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Copper is on a tear. On Thursday it hit an all time high on the London Metal Exchange of $10,000 a tonne. Key industry mining stocks, FCX, SCCO, BHP, RIO, AAL.L and XTA.L, traded on heavy volume throughout the week before reaching tops on Thursday. On Friday they eased slightly on moderate volume in profit taking. On the COMEX futures continued higher on Friday and every open contract between now and 2014 added between $ 0.035 and $0.039 to its price.

Supply

There is a saying in the commodities markets that the best cure for high prices is high prices. That is, when prices are high producers will ramp up production to meet demand, which lowers prices. Or, alternately, consumers will decrease consumption as the price rises, again with the effect of lowering the price. In addition to those correctives, consumers will also substitute other products in as many cases as possible which will also decrease demand and therefore the price.

That’s in the first week of Economics 101; however, if you didn’t drop the course then to take a subject that’s less quantitative, for example Art History, you know there’s more to it than that. In the case of ramping up production of copper if producers decided in mid to late 2010 to do just that it would be not be until 2014 that the increased production would be up and running long enough to fill the supply requirements. To start a Greenfield operation, or make a significant expansion in an existing mine, take much time and much money,

First, environmental concerns have to be addressed and permits granted. This may or may not also be a serious political issue. Then the project, usually costing many millions of dollars, has to be financed. After that all manner of things can go awry or be delayed. In this mature industry all the low hanging fruit has been picked so the incremental cost of new production is high.

Miners are facing the decreasing quality of ore; unfortunately low grade ore costs just as much a ton to move about as high grade ore, and it takes a lot more of it to produce the same quantity of saleable product. BHP Billiton (BHP) is forecasting a 10% drop in production in its largest Chile mines for just this reason. Freeport McMoRan (FCX) cites safety issues at the huge Indonesian Grasberg mines as the reason for a 130M ton reduction in production there in 2011. Southern Copper Company (SCCO) may face labor actions at its Chilean mines. The Democratic Republic of Congo decided to change or cancel contracts for companies that have already invested huge sums on mines in the country. Logistics are a problem from Zambia to Mongolia.

There are several projects under development that will begin producing copper this year and all told about a dozen going into production between now and 2015. However, it does not appear that production will increase any faster the historic 3% or so a year. The price elasticity of supply measures how the amount of a product firms wish to supply changes in response to a change in price. It does not appear that the price of copper causes much near term increase in the supply of copper therefore we can state that there is little supply elasticity as a response to copper prices.

Demand

Copper is widely used in manufacturing, construction and electric energy distribution. In an economic model we might expect a decrease in demand due to its current high price. Global demand will outstrip production this year due to two factors. First, copper inventories worldwide and especially in China, the US and Germany have been drawn down to their lowest levels in years. The London Metal Exchange’s warehouse inventory has dropped from 540,000 tonnes a year ago to 400,000 tonnes now.

Second, copper closely tracks industrial production, construction and the expansion of electrical energy development. For many products, for example an automobile, copper is not a high percentage of the production costs. Therefore, the number of cars manufactured is not going to decrease as the price of copper goes up; the usage depends more on the price and demand for cars than it does the price and demand for copper.

Price elasticity of demand measures the percentage change in quantity demanded caused by a percent change in price. We can state that copper’s demand is relatively inelastic to price. China, the world’s largest copper user, continues to grow industrially, in housing construction and in the distribution of electricity. It is anticipated the emerging nations will expand at a greater rate than the developed countries thus also increasing demand for the red metal.

Price

We have discussed above that an increase in price does not necessarily increase the production and supply of copper. Therefore, it can be stated that the price elasticity of supply is very low. Because an increase in price does not diminish demand a great deal we can state that the price elasticity of demand is also quite low.

The other factor which contributes to price is the cross price elasticity of demand. This measures the percentage change in demand for a particular good caused by a percent change in the price of another good. That is to say, for some applications aluminum can be substituted for copper. The usual ratio between the price of aluminum and the price of copper is 2:1 or 3:1. Currently it is about 4:1, which means that aluminum is relatively cheaper than usual.

One might expect that in this case there would be a lot of substitution for cost savings. However, that is not the case as aluminum can only be used in a few cases. In this case we find that the prices of aluminum and copper do not affect each other very much. That is, there is low cross-price elasticity.

What This Means

Very simply stated the demand for copper is increasing at a faster rate than the supply. This is exacerbated by low warehouse stocks worldwide. Copper’s demand is inelastic to price; coppers supply is inelastic to price; there is little cross elasticity between copper and aluminum. Therefore, there will be a shortfall through the years of 2011 and 2012 and users of copper will raise their bids in the marketplace and the price may be expected to rise.

Source: The Price of Copper: A Matter of Supply and Demand