Metals & Mining: Copper Price Fundamentals & Outlook

Copper Price

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.

5 Year Copper Price Chart

17 Year Copper Price Chart

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

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.

Supply

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.

Copper Industry Cost Structure

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?

Freeport North American Unit Costs

Source: Freeport-McMoRon 2015 Annual Report

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.)

Copper Production Cuts

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.)

Average Copper Grade 2012

Source: http://.snl.com/cache/18324405.pdf – Metals EconomicGroup 2012 Copper Study

 

Conclusion

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.

Sources

(1.) GFMS Copper Survey 2016; Thomson-Reuters

(2.) http://www.mining.com/copper-minings-deepening-costs-crisis/

(3.) http://www.mining.com/codelco-vows-not-to-cut-copper-output-even-if-prices-keep-falling/

(4.) http://www.reuters.com/article/us-chile-copper-output-idUSKCN0X328V

(5.) http://www.mining.com/worlds-no-1-copper-miner-codelco-posts-historic-loss-of-1-4bn-in-2015/

(6.) http://ofccolo.snl.com/cache/18324405.pdf)

(7.) http://www.minerals.statedevelopment.sa.gov.au/__data/assets/pdf_file/0018/251604/20150505_PDF_Richard_Schodde_presentation_to_Copper_Summit_May_2015.pdf

(8.) http://www.minexconsulting.com/publications/Schodde%20presentation%20to%20IGC%20Aug%202012.pdf

(9.) GFMS Copper Survey 2016 (pg. 32); Thomson Reuters

Metals & Mining: Alternatives to DCF Valuations in Exploration Projects

Introduction

In this article, I wish to offer a brief synopsis on the use of valuation techniques as applied to exploration projects of junior mining companies, and extend a few thoughts on the generally accepted valuation approaches.

The defining nature of exploration projects, relative to finance, is their great uncertainty. Serious debt financing is virtually unavailable to juniors until after the full-feasibility stage, and for good reason. It is exceptionally difficult to convert even a proven mineral reserve to cash flows, with perhaps as few as one in ten-thousand exploration projects reaching the development stage (1). This difficulty arises from the extreme level of risk at all stages of the project. At the exploration stage, there is primarily geological risk (ore grade, tonnage, and deposit shape, for example); the development stage brings forth geographic/infrastructure risk, as well as enhanced exposure to cycle risk, be it macro-economic or in commodity price; lastly, the production stage is vulnerable to socio-political and metallurgy (processing) risk. There is virtually no point in time where a mining company is not exposed to some, if not significant, amounts of risk. However, it is important to mention here that risk is generally a decreasing function of project development, while certainty and price are an increasing function.

For exploration properties in particular, the extent of the level of risk, paired with the large amount of unknown information, leads to serious problems in valuation. The most widely used method of valuation, the Discounted Cash Flow model, is for all practical purposes useless in light of these characteristics. The inability to model cash flows with any hope of accuracy lasts until at least the pre-feasibility study, where a mining rate, ore grade, recovery rate, and various costs can begin to be estimated. A basic model is offered at this stage; however, an analyst would still be remiss in relying heavily on this model alone due to the the huge uncertainty and risk that still exists within that model. (2).

So what techniques of valuation are available to the mining analyst focusing on exploration properties if the DCF model is generally inappropriate for the task? I will discuss two separate approaches, the cost approach, and the market transaction approach, and offer my thoughts on each.

The Appraised Value Method: A Cost Approach

The appraised value method is “based on the premise that the real value of an exploration property…lies in its potential for the existence and discovery of an economic mineral deposit.” Reasonably justified past costs considered contributory to value, in addition to estimated warranted future costs (sampling of the property, for example), are an approximate determinate of value. These past and future expenditures can be marked down appropriately in the case marginal properties. (3).

This method is suspect due to key flaws in theory, and practice.

Firstly, the method invokes similarities to the cost-of-production theory of value, which has been widely panned by economists in favour of the subjective theory of value (4). And in applying subjective value theory, we can see that the cost approach is not only non-sensical, but also arbitrary. While the aforementioned premise to the appraised value method is true, in what way does the costs involved justify value proportionally? It is true that exploration and drilling costs will eventually reveal the true value of a deposit; but it does not follow that the numeric quantity of those costs have any bearing whatsoever on the actual resource value. Rather it is the metal price, ore grade, and tonnage, among other items, that determine the deposit value as more information is discovered in sampling.

And in practice, we see the absurdity of the appraised value method. Imagine a case where there are two properties with identical geological attributes: one exploration property is extremely conservative in their expenditures, while another is quite liberal, and both properties are consistently finding promising geological developments. According to the cost valuation approach, it is the liberal spending property that will be higher valued, despite the fact that the conservative spender actually has more value in reality.

Thus, in my opinion, the appraised value method should by no means be an appropriate valuation technique for exploration properties. While it may offer some utility as a secondary source of valuation, it should certainly not be relied on primarily.

Comparable Transactions: A Market Approach

The comparable transactions approach estimates the value of an exploration property by sourcing similar projects to determine what the market would pay. The primary weakness in this approach is the drastic variation from property to property in the mining industry. No ore body is identical, which affects cost predictions for infrastructure, socio-political risk, and metallurgy risk, subsequently affecting value in different ways. Because of this impreciseness, the estimation is best conducted in terms of a range, rather than an exact value. The relatively small volume of market transactions at the exploration stage presents another challenge to this approach. This further exacerbates the difficulty in comparisons, as the body of information to benchmark against is fairly limited. Lastly, differing price points in the commodity cycle for when the properties are compared can lead to further inaccuracy in valuations. (5).

That being said, the comparable transactions approach seems to be the more reliable technique for valuation of exploration projects as compared to the appraised value method. Despite its many short-comings, a market approach at least provides some concept of relative pricing points for properties.

But that concept perhaps best illuminates my dissatisfaction with the comparable transactions approach for exploration properties. It is concerned with price, not value. And investors taking this approach leave themselves with no enhanced knowledge of the fundamental value of the property, and furthermore with no true margin of safety.

Conclusion

Overall, while both the cost and market approaches have their use, it would be unwise for an analyst to base his investment policies on these approaches, in my opinion. They ought to be considered secondary tools of which valuations can be referenced to, rather than primary methods in themselves.

Sources

1. https://www.aadnc-aandc.gc.ca/eng/1100100023711/1100100023713

2. http://web.cim.org/mes/pdf/VALDAYLarrySmith.pdf

3. http://web.cim.org/mes/pdf/VALDAYBill_Roscoe.pdf

4. https://en.wikipedia.org/wiki/Cost-of-production_theory_of_value

5. http://web.cim.org/mes/pdf/VALDAYBill_Roscoe.pdf