- After a multi-year hiatus, resumption in the annual growth of global mine production started in 2012, and now has the market for refined copper poised to enter into surplus supply.
- Further urbanization and industrialization of China, and to a lesser extent India, will continue to increase copper intensity; persistently threatening to overwhelm annual global copper production by 2019.
- It’s your father’s Oldsmobile – without continued rapid copper price appreciation, a return of responsible business practices to the exploration sector is warranted.
- Though important, potential tonnage is set to take a back seat to grade, capital costs, environmental impact, and geopolitical jurisdiction.
Introduction - copper, a metal for the ages
Internationally, the market for copper is one of the largest of all metals behind iron and aluminum. The size of the global market for refined copper is over U$150 billion annually. Copper has been a material component in the evolution of human civilizations for thousands of years, and the contribution of the metal defined the Bronze Age. Copper is easy to work with, an efficient conductor of heat and electricity, corrosion resistant, and abundant. In fact, the US Geological Survey (USGS) estimates 2013 global land-based copper resources of over 3.1 billion tonnes of which 690 million tonnes are listed as reserves. These estimates have more than doubled since 1970 as annual world mined copper production has increased. As an added benefit, recycling contributes substantially to the amount refined copper available, with estimates ranging from 20-30% of annual refined copper production.
Copper Pricing - China is the 800 pound gorilla
Except for a brief spike in 1994/95, nominal prices of copper remained consistently below U$1 per pound from 1980 to 2003. In fact, the annual average price throughout this period had a mean of U$0.90 and a median of U$0.82 per pound. The emergence of the BRIC nations from economic malaise has heavily impacted certain metals prices - iron ore being the most notable - but copper, lead, and tin prices all appreciated over 300% between 2003 and 2012. The shift over the last 20-years in industrial production away from developed countries to China has been both swift and staggering. China is now the largest consumer of many base and industrial metals, representing approximately 43% of global copper demand in 2012.
Source: ICSG and IMF
Mined Supply - in South America we trust
The composition of global mined copper production has also undergone a material shift over the last 30 years. In 1980, global mined copper production was regionally balanced, with North America representing roughly 28%. However, the current situation is markedly different. Mined copper production in North American has since stagnated; while Latin America and, to a lesser extent, Asia increased production substantially. In 2012, Chile alone represented 33% of global mined copper production. Chile is home to many of the largest copper mines including Escondida - the largest copper mine in the world with low cost production. For many developed nations within the Organisation for Economic Co-operation and Development (OECD), developing significant new (Greenfield) copper mining projects has become a serious challenge as stricter regulations, environmental concerns, and an inability to accurately predict capital expenditures (Capex) prohibitively increase project costs without removing the risk of significant political opposition. The current hostile environment was evident in the recent saga surrounding the large scale Pebble Project in Alaska.
The Spread Sheet Effect - sowing the seeds for higher copper prices tomorrow
For major international mining conglomerates, controlling spending is now in vogue. Xstrata (now a merged entity with Glencore) during a 2011 presentation, using Wood Mackenzie data, concluded both Greenfield and Brownfield copper projects had experienced an average capital cost intensity of U$3.49 per pound worth of annual production from 1985 to 2011, adjusted for inflation. Further, their expectations increased to U$6.79 per pound through 2012 to 2015 for Greenfield copper projects under construction. Therefore, it's not surprising to see large mining companies focused on cost. For example, Freeport-McMoRan Copper & Gold (NYSE: FCX) targeted reductions of U$1.9 billion in spending for 2013 and 2014, as well as potentially deferring other spending commitments. Within the mining sector, the time required to develop Brownfield projects through to production is expected to take roughly 8 years, and Greenfield projects twice as long. Though mined production of copper is set to increase over the next few years, increasing demand and reduced capital investment for exploration and development of new deposits will likely lead to material supply shortfalls around 2020.
The long-run trend of falling head grades for copper is an additional concern. Since 2000, average head grades for copper, without adjusting for production weightings, declined from 1.3% to 1.1% in 2012. Furthermore, the weighted average head grade for mined copper is likely less than 1% as several of the world's largest copper mines have been in production for many decades and are now mining extremely low grade ore (less than or equal to 0.5% Cu). As head grades decline, costs rise for a given tonnage. For low-grade mining operations to be economical, scope and/or scale must be sufficient. The economic benefit of scale refers to the unit cost savings achieved from increasing production through efficiency gains and the conversion of certain variable to quassi-fixed costs. The economics of scope refers to the production of multiple products, such as gold or other metals being a notable by-product of several different copper porphyries. In the absence of scope or scale, the long-run economics of relatively low-grade mining are unstable due to reliance on increasing commodity prices and concentration of operations to low-cost jurisdictions. Unfortunately, political risk and rapid cost inflation are serious threats for much of the world. The South African mining industry is a prime example as labour disputes, increasing government demands, and increasing extraction costs squeeze margins.
Copper Mining in the US - uncertain footing
Domestically, the US is home to two world-class legacy copper assets. The Morenci mine in Arizona, owned and operated by FCX, and Bingham Canyon mine in Utah, owned and operated by Kennecott, a division of Rio Tinto. Both mines have been operating for over 100 years and now have similar grades for listed proven and probable reserves of less than 0.5%, but are among the world's largest producing copper mines measured by potential annual capacity. Over the long term, it is uncertain whether these operations can continue to increase production to offset declining grades without the price of copper rising substantially.
Due to the difficulty in developing Greenfield mining projects, the US appears reliant on expansion (Brownfield) projects where existing production is, or previous was, in place reducing the likelihood of opposition. For example, Nevada Copper Corp (OTC:NEVDF), is advancing the Pumpkin Hollow Project in Nevada, which was first explored by US Steel (NYSE: X) back in the 1960s. From feasibility and technical reports, Pumpkin Hollow likely hosts proven and probable mineral reserves of 1 billion and 4.1 billion pounds of copper for the underground and open pit, respectively. Optimal annual mine capacity from both underground and open pit operations, assuming straight-line production, could total approximately 250 million pounds of copper through 2016 to 2027, before the underground is exhausted (the open pit would continue to operate).
Copper Exploration - finding silver linings
In the current global copper environment, where supplies, excluding secondary production ("scrap"), and first order consumption are largely being driven by single countries, there is upside for investors in well-managed exploration companies who are willing to be patient. Copper demand out of China should continue to be robust as Chinese economic growth is expected to remain healthy, albeit slower. The urbanisation of China is a long-run phenomenon that will take years, if not decades, to complete. Further, India is a significant wildcard for future demand as bureaucracy and inadequate infrastructure has seemingly hindered economic development up to this point. India's population could surpass China's as early as 2025, and is relatively poor when compared to even other BRIC nations; indicating tremendous potential if the country's newly elected government is able to make positive changes.
From a supply perspective, the dominance of Chile in primary production has sewn vulnerability into the global supply chain. There are two important challenges facing the Chilean mining industry that will impact the price of copper:
- Electricity - Chile generates enough power to meet aggregate demand. Unfortunately, there is a clear lack of transmission into the northern Chilean desert where large copper districts are located. Although, this problem has been known for some time - the compound annual growth rate for electricity costs stand at 11% since 2000 - there has been little action taken due to the required Capex investment and uncertain regulatory environment. Estimates regarding the mining sectors current representation of electricity demand in Chile vary between 20-33%, and these power costs are currently some of the highest faced by any major copper producing country. Peru, Chile's northern neighbor, appears to have realized the opportunity to supply electricity to these stranded mining operations; however, development will not be completed overnight. The solution to adequate power resources is becoming increasingly complicated as thermal coal generation comes under attack in much of the world. Until adequate power infrastructure is built, mining operations will likely face increasing electricity costs.
- Water - there are limited water resources in northern Chile, and it is both physically and politically impalpable to continue draining aquifers to meet mining requirements over the long term. Desalination facilities are now inevitable, but who is responsible for construction of plants and pipeline network across the region is less clear. What is clear is that desalination will increase costs. BHP Billiton has taken the initiative at the Escondida mine and is currently in development of a desalination facility, expected to be completed in 2017 costing U$3.43 billion.
Source: Reuters, IMF, and ZC estimates
Short-Term Price Forecast - caught in the crossfire
On average, copper prices are likely to be range bound throughout 2014 and 2015 before creeping higher. Growth in mined copper production stagnated between 2008 and 2011 as a result of the Global Financial Crisis (GFC) and the subsequent decrease in investment spending by large mining companies led to the deferral of several projects. However, the eventual start of production from these projects meant substantial growth in mined copper production in 2012 and 2013. The International Copper Study Group (ICSG) expects continued mine growth of 4.7% in 2014 and 7.3% in 2015.
Source: ZC estimates
The ICSG also expects secondary production, which includes the recycling of new and old scrap, to increase. We however, expect some relief on this front as scrap utilization appears positively correlated to copper price movements. If copper prices come under sustained downward pressure, we would expect reduced incentive for recycling processes, alleviating some of the pressure.
Source: ICSG and ZC estimates
In aggregate, we estimate growth in global production of refined copper to remain in excess of requirements for the next several years as deferred mining production continues to enter the market. We do not expect the situation to reverse prior to 2017/18, preventing copper prices from mounting a sustained rally. However, there is no expectation for a collapse in copper prices due to a combination of factors:
- Continued cost pressures for many of the largest mining operations - these pressures will likely continue as labourers demand higher wages, governments look to recoup spending commitments, and average ore grades continue to decrease.
- The International Monetary Fund (IMF) expects global growth in purchasing power parity to remain resilient underpinning continued demand for many base metals.
- Days of inventory - the ICSG estimates an annual surplus of global refined copper production of approximately 400 thousand metric tonnes (893 million pounds) in 2014. The last annual surplus took place back in 2009. However, current days of inventory have fallen by more than half from pre-2004 levels of well over 2 months of annual demand. Reduced inventory coverage indicates relatively short-lived disruptions would have an asymmetric impact on pricing of the metal.
Copper Demand Drivers - should we be worried?
Copper demand is a function of four major segments:
1. Real economic growth
- Transportation systems - according to the Copper Development Association the average vehicle in the US contains over 50 pounds of copper, and even more for electric cars. The average railroad locomotive uses 11,000 pounds of copper, while electric subway cars, trolleys, and busses contain a weighted average of 2,300 pounds. When these numbers are combined with farm and industrial equipment, as well as airplanes, the critical nature of copper in the development of modern industrial societies is plain.
- Industry - much of developing Asia is transitioning from rural agrarian based economies toward urban manufacturing based economies that require increasing amounts of commodities including copper. As China's economy continues to emerge, there are other Asian nations looking to "emerge". The ASEAN-5 (Indonesia, Malaysia, Philippines, Thailand, and Vietnam) have had recent geopolitical struggles, yet many have made substantial progress since the late 1990s. In particular, Indonesia and Vietnam appear to offer strong industrial growth potential.
Source: ICSG, IMF, and ZC estimates
- Building Construction - China and India should continue to require massive infrastructure investment as urbanization continues, of which copper will be instrumental. Intensity of copper use should be materially higher during development and construction of physical infrastructure than in developed economies. In China, between 2002 and 2012 over 178 million people moved into urban centers. BHP reports copper usage intensity in China increases by a factor of 2-3 times when comparing urban centers to rural villages. KPMG expects on average 15 million people to move into urban centers every year in China between now and 2030. Copper wiring and piping, as well as copper alloys are used extensively in both commercial and residential construction. In the US, the average single-family home of approximately 2,100 square feet uses 439 pounds of copper, while the average multifamily unit of 1,000 square feet uses 278 pounds of copper.
Source: World Bank
- Power & Telecom Infrastructure - copper is one of the best metals for conductivity and corrosion resistance. Though silver is a better conductor and gold more stable, the price differential of these two metals relative to copper prohibits substitution. Therefore, copper is ideal for power cables, building wiring, and telephone wire.
3. Capital Investments
- Technology - energy supply concerns and environmental worries, combined with increasing efficiencies and decreasing system costs for renewable energy technologies will continue to fuel renewable energy growth over the long term. Renewable energy plants require more pounds of copper per megawatt (MW) of capacity added than traditional fossil fuel plants (FFPs) and nuclear power plants (NPPs). Aluminum substitution for land based renewable technologies is a concern. However, the corrosion resistance of copper is important for offshore wind, which is likely uneconomic in the current environment but whose advantages should ensure eventual development along the US eastern seaboard.
Source: BBF Associates & J.A. Kundig, Ph.D.
4. Regional factors
- Population - global refined copper usage per capita (RCUC) increase from 1950 to 2012. However, between 1973 to 1993 RCUC was fairly constant at 4.4 pounds per capita before trending higher; again, illustrating the impact of non-OECD Asia development on copper usage intensity. Continued convergence of non-OECD Asia toward developed OECD should continue to drive RCUC from 6.6 in 2013 to 7.5 pounds of refined copper per capita in 2019.
Source: ZC estimates
Long-Term Outlook - exploration to benefit from mining sectors Capex cannibalisation
Copper supplies are likely to exceed demand in 2014 and 2015; we further expect this situation to persist for 2016 and 2017. This is less than an ideal environment for promoting rising copper prices. However, the economics of copper mining have changed dramatically over the last 11 years. Operating costs for the sector have risen substantially while head grades have, and are expected to continue to, decline. Additionally, copper inventories are also near historic lows preventing prices from moving back to pre-2004 lows. Over the 10-year forecast period, copper price are likely to rise as capital costs and regulatory risks for large scale mining development projects have become significant hurdles deterring investment into future production.
Source: LME and ZC estimates
Conclusion - junior exploration focused on grade over tonnage will add significant value
Expectations for the copper mining sector suggest there is little value in defining and proving-up low grade-large tonnage copper deposits in the current market, especially where environmental concerns are forefront.
If the economics weren't enough, the prospective Pebble Mine Project in Alaska - now orphaned as Anglo American and Rio Tinto have withdrawn - illustrates the difficulty in receiving regulatory and political approval is in much of the developed OECD when there is significant pressure from environmental groups. However, all is not lost, as previous exploration seemed to pay only marginal attention to grade and capital cost; instead preferring large tonnage-long life copper porphyries. Intuitively, the larger the project size the more access to financial and political capital is needed. In contrast, projects with potential average head grades above the world average should attract investment dollars even with reduced tonnage. To clarify, deposits with mid-sized aggregate tonnage (reserve size of approximately 450 million pounds of copper), and an average in excess of 1.2%, will have greater financing options and likely receive regulatory approvals faster, all else equal. The economics should improve with increasing head grade, all else equal; while a smaller operation may perversely increase the likelihood of approval.
Of course, there are other considerations including location, existing infrastructure, potential mine type, management, access to capital, share structure, environmental impact, etc. However, initially using grade, tonnage, and jurisdiction to vet projects provides value within the investment decision process.
Source: Stockwatch as at June 18, 2014
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