Copper: For And Against

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By Greg Peel

Why is copper up 45% from its last low? BecauseChina is restocking. China ‘s restocking cycle is a “strong seasonal event”, note the analysts at BA-Merrill Lynch. China ‘s state authorities are regular buyers of copper in the first half of the year, at least until May. Typically the May holiday break in China signals the end of the buying cycle.

China has been restocking now for six months. Indeed, the copper price is up 78% from its December 2008 low to US$2.20/lb – its highest level since October. Regular cycles aside, when copper fell to US$1.50/lb it was a clear green light for China to pick up stockpiles at cheap prices. Aside from state-owned industry, notes Merrills, China ‘s State Reserve Bureau has been buying for the first time in two years. The Bureau is a long term counter-cyclical buyer.

Aside from China ‘s desire to build strategic stockpiles for industry, China has also been looking for an alternative means of investing its foreign reserves – mostly US dollars – other than in buying more and more US Treasuries. China is between a rock and a hard place on US Treasuries. It lost heavily on bond investments in 2007-08 when the Fed went into its initial rate cutting phase and the US dollar collapsed, but has been winning heavily more recently as the US dollar has rebounded on a global flight to safety into US bonds. Nevertheless, China is more than worried about the US printing currency at will. Another bond price collapse could be just around the corner.

It is therefore in China ‘s interest to remove itself as much as possible from direct currency risk. One option is to go straight to the source and buy the very commodities it lacks – real stuff, not funny money – to fuel its hopeful domestic economy stimulus. In Australia, that has, for example, meant an investment in parts of OZ Minerals ((OZL)) that surprised analysts, and an ongoing attempt to secure a slice of Rio Tinto ((RIO)) at a price no other player was prepared to pay. China is making similar investment attempts elsewhere in the commodity-producing world, but it is also buying commodities, such as copper.

Despite six months of frantic Chinese buying, inventories of copper held at metals exchanges around the globe are up 145% since the fourth quarter last year, Merrills notes, and total global inventories are estimated to have exceeded one million tonnes for the first time since the 2001-03 recession. Chinese buying has sparked a massive short-covering rally, further fuelled by (and fuelling) a bank-led stock market rally, by optimism in the wake of the G20, by inflation fears related to the aforementioned US money printing, and by a misconstrued belief that Chinese copper buying is simply evidence of a US$600bn stimulus package at work.

What hasn’t changed is real demand. Demand from the other big manufacturing centres of the US and Europe and the rest of Asia remains very weak. Merrills believes the copper rally will “hit a brick wall” in May as Chinese sales halt. This could prompt a retracement back to support at US$1.50/lb, the analysts suggest.

And Merrills is not alone.

Canada based Salman Partners notes that copper buying on the London Metals exchanged “stumbled” last night in the wake of the Chinese GDP announcement – at 6.1% the lowest annualised result since China started keeping records. LME traders also now fear that the short-coverers are about covered. Another fear is that across the globe, copper smelters that have not shut down have simply dropped back to minimal production, and higher prices could prompt a premature and self-defeating ramp-up.

But not everyone agrees that this copper rally is simply a mirage.

Canadian resources specialists Desjardins Securities suggests there is more at play than just seasonal stockpile building. For starters, the scrap market – a traditional source of cheaper supply – has dried up in China, forcing the country to import more of the newly refined stuff. But more importantly, Desjardins does believe there is a genuine pick-up in demand behind Chinese buying, beyond simple restocking.

Desjardins is happy to suggest that the Chinese stimulus package is indeed a real fillip to copper buying. Aside from the move to rebuild much of the earthquake-devastated Sichuan province, China has committed US$59bn in 2009 and US$62bn in 2010 on power grid projects. The analysts forecast Chinese copper demand to maintain a growth rate of 6-8% which should provide “strong support to the overall market”, with the stimulus package the initial impetus.

Remember how China went on a massive public works spree prior to Beijing 2008, leading analysts to correctly predict the subsequent crash in commodity prices just as quickly as the torch was extinguished? Well Desjardins notes the 60th anniversary of the People’s Republic falls in October, and that the Asian Games will be hosted by China in 2010, and that the 2010 World Expo will be held in Shanghai.

None of this, however, prevents the copper market from taking a rest in May, and potentially falling into a vacuum. Desjardins is forecasting a 2010 average copper price of US$3.00/lb – another 40% higher than where it is now. Merrill Lynch is still running with a 2009 average price of US$1.50/lb, although the analysts admit that this recent rally may force an upward revision to that average. But while Merrills is warning of a big price drop in May, if not before, this is only a short term view – a matter of weeks and months.

In the longer term, Merrills is expecting a “sustained” recovery in demand for all commodities within the next six to twelve months, based not on an end to the global recession (which Merrills concedes might last a while yet) but on stimulus-based demand from emerging markets (those with all the money) specifically directed to materials-intensive infrastructure projects.

From a price perspective, rising demand will also meet falling supply. Not only are production and project cuts widespread across the globe – from Australia to North America, Zambia, Chile and Peru – and Chinese smelting capacity being curtailed or closing, but when the copper price was testing its highs over US$4.00/lb in early 2008 it was as much to do with supply constraints as anything else.

Chinese commodity demand moved so fast during 2003-07 that the world was caught napping. Initially analysts assumed supply would catch up eventually as it always does, but they soon realised they had underestimated both the sheer strength of Chinese demand and the barriers to rapid supply response caused by rapidly increasing costs involved in the process. While new supply was slated, many of those projects have since been scrapped or put on hold. In short, supply never caught up.

Desjardins agrees. While China ‘s economy is only growing now at 6% instead of 12%, the drop in potential production prompted by the commodity price collapse has only put us back where we started. Eventually the global economy will turn around, and when it does there will not be enough readily available copper.

Dennis Gartman, of the revered Gartman Letter, is a firm believer in buying commodities and commodity stocks for the longer term. As the GFC plays out, Gartman is loading up on “stuff” and “producers of stuff”, meaning real commodities.

For Australian investors, it thus comes down to a matter of horizon. Longer term there is little disagreement that commodity prices will one day rise again, if, perhaps, not quite as quickly this time. Shorter term there are too many factors pointing towards the current rally in copper being at risk. Taking that up to the stock market level, clearly Australia will feel the brunt if commodity prices take a shorter term turn for the worse. And you know what they say: Sell in May and go away.

The ASX 200 has today punched through its January intraday high and is thus in 2009 blue sky. Overall momentum is to the upside, so this breach could see another strong push upward. But don’t be the last investor to get on at the next peak. Longer term there will be better opportunities.

And if I’m wrong, who cares? If this is the start of the next bull market it will matter little if you miss out on the first leg. The evidence suggests otherwise, however.

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