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7 Mt of Copper in 7 Years... Not LikelyGianni Kovacevic Investors in the natural resource space have lived through the best of times and the worst of times over the past couple of years. The TSX-V is now at the same level as it was in early 2006 all the while commodity prices continue to be very strong. Faced with overwhelming global financial turbulence and illiquidity the investments made by these investors have been punished which begs the question, who actually accepts this torture and invests in resource stocks? First and foremost it is important to recognize that a group the size of an onion skin invests in this extremely volatile space. From the steep run up to May 2006 all commodities and junior mining shares climbed to record levels which was followed by a sideways trading pattern and major sell offs in August 2007, January and March 2008. Two major groups make up the bid side of the junior resource market which explains the current thinly-bid market. The smaller of these two groups is retail investors who amongst hundreds of millions of potential investors can be counted as negligible. These folks have limited mass buying power when spread over the thousands of exchange listed companies and slowly get smoked out as they buy all the way to mini tops and sell to create new bottoms in no bid markets. The larger group is a select number of fund managers with the adequate experience to make investment decisions for this pool of capital both short and long term. The problem here is that this capital stream has faced an unimaginable tide of redemptions since mid 2007 which continues right through 2008. "Hit the bid" that did not exist has been moaned out on a daily basis by these redeemed commodity believers as the fence sitters on TV who hate copper and gold so much have been saying, "I told you so." These same TV fence sitters have told us for years that bank stocks are safe as houses (hopefully they are not in Las Vegas or Miami) and that commodity prices are going to fall back to historic levels pushing all resource based stocks back to the penalty box and explorers to the showers. So the question is when does the tide turn as commodity prices in fact rise, demand continues to grow (even with a slowing US economy) and the metals producers mint real money and real balance sheets? If a crystal ball could be found its base would be made of copper. From the 25 most traded commodities, the 3 most recognizable for this topic are oil, gold and copper. Oil speaks for itself with more and more consumption, a certain amount of speculation and a lack of discovery of major new fields. Gold equities have disappointed as few have outperformed the US$ Gold price in the last couple of years. Gold producers at least trade at a relatively fair multiple to earnings ratios with respect to copper producers some of which trade at only 3 or 4 times earnings. Being a gold bug certainly does not make someone a believer in copper. It now costs many gold producers over $500 per ounce to extract gold and the global average is well over $400 per ounce. Factor in $140 oil and one can wait and see what the balance sheets show in the coming quarters. On the flip side many global copper producers are seeing cash costs climb to over $1 (without net byproduct credits) whilst they continue to sell the red metal for almost $4 per pound. The future forward price curve for gold is acceptable however it's an absolute hellish Friday the 13th nightmare on Bay St. for copper. When the current valuation of a basket of copper producers or soon to be producers is analyzed it is found that the implied long term copper price in 2012 crashes below $1.40 per pound. Does the World come to and end in three and half years? If your answer is yes you shouldn't be investing any money in the first place. If your answer is no, then recognize the almost certain reality that the future forward price curve for copper will be higher than $1.40. With lifting costs close to this level there would be little profit for many producers in three and half years or better put some mines would shut down followed by yet tighter supply. Compare copper producer A to gold producer B who for this example sells gold today for $900 per ounce and profits $400 or around 80% for every dollar invested to lift gold. The copper producer sells copper for $4.00 per pound and profits around $2.80 or almost 300% for every dollar invested to lift copper. Gold would need to trade at over $2,000 an ounce today to give the same return not to forget that gold producers usually trade at higher earnings multiples. Furthermore most major gold producers are lucky to have 10 years of proven reserves while many copper producers have in excess of 20 years of proven reserves in the ground. Even if copper prices crashed in half they would still make an almost 100% margin from lifting costs. Copper producers should in the course of the next quarters start to reflect the reality that the implied forward price curve will likely not be $1.30-$1.40 and more closely reflect the long term estimates of already very conservative analysts in the $1.80 and climbing range. Why? There are certain irrefutable figures to be aware of with respect to copper consumption and production. Before CHINDIA was part of the investors lexicon the world had an insatiable appetite for copper. The graph below shows over 100 years of almost continuous demand growth (4% y o y) that is now being exacerbated by CHINDIA, absorbing a slowing US economy (only 11% of global copper consumption) and pushing demand to 5%-6%.  Interestingly enough production has also grown by an average of 4% y o y since 1900. In 2007 demand had reached 18Mt and is growing by 5% or over 900Kt per year. Producers are having a difficult time keeping up with the eighth wonder of the world, compound interest as very reliable consumption continues to march on while new supply simply can not keep up. We have entered a time where putting two or three mega mines into production does not even keep up with demand of almost 1Mt per year growth, which is equal to the world's largest sulfide mine Escondida. There are 800 existing and planned copper mines, plants and refineries around the world that added to production of 18Mt (15.3Mt mined & 2.7Mt recycled) The incredible statistic from this data is that the top 20 operations supplied more than 50% of the metal yield.  The estimated demand increase for 2008 of 900Kt of copper would be approximately 7Mt compounded over the next seven years or equal to the current total output from the top 15 operations in the world. Can the mining companies put 7Mt of new production on-line in the next seven years? Can they duplicate the 15 largest operations? Even if everything goes as planned with no hiccups, environmental, governmental, permitting, striking, NGOs etc. etc. issues including the ability to finance about $150 billion this would still simply keep up with very reliable demand to have no net short fall or surplus and yet again continued higher prices. With a hiccup down the line we could see a real net shortfall and considerably higher copper prices. To illustrate the significance of the 7Mt of future supply required look at three recognizable copper development projects. Petaquilla, Galore Creek and Copper Mtn. have estimated capital costs of US $3.5, $5 and $0.5 billion for estimated metal yields of 233Kt, 200Kt and 50Kt respectively. Thus to realize the 7Mt required over the next 7 years, mining companies will need to commission 15 PTC, 15 GC and 15 CUM like projects. Assuming that these 45 hypothetical projects get the green light they would require almost $150 billion of capital expenditure. If with a magic wand one could start all 45 projects tomorrow they would come on line in the next 3-7 years. Not Likely. Patiently look at well run copper producers or soon to be producers for opportunities as low risk investments in what WILL be a very turbulent remainder to 2008. In fact dollar cost averaging starting in the fall should be the way to buy. This December's tax loss season will be especially nasty as investors write off losses and hit bids so be patient, hold stink bids and prepare for the red metal to gain a little bit of respect. Gianni Kovacevic 321gold Ltd |
