Wednesday, March 11, 2015

Copper prices have further downside risks

The commodity price boom that began after China joined the World Trade Organization in 2001 has turned to bust. Copper prices are down 41 percent from their 2011 peak and probably have a lot further to go. 

So why are copper producers ignoring all the obvious economic signals -- lower demand, excess supply and falling prices -- and ratcheting up production? The answer is that producers have powerful incentives to increase output. 
(Disclosure: Gary Shilling manages investment portfolios in which copper is shorted, so I have a financial interest in falling copper prices.) 

Let me explain. Think back to the early 2000s, when it was accepted wisdom that fast-growing China would soak up most of the world’s commodities. China, indeed, has been buying more than 40 percent of annual global output of copper, tin, lead, zinc and other nonferrous metals. It's been gobbling up 50 percent of seaborne iron ore and huge quantities of coal. And it has built large stockpiles of crude oil. 

As manufacturing shifted to China from Europe and North America, the Middle Kingdom became a much bigger buyer and user of commodities than its domestic economy required. 

The jump in prices led commodity producers to invest in big new operations in Australia, Brazil and elsewhere. Many of these projects came online just as global demand slowed in a classic boom-to-bust commodity cycle. 

But even as China's commodity-intensive exports to North America and Europe atrophy and China's own infrastructure spending slows, excess capacity keeps building. The reason: It’s not economical to suspend some of these projects due to high sunk costs and shutdown expenses. Some producers, moreover, may not be free to slash output as prices swoon, especially if they’re government-controlled and need foreign exchange to service sovereign debts. 

To see how market versus non-market forces are interacting, compare two widely used metals, aluminum and copper. Aluminum prices are down 32 percent from their April 2011 top, much less than copper's 41 percent freefall. Six of the top 10 aluminum companies are in Russia and China, where government decisions, not economic forces, often prevail.

The government and state-owned enterprises in China push aluminum output to provide employment and to achieve other national goals, such as self-sufficiency in aluminum. In Russia and India, the goal is to generate revenue from aluminum exports that can be exchanged for currencies needed to pay down debt; in Brazil, the driver is substituting domestically produced aluminum for imports. 

Aluminum production in these emerging economies has been booming. Even though half of China’s output is produced at a loss, the Chinese government buys excess metal from smelters to avoid bankruptcies, bad bank debts and unemployment.

 Much of the surge in aluminum output, however, is offset by cutbacks in the U.S., Canada and Australia. Alcoa, for example, is closing high-cost plants around the world. Since 2009, the aluminum industry in developed countries has shuttered more than 50 smelters. These moves have kept global prices from plummeting. 

By contrast, copper is produced mainly in the developing countries of Chile, Peru, Congo, Zambia and Russia. China is a net exporter of aluminum but an importer of copper. China had been building copper stockpiles but apparently that has slowed, along with China's slackened growth. The premium paid for copper on the Shanghai market over the London Metal Exchange was $85 a ton at the end of January, down from $160 a year earlier.

Copper output in developed countries has been restrained by falling prices, except in the U.S. and Australia, where output has risen because the marginal cost of production is even lower than market prices. Copper inventories are rising as output grows in Chile, China, Russia and other countries. In Chile, the world’s largest copper producer, stocks rose by 170,000 tons in the second half of 2014, the highest in a decade except for a brief spurt in 2013. 

Copper is used in almost every manufactured product, from plumbing fixtures to autos to machinery. Some 56 percent goes into electrical equipment and construction, which are weakening as China's economy shifts from an emphasis on manufactured exports, infrastructure and construction to consumer spending and services. 

Since copper is traded in dollars, the strong greenback makes it more expensive for non-U.S. buyers, putting more downward pressure on prices. At the same time, since about 93 percent of copper is produced outside the U.S., labor and other production costs are dropping in dollar terms, encouraging yet more output.  

The upshot is that about 20 percent of mined copper worldwide is unprofitable at current prices.  A global copper surplus is likely this year, the first since 2009, with supply exceeding demand by 500,000 tons, or 2 percent of annual refined production, according to Goldman Sachs. The International Copper Study Group, made up of copper-producing and consuming countries, says demand will rise just 1.1 percent this year while output jumps 4.3 percent. 

In an atmosphere of falling commodity prices, copper will probably continue to be weak; it's a favorite short in portfolios I manage. The lower the price of copper, the more developing economies must produce and export to get the same number of dollars to service their foreign debts. And the more they export, the more the downward pressure on copper prices. That forces them to produce and export even more, in a self-reinforcing downward spiral. 

Look out below.