 Copper Bull Market
2
Scott Wright
Zeal LLC
Jun 1, 2007
Five years into its amazing
bull market, the king of the base metals continues to hold strong
through a renewed onslaught of adversity. After an exciting
2006 that saw copper shatter all-time highs, this red metal continues
to trade at levels that most thought improbable several years
ago.
Copper's success has given
it quality time in the spotlight which has ultimately garnered
it increasing mainstream attention. Even on CNBC when headline
metals quotes are periodically displayed, copper now shares real
estate with gold and silver. But is the fame and fortune that
copper had thrust upon it sustainable?
It is first important to get
back to the basics and analyze the drivers that brought copper
to this point. And as usual, market prices ultimately react
to simple economic fundamentals. Fundamentals and prices feed
off each other to create a balance. Simply put, supply and demand
dictate the markets. But if one side has prevailing strength
over the other, prices can trend sharply to reflect such realities
in order to reacquire this balance.
Unlike the precious metals
with their monetary attributes that give them an extra leg to
run on in their own bull markets, the base metals bulls are typically
guided solely by underlying economic cycles. And copper falls
in this group as a metal thats momentum is being guided by an
active global economy.
With a strong global economy
in recent years the price of copper has been run up as increasing
demand has chased after a less resilient supply stream. With
an imbalance presenting itself to the markets, and those demanding
copper remaining steadfast in their desire for the metal, prices
only had one place to go, up.
Now throughout history the
economic balance for any commodity constantly shifts. And this
isn't the first time there has been a supply pinch for copper.
But in looking at this long-term copper chart, it is obvious
that there has been a structural shift in the dynamics of this
metal.
In the last several decades
copper has bounced between about $0.50 per pound on the low end
and $1.50 on the high end. But in its current bull that began
in 2003 off the long-term support of its quasi-flat trend over
the last 30+ years, copper powered through the $1.50 mark like
a jet through the clouds, with no resistance at all.
After so many years in this
range, what on earth could prompt such a massive breakout to
the upside? I believe the ultimate driver for the push that
more than doubled copper's all-time high of the late 1980s
in just the last two years is fundamentals.
These fundamentals are largely
the result of an economic cycle that has greatly increased the
demand for base metals. And this cycle is unlike anything we
have ever seen in history. A new variable has been added to
the structure of the modern global economy. And this variable
is Asia.
Asia, led by China and India,
has a population of nearly 4 billion people, over 60% of the
global population. But throughout history the economies of these
long-repressed nations have had little impact on the global commodities
markets. These once-closed economies now vie for the commodities
that have modernized most of the rest of the world.
Asia is going through an upgrade
of sorts in which its people, who have more money and disposable
income than ever before, are starting to demand what the Western
world has taken for granted for so long. In China cities are
growing like mad as open commerce and upgraded technology enables
the populace to make greater economic contributions.
And China is a country where
up until recently less than 1% of the population owned automobiles
and modern housing was only a dream. Since cars and other modern
amenities are now becoming available to a greater percentage
of the people, the 50 and 400 pounds of copper it takes to build
a car and standard single-family residence respectively can really
accelerate the demand for this commodity.
And in a growth economy cars
and houses are only a fraction of the copper that will be required
in an infrastructure build-out of major cities and ports. Industrial
machinery, office buildings, mass-transportation equipment, electronics
and general consumer goods will all demand significant copper.
With the demand for copper
greatly increasing over the years, the producers have really
had to step up their production. Copper mining accounts for
about 2/3rds of annual copper consumption with recycling picking
up the balance. And though there were lulls in exploration and
discovery during the bear-market-low prices of the 1980s and
the several years on both sides of the turn of the century, mined
production has continued to rise over time.
In fact, according to data
from the US Geological Survey, the global mined production of
copper is up over 70% since 1990. Nearly every year in this
span has seen a rise in production volume over the previous year.
And according to the International Copper Study Group (ICSG),
world mined copper production is expected to rise by 6.3% this
year over last.
In taking an isolated look
at the supply growth of copper brought to market each year, things
don't look too bad right? Well market pricing could not care
less what supply is doing in isolation. Market pricing only
cares how supply is doing relative to demand. So since prices
have been going ballistic lately, it is apparent that rising
supply has still been pinched to meet very strong copper demand.
And this has been evident as
measured by the dwindling global stockpile levels in recent years.
A couple of months ago I wrote about base
metals stockpiles as measured by the London Metal Exchange
(LME), the world's largest non-ferrous metals exchange. Analyzing
stockpile levels sure provides excellent insight into this copper
bull.
From its recent 2002 high near
1 million metric tons, LME copper stock had dwindled to less
than 100,000 metric tons last year and currently resides under
200,000. It makes sense that an 80% drop in stockpiles would
have a sizeable impact on copper's price. Falling copper supply
naturally raises prices for those competing for it.
So with major commodity exchange
and government copper stockpiles all dipping to historic lows,
sometimes measuring only a matter of days' worth of global consumption,
I believe speculators have built a risk premium into the price
of copper.
This risk premium is in place
because any supply disruption would have a major impact
on the markets. When geopolitical uncertainty happens in this
industry, market mavens pay close attention. For example, when
labor problems came to surface at the massive Grasberg mine in
Indonesia earlier this year, the markets were on edge. And when
anything labor related occurs in Chilean copper mines, the markets
sweat in their boots. Chile only produces about a third
of the global mined supply of copper.
This next chart zooms in on
copper's current bull market. As the global copper shortage
was exposed to the broader markets and LME inventories remained
in the sub-100,000 metric-ton level, 2005 saw copper jump above
$2.00 per pound for the first time ever and it has not retreated
back to this level since.
Following this surge over $2.00,
the first half of 2006 saw copper again tear skywards as speculators
got a bit euphoric. An amazingly powerful parabolic surge shot
copper above $4.00. Even the most fanatical fundamental cheerleaders
got a bit worried, and of course the skeptics jumped on board
and began to present their doomsday scenarios claiming that copper
was in for a crash and that its bull was over.
Though I believe copper's bull
is of the secular sort that should last for another decade or
so, it was odd to see such a well-defined parabola this early
in a secular bull market. Parabolas usually only happen toward
the end of bull markets once the general public jumps onboard
a trend and bids a price to its glorious pinnacle before an imminent
crash that typically leads into a bear market. We are not at
this point yet.
So I thought it would certainly
be interesting to see how this parabola played out to the downside.
Well much to my delight, confirming copper's continuing fundamental
strength, its correction wasn't as bad as many had predicted.
After an initial 24% correction in just 15 trading days off
its May high, copper consolidated sideways in the form of a wedge
that remained on the high side of the steep parabola.
With copper still above the
$3.00 range, Q4 and the first couple months of this year saw
fundamentals turn against it. Copper eventually broke its wedge
to the downside as LME stock levels embarked on a sharp rise
that doubled warehoused copper stock. Because of this inventory
build a chunk of the risk premium I highlighted earlier was subsequently
lopped off which saw copper retreat down to the $2.50 level.
After 41% was shed from the
top of the parabola, fundamentals yet again guided the price
of copper to the upside as big inventory draws gave boost to
a recent 57% rally. With copper now down a bit off its highs
over the last month, it will certainly be interesting to see
what kind of a trading pattern emerges at these still historically
high levels and how fundamentals will continue to guide it.
And I expect stockpile levels
will continue to have an impactful and real-time influence on
price levels. Not many assets or even commodities have such
measurable fundamentals as copper and the other major base metals.
With above-ground stockpiles still historically low, this risk
premium will flow and ebb as demand swings the stockpile levels.
And the strong demand that
has the biggest influence on the copper markets comes from the
Asian consumers, in particular China. In 2006 China was responsible
for about 20% of global copper consumption. So when China's
demand for copper hungers or satiates, the markets react.
Interestingly a big reason
for the LME inventory build toward the end of last year and into
the beginning of this year can be linked to China's action in
the copper market. In Q4 China supposedly embarked on a de-stocking
mission in which government and public copper stockpiles were
drawn down without equivalent replenishment.
Without China commanding its
usual large copper imports, global stockpiles built up and prices
went down. Well eventually China would need to replenish its
copper stocks. And we can deduce that this began to happen in
Q1 as global stockpiles dropped and prices rose. This was made
apparent as revealed in an Interfax-China article that identified
the Customs General Administrations' recent report showing that
Chinese copper imports for the first four months of this year
increased by 130% over the same period last year.
China's copper activity can
certainly make an impact on the global copper markets. And its
continued double-digit economic growth will keep it a major player
well into the future as it industrializes and modernizes its
massive nation. But though China is a big piece of the pie,
we still need to keep an eye on how the rest of the world factors
in to the fundamental side of the copper trade.
Many other emerging economies
have and will demand a lot of copper now and in the future.
And I believe supply will continue to be tight for many years
which may lead to an acceptably high copper price going forward.
But a recently-released ICSG report that provides 2007 and 2008
forecasts throws some interesting twists into the near-term future
of copper that has the bears dancing in the streets.
After three years running of
refined copper deficits, the ICSG reported that 2006 actually
ended with a copper-market surplus. It also issued projections
for 2007 and 2008 that hinted at further surpluses. As part
of its calculated data, the ICSG reported flat mined copper production
last year due to various global production problems and projects
2007 and 2008 mined production to increase by approximately 6%
and 7% respectively.
Now at first look this information
does not appear to be very bullish. But now we must revert back
to China. One factor to keep in mind is that the ICSG does not
take into account any changes in China's State Reserves Bureau
(SRB) stocks. Since SRB stock information is unreported, the
ICSG cannot include its purported activities in its official
calculations.
The ICSG is indeed a respected
intergovernmental consortium of copper experts, and the information
it provides is valuable and influential. But it is important
to view its projections objectively. The copper surplus that
the ICSG projected last year combined with the surpluses it is
projecting over the next couple years amounts to about 1 million
metric tons. This is a trivial amount over this time horizon
as SRB stock fluctuations and implied usage alone could easily
wipe away and even turn these figures to the negative.
It is understandable why the
ICSG cannot estimate estimates that China will not provide, but
it is important to attempt to factor in different variables to
gather a strategic picture of the tight copper markets. Unfortunately
many of the copper scoffers use this headline information to
credit their stances without further investigation. But even
with the very conservative projections that the ICSG reports,
to me it is still quite apparent that an economic balance is
far from a reality for copper.
Going forward it will still
be key to watch the actions of the world's largest copper consumer.
Various experts project Chinese copper demand to continue to
grow in the 5% to 10% range for many years into the future.
The ICSG projects global refined copper usage to increase by
4.7% this year and 3.6% in 2008. And I suspect that any decline
in usage by any of the Western nations, most notably the US,
will be more than made up for by Asian growth.
On the mining side of things
the producers that are bringing this metal to market have certainly
been ramping up their efforts to try to meet demand. This is
seen by the mine production growth over the last couple decades
as well as ICSG's forecasts going forward.
But like any other finite resource
that is extracted from the earth, copper mining is very expensive
and comes with extensive lead times to open up new mines. In
order to tap the earth's extensive copper reserves, exploration,
permitting, development and construction all need to flow through
a mining plan before a deposit can deliver its metal to the market.
This process can take up to
a decade from beginning to end. Fortunately with the high copper
prices today, many of the existing mines have picked up the slack
and have cranked up their capacity. Unfortunately this does
not speed up the long process of bringing promising new ore deposits
to life.
In reality the incumbent mines
that have been producing copper for many years are running out
of this metal. The bear market years where little time or capital
was put into exploration are now coming back to haunt the mining
companies.
Thankfully with this bull maturing
a number of fresh new deposits have been identified and developed
and are moving through the mining pipeline so they may eventually
replace the older mines. It's just going to take time for this
pipeline to turn over, which is why commodities cycles are quite
extensive.
Overall I do not see the copper
market becoming any less volatile in the near future. The China
factor, geopolitics, speculative excitement and a number of other
factors will likely contribute to wild swings in the price of
copper. And regardless of this volatility, I believe these high
copper prices are here to stay.
Those that are playing the
futures markets should perform quite well in this copper bull,
but I believe the easiest way for investors to capitalize on
copper's gains is through the mining companies that bring it
to market. Many copper miners are leveraged to profit on each
cent copper rises assuming they can control their costs.
And copper miners are not the
only miners profiting on copper in today's environment. Many
other metals producers that have copper within the ore of the
primary mineral they mine are also profiting. A number of the
best-performing gold stocks have strong copper byproducts that
have really boosted their profits. These hybrid miners are able
to credit their excellent byproduct revenues to the cost of their
primary metal and obtain excellent profit margins.
At Zeal we have been recommending
copper and hybrid mining stocks to our newsletter
subscribers since the beginning of this bull market and have
realized some fantastic gains. We are very bullish on the future
of base metals, especially copper, and when the markets are technically
favorable we will continue to recommend these stocks to our subscribers.
If you would like cutting-edge commodities market analysis and
high-probability-for-success stock picks please
subscribe today.
The bottom line is copper's
fundamentals still remain strong. Supply is barely able to keep
up with demand and the Asia factor continues to be the cornerstone
of this secular bull market.
There will always be those
folks calling for an end to this copper bull, but the fact is
the global economy is radically changing. Copper and all the
base metals are an integral part of these radical changes. It
will take many years for demand to subside significantly. The
metal and the miners that bring it to market should greatly prosper
as this bull runs its course.
Scott Wright
June 1, 2007
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