Commodities | May 18 2006
By Greg Peel
Let’s say you own a copper mine. Yes, lucky you. Now in your mine lies copper ore of varying degrees of grade – from high grade that is cheaper to extract and from which more copper can be produced, to low grade which is more expensive to extract and from which less can be produced.
Given the world is crying out for copper, and the price has surged due to a lack of supply, you would go straight in and dig up the high grade stuff so you can get copper to the market as quickly as possible, wouldn’t you?
No, you wouldn’t. When the price of copper was low it was uneconomical for you to even bother with the low grade stuff, such that it would likely remain in the mine forever. However, prices are now at record highs! It is now an economically astute move to spend more money to extract the low grade ore while you can sell the resultant metal at a profit. Production may be lower, but the life of your mine is greatly increased and you can save up the high grade stuff for later.
This is what has been happening in the world’s mature, giant copper mines.
Citigroup has analysed four of these mines – Kennecott Utah, owned by Rio Tinto (RIO), Escodida in Chile, owned in part by Rio and BHP Billiton (BHP), Mt Isa in Queensland, originally the home of MIM but now owned by Xstrata, and Olympic Dam, which was once the jewel in WMC’s crown but is now owned by BHP. In 2005, these four mines produced 16% of the world’s copper.
In each case, Citigroup has found over time that as copper prices rise, grades fall.
The upshot of this is that analysts who assume that increased prices must naturally lead to increased production are wrong. As lower grades are targeted production levels fall. This would go some way to explaining why the increased production that the world has been expecting for the last couple of years simply hasn’t materialised.
So does this mean prices will have to remain high at least until all the low grade ore is finally out of the ground? Not necessarily. For starters, Citigroup notes recent start-up mines – a proper response to higher prices – are boasting good grades. It is only the older mines which will reduce production.
Moreover, if there is any drop-off in demand, and at some price there must eventually be a drop-off in demand, prices will begin to retreat. This is when the big mines will go back to targeting the higher grade ore. They will need to up production to ensure they sell enough copper before the music stops and no one can find a chair. In other words, they will exacerbate a price fall.
Citigroup notes that copper grades have actually been falling for half a century. Two ways of producing copper metal are by smelting or through on electrolytic process. Oxide ores are suitable for electrolysis but to date sulphide ores are not. The amount of electrolytically produced copper is about 19% of total production. This is the cheaper method.
Citigroup suggests that electrolytic production will be sustained at 19% for about five years before it starts to decline. This is because copper mines are going deeper and deeper, and this is where more sulphide ore is found. Technological advances may yet come into play before then, and BHP has been experimenting with electrolytic production from sulphide ores. Notwithstanding a breakthrough, copper mining should only become more expensive.
Citi also notes that the world’s large open pit mines have kept costs down over the years, but new projects are unlikely to match the giants. Copper mining will be forced to go underground.
The average margin for a copper miner is 39% between cash production cost and sale price. Over cycles there can be wild swings (to below 20% or above 55%) but Citi notes there is no long term trend towards the compression or expansion of margins.
The current cost of producing copper is US58c/lb. (Margin numbers are based on the long term average copper price, not on spot. If current costs are US58c/lb consider that spot is US389c/lb). Citi suggests new project costs will be more like US70c/lb. Applying the margin leads to a long term copper price of US115c/lb.
What conclusions to we draw from this? If long term copper production costs rise then prices must also rise, but then this analysis looks almost ridiculous when considering today’s spot prices. Hence there can still be major falls in price in the future to something more akin to the average.
However, the whole argument of the super-cycle thesis is not just that China et al will cause a protracted period of higher prices, but that we have witnessed a "secular" jump in prices, meaning longer term forecasts need to be step-jumped up to a new level, rather than just averaged out over a hundred years of which 2005-06 will barely cause a blip.
Some brokers have made some such jumps, while others prefer to stick to historical levels. Nevertheless we are still working off stock price valuations where, for example, the long term oil price is US$30/bbl. As China has only just begun buying cars in any meaningful sense it seems this price may end up being optimistic, notwithstanding any other factors.
However, there are dangers in shifting prices higher out to the distance when it comes to stock valuation. The nature of discounted valuation means incremental increases in the distance can cause major valuation shifts today. Some brokers have tried this exercise for the sake of it, and are left with BHP prices approaching $100! Thus it is safer to be conservative, and make recommendations based on short term moves.