This following is the concluding part of a talk on the copper market, delivered at the recent convention of the Prospectors & Developers Association of Canada in Toronto. Part one appeared in our April 8-14 issue.
On the copper supply side, the big constraint in 2004 was concentrates, whereas this year output restrictions are on the smelting side. Production rates at the world’s two largest copper mines, Escondida in Chile and Grasberg in Indonesia, are now back on track and have, along with other new output, helped push treatment and refining charges sharply higher. Although there is adequate global smelting capacity, it will still take time for the rise in concentrates production to feed through the system. Not helping the situation is the fact that an unusually large number of smelter maintenance shutdowns are scheduled for the first half of 2005. We estimate, as a result, that global smelter output would be 450,000 tonnes lower in the first half than in the second half.
Along with buoyant demand conditions and an expected pick-up in seasonal demand in the second quarter, the lower smelter output will keep the market extremely tight, especially through the first half of the year. This environment also leaves the market extremely vulnerable to any supply-side disruptions or positive demand surprises, which could easily generate fresh price spikes.
Given the high copper price, it would be surprising if there were not a lot more copper production coming on stream this year. And there will be. The new Sossego mine in Brazil is ramping up to full capacity of 160,000 tonnes per year, and the restart of
However, mine output in the world’s largest copper-consuming region, China, will be only marginally higher, rising by less than by 50,000 tonnes this year. In terms of demand, we estimate China requires an extra 300,000 tonnes of copper over the same period. This allows for a slowdown in Chinese copper consumption growth, from 15% last year to a projected 10% in 2005. Hence, Chinese total copper imports will remain at high levels.
So while global output growth will be higher again this year, and expansion programs are probably underestimated too (they usually are), the big difference is that few large copper mines will be starting up in the next few years, compared with the 1990s (when Escondida and Grasberg started production, which together currently produce almost 2 million tonnes of the red metal annually). New mines, such as the 180,000-tonne-per-year Cerro Verde in Peru, jointly held by
The fact that copper supply has failed to keep up with demand can partly be explained by a decrease in exploration budgets. Spending on exploration has been a lot lower in recent years, owing to the depressed price environment, and only recently has spending started to pick up. However, it can take at least five years before this translates into final cathode production.
One effect of the supply-and-demand imbalance has been a sharp reduction of refined copper inventories, which are now at critically low levels. Combined copper stocks on the London Metal Exchange, Comex and the Shanghai Futures Exchange are only about 100,000 tonnes. If demand is slowing and output rising, why, one might ask, is the falling inventory trend not reversing? And if there is a large off-warrant holding of material, as some speculate, why is this material not attracted on to warrant by the steep backwardation?
Indeed, some large deliveries emerged in the second half of last year, and again at the beginning of this year. But these were sporadic and not part of “a large unreported stockpile.” Instead, we believe some of this material came from European consumers who had overestimated regional demand conditions and stocked too much last year. In the current tight market conditions, market participants are holding onto their metal, especially given the smelter shutdowns scheduled over the nearer term, but we believe market concerns over large quantities of unreported copper stockpiles are no entirely warranted. Meanwhile, in China, the Strategic Reserve Bureau has practically nothing left with which to supply the market and is rather looking to rebuild its strategic stockpile of copper, which also highlights the low level of global copper stock holdings.
Part of the upswing in copper prices has been driven by cyclical factors. However, crucial to the current copper bull market is the fact that structural changes are occurring at the same time. It is not only the more liquid, often speculatively driven, nearby contracts that are trading higher on the London Metal Exchange, but also far-forward prices. Five-year copper prices are following a trend similar to that of oil, where long-term prices have increased as a result of stronger demand growth and under-investment in output capacity. The rise in far-forward copper prices has several explanations. Producers have been reluctant to sell into a rising price trend, consumers have continued to hedge forward, and investor activity has also increased farther out the curve.
Despite this, reported speculative length in the copper market is not excessive. Indeed, the net long fund position on Comex is still only half of the record net long reached in the fourth quarter of 2003. With prices near historical highs, hedge funds are discouraged by a much less attractive risk/reward ratio and are mainly involved in protective option trading strategies. Technically driven activity by Commodity Trader Advisors has also been reduced after some extreme daily price swings over the past year.
Non-traditional commodity investors (such as pension funds), however, are now showing huge interest in commodities through indices and various structured products. Mutual funds have seen a massive increase in interest for commodity investments. Total funds under management by three of the major commodity-investing U.S. mutual funds have risen from less than US$280 million two years ago to almost US$8.5 billion today.
Although these are big figures, they actually represent only a tiny portion of total assets held by this type of funds, which is almost US$8 trillion. But what impact does this type of fund really have on metal prices? Even if total institutional investment is now around US$45 billion, this still accounts for less than 5% of total commodity market turnover each month, and about 15% of the turnover in base metals.
Crucially, the interest among funds to buy commodities as an alternative investment shows no signs of abating. At times of upside risk to inflation and uncertainty over equity market performances, inversely correlated commodity markets are regarded as an attractive portfolio diversifier. This sort of interest has obviously seen impressive price rises, with total returns enhanced by steep backwardation.
Barclays Capital recently hosted its first commodity conference for institutional
investors. From a survey of the more than 150 attendees, it was interesting to learn that about two-thirds of funds had no exposure to commodities at all in 2004. But over the next three years, two-thirds said they were likely to have more than 5% in their portfolios, clearly suggesting that the copper market will see more money from this type of investor.
There are fundamental reasons why copper has reached its highest price levels in 16 years: strong Chinese demand; the cyclical upswing in the U.S.; under-investment in new supplies; low inventories; a falling dollar; and increased investment interest in commodities as an asset class.
Despite various market concerns, there are still no conclusive signs that the uptrend in prices is about to reverse. Even though supply is accelerating and demand is slowing, we expect the copper market will remain in deficit this year, with prices, as a result, staying pressured to the upside. In the current environment of extremely low inventory levels, we would not rule out a price spike to US$4,000 per tonne over the next six months.
In real terms, copper prices are still about 30% below the peak of the last major commodity bull market, in the late 1980s. Our copper price forecast for this year is higher than it was for 2004, but perhaps we are too cautious in predicting an average cash price of US$2,900 per tonne. We do expect prices to ease back through the second half of 2005 after a cyclical price peak by mid-year.
— The opinions presented are the author’s and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the author at ingrid.sternby@barcap.com
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