Copper is the consensus metal for 2011 (December 21, 2010)

When it comes to metals with the best fundamentals, the consensus moving into 2011 seems to be that copper wins hands down.

“Everybody seems to be bullish on copper and I hate to be a consensus guy but it probably has the strongest demand story from China,” concedes Na Liu, founder of CNC Asset Management and a strategic advisor on China to Scotia Capital. “It’s trading way above marginal production costs.”

Liu points to electricity grid expansion in China as the basis for much of his optimism. In China’s next Five Year Plan (2011-2016), the government has earmarked between 1.5 trillion renminbi and 1.7 trillion renminbi (US$22.5 billion and US$25.5 billion) for grid expansion. That works out to about 300 billion renminbi (US$45 billion) per year and much of that investment is front-loaded, he says.

“People don’t understand those kinds of numbers yet so next year demand might surprise people,” he says. “Grid expansion next year will consume a lot more copper than people expect.”

And while some people believe China’s efforts to cool its overheated property market will have a negative impact on copper demand, Liu points out that construction use of copper is just 15%-20%, compared to the over 50% used for electrical purposes. Of that, about 11% goes to grid expansion.

Liu is also confident that Chinese demand for many metals, not just copper, will remain strong in 2011 due to the stocking-destocking cycle. In 2009 China “did a fantastic job” of stockpiling metals, he explains, particularly aluminium, nickel, copper, and zinc. In 2010 China destocked, and 2011 will probably be a restocking year, he argues, if the economy is resilient.

“How long can destocking last? It can’t last forever,” he says. “So China will have to start restocking and that will be bullish for metals because it will push up prices.”

Patricia Mohr, vice president economics at Scotiabank in Toronto, expects copper to touch US$5 per lb. as 2011 unfolds. The metal climbed to a record US$4.20 per lb. on Dec. 14, up from US$3.17 per lb. in late 2009. The previous peak was in July 2008 when copper hit US$4.08 per lb. Mohr says if copper reaches $5 per lb. in 2011 it would yield a 70% profit margin over average world break-even costs including depreciation.

Mohr argues China’s economy has re-accelerated in recent months and while there is some concern about inflation heating up, the decision earlier this month by the Peoples’ Bank of China not to raise interest rates means that while Beijing may move to a less accommodative stance on monetary policy it’s not tight enough yet to be a concern. She expects China will clock GDP growth next year of 9.5%. And that’s good for metals.

“China consumes 40% of the world’s copper, aluminium, nickel and zinc, she says, “and we are still optimistic on the outlook for China next year.”

Mohr also points to the copper supply deficit in 2010 (a shortfall of 235,000 tonnes of refined copper) and argues the deficit is likely to grow to 560,000 tonnes in 2011. “World mine production has only expanded by 1.9% per year from 2006-2010, not keeping pace with demand growth,” she says, noting that mine output may increase by just 1.4% in 2011.

Michael Smith, president of T&K Futures & Options in Port St. Lucie, Florida, believes there will be a correction in the price of copper “but nothing huge — maybe coming down 40¢ or 50¢ from where we are now and then running right back up.” By the end of 2011 he reckons copper could reach US$4.75 per lb.

Jeffrey Christian of the CPM Group in New York forecasts the quarterly average price of copper will go up to US$9,100 or US$9,200 per tonne over the course of 2011.

Carl Firman, a metals analyst at commodities consultancy VM Group in London argues the concentrate market is going to tighten considerably and will impact smelters and refined production. “Smelters are going to have to shut down capacity,” he maintains. “Demand is growing pretty strongly at 4-5% and I don’t see refined supply growing at any more than 3%. And then you’ve got the ETFs – 150,000 tonnes will be sucked up into ETFs over the next year to two years, which is not good for the deficit environment. It’s just going to make things worse.”

Firman adds that with such high prices for copper there is likely to be demand destruction ahead and perhaps permanent substitution. “The copper market is going to be very tight and prices are going to be very high and there’s definitely going to be some substitution,” he reasons. “Consumers may even look at plastic pipes rather than buying expensive copper ones.”

Nic Brown, an analyst at Natixis in London, concedes that the copper market is tipping into deficit and while there are a lot of new mines being planned and built, very few of them will be producing very much until the latter part of 2012, if not 2013. But he argues the supply problem and the tightening of the market due to ETFs is already priced into the market.

“While copper prices may go higher they will increasingly struggle because the market is already priced for it,” he says. “If anything there is more likely to be negative surprises on the downside than positive surprises on the upside. We wouldn’t be recommending shorting copper, but at the same time, much of the positive scenario we do envisage in terms of copper fundamentals is already priced in.”

Views on whether copper ETFs will be successful, however, are as mixed as where the copper price will end up next year.

People like Smith of T&K Futures believe they will be “the best thing ever for copper prices.” But others aren’t so sure because copper costs so much to hold and store and insure and transport.

Brown of Natixis says that while the ETFs that were launched in platinum and palladium at the end of last year and in the early part of 2010 were “spectacular successes” and gold ETFs have also been a great story in terms of investor demand and creating additional ways in which investors can access these markets, “it’s deeply questionable” whether these products will be as successful in the base metal markets.

“I struggle to see how base metal ETFs can be as successful as precious metal ETFs because the dynamics of the total return calculation are not in their favour,” he argues.

Simply put, the high cost of storing base metals works against copper ETFs, making them less attractive to investors than being long on copper futures.

“If you are buying copper through an ETF linked through a standard cost of storage you are buying into a steep forward curve and you are constantly paying for the privilege of holding it,” he says. “In precious metals it’s not a big deal, the costs of storing aren’t that high, but with base metals it’s a significant cost and investors who are potentially looking at buying these things have to think about the negative yield they are locking in.”

Brown also argues that there is the possibility that global regulators might perceive copper ETFs as “cornering the market in essential raw materials that are in scarce supply and therefore might take a dim view of these vehicles.”