Whither Copper?

by: Hamlet Capital

According to the analysts discussed herein, copper's weakness in 2012 is not likely to be repeated. Goldman Sachs, RBC Capital and BNP Paribas anticipate improvements in Chinese construction, U.S. housing and development in emerging economies will boost copper prices. Morgan Stanley wrote of strength in China's power infrastructure and projected increases in appliance and auto production that will keep demand high. According to official estimates by Antaike, demand is likely to recover in 2013 because of recently-announced infrastructure projects in China.

Goldman's forecast of $3.62 per pound copper by April and $4.08 by July were tempered by others recognizing high inventories. Barclays expects copper prices to average $3.59 in 2013 on account of high stockpiles in China and increased mine supply. They noted higher prices will be difficult to sustain without consistently stronger Chinese demand. Commerzbank observed that moderate inflation in China could prompt monetary stimulus, thus increasing copper demand, but was careful to note that this effect might be dampened due to new copper projects coming on-line in Mongolia, Peru and Chile.

Some analysts are not so optimistic regarding new mine production and point to serious supply considerations. Scotiabank noted that mine delays in Peru and Chile, which account for more than 40% of the world's copper supply, are expected to lend support to copper prices in 2013. Tom Meyer with Scotiabank estimates that about $57 billion in mine investments have been delayed or shelved in Chile and Peru. At least 15 mining projects in Peru alone have been delayed because of social unrest. Combined with expanding Chinese urbanization and infrastructure building, near-term supply constraints could send copper to $4.29 per pound in 2013 and $4.80 in 2014, Meyer claimed.

While analysts rightly weigh Chinese copper demand, which accounts for 43% globally, it is supply issues which are a glaring concern, as miners are no longer saturating favored areas with projects. Citing a 20-percent rise in energy costs, Antofagasta (OTCPK:ANFGY) recently scrapped expansion plans for its Chilean Antucoya project slated to open in 2014. To make matters worse, Chile's Supreme Court rejected the planned $5 billion Castilla power plant project citing environmental concerns. Barrick's (NYSE:ABX) Pascua Lama mine was to be supplied with power from that project, which may incur additional delays and costs.

Constraints on companies like Barrick are not limited to South America. In the Middle East, Barrick lowered its copper production forecast for 2013 based on permitting delays at its Jabal Sayid project in Saudi Arabia. In Asia, local opposition has affected Xstrata's (OTC:XSRAY) proposed $5.9 billion copper and gold project in the Philippines, where the government would not issue permits without first enacting a new mining reform bill. In Africa, state plans have limited access to the rich copper deposits along the border between Zambia and the Democratic Republic of the Congo, as both countries are amending their mining laws to include a 35% stake per project for their governments. In Mexico, copper production recently suffered its biggest single-month fall in two years during October. Even in supposedly friendly mining jurisdictions like Canada, Taseko (NYSEMKT:TGB) is struggling with labor disputes and First Nations' objections, while Teck (TCK) has been frustrated by environmental opposition.

These permitting, labor and environmental barriers are added burdens on top of already declining copper ore grades. In its 2012 yearbook, the International Copper Study Group (ICSG) reported that the mine capacity utilization rate averaged 81% between 2008 and 2011, while production grew annually on average by only 0.9%. The ICSG cited factors for this disparity that included lower ore grades, labor disputes, technical problems, and temporary shutdowns or production cuts. With lower ore grades, Fitch Ratings warned,

In 2014, substantially all the mine production growth will come from new greenfield projects and these are subject to higher risk of production shortfall. New production from Africa, where infrastructure is less developed, also faces higher risk of shortfall particularly from power disruption.

Lower-grade ores have made for larger operations in more remote areas, where there is poor infrastructure and a dearth of qualified personnel. As Rick Mills has pointed out, capital and operating expenditures have inflated across the whole mining complex on account of these declining grades. Capital-intensive greenfield projects in riskier locations require substantial infrastructure spending and come with a higher risk of delays and cost overruns. It is for this reason that he favors brownfield mines in locations with adequate existing infrastructure.

Given the World Bureau of Metals Statistics (WBMS) reported copper deficit of 129,000t for the first half of 2012, there is little short of a severe global slowdown that could rectify this imbalance. Producers are fighting an uphill battle in terms of declining ore grades, increased expenditures, resource nationalism, and environmental and labor issues. It is unlikely that copper miners can fill the deficit void in the near term. Substantial demand increases would herald a massive jump in prices, not unlike that from 2005 to 2007.

Ranked from best to worst, senior miners listed below all had negative earnings growth in 2012.

Southern Copper (NYSE:SCCO), which operates in Peru, Mexico and Chile, has a relatively high valuation with a forward P/E of 15.25. Its margins are very strong, with a 52.55% operating and a 29.01 profit margins. With a good return on equity at 36.29%, it pays a generous dividend.

Freeport-McMoRan (NYSE:FCX), which was punished by shareholders for its decision to expand into energy, is relatively cheap with a 7.63 forward P/E. Though its projected annual EPS growth over 5 years is only 4.7%, its books are strong with a 16.98 debt-to-equity ratio. Its copper operations are widely spread, however, projects in Indonesia and D.R. Congo are at a higher risk for exposure to resource nationalism.

BHP is the most expensive of this group, with a forward P/E of 16.55. With copper operations in Peru, Chile and Australia, it has had a constantly rising dividend over the past decade, currently yielding 2.90%. Its current ratio of 0.93 should be cause for concern.

Vale (NYSE:VALE), with copper assets in Brazil, Canada, Chile and Zambia, had a poor 2012. Though relatively cheap at 8.95 forward P/E, its return on equity is weak.

In addition to undesirable returns on equity, Rio Tinto (NYSE:RIO) and Teck both have poor gross and net margins. Rio's forward P/E of 8.32 is significantly lower than Teck's 15.21 valuation. Both companies' dividends yield 2.50%. Both outfits mine copper in Peru and Chile, with Rio having additional operations in U.S., Australia, South Africa and Mongolia, and Teck having Canadian assets. Rio's Mongolian locale is subject to a higher risk for exposure to resource nationalism.

Though better known as a gold miner, Barrick has significant copper resources in Chile and Zambia. Though cheap with a forward P/E of only 7.06, Barrick's balance sheet has a relatively high debt to equity ratio of 50.24. Its net margin is only 6.32% and its return on equity is a slight 12.92. Of this group, its dividend is lowest, yielding 2.30%.

Short of buying copper futures, the closest instrument tied to the spot copper price is iPath's copper ETN (NYSEARCA:JJC), designed to reflect the performance of COMEX futures. To avoid risks associated with companies, namely labor disputes, permitting, high capital costs, negative publicity, and so on, JJC is recommended as the safest vehicle to take advantage of copper price increases.

Supply concerns are likely to be an important and volatile factor for copper throughout 2013, perhaps more so than Chinese demand. A close monitoring of events and a thorough assessment of derived instruments could make for a profitable year in copper.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.