PRICE RISE HAS STRONG RATIONALITY LONG TERM - BUT NOT NOW...

PRICE RISE HAS STRONG RATIONALITY LONG TERM - BUT NOT NOW
Copper: on fire or about to crash and burn?

A detailed analysis of the current state of the global copper market and the 'China impact' and views of what is in store longer term from the latest VM Group analysis prepared for BNP Paribas/Fortis Bank.

Author: Carl Firman and Gary Meade
Posted: Monday , 03 Aug 2009

LONDON (VM Group) -

2009 has been kind to commodities - none more so than copper. Who would have thought at the end of 2008 that copper would be one of the best performing commodities just seven months later, with its price up more than 80%? Yet commodities, per se, have confounded conventional economic thinking which holds that, when global industrial demand collapses prices must fall and remain weak, and only rise once recovery becomes clear.

So it has been in previous global recessions, but not so in this one. The recovery in the copper price has almost made up for half its fall at the onset of the current global recession, while the only other example where the copper price has responded positively during a downturn is in the 1981-1983 recession, but then the rally was far weaker.

We pin this behaviour on 'the China factor' and to commodity prices that have been far more anticipatory of the global economic recovery ahead than their underlying near-term fundamentals support. This is symbolised by the close correlation between the copper price and FTSE World Index , and by the price of the weakest base metal, aluminium, which has increased by 43% from its low in late February, despite LME stocks rising to a record of more than 4.55 Mt as of 27th July.

The only real explanation for this remarkable turnaround is that there is right now a heavy speculative bet that the scramble for raw materials by China and other developing nations is set to spark commodity boom Part Two, and that the current recession has been merely a hiccup in the process. If this notion holds true, what might happen to prices once the recession has clearly ended, and Western world demand returns? In our view, we are already witnessing this shift in sentiment and a re-emergence of the commodity price boom - albeit one still on the starting blocks, with perhaps one or two false starts ahead.

A few key ingredients have supported copper's rise, but China's insatiable thirst for raw materials has done more than anything to bolster battered sentiment and reduce the LME stock overhang. More recently, indications that OECD destocking has now ended and a bout of restocking may be on the horizon is also buoying the market, especially since the lion's share of refined copper is in China.

In late July, copper's cash to three-month spread on the LME teased into backwardation, while the premium between the higher cash price to far dated contracts widened significantly, suggesting that near-term tightness might provide a basis for a further run up in copper, despite consensus expectations of range-bound trading or perhaps even a price correction in Q3 2009. China again surprised by its appetite for the metal, with the biggest ever volume of refined copper imported in the month of June, while a raft of positive US data and a weakening US dollar saw copper breach $5,600/t (LME three-month).

We are not of the view that the near doubling of the copper price since its December low of $2,820/t is due to any pick up in real global demand. Rather we see it as having more to do with the huge spate of restocking in China, and expectations that, somewhere along the line, real physical tightness will again emerge in the copper market, due to worries about its medium to long-term supply-side fundamentals. This has provided a platform for prices to spike higher, in anticipation of better times ahead.

To put this into perspective, the LME three-month benchmark copper price has risen more than 90% so far this year, while LME warehouse stocks rose from 336,700t on 1st January to 548,400t in late February, before halving by July.

Such astonishing dynamics should suggest that the global recession is well and truly behind us, since copper traditionally is extremely sensitive to changes in global industrial output. But this is not the case. Chinese restocking has been so great that it has claimed a huge volume of available copper, and in doing so has provided a platform for traders to seek profit from the positive arbitrage trade between the higher Shanghai price over the LME price, which in April was more than $1,000/t.

China's imports of refined copper in June, 378,943t, the fifth consecutive monthly record, beat all expectations. The consensus view had been that June would see a month-on-month fall, due to the partial closure of the arbitrage window from mid-May, and to reports that Chinese restocking was drawing to a close. However, we suspect that some of these imports were due to arbitrage trading in the three months to May, with the metal booked for June delivery. And Chinese restocking appears still to be very much alive, despite reports to the contrary.

Importantly, much of these imports of refined metal have merely joined the growing volume of metal that has been built up in Chinese bonded warehouses, due to the now weaker Shanghai/LME differential. This suggests that not only is China saturated with metal, but also that demand is a lot weaker than implied.

Yet the inflow of refined copper into China in the period December 2008-June 2009 is almost 2 Mt, up 149% from the same period last year and 101% from the same period two years ago. It is therefore not surprising that this has seemed very bullish for the copper price, especially since it has drawn more than half the metal that had been sitting in LME warehouses.

Outflows in LME inventories became apparent during early February, when refined copper held in LME warehouses in Singapore, Korea and Malaysia were emptied out by May, suggesting the metal was bound for import-hungry China . European LME warehouses were next, with nearly 200,000t of metal removed between late February to the end of May, while LME warehouse stocks in the US have only begun to fall since late April, and by only 50,000t as at July.

Increased Chinese production of refined copper also corroborates the view that Chinese demand is healthy as does the increase in Chinese production of copper products over the same period ñ but this does not tell the whole story. We believe that a large volume of China's copper products have gone into stocks, and we know that restocking by China's State Reserves Bureau (SRB) -officially claimed to be 235,000t, but unofficially probably much higher -provincial governments, consumers and funds have soaked up a considerable amount of refined copper, over and above that already held in bonded warehouses, which is estimated at more than 150,000t. At some point this dynamic will become unsustainable and will not only impact Chinese imports but also the price. In other words- what has gone into stocks must inevitably one day come out.

SHORT-TERM FALL IN CHINA'S DEMAND LIES AHEAD?

The timing of this may be closer than thought, and we already suspect that Chinese demand will fall in July, August and September. However, this may neatly coincide with a ramp-up in Western demand, through restocking or perhaps some real improvement in industrial usage. So this oversupply of Chinese copper might then find itself being shipped abroad, since current LME stocks only account for about five days worth of global consumption. This tightness is already apparent in the LME copper's near-term spread; should it persist, then there is the possibility, however remote, that the Shanghai/LME arbitrage trade could go into reverse and compel metal to leave Chinese shores.

Yet, despite our forecast that some Western restocking may take place, this may not become evident until the end of August. By that time, should Chinese July imports of refined copper fall, the copper price could weaken. But the emerging possibility of Western restocking will help prices remain relatively strong; they could fall back down to May levels of around $4,500/t-$4,600/t in Q3, before recovering again in Q4, to challenge its 2009 highs, as Chinese demand returns and the economic recovery in the US become clearer. However, we suspect the risk is to the upside as momentum is currently with the bulls.

Copper's strength is not based purely on expectations that Chinese demand will continue to increase and on anticipated Western economic recovery. There is additional support from worries about copper's medium to long-term supply picture. This was already in place before the recession took a firm stranglehold and was compounded in late 2008 and early 2009 when a large volume of mine and smelter production was cut on the lower price, delaying and/or terminating many projects, as the financial system collapsed.

Given current visible inventories, which remain well below the norms of previous global recessions (albeit that the present situation has been artificially created, as metal has flowed into invisible off-market inventories), when global demand recovers these stocks could become rapidly depleted particularly as idled mines will take some time to be brought back online. This raises difficulties for the miners, who must decide whether the worst is over and risk bringing on spare capacity to fill the potential supply gap, or miss out on the early bonanza.

The International Copper Study Group (ICSG) summed up the medium-term copper supply problems alarmingly in July by significantly revising down to 3.8% its projection for mine production capacity over 2009-2013 from a previously anticipated rate of growth of 5%; this means some 3.9 Mt of new mine or expanded mine supply will come on stream over the next four years, or about 1.2 Mt less than that previously forecast.

The financial fallout and resultant deep recession has forced the postponement of mine expansions and new projects, and this will inevitably mean a tightening of the copper market ahead, especially in the context of continued demand growth from emerging nations and the eventual recovery in Western demand. A serious market deficit is on the cards late next year and into 2011, with the growing possibility of a copper price that will most probably trump previous records, in nominal and perhaps even in real terms.

The ICSG also predicts that copper concentrate production will increase more than smelter capacity over this period, but, due to the current low utilisation rates that smelters are currently operating under, ~78% presently (~82% in 2008), there should be 'sufficient' capacity to process material. However, this might suggest that treatment and refining charges are set to rise as smelter availability decreases - but this will not worry miners, if the copper price returns to record highs.

Realistically, there is no shortage of new mine supply in the medium-term, owing to the large numbers of world-class green-field projects hosting estimated mineral resources of >500 Mt, which have come online or are due online within the next seven years. But USGS predictions, that at current rates of copper consumption of 18 Mt/y, the entire world's identified copper reserves will last just 31 years, cast a gloomy light on the long-term picture.

World copper consumption rates are vastly going to exceed 18 Mt/y, as urbanisation rates rise and this will draw down existing reserves even quicker. According to Rio Tinto, growth in copper demand will double in the next 15 years and require 12 new Escondidas - which is currently the largest copper mine in the world and capable of producing as much as 1.2 Mt/y of copper. These are bold claims from a miner with its own interests at heart, but might be nearer the truth than not.

With Chilean mine production nearing its peak, (Cochilco expects production to increase through to at least 2012) the world will become increasingly reliant on green-field projects to make up for the supply shortfall, and most of these are based in regions with high levels of risk, both political and commercial, such as the DRC, Russia, Pakistan and Mongolia . These areas of the world have a lot of copper - potentially. But that potential may be perpetually a promise rather than a reality, given the risks involved.

For example, five years after starting talks, Ivanhoe Mines is still locked in discussions with the Mongolian government over an investment agreement for the giant Oyu Tolgoi copper-gold project. It may not be any easier for the promising Rekodiq copper project in Pakistan or the Udokan project in Russia to get off the ground. Rekodiq has an estimated mineral resource of almost 5bn tonnes and Udokan at least 1bn tonnes; it is likely that both these estimates will increase as drilling delineates further mineralisation.

If all goes according to plan, and that is a big 'if', then we estimate that some 6.5 Mt/y of new copper mine capacity will come online in the next seven years. The largest such project currently, in resource terms, is the huge Pebble deposit in Alaska , which is owned equally by Northern Dynasty and Anglo American. Although it is low grade, it is estimated to contain 32.7 Mt of copper, or almost two years of current global consumption.

According to the owners, at full capacity the mine will be able to produce about 500,000t/y of copper after 2016, which is equivalent to the annual output from Codelco Norte in Chile or Freeport McMoRan's majority-owned Grasberg mine in Indonesia. In contrast, the Escondida mine in Chile produced almost 1.25 Mt of copper in 2007 and 0.99 Mt in 2008. However, the recently started Tenke Fungurume mine in the DRC promises to expand its resource base many times over, while as we mentioned the Udokan and Rekodiq projects are also potentially colossal in size.

Other truly world class projects include Rio Tintoís La Granja project in Peru, which has an estimated mineral resource of 2.77bn tonnes at a grade of 0.51% copper, and Xstrata's Tampakan project in the Philippines, which has a mineral resource of 2.2bn tonnes at a grade of 0.6% copper. At full capacity, these two deposits alone will contribute about 825,000t/y of copper, but should Rio Tinto's prediction that 12 new Escondidas will be necessary to fill the gap between demand and supply in the next 15 years, then further deposits must be developed, and the collapse in credit availability due to the financial crisis has not helped matters.

Overall, we have identified about 70 new projects with estimated mineral resources of more than 100 Mt that may fill and perhaps exceed this shortfall in supply, but there is no guarantee that the majority of these will be developed.

It is these concerns that have formed the bedrock of support for the copper price,because in years ahead the market dynamics look more heavily under the influence of supply problems than ever before. The temporary slowdown in Chinese development and that of many other emerging nations due to the global recession looks likely to be just a pause in the general scramble for raw materials. In theory there is no shortage of copper deposits, but in practice getting all these developed and put into production will be extremely challenging, not least because a significant proportion are in politically unstable jurisdictions of the world, but also because many are likely to yield a lower ore grade and will therefore be more expensive to mine.

So the price rise in copper since the start of this year has a strong rationality to it in the longer term, but not right now. The market is pricing in expectations of tightness ahead, backed by the belief that demand will exceed supply. This will be common in most commodities, especially as we enter 2010, and will necessitate higher prices to encourage exploration and development of costlier and more risky supply sources. The metals' rally in 2009 so far stands as testimony to this fact, and China knows all too well that it must control as much supply as possible in order to fulfil its own developmental goals.
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The VM Group is a London based research consultancy which specialises in analysis of precious and base metals, energy, agribusiness and renewables. In addition to a series of special reports produced for BNP Paribas/Fortis Bank, the group also undertakes custom-built research and consultancy commissioned to meet specific client needs. For further information go to www.virtualmetals.co.uk. For a 36 page pdf of the full report from which the above section is excerpted click here
http://www.virtualmetals.co.uk/pdf/FAMM0907.pdf