COPX: Supply Shortages May Push Copper Much Higher

Harrison Schwartz profile picture
Harrison Schwartz
12.29K Followers

Summary

  • Copper has had a difficult few years due to slowing demand growth from China.
  • Supply has been growing at a slower pace than demand, and global stocks appear to be low.
  • Supply disruptions in Latin America (specifically Chile) may grow due to expanding protests in the region.
  • Many miners are cheap on a P/B basis and could gain tremendously once the market realizes inflation is rising.
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(Source: Freeport-McMoran)

Copper was a hit from 2004 to 2012. China's effort to rapidly expand infrastructure and production drove up prices and caused huge profits for those in the copper business. The economies of Chile and Peru, which make most of the world's copper, grew rapidly, with Peru marking a 5%+ growth rate every year until 2013 besides the recession years (when it only suffered 10 basis point drop).

The punch bowl has been away for some time. Demand from China has fallen drastically, and prices are down around 40% from their 2011 high. Recession scare after recession scare, copper prices have been stuck in a range for years, and many producers are struggling to make ends meet.

While I'm still hesitant on the equity market, I like copper miners today. Not because I expect a huge increase in demand soon, but because growing production shocks and rising inflationary fundamentals threaten supply. Over the long run, rising demand for homes and infrastructure in the U.S. and industrial growth in frontier markets will likely bring about another surge in demand for copper.

Investing in Copper Miners With an ETF

One of the easiest ways to invest in copper production is through the Global X Copper Miners ETF (NYSEARCA:COPX). As you can see below, the price of COPX is largely a function of the price of copper:

ChartData by YCharts

This is important because it ensures that investors can gain more diversified exposure with COPX than with other equity ETFs.

The fund has $55 million in AUM with a low expense ratio of 65 bp and a 1.8% post-expense dividend. It also has a high beta to the S&P 500 of 1.2 with a standard deviation of 30%, so it is certainly not for risk-averse investors. Even more, many of the miners are barely turning a profit today, though prices have risen, so profitability next quarter will likely be better than last quarter's.

Take a look at the select fundamental statistics for the fund below:

(Data Source: Uncle Stock)

As you can see, the ETF has a low weighted average EV/EBITDA of 7.5X but a high weighted average P/E of 20X, which is a sign that much of the current profits are going to interest payments. This also is a signal that profitability can be improved if the debt is reduced.

The fund is also relatively cheap on a P/B standpoint, as it's trading at a weighted average P/B of 0.9X, with many of its smaller holdings trading far below book value.

Importantly, most of the miners are operating in Latin America and Asia, where borrowing money comes at a much higher cost. As seen in the many below one current account ratios, debt is a problem for most of these companies, and some are likely struggling to maintain cash reserves due to the monetary and economic environment.

While the monetary environment in Latin America continues to look unstable, it seems that the economic environment facing copper is finally reversing.

Looking Top Down

Recent data from the International Copper Study Group showed that world copper mine production declined about 0.5% this year. This occurred as a production upgrade disruption in one of Indonesia's large mines, as well as production disruptions in Chile earlier this year. To my surprise, demand in China has also risen in recent months on the back of improved factory activity and was at a 13-month high at the end of November.

Speaking of which, it appears that Chile (which produces 30% of global copper) may see increased supply shocks. Back in October, workers at one of the largest mines (Escondida) walked off the job in support of protesters. Two weeks prior, workers at Antofagasta (OTC:ANFGF) rejected a salary adjustment and voted to go on strike. While these disruptions have only had a marginal impact on copper prices so far, if protests continue to climb, I imagine the impact will grow.

According to the ICSG study, global mine capacity utilization has risen 5% from May at 81.4% to August at 86.2% (most recent data). If this figure climbs higher and demand does not fall, copper may certainly break out. In fact, when adjusting for unreported stocks, there is evidence that copper has been in a supply-demand deficit this year. Take a look at the chart on the bottom left-hand side below:

(Source: Capital Economics)

As you can see above, the black adjusted line indicates a significant deficit. Even more, the top right-hand side corner indicates stocks have declined significantly since Spring, while the top left-hand side corner shows that investors are net short.

Bottom Line

In my opinion, the reason for the depressed price in copper miners today has a lot to do with the narrative driving the market. Most speculators/investors have the mindset that the world is going to go into a recession and inflation will fall and cause copper to crash. Essentially, they believe that 2008 will repeat itself exactly and are avoiding buying everything that had underperformed then.

This bias has caused most of those assets to become unreasonably depressed when the fundamentals are accounted for, particularly with regard to inflation. If you look below, you can see the core inflation (excludes food/energy) has actually been rising since 2015, and the breakeven inflation rate has made a double bottom:

ChartData by YCharts

There are many old cases where inflation rises in the face of slowing economic growth, primarily due to monetary instability (i.e., large public debt) and cost-push factors like production disruptions due to unrest. Both of these factors seem to be true today and may cause many mining and energy stocks to actually perform well in a generally bearish environment.

While I like COPX, one can probably see better returns if they focus on U.S.-based producers. As I've noted in many of my recent articles, the U.S. government is making an effort to protect its starving mining industry. Most copper miners, including the U.S.-based Freeport-McMoRan (FCX), have vast global operations, but FCX is one of my favorites, since it has a production advantage in the U.S. market.

Overall, now seems like a good time to slowly build a position in copper miners. It seems that the bottom is in for Dr. Copper, but the market can throw some surprises. Many miners are very cheap from a P/B standpoint and are likely to see cash flow improvements over the coming quarters due to rising prices and weak supply. While I do not have a specific price target on COPX, I expect the ETF to outperform the market over the next 5-7 years with a very strong next twelve months.

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This article was written by

Harrison Schwartz profile picture
12.29K Followers
Harrison is a financial analyst who has been writing on Seeking Alpha since 2018 and has closely followed the market for over a decade. He has professional experience in the private equity, real estate, and economic research industry. Harrison also has an academic background in financial econometrics, economic forecasting, and global monetary economics. His promise to readers is that he will tell the truth as best he can see it, with no sugar coating and no hype - even if his view disagrees with the popular narrative (which it usually does these days).
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FCX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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