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Miguel Herschberg
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Miguel Herschberg graduated from the London School of Economics (LSE) with a BSc. in Mathematics and Economics and a MSc. in Applicable Mathematics. He is currently at the University of Illinois at Urbana-Champaign (UIUC) specializing in Industrial Organization. He is passionate about... More
  • Copper: Demand and Supply analysis 0 comments
    May 18, 2010 11:39 PM | about stocks: BHP, FCX

    This is a forgotten article. It dates back to January 2010. On the one hand, it is a bit old and many events (ie Chile's earthquake and Chile's presidential election) have occured since then. On the other hand, despite Chile's tragic and unpredictable event, I believe that the market fundamentals have clearly not changed at all.

    Copper is surprisingly up nearly 130% since the beginning of 2009, especially given the sluggish pace of the economic recovery. The big question for investors in 2010 is whether to enter or exit the copper market.

    As with any market, to determine if the commodity is over or underpriced we must analyze the interations between the supply and demand curves.

     DEMAND:

    Among the few items driving prices higher are: the dollar, the expectation for a recovering worldwide economy and strikes at copper mines in South America.

    Briefly speaking, copper is mainly used in the construction, automotive and electrical industries and for this reason, a positive correlation between economic growth and copper price can be observed. The incredible price increase during the year 2009 can be partly explained based on investors’ strong expectations of a fast economic recovery.

    Building construction accounts for anywhere between 25 and 46% of all copper demand and electrical transmissions another hefty share. As I mentioned before, this implies that as the economy heats up, copper consumption should rise and its price ought to follow suit.

    However, there really haven’t been any numbers domestically to support a strong economic recovery. On the other hand, the Fed’s decision to keep interest rates close to zero, might end up benefiting the construction sector. So far, there is some little evidence suggesting at least a little pickup in the construction sector.

    It is important to realize the importance of China and the US in this market. China is the world’s largest copper consumer (with about 38% market share) and is followed by the USA, India and other developing economies. There are some analysts who suggest that the USA is the world’s largest consumer, but given the recent growth in the Chinese economy and the stagnation of the US economy, I have opted to consider China as the most important consumer.

    China is expected to expand 8.5% this year. Urbanization plus the next industrial revolution led by hybrid cars need plenty of copper. The current figures suggest that it plans to boost its annual production of electric or hybrid cars from 2,100 to 500,000 in the next two years. Such a shift would require huge amounts of electrically conductive copper.

    China’s record levels of copper imports this year has made up for some of the slack demand in the US and Europe. The worrying side is that China has increased dramatically its exports of copper and reduced the amount imported. This suggests that China has already bought all the copper needed and its plans have already been reflected in the price of copper.

    According to Bloomberg, refined copper exports by China have jumped 73% to the highest level in 14 months. Imports, on the other hand, have declined for the third time in four months. But if China’s economy continues expanding, why are Chinese copper exports rising? If China has a desperate need for copper right now (given the fact that they are a big net importer of copper) why are the traders exporting country?

    The truth is that imports of copper into China will perhaps slow down as it has been importing at a record pace. This is a clear indication that China is buying up industrial metals on a scale that appears beyond the usual commercial reasons and even though there is some controversial, it may be possible that Beijing may have made a strategic decision to increase its inversion in base metals as an alternative to US Treasuries and dollar holdings.

    Moreover, China Daily reported on Nov. 12 2009 that copper stockpiles held in duty-free warehouses in China may be re-exported. With copper price doubling up in 2009, this re-export could also be a strategic tactic of Beijing in an attempt to push down the prices of copper.

    Some analysts have also been suggesting that there will be an increase in the demand from India and other developing countries in the long term as the develop infrastructure and capacity. India’s $1.2 trillion economy expanded 7.9% in the 3rd quarter of 2009 and copper demand in India is expected to soar by 6% next year, in line with the GDP growth forecast of 7%.

    As I argue in the “supply section of this article”, we are currently observing an increase in inventories. When factories idle or cut shifts, inventories tend to rise significantly, pushing prices down. Assuming China’s growth and copper consumption will remain at the same levels as last year, India is predicted to increase its copper demand by 7% and the USA is expected to continue its economic recovery. Why then, are inventories increasing?

    This is clearly signals that the US’s recovery is not as optimistic as investors have expected. One of the variables that investor’s should be tracking during 2010 is the level of inventories. If we do not see inventories falling at a strong pace soon, then we should be very suspicious about China’s growth figures or the US economic recovery. Problems in the US economy will invariably lead to falling copper prices. In other terms, if inventories keep increasing or remain constant, then there is a strong probability that there is excess supply and thus, we should bet on falling copper prices.


    SUPPLY:

    The main supply issues affecting the copper market are without any reason of a doubt, strikes in developing countries and technical defaults in the mines’ operations.

    Australia, the World’s 5th largest producer, forecasted less production for next year. The projection was slashed by 15.8% and the forecast of refined copper output took a hit, dropping by 13%. Furthermore, there are problems with BHP Billiton’s Olympic Dam mine which sits on the 4th largest copper deposit in the world. According to the news, an accident in early October, shut the mine’s main haulage system, cutting production by 75%. BHP Billiton expects the mine to be back in full operation by Q3 FY10.

    The fact that the worlds 4th largest copper deposit is working at 25% speed adds support to the idea of a potential global copper supply deficit.  Macquire predicts it will take up to two years to climb out of the looming shortfall.  Accordingly, it has raised its price forecast for copper in 2010/11, 2-3%, up to $3.25 to $3.40/pound. At this time, copper was trading around $3.14, now it is trading at $3.42. The price volatility doesn’t seem to follow Macquire’s prediction. 

    There are also analysts who are pointing to rising inventories and suggest we may see a surplus instead. Inventories at LME have actually risen quite steadily, even as prices have also been rising. Price and inventory are not always negatively correlated, but they are at least related (low inventories generally move in the same direction as high prices and vice versa). Right now, that relationship seems completely broken and this shows that copper’s price has decoupled from its fundamentals, and it’s now trading like a precious metal, fluctuating on the dollar. 

    Like most commodities, copper is traded around the world in dollars so prices can be very dependent on the US currency's strength. Copper has been traditionally used as hedge against inflation. Investors anticipating that the weakness in the US Dollar will continue, may push the price of copper and other base metals, upwards.

    Furthermore, there have been several strikes in South America and large copper mines have their work contracts ending in the next two months. However, the latest data from LME shows that stocks in LME and Shanghai exchange warehouses are enough to cover the lost output from strikes at Chuquicamata (one of Chile's biggest mines) for more than a year.

    Today two major strikes have ended forcing the price downwards. In particular, Codelco Copper Strike at the Chuquicamata mine ended today. Chuquicamata produces half of the company’s total output of 1.55 million tons. Codelco supplies about a 10th of the world’s mined copper. Xstrata Plc, the fourth-largest copper producer, also reached a wage agreement at its Altonorte copper smelter in Chile which has disrupted supply for eight days.


    CONCLUSION:

    To sum up, given the fact that the two most important strikes affecting the production of copper have been solved and that inventories have risen continuously for the 43rd day, there is no reason to suggest that there will be a decrease in supply. Furthermore, the inventories levels are more than enough to cover the potential output lost from Australia and therefore supply should increase. Barclays has indicated that the supply is expected to increase by 8% in 2010. I think this overly optimistic but if all the trade unions’ strikes are resolved, then Barclays figures may be possible.

    This year, investors should look at demand rather than supply. Copper is a very inelastic metal and is small movements in demand may produce big price fluctuations. Among the variables investors should watch are:

    • The US construction figures.
    • Any information that is related to the US economic recovery pace. I strongly believe that the copper demand will be influenced strongly on the level of the US economy
    • The automotive industry and the development (or change in production plans) of hybrid cars.
    • The level of inventories.
    • China’s copper import or export change.
    • The movements in the US Dollar and the US inflation figures.

    Other variables to pay attention to include:

    •  The final outcome on Xstrata and Codelco strikes. I will closely follow other strikes and Chilean politics (especially since the Cabinet may change soon).
    • India’s and Brazil’s economic growth figures.
    •  Australia’s copper production figures.

     It is very unlikely that copper will repeat its performance of 2009. In the short run, we are most likely to see a huge downward correction in the price of copper. This may be a consequence of the lack of figures to signal a strong and fast recovery of the US economy and will be influenced by an increase in production from Chile. In the long term, copper is a very good and sensible investment especially as the US economy recovers.

    Disclosure: No positions

    Disclosure: No positions
    Themes: Copper Stocks: BHP, FCX
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