The Real Message Behind Rising Copper Prices

Includes: BHP, FCX, RIO, XSRAY
by: Investment U

by Tony D’Altorio

Most people understand copper’s vital role in the global economy. The red metal is often said to have its Ph.D. in economics because of its sensitivity to global growth.

Earlier this year, copper soared past previous records to $10,000 a ton on the London Metal Exchange. Taking that as a sign of rapid economic growth ahead, bulls took off with the idea and never looked back.

But maybe they should.

Investors need to look at the supply and demand laws that govern commodities. And as such, they need to understand whether strong copper prices are a result of a global demand surge and strong economic activity… or simply a supply-side shock…

Lack of Supply Causes Copper Prices to Remain High

Despite a recent correction in price, copper prices remain high. But that’s because of a lack of supply, not booming demand.

Since 2005, mined copper has fallen short of production targets by at least 5% a year. That equals about 1 million lost tons annually.

So even if global economic growth were modest, copper prices would still be high. This is the same situation we saw in late 2009 and early 2010.

And globally, production could fall further in 2011, according to leading industry consultancies, CRU and Brook Hunt. Already, output at four of the world’s top 12 copper mines is set to drop significantly this year.

Freeport-McMoRan Copper & Gold (NYSE: FCX), the world’s biggest listed copper mining company, highlighted that problem in January. It found that production fell by almost 5% year on year in 2010.

In February, another significant mining company, Xstrata PLC ADR (PINK: XSRAY.PK), admitted much the same. The “development of new copper projects,” it said, “remains challenging due to skilled labor and engineering shortages, more onerous environmental and planning regulatory requirements, community dissent or increased political risk.”

Meanwhile, the quality of the remaining ore at existing mines is falling, adding to the drop in production.

Copper Mining Exploration Continues

Yet high copper prices are encouraging mining companies to keep exploring, despite lackluster results.

For example, according to a report by the Metals Economics Group in Canada, copper exploration financing surged to $1.2 billion in December 2010. It only stood at $300 million the month before though.

The increase did little good, as December produced only one new find that may or may not be worth it. November also yielded a single possible candidate.

In addition, most of the “discoveries” last year were simply extensions of ore bodies next to existing mines, rather than entirely new deposits.

As for the projects now coming on-stream, the Metals Economic Group says they’re all known deposits. Some were discovered 20 years ago but won’t start producing until the middle of this decade.

And yes, it can take that long for a new copper mine to come on-stream. The Group’s CEO, Michael Chender, says, “The inference is that it could take another 20 years for a new generation to progress from greenfield discoveries to mines.”

Copper Investors Wearing Rose-Colored Glasses

Investors would do well to read the signs clearly instead of looking at copper through rose-colored glasses.

The commodity is certainly undergoing an imbalance of supply and demand right now. But that’s due to a lack of supply, not because of any booming economic growth.

This is great news for shareholders of big copper companies like Freeport McMoRan, Xstrata, Rio Tinto ADR (NYSE: RIO) and BHP Billiton ADR (NYSE: BHP). But investors shouldn’t automatically expect the same for the global economy.

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