Copper Bull Marches On
Scott Wright October 30, 2009 3065 Words
Though not the most exciting of the earth’s minerals, the bellwether base metal has wrangled up a following. Since the beginning of copper’s powerful bull run, that took out all-time highs in 2005, this metal has made a place for itself on headline business-channel tickers and in everyday trader talk.
Today copper’s price action holds its place with oil and gold as a general barometer to gauge the health of the commodities markets. And this place among the commodities elite is righteous. Copper is an indispensable element of the global infrastructure build-out, its underlying fundamentals are transparent, and it trades in a very liquid marketplace.
But within this marketplace lies extreme volatility and a growing sense of uncertainty. On the volatility front all you need to do is glance at a price chart of any duration to see copper’s wild swings. Whether you trade futures or mining stocks, whether you are a swing trader or long-term investor, the copper arena is not for the faint of heart.
The speculators and investors that correctly game this market when volatility is to the upside have seen extraordinary gains. From its late-2001 low of $0.60 per pound, copper has had an amazing run in which its price rallied past $4.00 in 2008. Even capturing a small portion of this 575% trough-to-peak gain has been quite rewarding.
Of course volatility shows itself to the downside as well. For example, it only took 9 months for copper to shed 41% off the top of a major upleg that climaxed in May 2006. Now after it hit bottom it eventually clawed back to its highs. But even within this subsequent uptrend, volatility was still readily apparent. It hasn’t been uncommon to see 10%+ swings in a matter of weeks, or even days in some cases.
Moving forward, the price action that unfolded in the second half of 2008 was the epitome of downside volatility. The initial selling, as part of a healthy post-upleg correction, quickly took copper to the bottom of its trend channel. But instead of consolidating and finding a baseline for its next run higher, the selling would be accelerated thanks to a global economic crisis that culminated in the panic selling of nearly all assets.
By the time the dust settled, copper would shed a whopping 67% in only 6 months. The wild volatility showcased in this panic environment created extreme uncertainty in the copper markets. And this uncertainty is spread across a whole gamut of industry stakeholders.
We are seeing the miners throttle back exploration capex and cut production where they can. We are seeing industrial consumers radically alter output and stretch in-house inventories thin. And analysts are running around with blindfolds, pinning the tail all over the donkey.
On the mining front, some of the world’s largest copper producers have reacted strongly to this metal’s sharp decline. Up until copper’s turning point in mid-2008, this sector had seen incredible growth. In a business that is normally slow to respond to market conditions, copper miners ramped up production by over 12% from 2003 to 2007.
Over this span of time the world’s copper-mining industry experienced an enormous infrastructure build-out. Massive amounts of capital were poured into the expansion of existing operations and the development of new mines. The miners were resolute in their quest to meet fast-growing demand and take advantage of the high-price environment. But the global economic crisis would quickly change this industry’s outlook.
I don’t believe the copper-mining industry grew too much or too fast, but thanks to the panic some are crying foul. While I’ll touch on this structural argument in a bit, I will acknowledge that the panic has altered copper’s interim fundamentals. Where just a year or so ago this market was faced with what seemed like indefinite supply constraints, there is now a slight oversupply that the mining industry has had to painfully deal with.
And the fact that mine production will continue to see growth in the coming years will not make things easier. With copper production from new projects more than offsetting the production cuts seen elsewhere, the International Copper Study Group (ICSG) is forecasting mine output to grow by nearly 3% in 2009, and then by another 7% in 2010.
But interestingly, even with this expected mine production growth the ICSG expects capacity-utilization rates to decline to around 81% in 2009. This would be the lowest level in 20 years! Higher mine output and reduced capacity may seem like conflicting signals. But this capacity utilization is not referring to mine production capacity, rather refinery capacity.
A big chunk of the copper that comes out of mining operations is in the form of concentrate, which is useless until it is refined. After scrap and concentrate are fed to a refinery, it is the resulting product that makes up the supply side of the balance. Due to feedstock shortages, operational constraints, and temporary cuts at the refinery level, the overall copper balance is not as splayed as mine production growth rates would have you believe.
As for the overall balance of the copper market, the ICSG forecasts at least 3 years of a supply surplus that began in 2008. But interestingly this surplus is not expected to be a result of supply and demand moving in opposite directions. It is the product of slightly lower demand scrubbed up against relatively flat refined supply.
What is expected to be a marginal demand decline follows a huge 16% demand increase from 2003 to 2007. But the foreboding of this slight consumption drop, less than 3% through 2010, has the ability to rock the interim sentiment of the copper market.
Much of the negative sentiment from this slight demand slump has of course already been reflected in copper’s lower prices. It can also be fundamentally measured when looking at aboveground stockpile trends. As seen in the following chart, the uncertainty spawned by the panic really handcuffed copper’s end users. And they reacted by drastically altering their consumption habits.
The principal economic drivers of the base metals bulls are structural supply deficits. And when supply struggles to keep up with demand, prices are naturally going to rise in an effort to bring the markets to a balance. In copper’s case this trend was easy to see in the flagging stockpile levels at the London Metal Exchange.
By 2005 the warehoused holdings of the LME’s copper cathode had quickly emptied to where there was only about a day or two’s worth of inventory on hand. LME stockpiles had fallen by over 90% since 2002 before they finally hit bottom. And of course these alarmingly-low levels were cause for a risk premium affixed to copper’s price.
As you can see these low stockpile levels persisted well into 2008. With copper consumed at a rate of about 50k metric tons per day, the realization of such a minuscule supply held by the world’s premier nonferrous metals exchange had a resounding effect on the entire industry. Traders watch these LME levels very carefully. And as seen by the clear inverse correlation, they traded copper accordingly.
As mentioned, the panic had an immediate and material effect on consumption patterns. The sharp rise in LME stockpile levels didn’t happen because mine production had accelerated. It happened as a result of dramatic consumer reactions to the new panic environment.
Copper consumption appeared to grind to a halt as LME stockpile levels nearly tripled out of their 4+ year sideways trend. In fact, there was so little interest in buying copper that stockpiles continued to climb even after the panic bottom was in and copper’s price stabilized at 4-year lows. As the LME stockpiles continued to climb into 2009, the disconnect of this long-standing inverse correlation became apparent.
This was the case for all the base metals. Prices bottomed toward the end of 2008, yet stockpiles have continued to rise in unison with the price recoveries. In actuality one of the main reasons for this disconnect is prices fell too hard, too fast. And since the price declines weren’t fundamentally justified, the metals haven’t had to rely on fundamentals to get their prices back to where they need to be. In fact, commodities are temporarily slave to the directionality of the S&P 500. Fundamentals will eventually retake the driver’s seat, but for now all assets affected by the panic have grouped together in their various recoveries.
Recent price action aside, what is unfolding at the LME has been cause for extreme analyst dissention. If you look at 10 different reports on the current health and future of the copper markets, you’ll get 10 very different opinions. The analysts are looking at this fundamental gauge in very different ways.
Now I’m not going to offer a contrary opinion and tell you all the other analysts are wrong. But I will emphasize the importance of understanding the copper markets in strategic context. All too often it is easy to get bogged down with the details of the interim happenings in these markets. But don’t lose sight of copper’s secular trend.
Copper is still in a secular bull market, and probably only about halfway through it. Even at its panic bottom copper was still 111% above its 2001 low, well within secular trend sans the recent 137% recovery surge. And even if the ICSG is correct in its supply/demand forecasting (this organization is by no means the definitive oracle of the copper markets), the sum of the 2008, 2009, and 2010 surpluses don’t make up for the net supply deficit over the previous 5 years. There is still a structural supply deficit, and thanks to the panic it will likely get worse before it gets better.
It’s also important to understand that the remaining portion of copper’s bull will not be driven by the mature Western economies that are currently suffering major recessions. Some folks cringe when they hear the beating of the Chinese drum, but there is no denying that it is China that will lead the world’s developing economies in driving commodities prices much higher than they are today.
Even the ICSG acknowledges the major role that China plays in the copper trade. Its latest report shows an average decline in copper usage of 17% in the 3 major markets of the US, the EU, and Japan. Yet thanks to China’s “apparent usage” growth rate of at least 26% in 2009, world copper demand is only expected to be down by 1.6%. Provocatively, without China world copper demand would be down by 12% this year!
Much of this Chinese copper consumption is directly used in infrastructure projects, but a lot of it is also shunted into massive government and private stockpiles. China has smartly been taking advantage of the lower copper prices to grow these stockpiles, of course with the help of its huge $585b stimulus. And this stimulus is structured to support a sustained high level of copper imports well into 2010.
It is impossible to know the true size of China’s stockpiles, as this country isn’t too fond of reporting any of its strategic data to the rest of the world. But I’ve seen reports suggesting that China is sitting on as much as 1500k metric tons of copper. Much of this will eventually be used in development projects, but I wouldn’t be surprised if China was buying copper to replace some of its US dollar holdings. Even if China converts a small portion of its forex reserves into physical commodities, this alone will be a huge boost to commodities prices for years to come.
China also understands that it will not have free reign over copper supplies, at cheap prices, for long. Eventually it will have to compete for copper with the world’s other major economies as they pull out of their recessions. Overall it is China’s actions that are a major reason for this sector’s strength in 2009. Copper is the only base metal to exhibit a net stockpile draw, and this is impetus for the impressive 137% gain off its panic bottom.
Many analysts are skeptical of today’s China-supported copper market. They believe that once China stops buying this metal at such a furious pace, there will be a major crash. They are also of the opinion that this bull is over and we will never see $4.00 copper again. But I believe the folks in this camp are sorely mistaken.
While it is unlikely that China will be able to sustain such a high level of demand, copper’s long-term supply/demand fundamentals should be fine even amidst China’s easing. Yes we may currently be in the middle of a short-term supply surplus, but it is highly likely this will roll back over into a deficit in the coming years.
And believe it or not, the aftereffects of the panic environment are likely to make things worse than they would have been without a panic. Unfortunately it is the mining industry that will suffer the most. And many of the problems it is experiencing today, and those yet to come, will be born from the financial side of things.
In order to fund their aggressive development plans, the miners have taken on huge debt loads in recent years. This is normally not a problem in this type of business, as higher average prices would allow payback to be routine. But with the average copper price trending down from $3.15 in 2008 to $2.19 so far in 2009, debt payback is a bit more of a challenge.
And what makes this situation worse is these miners are watching their production costs rise. If copper prices remain low and there is continued downside volatility, unexpectedly-low cash flows will hinder the ability of some miners to pay back their debt.
In addition to debt-payback issues, the other big problem on the financial front is procurement. With the global economic crisis having a colossal negative impact on the debt and equity markets, the miners have really struggled to raise capital. The banks that are still actually loaning money have been a lot more hesitant to do so in the mining sector considering commodities price volatility. It has become a lot more difficult for the miners to refinance existing debt and acquire new lines of credit.
And the struggles raising capital on the equity front are just as precarious. With share prices down and less investor interest, even the larger copper miners are hesitant to tap the equity markets. And where the debt problems only trickle down to the smaller mining companies, the equity problems pound on them with the force of a raging waterfall.
Since the junior copper producers and explorers typically don’t have access to the debt markets, the equity markets are their sole source of capital. And these markets have violently seized up since the panic. Check out the essay I recently wrote on junior mining stocks for more thoughts on junior financing woes.
Ultimately these financial problems will manifest as supply problems. If the miners continue to have trouble procuring the necessary capital for exploration and development, we could see big supply disruptions. The copper mining industry has done a fine job expanding its infrastructure. But it is a work in progress, as this industry needs to be continually making discoveries and building mines to replace those that are being depleted. A constant flow of capital is needed in order for this to happen.
Also supporting copper’s long-term fundamentals are simple mine-level economics. The global economic crisis hasn’t changed the fact that we are in an environment of rising operating costs. And on top of that the miners must deal with the poor state of the US dollar. Many of these companies sell their copper for dollars and must then turn around and pay their mine expenses in a stronger local currency. They really need high-dollar copper in order to survive as long as the world’s reserve currency is weak.
Overall, even though the mining industry will have to scramble to recover from the panic splash damage, it is the elite mining stocks that will thrive as copper regains its footing. At Zeal we’ve been able to wade through the panic muddle, not losing sight of copper’s secular bull, to buy when others have been afraid. And in our newsletters we put our money where our mouths are.
Between both our weekly and monthly newsletters, the average realized return on our 2009 copper-stock trades is 88%. The average realized return on our copper-stock options trades is 264%. And a long-term investment in one of the world’s elite copper stocks that we opened in November 2008 already had an unrealized gain of 180% as of last week.
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The bottom line is the copper markets are currently going through a rebalancing effort to adjust for what has been a wild and crazy scene over the last year or so. In finding this new balance copper’s interim fundamentals have swung to the bearish side. And according to the ICSG we are in the midst of a period where falling demand has put the copper trade in a surplus. But nothing is clear cut in copper’s volatile, yet exciting, marketplace.
The China factor has taken a lot of the punch out of the fight, with its voracious appetite for this metal bridging what could have been a far worse situation. But regardless of the interim fundamentals, copper’s long-term fundamentals are strong and its secular bull is still intact. Investors can play this wacky market by keeping close tabs on what are likely to be post-panic mining woes, and then cherry-picking the elite mining companies that are positioned to thrive in the rebuilding efforts.
Scott Wright October 30, 2009 Subscribe at www.zealllc.com/subscribe.htm