Copper is regarded as the most valuable of primary base metals, barring nickel, even though it is not the largest base metal market in the world.
Indeed, it is considered a barometer for the state of the economy, given its significance in global industry. It has a myriad of end-use markets including building construction, electrical and electronic products, transportation equipment, consumer and general products as well as industrial machinery and equipment. It is also one of the most recycled of all metals and can be alloyed with other metals for use in highly specialized applications.
Unsurprisingly, given this significance, the price of copper has also closely reflected the economic crisis the world has experienced over the last few years—from a peak of $8,924/ton in July 2008, copper prices dropped to $2,837/ton in December 2008 and has now rebounded to $9,848/ton.
SUPPLY DYNAMICS
While there has been a 330% upswing in prices since the 2008 bottom, this increase is only partially due to an improving economic situation or demand growth—the key driver is, in fact, a severe supply constraint. Current prices of $9,848/ton (as of Feb. 16, 2011) have been mainly driven by expectations of severe concentrate shortages of about 400,000 tons in 2011. This is likely to result in refined copper production of 19.3 million tons as opposed to expected usage (demand) of 19.7 million tons for the coming year.
Mine output has trailed refined production capacity in both 2009 and 2010 and this trend is expected to continue in 2011 as well. This supply constraint is actually triggered by low output coming out of global mines—various estimates indicate that mine production will only reach 17 million tons in 2011, which is not expected to be enough to sustain projected demand from high usage countries such as China and the US (which together consumed more than 68% of the refined copper produced worldwide in 2010).
Mines are only operating at about 80% capacity due to lower grade ore deposits in several ageing mines and also because most of them have now gone underground after having initially started off as ‘open- cut’ (mines that are open to the air and involve less capital expenditure because the ore is close to the surface of the earth). Consequently, this has resulted in higher extraction costs making it increasingly more expensive.
Copper LME Price ($/ton)
Adding to the supply constraint is the fact that much smelter capacity was not profitable up to December 2010, because of the prevailing rock-bottom treatment and refining charges (Tc/Rc) that smelters can charge mines. From a high of about $240 per ton during the pre–recession period, these charges dropped to approximately $12/ ton. This significant drop in Tc/Rc rates can be attributed largely to the fact that most mines have their own smelter operations and only a small proportion of the ore is sent to standalone smelters for further refining. As a result, such smelters have no option but to scramble for ore concentrates and accept the miners’ terms. To balance this skewed market power, smelters are increasingly investing in their own mines. For example, Boliden was primarily a custom smelter before it started the Aitik mine in Sweden and Vedanta Resources acquired a copper mine in Tasmania to feed its smelters in South India.
Custom smelters operate on unpredictable margins, with 2010 operating margins of about 30%, but there is no saying how sustainable even those margins are, as lower Tc/Rcs can wipe them clean. In contrast, it costs miners less than 25% of the concentrate sale price to dig out the ore.
It is, in fact, the higher profitability from mining operations that is the chief reason for the labor unrest in copper mines in Chile (the world’s largest producer of copper concentrate) where mine workers are demanding wage hikes linked to the market price. It is also the reason for short term spikes in the copper price and lower Tc/Rc as more of the concentrate is held back for opportunistic reasons.
Thus, in sum, mines operate at about 80% capacity as lower ore grades and depletion make recoveries more difficult as well as expensive. Copper mines have been likened to patients in an ICU—only surviving on life support in the form of ever higher prices.
Supply disruptions like the SAG mill issues at Escondida in Chile and shaft outages at Olympic dam in Australia removed significant concentrates supply in 2010. Future supply shocks could come from copper mines in Australia, as miners and the government are locked in a dispute regarding the administration of the Mineral Resources Rent Tax.
All of the above being said, supply constraints should ease somewhat going forward, as new mine capacity—notably from Codelco’s $2 billion greenfield expansion in Chile, Rio Tinto and Ivanhoe Mines’ expansions at Oyu Tolgoi in Mongolia (nameplate capacity of 400,000 tons of contained copper) and Xstrata’s still to be approved $5.2 billion Tampakan mine in the Philippines—come online. Much of this capacity was deferred due to the credit crunch during the global financial crisis This has had a positive impact on Tc/Rc contract negotiations for 2011, where smelters won fees of $256/ ton.
DEMAND DYNAMICS
China remains the largest consumer of copper, accounting for nearly 50% of the world total. Its consumption grew 6% in 2008 and about 40% in 2009, and it is expected to grow by about 5–6% during 2011. (The reason for the abnormal growth spike in 2009 was opportunistic stocking at the lower price levels.)
Additionally, China sought to substitute its scrap supply with refined copper in 2009, as the recession era price slump drove scrap dealers out of the market. The recovery in price however, has increased scrap supply, which will likely reduce refined copper imports into China. This is good news for the miners as the demand becomes more broad- based, rather than solely China driven.
In contrast, other major regions (US and the EU) have had mixed growth since 2008. While US consumption dropped by 11% and 18% in 2008 and 2009 respectively, the EU declined 3% and 17%. However, improving economic conditions indicate that growth in the US and EU will be about 2–3% in the coming year.
THE NEAR TERM OUTLOOK AND INVESTMENT OPPORTUNITIES
As mentioned earlier, the deficit in usage versus production in 2011 is expected to be in the 400,000 ton range and is likely to expand, conditional upon new mines coming online soon. That being said, it is possible that, with copper prices at $9,848/ton, no real cost push at the mines and China yet to digest its hoard, copper could be in overbought territory. Thus, as the US Dollar regains some ground, and China firms up rates, $8,500/ton looks more sustainable within a 1 to 2 year period. The fact that the copper market is in backwardation, i.e. the future price is lower than the spot price, also supports that view.
There are several mining and smelter companies that have exposure to copper and have seen tremendous run-up in share prices since mid 2008. The most prominent among these include Freeport MacMoran (current market price of $53 as of Feb. 18, 2011), Antofagasta (CMP of £14) and Boliden (CMP of SEK132), which typically derive approximately 90% of their revenues from copper. Freeport MacMoran’s share price has grown by six times since December 2008, while that of Antofagasta and Boliden have increased by 5 and 7 times respectively. The significant share price run up for these three companies is well supported by their healthy 2010 average return on equity (ROE) of 47%, 21% and 20% respectively. Bloomberg consensus estimates indicate that for the 2011 period, Freeport MacMoran will post an ROE of 35%, while Antofagasta and Boliden are expected to return 20% and 21% respectively. While much of this is already factored in their current price (for example Antofagasta’s one year consensus target price is £14.82 whereas that of Boliden is SEK130), there looks to be a 20% upside potential for Freeport MacMoran whose 1 year consensus target price is set at $64. Much of this is already factored in their current versus one year consensus.
Important Notice: This Communication has been prepared by The Smart Cube (TSC) on an independent basis and the insights included are based on its own research and from sources believed to be reliable. The views mentioned in this communication do not in any way constitute investment advice and should not be construed as an offer to sell, a solicitation to buy, or an endorsement or recommendation of any company, security or commodity. TSC disclaims all responsibility for investment decisions based on the content of this Communication or the dissemination or distribution of this Communication to a third party. Also, any conclusions, calculations or determinations reached constitute TSC’s views as at the date of this Communication and are subject to change without notice.
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Author: Pranav Kumar
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