Rudi's View | Nov 21 2006
By Rudi Filapek-Vandyck
The global investment community has taken an increasingly negative view on the market dynamics for copper over the past few weeks. Not only has this caused some sharp downward price movements for the industrial metal, the weakening spot price for copper has been held largely responsible for weakness in other base metals as well as in share prices of commodity producers across the globe.
The market’s bearish stance reached a peak last week with data from the New York Commodities Exchange (Comex) showing non-commercial traders in copper Futures had built up the largest net short position since the market turned in April this year. Some market followers have calculated the average net short position for non-commercial traders has been floating around 3000 Futures contracts. Last week’s data revealed a market that had scaled back its long positions by over 1000 contracts to 10,013 and significantly increased short positions by 3,370 contracts to 27,023 contracts. The net short figure of 17,010 contracts is by far the largest among all commodities, soft and hard, even outnumbering the likes of sugar and heating oil by a significant margin.
No wonder the spot price of copper has taken quite a serious beating recently. Since May 11 the metal’s spot price has declined over 25% and current signals are that further weakness is likely. This makes copper the worst performer amongst all metals since the May correction started. As copper is widely regarded as one of two leaders of the current commodities boom, and with the other one, crude oil, having even performed worse and still struggling to find a price bottom, it is easy to see why some investors have now lost faith in resources.
What has happened?
Let’s start with the more speculative theories as I am sure you’ve all read about the US economic slow down at least a hundred times by now.
Rumours are circling at least one prominent hedge fund in the US has run into troubles. As is usually the case, these rumours are hard to verify. They may not even be true. But as shown in the case of Amaranth Advisors two months ago, the forced unwinding of speculative market positions can place a sudden downward pressure on any given market.
So far the managers at Amaranth have admitted losing US$5bn in what turned out a bad bet on how much natural gas will cost next spring. It is believed that the unwinding of Amaranth’s market positions exacerbated the steep decline in the price of natural gas which came at a time when the market proved highly sensitive regarding the price of crude oil. In a matter of days spot crude oil lost US$10 per barrel in September.
Is another hedge fund loss responsible for much of copper’s recent price weakness? We won’t know until the news breaks.
Another rumour which equally refuses to lie down, and also has its merits, is that Chinese buyers are trying to goat the price of copper down. This would make a lot of sense as China is now the world’s largest buyer of copper so that today’s price weakness can lead to significant savings next year. It would also concur with the observations made by Macquarie analyst while touring through China that local copper buyers, such as building companies and producers of industrial wires, are very much focused on substitution of the metal and on secondary supply (scrap). It is Macquarie’s assessment that this will have an impact on the price outlook for copper in that any rebound in demand is likely to remain benign.
Not everybody subscribes to the Macquarie view. Analysts at GSJB Were, for instance, conducted their own tour through China recently, and they returned with the feeling that current destocking will be followed by a sharp pick up in Chinese imports again. However, even GSJBW acknowledged it may take up to three months before the market will see evidence of this renewed demand flowing through.
Meanwhile, copper demand in the US and Europe has been rather weak recently. In addition, several economic data from Japan, China, Europe and the US have surprised on the downside in the past few weeks fueling expectations that the coming two quarters, in particular in the US, are likely to generate rather weak economic figures.
All this adds up to likely more price weakness for copper in the short term. And because of the bellwether role of the metal, other metals and commodities may be dragged down as well.
The impact on resources companies, including the big diversifieds such as Rio Tinto (RIO) and BHP Billiton (BHP), is an undisputable negative one. Even without the possible sector wide ramifications, copper is the largest contributor to both companies’ earnings. Some market commentators have suggested that a positive conclusion to the upcoming annual iron ore contract negotiations may compensate for the copper weakness and possibly provide the resources sector with a renewed élan.
Certainly, a tighter than expected iron ore market is likely to result in another price rise from next April onwards. Even the Chinese authorities seem to have accepted this judging by the fact that a Chinese industry newsletter recently was allowed to publish an interview with a CVRD official who predicted next year’s price rise could be as high as 40%.
But the upcoming negotiations are likely to be protracted, just like this year, and current market estimates are for a price rise in the order of 7.5-12.5%. This may not be enough to offset copper’s price fall in the year ahead.
The good news is that many a resources stock is dirt cheap. Some market commentators talk of the cheapest valuations since the start of the current cycle. This would suggest a sharp rebound in share prices lies ahead once the world has become comfortable with the degree of slower economic growth throughout the globe (but predominantly in the US).
Another positive, as pointed out by technical chartists at Barclays Capital, is the fact that despite the significant market pressure, the copper price has remained fairly resilient so far.
Probably the best proof that the commodities super cycle is still alive and well is the fact that takeover activity inside the sector is showing no signs of abating. This week’s announcement of an agreed offer for out of favour copper producer Phelps Dodge by the much smaller Freeport-McMoRan again signals the sector is flush with cash and willing to invest it in longer term prospects at significant premiums above today’s asset valuations.
Of course, the investment horizon for management teams at Phelps Dodge and Freeport-McMoRan is much, much longer than the next few months.