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Playing For Copper Upside
FN Arena News - April 04 2008

By Greg Peel

Let's start with a chart:

As we can see copper has been undergoing a sustained sideways consolidation ever since its upside explosion in March '06. Clearly that run-up was bubbly, so the market came all the way back over 12 months before rallying again, just to prove a point. A new line of resistance was established across the tops at around US$3.75/lb, before the credit crunch/US recession kicked in.

But while the rest of the equity market was imploding and the US dollar was placed on a drip, global investors decided hard commodities were the only place to be. Thus we bubbled our way back up to test the high at US$4/lb. There was a brief pop as hedge funds quickly deleveraged, but we're back in sight of the top once more. Zooming in to three months...

...we see the metal set to test both the high and the three-month trend line. Missing from the chart is last night's move up to US$3.92/lb. So will we break?

There are a lot of push-pull factors working on copper - the bellwether of all industrial metals - at present. Since the Fed's rescue of the financial markets there has been a good deal of unwinding of the short financials/long resources trade, meaning copper has been sold not so much for fundamental reasons, but to free up cash to go back into financial stocks. Nevertheless, fundamentally even the Fed is now talking about a US recession, and we have to remember that copper is something that is actually "used". It is not something esoteric like a leveraged asset-backed high-yielding security. Therefore a downturn in global economic growth should, by rights, affect a fall in the demand for copper.

And to top things off, the Fed actions have also meant a stabilisation of the previously sliding US dollar. A falling dollar mathematically implies a higher copper price.

The world may fear an economic slowdown - something the IMF now believes is likely - but the fact remains copper is still in short supply. At last count there was only about 100,000t sitting in London Metals Exchange warehouses across the globe, which suggests that any sort of supply disruption at any mine will send the world into a sudden shortage.

What has been proven in 2008 is that the great rush to open, reopen or ramp up mines of any description across the globe has resulted in the overextension of tired old equipment, the exposure of inadequate transport infrastructure, the exposure of inadequate power supply, and the explosion of costs involved in all of the above. The mining industries of China and South Africa all but shut down earlier in the year, in the former case due to a great extent to snow but in both cases due to a systemic lack of power. Similar problems are being experienced in Chile, a major copper producer, and let's not forget Australia, where power is fine but infrastructure costs have also soared.

So as far as the supply side is concerned, it wouldn't take much for copper to suddenly become scarce. There is only a gradual backwardation in the copper futures contracts at present, meaning the spot month is not currently spiking simply on lack of immediate supply. Adjust for the cost of carry, and the futures market is suggesting high copper prices are here to stay for a while.

Returning to the recession story, we can then address the subject of demand. The analysts at GSJB Were are forecasting copper demand to fall in the US by 5.5% in 2008, Western Europe to fall by 2.2% and Japan by 1.0%, representing the world's three largest economic zones. But Number Four with a bullet is China, and Weres is forecasting an increase in copper demand in China of 15%. Throw in increases for Russia (8%), Eastern Europe (5%), and "Other Asia" (4%), and the stage is set for demand to still potentially outstrip supply by some margin.

Goldman Sachs (ie the GS in GSJBW) analysts wear their title of the "copper bulls" proudly. GS was the first major house to suggest a commodity super-cycle, or as the analysts refer to it, the "stronger for longer" theme. Their resolve has not wavered in the big picture. What they also recognise is that pure-play copper stocks tend to outperform the price of copper on the way up, and underperform it on the way down (meaning falling further). That's one reason why metal pure-plays can be very volatile, particularly now that metal prices are a lot more volatile than they used to be.

When copper was on the up prior to the credit crunch, copper stocks were running up hard. When recession talk hit, they fell harder than the metal did. Now that we appear to be reaching a level of consolidation once more, GS believes copper is set to break up again and if it does, Australian copper stocks will shift back to outperformance.

From a specific stock perspective, there's always the old chestnuts of BHP Billiton (BHP) and Rio Tinto ((RIO)) but these are far from pure-plays. Oxiana ((OXR)) is one way to play copper in the large caps but Weres suggests the Zinifex ((ZFX)) merger will crimp Oxiana's earnings in the short term . Nevertheless, Oxiana is an attractive longer term play, and Oxifex will be a more powerful acquirer as a merged entity.

Moving down the capitalisation list, Weres likes Equinox ((EQN)), Pan Australian ((PNA)) and Aditya Birla ((ABY)). The analysts have a Buy on each of these three as well as Oxiana and Zinifex.

Another contender is Kagara ((KZL)), but the analysts currently rate the stock as Hold due to its problems with all the recent Queensland rain.