Supply Side for Copper: A Game Changer in 2010?

Copper has had one hell of a run. On October 20th, I wrote a post for Seeking Alpha arguing that even if copper did not break through the $3/lbs. level, mining stocks would be able to fare just fine. My argument is relatively simple and straightforward: with copper prices significantly above even the producers with the highest marginal cost of production (somewhere between 90 cents to 1.50/lbs.), copper miners can earn an excellent return on invested capital. So long as copper prices remain strong (notice I did not say 'keep climbing'), copper mining companies should continue to drift higher and I would expect them to outperform the general market.

Some recent data put out by Barclays indicates that the supply of copper is expected to increase by 8% in 2010. This would undoubtedly be a significant headwind for the price of copper to overcome, if it were only true.



The reality of the situation is probably nowhere near as extreme as 8%. In fact, investors must ask if that number is even logical. Very few companies maintained capital budgets over the course of 2009 and quite frankly they probably won’t bring their budgets back into full swing during 2010. As I recall, a lot of the mining companies I tend to focus on cut their cap-ex spending by at least 30%. Where in the world is this 8% increase in supply going to come from?

I am not exactly sure why analysts that forecast mining supply are so off so consistently when it comes to projecting growth in mining supply. The reality of the situation is that they are consistently off target by being far too optimistic about the supply side of the equation.



Over the past 3 years, the analysts responsible for projecting mining supply have tended to overestimate the growth in supply by about 7% on average with respect to copper. So perhaps the actual supply of mining will increase by 1-2% during 2010, but one must seriously doubt it will increase by 8%.

In fact Barclays argues that,

it would be wrong to consider these current ‘market consensus’ projections for 2010 output as not at risk from some revision. There are some obvious sources of risks capable of disrupting current production schedules. First, the risk to output estimates stem from an increasing number of labour strikes – rising prices have inflated miner’s expectations, whereas mining companies are generally still in defensive balance sheet mode, meaning the risks of fall-out are high. Already there have been such episodes at mines in Canada, Chile and Peru. Related to this, lower capital expenditure budgets – in some cases close to bare minimum needed to sustain facilities - mean that output is generally at higher risk of disruption. In addition, many of the new mine projects coming online are located in less established mining countries, thus being at greater risk of logistical and labour deficits. Depletion of ore reserves is a particularly serious issue for copper and zinc mines, resulting in a moderation of run rates at existing mines as well as fewer new projects.

What can investors conclude from all this? Demand is not the only thing that affects prices. Sometimes the supply side of the equation is the crucial dynamic that can be missed by investors. I am not sure how one can measure how widespread a certain perspective is, but if the 8% supply growth view is a relatively entrenched view within market expectations for copper then the market might very well be setting up for some solid performance out of the red metal, as well as copper mining companies, throughout 2010 as their supply expectations are proven to be WAY too optimistic (yet again).

Disclosure: Author remains long FCX, PCU, and VALE.

Comments

[doubleguns]

Supply will be impacted as soon as the Chinese warehouses finish filling up.

2009 Nov 17 09:28 AM

[BudH]

China continues to build warehouses

2009 Nov 17 10:34 AM

[davidbdc]

Keep in mind that there are a couple of copper mines currently off-line due to labor disputes. Throw in a couple of very large mines under development in Mongolia and China and you have the potential for more than an 8 percent increase.

Then consider that China may have bought copper this year just as a hedge against the dollar and you may have more supply and less demand than current estimates. I own PCU so I want copper to remain around $3...but realistically I expect it to pull back at some point in time next year.

2009 Nov 17 03:10 PM

[Rohan C. Pease]

Valuation, Valuation, Valuation. I owned PCU at $18 this year and recently sold my stake. PCU and FCX have $3/lb for 2010 priced in to the stocks already. If you go long PCU at this level, you should expect copper to exceed $4/lb by next year to make any significant return.

2009 Nov 17 03:15 PM

[capt Brian]

Trying to keep it simple, [as I must due to my IQ], Copper is omnicient. Watch the price of copper, and it will tell you the heartbeat and health of the world economy. As copper prices rise, we are in recovery, as they fall, recessionary tendencies are looming more and more, as prices stay in the sub $3 / lb level, we are in stagnation. Depending on the level of the economies of the world when stagnation of copper prices begin, is the seriousness of the situation at the time. Using the Kitco copper chart, notice how price of copper presages the economies of the world. Now copper prices have gone up, [reason is not real imporrtant, the fact that prices are rising is.] At the sub three dollar level, it has paused, and I say the economy of the world has paused along with it. Yes, some users are stockpiling but I feel that has slowed to a trickle, and that 'buying bubble' has diminished somewhat if not totally. Copper is used in "all things in the economy", from Coins to Cars. So as the demand of copper goes, so mirrors the economy. Supply side economics are [for sure] important indicaters, but demand is, in this case, more powerful. AND demand is just not recovering. Real prices of copper could stay in this range or drift lower until manufacturing and economic recover is real, which when you bring a loss forward that has been shelved til you need a tax shelter does not increase demand for copper. I for one, do not believe in the recovery [yet I am going with the flow being long some stocks vigilantly] and ready to bail.
Copper tells me, we are not recovering.

I am buying numismatics, physical silver and gold, ETFC, PAL, GSS, and TTM, I am simply day trading these, and the only one I feel is a position trade is TTM, the rest have short term limits as I believe the market is ready for a fall

Happy grins to ya

Capt Brian
The Lost Navigator

2009 Nov 18 08:37 AM

[relaplan1]

I believe copper is principally niether a supply or demand play, but is principally a US Dollar play. And, it will continue to be such for the indefinite future.

2009 Nov 18 10:28 AM

[J. B. Wulff]

If you don't own FCX, always keep an eye on it. The folks who run this are quite simply superb in their execution over decades. I must confess that I recently was guilty of selling too soon. I made a bit, but missed a lot. Done it before, may do it again. I never stop watching. I have the princely holding of 14 shares from 1995. That's a dig at myself. When I first bought in, it was a sulfur business.

2009 Nov 19 03:53 AM

[Stone Fox Capital]

agree. Supplies never seem to come online as fast as expected. If it was, the world would be flooded with people selling copper at over $3.

2009 Nov 19 12:03 PM

[Windsun33]

What is scary right now about copper and some other base metals is that the prices on some are even higher now than they were 2-3 years ago during the great housing and auto boom years, when demand should have peaked.

2009 Nov 19 02:51 PM