What I'd like to do in this article is give a brief survey of copper mining, production and usage and then discuss my copper investment decisions. This is not intended to be an exhaustive survey, but instead is more like my previous article, which gave a brief overview of iron ore.
Broadly, the three types of copper deposits you'll read about in company reports are copper sulfide porphyry deposits, iron oxide copper (sulfide) gold deposits [IOCG], and deposits that are largely copper oxide. Porphyry deposits usually contain some molybdenum, silver and gold. Freeport-McMoRan's (FCX) Grasberg mine is an example of a large porphyryr deposit. Copper content of the ore of 0.5% or below would be considered low, whereas above 2% would generally be considered on the higher side.
The content of copper and other metals effects the cash cost of mining the ore. For example if the copper content is low you have to dig more ore to recover a given amount of copper and that costs money. It follows then that additional revenue from molybdenum and/or gold makes a project more profitable. IOCG, as the name suggests contain gold, and often contains uranium as well. The large BHP Billiton (BHP) Olympic Dam project is a IOCG deposit.
Investors also need to be aware that copper sulfide deposits are processed differently to copper oxide deposits. Copper is extracted from sulfide ores by a process called froth flotation. From there the copper concentrate is eventually smelted and electrolytically refined.
Because the ores contain sulfur, sulfuric acid is a by product of the process. Copper is extracted from copper oxide ores by first using sulfuric acid to leach the copper from the ore and then using a process called solvent extraction and electrowinning (SX-EW) to produce copper cathode, which is highly pure copper metal. The leaching process can take several weeks and although the sulfuric acid is collected and recycled, projects tend to be net consumers of sulfuric acid.
Currently approximately 22% of copper is produced by SX-EW. The cash costs for producing copper cathode from sulfides might range from 40 cents to 60 cents per pound depending on the scale of the project. To produce copper cathode from oxides the cash cost may range from 100 to 130 cents per pound.
These estimates are illustrative and will vary from project to project and depend on such things as the concentration of copper and other valuable metals in the ore, the depth and scale of the deposit, and the prices of fuel, sulfuric acid, labor and electricity.
Clearly copper mines, both sulfide and oxide, will be profitable at current copper prices. As a rule though copper sulfide deposits will tend to produce greater returns due to lower costs.
Chile is the worlds largest copper producer with over one third of world production. Peru produces about 8% of world output and the USA about 7.5%. Since early 2009 increases in supply have come from increased grades at Freeport McMoRan's (FCX) Grasberg mine in Irian Jaya, and new production at Equinox Minerals (EQXMF.PK) Lumwana mine in Zambia, and Freeport McMoRan's (FCX) Tenke-Fungurume mine in the Democratic Republic of Congo.
These two projects are in an area known as the African copper belt, which is located on either side of the Zambia - Congo border (see map below).
This increased production partially offsets declines in production at other established mines. The International Copper Studies Group [ICSG] forecast 2010 world mine production to increase by 2 per cent to 16.2 million tonnes with increased production coming from Chile and new production from Oz Minerals' Prominent Hill mine more than offsetting declines from reduced output at BHP Billiton's Olympic Dam.
Looking beyond 2010, the ICSG forecast annual mine production capacity for the period 2009-2013 to grow at an average rate of around 4.3% per year to reach 23.1 metric tons in 2013, which is an increase of approximately 19% on 2009 output. World refinery capacity is predicted to rise by 13%. So growth in mining capacity is predicted to outstrip growth in refinery capacity, which would reverse the current situation where refinery capacity outstrips mining capacity.
When considering the supply and demand fundamentals, investors need to examine where growth in demand is going to come from should the increased supply predictions eventuate.
As discussed in a previous article, United States consumption of copper has been decreasing for some time as we can see in the chart below.
The ICSG reports that usage of refined copper was down 20 % in the USA to Nov 09 (and down 19 % in the EU and 28 % in Japan). This doesn't bode well for a rise in copper demand in the foreseeable future.
Chinese "usage" grew by 41% in 2009 and essentially took up the slack left by sharp declines in usage in the US, Europe and Japan. It is generally assumed that a large proportion of Chinese purchases in 2009 were stockpiled rather than used industrially. Some pundits have referred to this as mindless stockpiling. For me, there doesn't seem to be anything mindless about it. The logic behind some of the increased importing of copper by China can be illustrated in the next chart where China copper imports are plotted agains the London Metal Exchange [LME] price.
We clearly see here that in the first half of 2007, 2008, and 2009 China increased its imports of copper when the price of copper transiently dropped. This seems to make sense to me -- buy at the low end of a price cycle.
In early 2009, copper prices plummeted to a 5 year low and China's copper imports soared. Again this seem like smart planning to me, nothing mindless about it -- use some of your US dollar reserves and take advantage of a 5 year low in the price. Of course Chinese buying stimulates a surge in the price so we have this feedback loop in the market.
The effect of Chinese purchases on the LME stockpile is shown in the next chart. Here I've inverted the LME stockpile so we can (hopefully) more easily follow how the LME stockpiles are influenced by Chinese purchases.
Apart from the "absolute" price of copper on the LME (and COMEX), the price relative to the price of copper on the Shanghai Futures Exchange [SHFE] also influences purchasing decisions. Arbitrage opportunities exist when the spread between the LME (and COMEX) and the SHFE widens sufficiently to offset the cost of shipping and taxes.
Note that trading on the SHFE is restricted to Chinese firms and commodities held on mainland China. Preference for imported copper partly explains the rising stockpile on the SHFE from under 20,000 metric tons in January 2009 to over 110,000 metric tons currently.
In other words, Chinese industry doesn't seem to have been drawing down the locally produced copper stockpile. Local Chinese copper production has also increased almost linearly for several years (I'm guessing the drops in production in the first quarter are due to the Chinese new year).
Another point to note is that as of July 2009 Chinese imports of scrap had dropped 36% year-on-year to 2.19 million tonnes. On the other hand the amount of scrap available may have been reduced to due lower global economic activity so it is unclear if scrap imports were reduced because refined imports were increased.
Economic Demand vs. Speculation
The total amount of refined copper used industrially is currently close to 16 million metric tons. In 2009 24.9 million contracts were traded on the LME. Each contract is for 25 metric tons of copper. The total quantity of copper traded on the LME was therefore 623 million metric tons. Each metric ton of copper will be hedged by many parties in the consumption/production chain.
For example producers, traders, fabricators, distributors, and so on will all hedge to some extent. Nevertheless the volumes being traded make it clear that industrial entities involved in the copper consumption/production chain are a minor proportion of LME activity. (COMEX and SHFE volumes need to be included as well).
It follows that price movement, either up or down, are not necessarily reflective of the real economy. Prices rise due to increasing demand, but when the amount of copper being traded is multiples of the amount being used industrially we need to be clear that we are talking about speculative demand for futures contracts, not demand for the physical metal.
From the point of view of the markets, or the commodity producer, it doesn't matter who the buyer is: more buyers than sellers means rising prices. The problem arises when you use market price -- at face value -- to draw conclusions about the economy.
So what happens when speculative demand is not aligned with industrial demand? What if the majority of buyers are not end users of the commodity and do not take delivery, i.e. speculative buyers? If the buyer doesn't take delivery then you would expect stockpiles to rise. In other words if industrial demand is not strong relative to industrial supply you would expect to see quantities of the commodity that are available, i.e. stockpiled, to increase.
Economics 101 tells is that if supply outstrips demand (i.e. rising stockpiles) the price should drop. In other words price and stockpiles should be inversely correlated. In the next chart I've plotted a rolling 4 month correlation between price and stockpiles on the LME. The green region is the region where the correlation is negative, meaning that prices and stockpiles seem to be moving according to economic fundamentals.
At the other end of the scale is the region where prices and stockpiles are positively correlated, meaning they are moving opposite to what every textbook every economics written would predict.
Another way of looking at this is to invert the price and normalize both inverted prices and the stockpile on a scale from zero to one. We expect that in such a chart the two lines would track each other reasonably closely. We see that they do track each other up until about the time that China had completed the majority of their importing. After that they diverge sharply.
What these two charts are saying is that even though the large buyer (China) had left the markets (broadly speaking), speculators still continued betting as though the party hadn't stopped. Of course when speculators out number industrialists, rather than providing liquidity to the market, speculators become the market, and therefore it will only be when the sentiment changes that this folly will correct.
So where to from here? Well I can't predict herd sentiment so I am currently avoiding until I see changes that lead to prices being more aligned to economic fundamentals. If and when a correction occurs I'll be looking to buy either or both of Freeport and Equinox. Freeport is probably well known among readers. Equinox has been producing for just over a year. In 2009 they produced 110,000 tonnes of copper and have forecast 135,000 tonnes in 2010. So this is a major project just beginning but with a mine life of 37 years.
The latest guidance from the company is that the cash cost is on the high side -- for a project of this scale -- at $1.35 per pound. Additional upside possibilities include uranium processing and increased copper mine capacity.
- Informative article from the Arizona Mining Association
- The Mining Valuation Handbook (Dr Victor Rudenno) A good book to have on hand for any investor attempting a fundamental valuation of a mining company.
- International Copper Study Group ICSG] publishes mining and refining output data, global usage data and annual forecasting of supply and demand.
- Copper Development Association
A big hat tip to Josh Hoyt of Metallic Conversion Corp for his insights into the scrap market, hedging along the copper chain, LME/SHFE spreads and overall general knowledge of the global copper market.
Disclosure: Author holds a long position in BHP