALL’s sponsor.

Bielski cautions that the Russians haven’t said their stockpiles are depleted; they have said that they will “stop exporting from their stockpiles.” No one knows how much, if any, palladium is left in those stockpiles, because the Russians have never released any data, he says. But, he adds, “They’ve clearly run down their stockpiles very substantially.” And he notes that it’s possible to do educated guesswork based on the mining of nickel by Moscow-based Norilsk Nickel, the world’s largest producer of nickel and palladium.

Johnson Matthey, a London-based precious metals refiner known for its accurate forecasts, has estimated that the Russian government will release 250,000 ounces of palladium into the market this year, down from 750,000 ounces in 2011. The firm also cites Norilsk Nickel’s guidance that it expects to be producing slightly less in the way of newly mined palladium this year, in the range of 2.6 million to 2.65 million ounces, down from 2.81 million ounces last year.

As result, Bielski is projecting that the global supply of palladium will fall short of demand by between 500,000 to 600,000 ounces in 2012 and by 800,000 ounces in 2013, in a total market of 7.5 million ounces.

In South Africa, palladium is a by-product of platinum. South Africa produces 60 percent of the world’s platinum, and “at the moment, there are some issues in South Africa, as the low price levels of platinum and palladium are pushing producers to shut down production that is uneconomical,” says ETF Securities analyst Simona Gambarini in an email. She notes that Aquarius Platinum announced the closure of its Marikana mine for late June, and with two other mines suffering problems with labor strikes this year, South African PGM [Platinum Group Metal] mine production was down 30 percent in the first four months of 2012, compared to the first four months of 2011, contributing to a tightening in supply.

Matthey notes that while new production of platinum from South Africa’s mines has fallen, releases of metal from inventories meant that total shipments from South Africa of platinum rose by 5 percent to 4.86 million ounces last year, and with a ramping up of mined output in North America following shutdowns in 2010, and new and expanding operations in Zimbabwe coming on-stream, the company expects platinum to be in a surplus again this year. That will keep the price in a range of $1,450 to $1,750 per ounce in the next six months, averaging $1,600, the firm says, in its 2012 forecast on platinum and palladium issued on May 14. As of July 9, the firm was posting a base price of $1,446 per ounce on its web site, slightly under that range. However, Johnson Matthey also believes the market for palladium will swing back into deficit this year, and that positive fundamentals are likely to support a price range of $620 to $800 per ounce and an average of around $715 in the next six months. On July 9, the firm’s posted base price for palladium was well under that, at $582 per ounce.

In that 2012 forecast, Johnson Matthey also notes that this year’s projected deficit of palladium would be in stark contrast to 2011’s surplus. The big reason for last year’s surplus, it says, was ETFs. The funds had been big buyers in 2010 but turned negative in 2011, returning 565,000 ounces to the market. Gross demand for palladium as a result fell by 13 percent last year to 8.45 million ounces, the report says. While both palladium and platinum are used for catalytic converters, which control auto emissions, platinum is used more for diesel cars, which represent half of the European market, whereas palladium is used more for smaller, more fuel-efficient vehicles.

Gambarini of ETF Securities notes that the Chinese government’s recently approved stimulus package includes a subsidy aimed at encouraging rural residents to trade their old vehicles for new, more fuel-efficient models. Since the autocatalyst market in China is almost entirely dominated by palladium, this is “particularly positive for palladium,” she says. Auto sales in China have been strong, with the sale of passenger vehicles rising 16.6 percent year-over-year as of May. And auto sales have also been strong in the U.S., where palladium also dominates, she notes.

Still, Gambarini is somewhat cautious. She says she is “overall positive about the fundamentals of palladium over platinum,” but both are “likely to be weighed down by the slowdown in global growth in the short term.”