The Copper Bubble that Didn't Burst

| About: BHP Billiton (BHP)

A funny thing happened on the way to the bursting of the copper bubble. It didn't happen. Those looking for signs of a top, however, need to get past their memories of the Internet circa 2000 and focus on commercial factors, which are anything but benign.

In contrast to the typical investment bubble, where trends are driven largely by sentiment, supply and demand for copper are driven by physical factors, the amount of mined metal that can be delivered, and the amount that's put to actual use, largely for making wire.

Demand has been strong thanks to buoyant construction markets, especially homebuilding in the United States and the ongoing industrial buildup in the developing world, particularly India and China. But the U.S. housing market is turning downward. Whether or not the other sources of demand persist may depend on the extent to which the Federal Reserve can succeed in its efforts to fine-tune monetary policy. This may apply to China as well, since a significant U.S. slowdown would likely impact demand for imports.

Clearly, a dramatic decline in economic activity would put downward pressure on copper prices. Less clear is how sensitive copper is to smaller reductions in demand. That's because the supply side of the equation is looking tight right now. London Metal Exchange [LME] warehouse inventories of copper, while not at trough levels, remain low by historic standards.

The situation was exacerbated this week by a strike at BHP Billiton Ltd's (NYSE:BHP) Chile-based Escondida facility, which is the world's largest copper mine.

We have lately been hearing much about how the presence of financial speculators have driven copper prices higher than even the fairly robust demand-supply factors could have on their own. But Commitment of Traders data collected for U.S. exchanges by the Commodity Futures Trading Commission suggest this is no longer a substantial factor.

The number of long COMEX copper futures contracts held by "non-commercial" market participants (i.e. investors) has declined so far this year and is now at an abnormally low level. Net commercial positions (longs minus shorts) are high.

The most sensitive copper-pricing issue may be the Escondida strike — not so much the stoppage but the prospective settlement. Labor strife is an issue commercial buyers have been thinking about for a while and a case can be made that it has been factored into copper pricing.

Table C shows our estimates of the degree of backwardation in copper. This is a condition where prices for longer-dated futures trade below fair values. It tends to occur when buyers who need a commodity for their businesses feel the need to pay up to assure delivery in the face of shortages, but are less willing to pay up for delivery dates in the future, when the conditions causing a shortage are expected to abate.

Once the labor situation settles down, however long that may take, commercial buyers may feel less compelled to pay up for near-term deliveries which might, in turn, cause the degree of backwardation to diminish. It may not eliminate the backwardation: the strike isn't the only supply issue impacting copper. But it is a big one at present so it's possible we may see some closing of the gap between spot prices and future fair values, probably through a decline in spot rather than an increase in futures.

That does not spell a bubble-bursting crash. Even if the spot prices fall below where the 15-month futures are now priced, that would still leave the price well above levels that prevailed prior to 2006. But a decline of that magnitude could damage speculators who interpret the recent rally, which recouped most of the correction that followed the May 2006 peak, as a sign the party is back on.

Disclosure: At the time of publication, Marc H. Gerstein did not own shares of any copper-producing companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

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