The ability of copper to maintain prices above $3/lb caught most Freeport-McMoRan Copper & Gold (NYSE:FCX) investors off guard, including this one. Stubbornly high inventories at the London Metals Exchange, or LME, combined with subdued China demand for copper should've crushed the prices of the red metal used in all kinds of building materials from plumbing pipes to electrical wires. One key to investing is noticing when a thesis doesn't play out and attempting to understand and adjust to the reasons.
A prime reason for the stubbornly high price of copper could be investment demand in China, where people prefer to own hard assets versus cash in the distrusted banking system. Such investment moves wouldn't be listed in the inventories on the exchanges, but it could help support the price of copper.
Regardless of the reason, copper prices could be on the verge of a major breakout higher. The recent price over $3.35/lb places it at an 8-month high with LME inventory levels plunging. Could copper be signaling a rebound in global growth, especially in the construction space in the U.S. and Europe?
The following table provides the copper stock levels at the LME warehouse:
Freeport-McMoRan still trades based on the price of copper, yet it now owns a large oil and natural gas asset after the purchases of McMoRan and Plains Exploration last year. For a pure-play on copper, investors might want to own Southern Copper (NYSE:SCCO) or the iPath Dow Jones-UBS Copper ETN (NYSE: JJC). Though Southern Copper is a U.S. based company it is majority owned by Grupo Mexico. This corporate structure is a negative for the stock, yet it oddly trades at a premium valuation to Freeport-McMoRan.
Another major concern is Southern Copper has potentially unsustainable profit margins near 27% in the last nine months. A new 7.5% royalty in Mexico on resource companies including copper miners could impact these profit levels. More importantly, the fiscal issues in that country might lead to higher royalties and taxes in the future.
The iPath Copper ETN is an attempt to reflect the returns of the futures contracts on copper via an unleveraged investment. Investors would want to use this ETN in order to avoid the government and operational risks of Freeport-McMoRan or Southern Copper. Considering the potential issue that those two countries face in countries such as the Congo, Indonesia, Mexico, and Peru, this ETN could have some upside if these companies ever ran into major issues that disrupted operations.
Benefiting from higher natural gas prices
Copper prices aren't the only commodity prices rising these days. Now that Freeport-McMoRan is heavily invested in the deep Gulf of Mexico properties with huge potential natural gas reserves, the price of natural gas could eventually impact the stock in a similar manner.
The stock initially plunged on the deal announcement for the oil and natural gas properties with investors concerned about the price paid for the struggling McMoRan. In addition, the move away from being a copper pure-play caused investors to look toward one of the above options.
In the third quarter, Freeport obtained 20% of revenue from oil and gas operations with the majority of the revenue now tilted toward oil. The $1.3 billion in revenue generated from these operations make for a significant division within the company. The majority of the development projects focused on the ultra-deepwater Gulf of Mexico involve vast natural gas resources that would benefit from higher gas prices.
Lower copper inventories and higher copper prices could push Freeport-McMoRan higher. Investors though should keep an eye on natural gas prices that might not move the stock in the short term, but the significant natural gas assets in the Gulf of Mexico will benefit substantially from more favorable pricing levels. The recent rise in both commodity prices could place Freeport-McMoRan in line for a strong 2014.
Mark Holder has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.