With the three-month copper contract recently touching $8,000/tn on the London Metal Exchange (LME), the question arises: What is driving the copper rally and how sustainable is it likely to be? The quick retreat of copper prices from these levels already has some suggesting the fundamental picture does not necessarily match what the price action would indicate, and inevitably at least some of the appreciation can be attributed to paper accounts (those which have no physical holdings) and market speculators. To what extent this is the case however needs to be assessed, evaluating what extent the economic recovery, and particularly economic growth in China, are having on the price of copper.
As with the broader commodity markets, one of the main reasons for the sharp gains in copper prices in recent months is the global economic bounce, as the world comes out of the trough of recession and into what general consensus now deems at least the first stages of recovery. As with all commodities, the global recession hit copper prices hard, with the three month LME contract losing two thirds of its price in the last six months of 2008.
Copper has a particularly inelastic relationship with the global economy, because its two primary areas of use, electronic goods and construction, are those cyclical sectors which historically suffer most during an economic downturn. Similarly, they are two of the areas which tend to benefit quickest during economic expansion (or in this case, recovery) and so as global economies continue to show GDP growth, as many have during the early half of 2010, one could expect copper prices to directly benefit, possibly seeing a sharper reaction than the broader markets as a whole (price inelasticity means that a small change in GDP growth for example, would lead to a relatively large gain in price).
If we look at copper prices during this year, we can see the three month LME contract is up 166% from its lowest point in December 2008, or seen another way, has retraced around 89% of the losses made during the recession, from the July 2008 peak. If we now compare this with the S&P 500 equity index during the period, a traditional, if somewhat simplistic, proxy for the global economy (although unlike GDP and industrial output numbers, this is not a lagging indicator), the index is only up around 71% from its trough in early 2009, suggesting the global economic recovery is somewhat short of what a copper price would indicate.
From its peak in summer 2008, however, this is a retracement of around 85% of its losses made during the recession, coming very much in line with the move made by copper during the period. This would seem to suggest copper is making a ‘reasonable’ recovery in line with global economic growth, however this may not be the full picture.
Although copper prices peaked in 2008, the S&P 500 actually saw its top in 2007, not far from the 1,600 mark. Looking at the recent growth as a retracement of the peak to trough losses, it actually only represents around 75% recovery in the S&P 500, and certainly suggests the retracement in copper may be somewhat ahead of itself in terms of the rest of the economy. This itself opens up the metal to some price depreciation risk in coming months, and coupled with any broader risks to the global economic recovery and the potential for a ‘double dip recession’ (the details of which go beyond the scope of this article), leads to at least some potential that the copper price rally may stall in the medium-term, during 2010,
One of the key drivers behind this fundamental recovery in copper demand is and will continue to be China, the world’s number one copper consumer. The latest GDP figures from this Asian giant showed an 11.9% growth during Q1 2010, largely above expectations in the 8-9% region.
This economic growth brings with it a natural increase in demand for commodities: China acting as a ‘power house’ for copper prices while the country’s consumption needs to be met by global supply. However, it is this rapid growth itself which acts as another major risk factor to copper prices going forward. This massive economic expansion in China is increasingly seen as ‘overheated’, and almost all expectations now suggest the country will need to start to instigate fiscal tightening, in order to curb inflationary pressure and match the 8% growth target it set out for 2010.
Naturally any slowdown in economic growth will likely bring with it a decrease in demand for industrial base products, such as copper. Analysts at Commerzbank for example, expect copper imports in the country to fall by one third, having peaked at a record high last year; one of the primary reasons they note, for the sharp gains in copper prices during 2009.
However the extent to which this fall in demand will hit copper prices is hard to judge. Codelco, the world’s largest copper mining company, has suggested recently that it would expect demand growth for copper outside of China, to compensate for shrinking demand in the Asian country.
It is also worth noting that any contraction in industrial output in the country, and thus copper demand, is also likely to be mirrored by contraction in copper production from the country. This will at least in some part, balance the supply side with the reduced demand from the country, to an extent limiting the downward pressure associated with a supply surplus. Yet looking at the total exchange stocks of copper as they stand today, the combined stocks at the LME, Shanghai Exchange and the Comex exchange are in fact higher than they were at their height in 2008 (itself a divergence at the time between the fundamental supply side, and the copper price which was then at its peak).
Total copper stocks in these three exchanges currently stand at around 782,591 tonnes, compared to an average in July 2008 of around 166,000 tonnes. This shows the global supply levels already have the capacity to absorb an increase in demand for the metal, or looked at another way; any decrease in copper output from China is likely to be discounted in a market that already has ample supply, while the fall in demand will have a more immediate impact given the tentative nature of the global recovery and global industrial copper demand.
Global economic growth and the continuing fiscal strength of China are two of the key underlying fundamental issues, which have been supporting the copper rally in recent months. Likewise, they offer two of the main risk factors going forward to the extent and sustainability of the copper price appreciation. What happens to copper prices going through 2010 and into 2011 will depend largely on the factors discussed here, but that is of course not the full story.
The effects of currencies, particularly the Chinese Yuan and the US Dollar, will also be key to copper price action going forward. Further to this, the extent to which recent gains have been the work of speculators, and what effect this may have going forward, is another area that cannot be ignored.
Disclosure: No positions