Freeport-McMoRan: Copper Glut Will Hurt Profitability

| About: Freeport-McMoRan Inc. (FCX)

Freeport-McMoRan (NYSE:FCX) could be badly hurt by a falling demand for copper in China. China's economy is slowing down and, with it, production of electronics and other items that need copper as a raw material. This is causing stockpiles of the base metal to gather dust in warehouses in Shanghai, which is driving down prices.

Bloomberg reports that prices for May delivery orders of copper fell by .6% in London. The fall was caused by reports that stockpiles in Shanghai exceeded present Chinese demands. A Bloomberg survey indicated that the March inventory was 530,000 tons, which was more than double that for the fourth quarter of 2011. The inventory then was 200,000 tons, which means that there were no buyers for around 330,000 tons of copper.

China's demand for copper fell by 12% between December 2011 and February, according to Reuters. Part of this fall can be attributed to the fact that exports of copper to China were too high. Shipments of refined copper reached a record high of 406,937 tons in December. That could account for a lot of the glut of the metal on the Shanghai market.

That's very bad news for Freeport-McMoRan, which bet heavily that China's demand for copper would remain high. The company's biggest copper operation is in Indonesia at Grasberg, and the main market for the Grasberg production is in China. Freeport has made a huge investment in Indonesia, even buying 25% of a smelting operation in the country.

Betting on China made a lot of sense for the world's largest publicly held copper mining company. These Chinese use 40% of the world's copper, and their demand for it seemed to be insatiable. Well, that appears to be no longer the case, which puts Freeport-McMoRan in a very awkward position.

China's demand has fallen because of the weak European economy, which has lowered the demand for consumer goods. Even the frenzy for devices like the iPad (NASDAQ:AAPL) doesn't seem to be reviving the economy. Part of the problem is that less demand for finished products in Europe means lower production and fewer jobs in China and less demand in China itself.

It is not clear if this is the end of the Chinese boom or not. What is clear is that if the U.S. economy does not start recovering and raise demand for consumer goods, Chinese copper demand will keep falling. That means bad news for Freeport-McMoRan and other copper producers that have bet heavily on China.

Copper makes up 73% of the company s known reserves and most of its future plans. In addition to massive expansion plans at Grasberg, that include underground mining, Freeport has long -term plans to develop a massive new mine at Tenke Fungurume in the Democratic Republic of the Congo. These plans center heavily on copper and seem to take the Chinese demand for granted.

At Grasberg, Freeport-McMoRan has no other mineral to fall back on. There is some gold there, but that only makes up about 5% of what is being mined. If the Chinese demand disappears, that could leave the company without any sort of all- back reserve.

Freeport-McMoRan is not the only copper company that is betting heavily on China. Glencore International (GLEN.L) is planning to restart its Philippines copper refinery sometime this summer. The facilities at Philippine Associated Smelting and Refining Company's refinery in Leyte were shut down by a fire in January. The fire destroyed pollution control equipment, but the new equipment should be in place for a June or July reopening, Reuters reports. The refinery processes copper ore from mines in the Philippines, Papua New Guinea (where Grasberg is located), Canada, South America, and Australia.

It is hard to say how this refinery's reopening will affect the situation in China, although. Although it will probably make the glut of copper at the Shanghai warehouses worse and drive copper prices down further. The Leyte facility refines 60,000 tons of copper concentrate a year, according to Reuters.

Continued investment in the copper industry still makes a lot of sense because copper prices have continued to rise despite the lack of Chinese demand. Copper prices have fluctuated between $8,200 and $8,700 a ton in March. Part of the reason why prices are fairly high is that there is still a 101,000 ton shortfall in global supplies of refined copper, Reuters reported. This is down from a 358,000 ton shortfall in 2011.

Copper inventories are at their lowest levels since January 2009, according to the International Copper Study Group. The Group predicted that there would be a 250,000 ton shortfall in copper supplies in 2012, which should disappear next year. So it is entirely probable that demand elsewhere in the world could make up for the decline in Chinese demand, although that may still depress prices, because China still accounts for 40% of the world's demand for copper.

The higher prices could also be caused by disruptions to the copper supply, such as the Philippine Associated Smelting and Refining shutdown and labor troubles at Grasberg. Grasberg has been hobbled by strikes and unrest over wages in recent months. Even though the last strike ended in December, workers are again threatening to walk because of unpaid wages.

Even with labor troubles and the decline in Chinese demand, Freeport-McMoRan's heavy investment in Grasberg and Indonesia makes a lot of sense. Shipping costs between Indonesia and China are certainly much lower than shipping costs between China and Chile, which is the world's largest copper producer.

Massive Increase in Chilean Copper Production Planned

Freeport-McMoRan's biggest competitor in the Chinese market is Codelco (the National Copper Corporation of Chile), the gigantic mining company owned by the Chilean government. Codelco is planning to invest $4.3 billion to expand and improve its facilities in 2012. This includes major expansions to the Ministrio Hales and El Teniente Mines. The company also plans to add 16,000 workers as well.

What this planned expansion will do the copper market is hard to say. One possibility is that it will greatly add to the glut of copper on the market. The International Copper Study Group is already predicting that the existing copper shortfall will disappear next year. If Codelco goes through with its plans and floods the market with cheap copper, it could depress prices and hurt private producers like Freeport-McMoRan and BHP Billiton (NYSE:BHP).

It should be noted that Codelco's plans would be very good for the Chilean economy and Chilean politicians. Codelco's board is appointed by the President of Chile and includes the country's mining minister and a representative of the miner's union. Obviously, Chilean politicians are more interested in re-election, which can be bought by promising their voters lots of high-paying mining jobs rather than the price of copper.

Codelco has also taken other steps to increase production. In January, it exercised its right to buy 49% of Anglo American Sur (Anglo-America's Chilean operation). The final price wasn't mentioned, but it was reported to be $6 billion.

Half ownership of Anglo American Sur would give Codelco control of even more of the world's copper supply. Anglo American owns the Las Bronces, Mantos Blancos, Mantoverde, Charges, and Collahausi mines in Chile. It also owns 44% of the Compania Minera Dona Ines Collahausi. In 2008, Anglo American produced 638,792 tons of fine copper in Chile, 174,203 tons of copper cathodes, and 462,488 tons of copper concentrate.

Anglo American Plans Massive Copper Project in Alaska

Codelco's move could hurt Anglo American PLC (NASDAQ:AAL), which has only three copper operations outside Chile, two in Peru, and the Pebble Partnership in Southwest Alaska. The Pebble is a joint venture between Anglo American and Northern Dynasty Minerals (NYSEMKT:NAK). Mining has not yet begun at Pebble, which supposedly contains one of the world's largest concentrations of copper. It is estimated that there are 80.6 billion tons of copper, 5.6 billion tons of molybdenum, and 107.4 million ounces of gold at the Pebble.

What the impact of all this added copper will do to the world's supply is hard to say. It would definitely affect Freeport-McMoRan, which is the world's largest non-government copper producer and the world's largest produce molybdenum through its Climax Mining subsidiary.

That is if the Pebble project ever goes into operation. The mine will need 67 different types of permits from the U.S. federal government, local governments, and the state of Alaska in order to go into operation. To make matters worse, it will undoubtedly face challenges and lawsuits from well-financed and politically powerful US environmental groups that could delay or halt it. Pebble also faces strong opposition from the seafood industry, which is also well -financed and politically influential.

This makes Freeport-McMoRan's expansion of copper operations in Indonesia and Africa look smarter. African generals and Indonesian politicians are greedy and sleazy, but at the end of the day, they want the mining to go on because it puts money in their pockets. US environmentalists and bureaucrats don't care about profits or working people's jobs, so they can't be bought off in the way that leaders in the developing world can.

Another threat to Pebble's future is the falling demand in China. Even if it goes into production, there could be no market for the copper produced there. Pebble would definitely be a threat to Freeport-McMoRan because it could rival Grasberg in scale.

The question investors have to ask is whether all this expansion and new production will lead to a copper glut that will destroy prices. With stockpiles growing and Chinese demand sinking, that is a strong possibility.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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