By Jon Ruff
Investors have turned bearish on commodities, particularly in the case of copper, where recent talk of a looming surge in new supply has sparked fears of a price rout. We're skeptical about the copper supply-glut story and don't think what's happening in copper is a "canary in the coal mine" for the rest of the metals markets.
Investors' worries about copper revolve around two issues. First, the markets are bracing for a flood of new supply, estimated to be the biggest increase in global mine output in 13 years. Second, copper prices look excessive at first glance. In contrast to many other metals, copper trades roughly 50% above "fair value," as defined by the marginal cost of production.
Case closed? Not so fast. First of all, if history is any guide, this supply glut will never happen. The mining industry has a horrendous record for fulfilling its own promises regarding new capacity. Copper producers have consistently and significantly underestimated the labor, political, and geological obstacles of bringing new mines on line, causing them to fall far short on new supply and cost projections for the better part of the past decade.
Furthermore, regardless of how the near-term supply/demand balances shake out, supply will not meet longer-term demand unless new mines get built. Unfortunately, new copper mines are expensive. Expanding existing projects often requires costly adjustments. For example, the century-old Chilean Chuquicamata mine has had to shift production from above-ground open-pit mines to much more challenging and expensive underground mines.
Building new mine sites is even more costly than expanding old ones, often involving less-politically stable countries and massive new infrastructure investments. For example, it took Rio Tinto (RIO, OTCQB:RTPPF) some 18,000 workers to build the giant Oyu Tolgoi project in the middle of the Mongolian desert, and also involved tracking down a new water source 30 miles away and constructing a dedicated power plant. Despite its hefty investment, Rio Tinto nearly suspended construction earlier this year when the Mongolian government threatened to renegotiate the economics of their agreement.
As we see it, the massive costs and risks involved in finding and opening new mines today hints at why copper prices continue to float above marginal cost: prices need to be high enough to provide miners with an adequate return on their investment in costlier and riskier new mines. Are prices higher than they need to be in order to induce the required investment? Modestly, perhaps, judging from the doubling in capital spending planned for 2013-2016 from 2009-2012 levels. However, if copper prices revert much further toward marginal costs, these projects may become uneconomical and eventually shelved, creating an implicit medium-term price floor.
Barring any deterioration in demand, we believe that there are too many uncertainties on the copper supply side to make a cut-and-dried case for a sustained price plunge. Moreover, while commonly regarded as the commodity bellwether, copper's supply dynamics are unique to copper and have only superficial relevance to the outlook for other parts of the commodities market. If anything, the unique risks and opportunities facing copper investors today highlights the benefits of diversification both within the commodity complex and between commodity futures and the stocks of commodity-producing companies.
Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Jonathan Ruff is Lead Portfolio Manager and Research Director of Real Asset Strategies