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Copper as an Investing Opportunity


  • Copper has declined due to a strong dollar, increased production and a slowdown in China.
  • In the long term a supply deficit is expected as mining grades are constantly getting lower and demand is steadily growing.

Introduction

Commodities in general have been in a slump for the last 5 years; the Dow Jones Commodity Index peaked exactly 5 years ago on April 26 2011. High 2011 commodity prices induced new investments that—combined with low interest rates—made it easier to finance new projects, eventually increasing supply. With limited growth in demand the inevitable result was a contraction in prices.

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Figure 1: DOW Jones Commodity Index. Source: S&P Dow Jones Indices.

But, commodities are known to be a cyclical business. The current low prices put off new investments and developments that limits further increases in supply and should bring to a commodity upturn cycle.

As commodity prices are mostly influenced by demand in relation to the business cycle, supply and production constraints, political issues, the value of the US dollar and investments funds speculation, those are the factors one should focus on when researching a commodity to invest in. This article will take a deeper look at how copper fits into the above picture.

Copper

Copper’s malleability, strength and conductivity make it useful in a range of building and electrical applications, and as it is found in nearly every home and vehicle, copper is the third most mined metal in the world.

538 2 figure copper prices

Figure 2: Copper prices. Source: Nasdaq.

Copper prices had been slowly falling since 2011 and further fell in 2015.

Copper Supply

One of the interesting things about copper is that many expect a looming copper supply crunch due to the fact that demand is constantly growing alongside global GDP growth, but the copper mining grades are getting lower and at current prices many of the new projects in development are not feasible.

The International Copper Study Group (ICSG) released its copper forecast for 2016/2017 back in March. World mine production is expected to increase by around 1.5% in 2016, already much lower than the 3.5% growth experienced in 2015 due to production cuts in the Democratic Republic of Congo and mine closures in Chile. In 2017 growth is expected to be 2.3% fueled by the expansion of existing projects and new mine developments.

In the longer term, there are several issues expected to limit copper supply. The first issue is that it takes more and more time from a discovery to actual production due to geological, environmental and political challenges. An example of that is the Oyu Tolgoi mine in Mongolia owned by Turquoise Hill (NYSE:TRQ). The site was discovered in 2001, first open pit mining began only in 2013 and underground mining that contains the main resources is expected to begin only in 2021, political and financing conditions permitting.

538 figure 3 years to production

Figure 3: Number of years from discovery to production. Source: Mining.com.

In total the average number of years from discovery to production has gone from an average of 7 years two decades ago to the current average of 20 years as new feasible mining opportunities are mostly found in difficult environments, like Mongolia for example.

The second issue is low mining grades. Due to the fact that the low fruit is usually picked first in the longer term copper is expected to become much scarce. The lower the grade of copper the more ore has to be mined in order to produce the same amount of copper. More mining means higher costs.

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Figure 4: Copper mining and reserve grades. Source: Mining.com.

Back to our previous example, the Oyu Tolgoi mine, which is the main copper development project for Rio Tinto (NYSE:RIO), as RIO owns 51% of TRQ, it has a reserve grade of 0.85%. Escondida, the world’s largest copper mine, owned by BHP Billiton (NYSE:BHP) is also experiencing lower grades. BHP anticipates 27% lower grades in 2017.

Lower mining grades and longer lead times should strongly effect copper supply.

Demand for Copper

Copper is used in various industries and the diversification provides a margin of safety in relation to potential disruptions in copper demand.

538 5 figure copper consumption

Figure 5: Copper consumption per sector. Source: London Metal Exchange.

Demand for copper is strongly related to global GDP as population growth and development leads to housing growth and more vehicles and technology being bought. Albeit with ups and downs, the global economy is expected to continue growing and therefore the demand for copper is also expected to grow. When this is combined with the previous supply analysis the following estimation is the result.

538 6 supply deficit

Figure 6: Copper supply deficit. Source: Mining.com.

Lower mining grades and higher demand could create a 10 million ton supply deficit in the long term.

In the short term demand disruption might result from a slowdown in Chinese economic growth as China is responsible for about 40% of global copper consumption. The current slowdown in China is the main cause for copper falling below $2.00 per lb. A continuation in Chinese growth and global development should remove fears around copper.

Another interesting variable is the increase in the number of produced electrical vehicles and a shift towards cleaner energy sources. The production of an electrical car necessities three times more copper than a gasoline powered car. Also, an average of 3.6 tons of copper is used to create a megawatt of wind power capacity.

Copper and the Dollar

Copper prices are expressed in US dollars and therefore copper prices are strongly influenced by US dollar movements.

538 7 dollar copper

Figure 7: Copper vs. the US dollar. Source: Stapleford.

The long term 0.8 negative correlation between copper and the US dollar means that 80% of the changes in copper prices can be explained by changes in the US dollar. Therefore, copper could be also considered as a strong dollar hedge.

Conclusion

The supply deficit should be offset by increased prices that could lead to increased production but at that point the gains from investing in copper should already have been made. Wood Mackenzie estimates that the global supply deficit for copper should amount to 10 million tons by 2028. By looking at the current production cost curve for copper such a supply deficit would trigger an immense boom in prices.

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Figure 8: Copper cost curve. Source: SNL Metals & Mining.

With copper demand expected to grow constantly and limited low cost production, the above cost curve indicates that a supply deficit could easily bring to copper prices of $4.00 per pound or higher. Any increase in copper prices above the cash costs is pure profit for the miners and therefore a copper supply deficit could create extraordinary returns.

The best way to invest in copper would be to find a miner that has low debt and low production costs so that it can survive the current slump and a long mine life in order to fully grasp potential future supply deficits. If you are less inclined to investing directly into a miner, a good option is copper ETFs.

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