The copper industry, as shown by the price charts below, has been in a bear market since 2011. Today’s spot price sits at $2.06/lb ($4,546/t), with a 52 week high/low of $1.96/$2.74. The spot price is down roughly 55% from an all-time high of $4.58 in 2011.
Those 2011 highs were primarily demand driven by China, and particularly their roaring housing market. Since that time, the price has steadily declined due to a surplus in the market, which was created by slower-than-expected growth in consumption, and increasing production. 2015 saw an actual surplus of approximately 350,000 tonnes according to a Thomson-Reuters, and predicts a surplus of around 150,000 tonnes per year from 2016 to 2018. (1.)
Demand for copper is heavily influenced by macro-economic trends, and the commodity is considered an excellent litmus test to overall economic health given its uses in transport, construction, housing, and electricity. The depressed spot price seen today is partly a consequence of lack-lustre global consumption, where growth shrank to 1.9% in 2015, down from 3.8% in 2014.
Asian consumption contributed to 66% of total consumption in 2015, with China alone consuming 46%. Refined consumption from China has slowed in growth over the previous 5 years, with the country facing serious macro-economic headwinds. GDP has fallen from 12% in 2010 to a meagre 6.7% in April of 2016. Poor macro conditions are likely to continue in the near-term, with hopes that the government making significant liquidity injections can boost demand in the medium to long term. There are also questions as to when China’s housing market will recover and resume consuming the copper materials it once did, which drove the price to its 2011 highs. There is currently a glut of supply in the Chinese housing market.
Europe and Russia account for 19% of total 2015 consumption, while North America accounts for 9%. European consumption saw moderate growth in 2015 after shrinking from 2010-2013. Russian consumption fell by 5% in 2015, while North American demand experienced virtually no growth.
The short term prospects for a demand-driven rally in price are precarious at best. Any significant uptick in demand will have to be driven by a rapid improvement in economic conditions, yet there is little cause for optimism. Chinese growth has been falling since 2010, and while the recent liquidity stimulus might bring about a boost to future growth, the housing market will remain seriously over-supplied. European GDP hasn’t exceeded 1% since mid-2010. The United States’ GDP in the first quarter of 2016 was a frightening .5%. And as Thomson-Reuters points out, should the United States’ slip into a recession, the consequences for the price of copper would be devastating. The metal’s price has fallen in each of the last nine recessions, the most recent example in 2008 bringing a 60% decline.
Over the medium to long term, however, a brighter picture is presented for demand. Developing Asian economies offer attractive long term fundamentals to the metal. Copper’s use in the expanding electric vehicle market also allows for long term optimism as controlling air pollution continues to become popular amongst governments and consumers. The lower price level of copper should serve to stimulate future demand to some extent, while also maintaining copper’s utility in various infrastructural uses. The years beyond 2018 are promising to the price of copper in this regard.
On the supply side, there is continued growth in production despite the falling price environment. In 2015, mine production grew 3.5%, as compared to 2.1% in 2014. This was largely attributable to production increases in Asia, with Mongolia and Indonesia, who faced export difficulties, leading the pack. South American countries such as Peru also saw a meaningful increase in production.
The depressed price of copper is shrinking producer margins substantially. Globally, net cash costs are down 4%, and total costs down 2%. Despite these cuts, the cash cost margin has fallen to 35% in 2015, down from 57% in 2012, while total cost margins are at 16%, down from 47% in 2012. The marginal net cash cost of production over the last four years was $2.32/lb, sitting above current copper prices.
The typical net cash cost for a major producer ranges between $1.25-1.75, which sits below the current price level with some room to breathe. But these cash costs do not tell the whole story. There also exists off-site costs, taxes, interest expense, and head office costs, among other items, which will boost the true unit costs of production, shrinking an already thinning level of profitability. The substantial depreciation, depletion, and amortization charges found on financial statements also should not be ignored. In an environment where both capital and profit margins are extremely tight, my suspicion is that companies will fail to make adequate expenditures in both exploration and mine sustaining costs, shrinking long term supply.
The cost crisis is here, and if an estimated 10% of companies are losing money on a cash basis at $2.40/lb copper, the implications for the industry are even worse near $2.00/lb copper. (2).
To take an example, I present Freeport McMaRon’s North American copper production (their most profitable). Total unit costs sit at $2.16/lb on a co-product basis. Ignoring inventory adjustments, depreciation, depletion, and amortization costs, unit costs still sit at $1.82/lb, offering extremely thin margins. Gross profit compared to 2014 declined immensely. Understanding that interest, management, and sustaining costs are still relevant to overall profitability, and whether or not mines remain in production, how much longer can operations be sustained? And how much lower will the price need to go before closures are a necessity?
In spite of the real impact of declining copper prices, production has yet to see many substantial cuts. The largest cuts came from major producer Glencore, who temporarily closed the Mopani and Katanga mines to make plant upgrades, hoping to bring down costs. Other major producers, such as Coldelco, Rio Tinto, and BHP Billiton have vowed to maintain production in hopes of holding on to their market share using low-cost assets. (3,4.)
The truth is, however, that many of these producers will have major difficulties in maintaining production at a copper price near $2.00/lb. Despite the steadfast sentiment, Coldelco admitted that it would have to consider cutting production at that price level, and the company may have their hand forced by recent losses and asset write-downs.(5.) Additionally, it would not be surprising if Glencore chooses to keep their mines closed at $2.00/lb copper.
If $2.00/lb copper sustains, I predict there will be more production cuts faster than is expected given the producers’ attitude. No one wants to be the first to move, but it is inevitable given how under-water many of these companies are (see: Freeport McMoRan, Glencore). And even if the price can stay above $2.00/lb, the long term economics of the price level favour supply destruction in the future. Companies sustaining production are depleting their reserves, and a decline in the average grade of copper used in production is both damning for long-term supply, as well as near term operating and capital costs. (6.) Additionally, copper mines enjoy a long average delay (time between discovery and production) relative to other metals at 17.1 years. This long delay time, compounded with low prices and slowing discovery rates, offer the future copper market protection to new sources of supply. (7,8.)
The Thomson-Reuters report offers a quote that sufficiently summarized my position:
“…delays today will have implications for supply tomorrow. Clearly a bullish argument for copper, but equally clear is that this is all about one’s time horizon. In the short term, the next two to three years or so, the incentive price argument is just not topical. Consumption is slowing, while mines from the last boom are still ramping up. Furthermore, operations suspended, downscaled or mothballed may restart, some with expanded capacity to enable lower costs, so that the potential shortfalls in mine supply (as demand ratchets up) will not be so dramatic. Further out, towards 2020, the fundamental metal balance starts to look more interesting.” (9.)
If prices continue to fall, or stay around $2.00/lb copper, I believe supply destruction will commence within the next year or so. If prices rise moderately to $2.25/lb, there may be a delay in capitulation as major producers clearly seem eager to maintain market share. While I do not pretend to know where near term prices will go, there appears to be a fair risk of a price decline from a demand side catalyst, such as an American recession or continuing Chinese struggles.
This industry has a year or two to go before the bull market returns. However, the long term fundamentals make copper an absolutely undeniable quality of investment for someone with an extended time horizon, and I am more than happy to be exposed to the industry at current price levels despite the potential for more headwinds to the industry. One can only sell high by buying low, and assets at this price level are extremely attractive.
(1.) GFMS Copper Survey 2016; Thomson-Reuters
(9.) GFMS Copper Survey 2016 (pg. 32); Thomson Reuters