Has copper hit the bottom?

The resurgent US dollar has put copper prices under renewed pressure, but some analysts believe that China's transition to a more balanced economy could provide alternative avenues of long-term support.

July 30, 2015

by Mark Robinson

Although London Metals Exchange (LME) copper prices are down 15 per cent since the start of the year, there could be more pain in store. The metals team at Goldman Sachs has substantially reduced its short-, medium-, and long-term copper price forecasts, with the rate for 2018 reduced from $8,000 to $4,500 a tonne - a 44 per cent downgrade. The analysts see increased downward pressure on Chinese demand growth, together with "less conservative assumptions regarding mining cost deflation". The end result is lower prices for longer - at least according to the Goldman Sachs team.

Copper is just one of a number of mining commodities where prices have come under renewed pressure due to doubts over Chinese demand growth. But copper has added exposure to the health of China's domestic economy because of widespread use of the metal as loan collateral.

During the years of runaway growth, China's base rate was generally well in excess of international levels. As a consequence, many domestic businesses opted to borrow money at dollar-linked interest rates. Usually this involved a letter of credit from a local bank to import copper, which would then sit in bonded warehouses as collateral. It's estimated that commodity-backed financing accounts for around a third of all short-term loans. If, as some fear, Chinese interest rates are on a relentless downward trend, it could put a serious dent in the amount of copper held in China's port cities.

Dollar strength and the Fed

The steep fall in Goldman Sachs' long-term pricing estimate is particularly worrying, given that it had been widely anticipated that the copper market was set to fall back into deficit over the next two to three years. Sentiment hasn't been helped by the state of LME inventories, which have all but doubled since January. And while there are still analysts who feel that copper is fundamentally oversold, there is now conjecture that metals markets are unresponsive to standard market levers. So US-dollar strength could be driving everything in the short term.

Traders have even started to price in the likelihood of an increase in the Federal Funds rate later this year. Federal Reserve chair Janet Yellen has been banging the drum on this issue for the past year or so - so the Fed will presumably have to follow through at some point. Higher rates would make US T-bills even more desirable, pushing up the dollar value in the process, thereby rendering dollar-denominated commodities - such as copper - more expensive to holders of other currencies.

In some respects copper's recent struggles are emblematic of the wider malaise in commodity markets. Demand is stifled due to the strength of the greenback (see box), while new supply - initiated during the upswing of the commodity super-cycle - is hitting markets at a time when inventories are high. All these factors are highlighted in the Goldman Sachs analysis, but it's not as though they haven't been wide of the mark before. And there are some well-placed voices of dissent - or perhaps qualification - depending on how you interpret them.

China's consumer culture

The commodities team at Macquarie Research recently characterised China's growth profile as having moved from "sizzling to simmering". The Macquarie analysts accept that the capital-intensive drivers of Chinese copper demand are faltering, but they maintain that the shift under way towards a more consumer/service-based economy will generate alternative demand as growth from construction slows.

There is mounting pressure on China to upgrade and expand its state grid network as China's burgeoning middle class demands ever more power for domestic consumption. Macquarie now estimates that by 2020 China's total copper demand (including both refined and scrap) will reach 13.5m tonnes, up from 11.0m tonnes in 2014 - a compound annual growth rate (CAGR) of 3.4 per cent.

Copper goes green

Aside from the ongoing revamp of China's electricity grid, another energy-related demand catalyst - the rise of renewable power sources - could help to insulate copper prices over the long run. Analysts at Bloomberg estimate that around $8 trillion will be spent on alternative energy sources between now and 2040 - that equates to two-thirds of total worldwide energy expenditure over the period.

Copper remains the prime conduit for electricity generation regardless of the technologies employed. But it's held that 'green' energy technologies typically utilise more copper per kilowatt than traditional sources. This promises to be particularly telling in the accelerated rollout of hybrid and electric automobiles, which use up to three times more copper than standard internal combustion engines.

Dollar strength = falling local costs

There's a flipside to continued dollar strength: copper's production costs have narrowed appreciably in the past few months. Miners are also benefiting from the slump in oil prices. So despite the fall-away in copper prices, there's little incentive to pare back production because they're still substantially above costs for the most part.

Even if you were to take the mid-range estimate ($4,775 a tonne) for marginal production - the rate at which the highest-cost copper mines break even - the current market price is still 9 per cent to the good. But most copper mines already operate well below the marginal rate. And operators were prioritising efficiency gains well before the recent price woes. BHP Billiton (BLT) reported a 13 per cent reduction in first-half cash costs at its giant Escondida copper complex and expects further substantial gains going forward. Research published by SNL Metals and Mining gives an average mined cost (including by-products) of $3,360 a tonne. In other words, there's still plenty of headroom.

Miners trawling the depths...
	Price	High (1-Yr)	Low (1-Yr)	Price change (6-mth)	Price change (3-Yr)	P/E	Div. Yield	Market value (£m)
Antofagasta	573	855	573	-17.4	-46.5	18.2	2.4	5,649
BHP Billiton	1,130.5	1,953.8	1,123.5	-14.4	-34.4	18.4*	7.7*	23,877
Rio Tinto	2,394	3,515	2,394	-16.7	-17.2	7.3	5.63	33,479
First Quantum Minerals (Lon)	580.5	1,462	580.5	-5.0	-50.3	10	0.88	3960

Source: Thomson Datastream, Bloomberg*

Favourites & outsiders:

When you consider the state of global commodity markets, it may seem fanciful to describe any of London's miners as 'favourites'. 'Outsiders' sounds far more apt - and fairly rank ones at that. Of the big three mining companies trading in London, BHP Billiton has the greatest degree of exposure to copper prices, with just over a fifth of its latest statutory revenues linked to the metal. For Rio Tinto (RIO) and Glencore (GLEN) the figures come in at 13 per cent and 8 per cent, respectively.

You would be swimming against the tide if you were to take a position in BHP - or indeed Rio Tinto - following the upcoming reporting season. But you need to bear in mind that analysts covering the sector have become ultra-bearish, which means that future earnings will of course look weak - maybe too weak. Obviously, both groups have massive exposure to iron ore prices, so even if the copper sell-off has been overdone, any subsequent bounce will have a limited effect on the miners' fortunes.

Outlining the virtues of a copper pure-play that has lost a third of its market value over the past 12 months might seem a hard sell. But we're confident that Antofagasta (ANTO) is a solid long-term bet in the sector. Admittedly, the stock has come under renewed pressure as the fall in copper futures might encourage management to reserve capital for acquisitive purposes. Antofagasta received around $1bn from the recent sale of its water business, but rather than distributing these funds to shareholders via special dividends - the Chilean miner's usual course of action - it may decide to look for some knockdown assets. Over the past 12 months, the group - majority owned by Chile's Luksic family - had to contend with protests and a lawsuit affecting its flagship Los Pelambres mine. But it now trades at 10 times JPMorgan's 2015 EPS estimate of $0.87 a share. Given its historical premium to the sector - and a propensity to return excess capital to shareholders - we feel the shares are undervalued even taking account of current market weakness.

IC VIEW: Even aside from the collateral angle, it would have been unrealistic to expect that China could maintain its explosive growth rates from the early part of the millennium, but the extent of the slowdown has caught economists off guard. Any view on the likely trajectory of copper prices is inextricably bound up with Chinese growth rates - for now, expectations on this front are as gloomy as they have been for some time.

China has emerged as a colossal consumer of copper. A rampant period of industrialisation, urbanisation and electrification saw the country's demand for refined copper rise from 1.8m tonnes in 2000 to 9.9m tonnes in 2014 - equivalent to a CAGR of 13 per cent. Meanwhile, ex-China demand contracted by 1.4m tonnes on aggregate over the same period, allowing China to rise from 12 per cent of global demand in 2000 to 45 per cent in 2014.

However, it is becoming clear that the engines that have driven China's growth in the past decade are losing thrust. The grand nation-building exercise of the 2000s is giving way to an increased focus on the 'quality' of growth, with little tolerance left for unbridled capacity expansion or unwarranted property development. While this certainly takes some of the momentum out of China's future demand growth, it does not mean that copper demand has to suddenly start contracting. Instead, we expect the next phase of China's copper demand growth story will be one of rising intensity of use.

Over the next five years, we do envision some shift in the make-up of China's copper demand. While we do not think that demand growth from copper and infrastructure will turn negative over this period (at least on a CAGR basis), we do believe that growth from these sectors will slow relative to the past five years and that this slowdown in growth will be more pronounced than for the transportation, industrials and consumer goods sectors. Even so, construction and infrastructure remain important sectors - accounting for an estimated 54 per cent of demand in 2015, dipping to 51 per cent in 2020 on our numbers.

As a beneficiary of economic restructuring, the consumer goods sector is expected to remain a substantial driver of copper demand in the longer term. Within this sector, 60 per cent of copper demand comes from white goods - particularly those products with cooling/heating functions such as air conditioners and fridges/freezers. For air conditioners, China's current penetration rates stand comfortably below those of developed Asian nations and as such have the potential to benefit from increased ownership levels, as well as a rapidly accelerating replacement cycle.

Colin Hamilton, Head of Commodities Research, Macquarie Group