Outlook for Copper Far From Rosy

| About: BHP Billiton (BHP)

There are a lot of concerns over supply sources in the copper markets, even if the striking workers at BHP Billiton Ltd's (NYSE:BHP) Escondida, the world's largest copper mine, have expressed hope that settlement talks may resume.

Labor difficulties at other mines and China's reported needs to re-stock following inventory declines are also helping copper prices. Considering the softening we're starting to see in U.S. economic reports, it's probably a good time to consider what the market is forecasting what will happen to copper prices once normal operations resume. The clues aren't very upbeat. Futures "backwardation" suggests a long-term sustainable trading range for the metal that may be about 20 percent below today's cash prices.

Table A shows a count of open positions maintained for U.S. exchanges by the Commodities Futures Trading Commission, telling us that even in recent weeks, during the Escondida strike, non-commercial investors (or speculators) have continued trimming already-reduced long positions. Commercial traders have continued to increase exposure.

Commercial buyers actually need the metal and often must buy it even at prices they know to be unsustainably high. It can be a lesser evil than canceling production altogether or seeking a substitute material. They cope with bloated prices by accepting lower margins on their own offerings or passing on price increases to their customers.

Still, we cannot conclude from the relative absence of speculators and the predominance of commercial market participation that today's copper prices can be sustained. A better gauge would be longer-dated futures, contracts that presumably reflect expectations for a point in time beyond which current supply issues are likely to have been resolved.

Table B shows that the copper market is presently experiencing a very substantial degree of backwardation, a scenario where futures prices trade at discounts to fair value, the latter calculated as spot prices adjusted upward to account for carrying costs likely to accrue while the contract is open.

This has been the case throughout 2006. So in a big-picture sense, perceptions of near-term shortage have been essentially constant. That means the price boom was caused largely by expectations of a sustainable increase in the trading range, a view that is consistent with the increased demand from nations like China and India.

Switching the focus from the forest to the trees, or perhaps even a few leaves, we note that the degree of backwardation has diminished, albeit modestly, since copper peaked in May.

Table C offers a different perspective.

The year-to-date price changes reflect the upward shift in the overall trading range. More recently, we see that the longer contracts have not shared much in the post-peak correction that we've seen in the cash market and with the three-month contract. The same can be said in the smaller declines we saw as the strike progressed and, presumably, as market participants have been contemplating settlement.

This doesn't justify a definitive statement about future copper prices, which can be expected to respond to substantial revisions, for better or worse, in growth expectations for big economies. Yet let's assume assume current macro-economic forecasts pan out. Because there's been so little real change in those long-dated futures, a case can be made that the equilibrium price range will be closer to $6,000, which is about where the 27-month future now trades, than to the approximately $7,500 cash price that now prevails.

At the time of publication, Marc H. Gerstein did not own shares of any copper-producing entity nor did he own copper futures. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

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