Copper: Undervalued Amidst The Big Buyout?

Includes: FCX, PD
by: Marc Gerstein

Dealmaking is hot nowadays. Usually, that means corporate assets are perceived to be generally undervalued. That's always a debatable assumption, but especially so with Freeport-McMoRan Copper & Gold Inc.'s (NYSE:FCX) recently announced agreement to acquire Phelps Dodge Corp. (PD) for about $26 billion in cash and stock. Copper, the commodity at the center of the planned acquisition, has been described in many ways, but "undervalued" is not among them. Should it be?

Freeport expects the deal to be immediately accretive to earnings and cash flows. Paul Forward of Stifel Nicolaus stated, in a Nov. 20 research report, that the proposed deal would represent "fair value" assuming copper can average $3.00 per pound on the New York Mercantile Exchange's COMEX division through 2007. Freeport apparently expects that to happen. Although copper now is just barely above that level, at about $3.12, the company does not plan to hedge by using forward contracts to lock in today's prices.

That's not an easy assumption for the casual observer to accept. Last Friday, weak data relating to housing, a key end market for copper, pushed the price down to $2.98 during pre-market hours. And stockpiles accumulated by the London Metal Exchange and the COMEX have been growing.

But later on Friday, it moved back above $3.00, as sellers failed to step up their activity. Labor leaders at Chile's large Codelco Norte copper facility are talking tough, suggesting higher bonuses may be needed to avoid a strike. And inventories in warehouses monitored by the Shanghai Futures Exchange dropped 10 percent last week, suggesting that China's inventory buildup, which put a damper on recent demand, may be unwinding.

In balancing the varying trends, Table A shows that different categories of domestic futures traders have very different vantage points.

Table A — Commitment of traders, net positions

Date Spot
Open futures contracts, net
Non-commercial Commercial
11/17/06 3.11 -17,010 19,172
9/26/06 3.52 -9,601 12,089
7/3/06 3.54 -2,439 3,292
3/28/06 2.55 1,542 -4,421
1/3/06 2.24 2,704 -4,174
Click to enlarge
Commodity Futures Trading Commission data relating to high-grade copper futures traded on New York Mercantile Exchange COMEX division.

Investors, classified by the Commodity Futures Trading Commission as non-commercial traders, are in liquidation mode. Commercial traders, on the other hand, are accumulating long futures positions.

It looks at first glance like the flip-side of what we've been seeing with oil, where investors tend to buy high and sell low as commercial users do the opposite.

It's one thing to say investors are right or wrong. When dealing with commercial users, the rules of the game change. They can't simply exit a market if they don't like what they see in prices. Homebuilders need wire and for that they need copper; case closed. The aggressiveness or lack thereof in their accumulation of futures contracts has something to do with price expectations but also a lot to do with perceptions of future supplies. Present increases in their net long positions suggest that the Shanghai Futures Exchange view of inventories may be more representative of what the trade sees than is the case with LME or COMEX data.

Also noteworthy are trends in the relationships between futures contracts and fair values (which are adjustments to spot prices that account for the cost of funds). Copper has, lately, been characterized by noteworthy "backwardation," a condition wherein futures trade at discounts to fair value. That usually occurs when traders perceive shortages that are very likely to be corrected in the near future.

Some of that correction has already occurred. China throttled back on previously aggressive buying. And a major strike at the large Escondida copper mine operated by BHP Billiton Ltd. (NYSE:BHP) has come and gone. That's been reflected in a decrease in the degree of backwardation we've seen lately, as reflected in Table B.

Table B — Copper futures price differentials from fair values

Based on
closing futures
prices as
of . . .
Contract delivery dates
Jun. '07 Sep. '07 Dec. '07 Jun. '08
11/17/06 -3.79% -5.80% -8.09% -13.59%
9/29/06 -8.47% -12.51% -16.56% -22.71%
6/30/06 -17.88% -21.61% -25.22% -30.34%
3/31/06 -16.23% -19.07% -21.78% - -
12/30/05 -30.37% -32.25% -33.17% - -
Click to enlarge
High-grade copper futures traded on New York Mercantile Exchange COMEX division
Fair value estimates exclude storage and insurance costs

What's interesting, though, is the manner in which the backwardation diminished. Back in the spring when copper was peaking, naysayers feared the gap would be narrowed through a collapse in the spot price. We did see a correction in the latter, but not a crash (spot quotes still remain well above year-ago levels). Table C shows that a big part of the decrease in backwardation came about through increases in the prices of longer-dated futures contracts.

Table C — copper% futures prices ($)

as of spot price Contract delivery dates
Jun. '07 Sep. '07 Dec. '07 Jun. '08
11/17/06 3.11 3.09 3.07 3.03 2.93
9/29/06 3.52 3.35 3.25 3.14 2.99
6/30/06 3.54 3.06 2.96 2.87 2.75
3/31/06 2.55 2.28 2.23 2.19 - -
12/30/05 2.23 1.68 1.66 1.66 - -
Click to enlarge
High-grade copper futures traded on New York Mercantile Exchange COMEX division

Perhaps when all is said and done, copper is just one more asset that may be seen more favorably off Wall Street than on it, and that the deal between Freeport-McMoRan and Phelps Dodge is philosophically in line with many others: an effort to cash in on something investors in general aren't seeing.

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

Note: This is independent investment and analysis from the investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by