Copper: Short Term Pain, Longer Term Gain

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-Copper surplus ahead
-Prices downgraded short term
-Long term Chile losing market share
-Long term prices upgraded
 

By Eva Brocklehurst

Copper markets are moving to surplus. Producers have been ramping up and, as China draws down inventories from Shanghai warehouses, supply will outstrip demand. All this is straight forward. Price forecasts are being downgraded as a consequence – for the short term. Commonwealth Bank analysts are actually upgrading longer-term price forecasts for copper. Moreover, the long-run sustainable price is also being raised. Why? Severe energy shortages in Chile, the world's foremost copper producer.

Weaker demand and strong supply will result in a surplus of 520,000 tonnes in 2013 and 299,000 in 2014 and the analysts don't believe weaker prices will be enough to signal a cut to output, as most project capital for the next two years has been invested. Copper demand is likely to grow only 0.3% in 2013 and 4% in 2014 and underpinning this forecast is the unwinding of China's copper financing trade and inventory draw down. A weaker financing backdrop reflects tighter credit conditions. The analysts believe Chinese banks will reduce lending to high-risk entities which previously used copper as lending collateral.

The analysts draw comparisons with aluminum markets in that surpluses are expected over the next two years. Cancelled warrants have jumped, which likely reflects intentions to shift copper stock to low-cost warehouses. Copper premiums have lifted and the analysts find the copper forward curve is sloping up. Inventory financing is looking viable. What makes stored metal valuable is that it provides a return to metal and warehouse owners. Given the extent of financing in China, where inventory was used for credit collateral until financial conditions were tightened, the volumes of copper available for inventory financing are substantial. Traders can realise spot prices plus an enlarged premium over 2013 and 2014. This inventory financing is opportunistic. It does not add to demand growth but simply provides a return to investors and warehouses.

Short term prices are forecast to be US339c/lb in 2013 and US310c/lb in 2014 in the light of the expected surpluses. This is a downgrade to the analysts' prior forecasts of 4.5% for 2013 and 17.9% for 2014. Despite lower prices, the analysts expect the surplus to be sustained for three years, driven by robust supply growth of 4.6% year-on-year.

Three quarters of final copper demand is dependent on manufacturing and construction, and manufacturing remains an important indicator of copper demand and price momentum. The analysts point to recent falls in global manufacturing performance indicators, particularly in the US and Europe. This has accompanied the recent falls in the copper price. Slight improvements in China and a bounce back in Japan have not been enough to drive these global indicators higher. There are some better demand indications ahead and the usual lags of six to nine months suggests that world industrial output should stabilise, or improve modestly, over the rest of the year. Similarly, Chinese infrastructure growth is expected to modestly improve over the year.

So that's the next two years out of the way. What's ahead? The analysts have forecast a lifting of the copper price from 2014 to 2016 as the surplus turns to deficit by 2016. Price support should also occur as Chile's energy costs rise. From 2018 to 2020 the prices should lift modestly, with expectation that cost growth in Chile's copper industry moderates and the power companies manage to provide adequate energy. The analysts have upgraded their forecasts 1.8% to US336c/lb for 2018, 6.6% to US344c/lb for 2019 and 8% to US346c/lb for 2020.

Chile accounted for nearly one third of world copper output in 2012 but insufficient power infrastructure, lengthy regulatory approvals and deeper mining along with depleted grades, has eroded competitiveness. This is likely to reduce Chile's share of world production to 23% by 2020. The analysts expect Chile to become a marginal producer of copper by 2020. Chile's average cost of copper production is expected to keep rising to 2017 and then moderate to 2020. The emphasis will shift towards Peru and Zambia, where significant growth in copper output should occur, aided by lower capital and operating intensity. It will be regulatory hurdles and political risk that will apply the most to these new contenders for Chile's copper crown.

Chile's electricity industry has changed significantly over the last 30 years. Hydro power has fallen from 77% of electricity production to 33%, because of recurring droughts. Fossil fuels now generate 61% of electricity. The analysts also note the country's long-term strategy on the power sector remains unclear. Nevertheless, a dependency on fossil fuels means a commitment to imports as Chile doesn't have an abundance. The country imports 74% of natural gas and 92% of coal requirements. The premium for electricity has potential to curb investment in Chile.

BHP Billiton ((BHP)) has stated that energy accounts for 20% of costs in Chile, about three times higher than the US or neighbouring Peru. The analysts also highlight the regulatory processes that have stymied two major projects – the Punta Alcalde coal-fired power station and the Alto Maipo hydroelectric facility. The delays these projects have endured highlights the risk involved with utility projects in the country.

The analysts found that new projects in Australia, Zambia, Peru and the USA require the lowest copper prices as incentive to development. In Peru copper mines have costs that are spread across the curve but the higher-cost projects are those that are ramping up. By 2020 most of the projects should be in production and have cash costs placing them in the lower half of the curve. The majority of Peru's projects also have low capital requirements relative to copper projects around the world. On the downside, regulatory approvals are subject to significant delays with water permits being the most contentious.

Next on the list is Zambia. Here, the richness of the copper reserves is not a new discovery, but development was impeded by political uncertainty and lack of investment until early this century. In 2013 the mines have cash costs in the upper half of the curve but by 2020 they are expected to consolidate towards the middle range. Risks are transport related, copper is transported by rail via other countries to the coast and this can be a challenge in a region prone to tension.

Another impact on copper over the longer term is the maturing of developing economies. The analysts observe that, over the longer term, tertiary industry – services, education and knowledge – form an increasing proportion of GDP growth. This is less copper intensive than manufacturing. Per capital copper consumption will continue growing in China and other developing economies over the medium term but further afield it will flatten as tertiary industry increases as a proportion of GDP.
 

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