How Chinese Defaults Could Create Opportunity

What commodity is the collateral of last resort for Chinese companies about to default? Copper. What commodity is ironically hitting new price lows this first quarter of 2014 after losing 16% last year? Again, copper.

Companies like Freeport-McMoRan (NYSE: FCX  ) , Glencore Xstrata (LSE: GLEN  ) , BHP Billiton (NYSE: BHP  ) , and Rio Tinto (NYSE: RIO  ) have large portions of their mining portfolio devoted to copper. As copper swings up and down in price, the value of their mining reserves becomes volatile. Their banks, who finance mines with reserve-based lending programs, are not thrilled.

There's plenty of copper in the earth's mantle for sure. These companies know the most efficient way to mine ore, that's a given. The real problem is how well these companies can live with their host countries while managing prices in globally financed markets.

How much is there?
According to the U.S. Geological Survey, there is over 3 billion tons of copper on land, not counting what is in seabeds. World production for copper in 2012 was about 17 million tons on about 680 million tons of developed reserves. U.S. consumption is about 1.7 million tons per year and rising at about 2-3% per year. The U.S. imports about 35% of its industrial copper consumption. Even Chinese consumption is up over 40% year on year for this first quarter of 2014.

So, for investors in copper mines, rest assured there is plenty of copper to go around. There is also steady demand for copper in everything from building materials to weather satellites.

Where is it mined?
Chile, Australia, and Peru boast the largest reserves and production levels. These mines produce at maximum levels in ore grades that are beginning to dwindle. This means that the amount of ore in a ton of mined rock is getting smaller and smaller. Production costs are thus rising for this reason alone.

Now add the cost of political instability to the production cost and you can see even more mine mouth inflation. Bilateral investment treaties between nations usually set up the commercial arrangements for a mining company to operate in a host country. Rio Tinto is a recent example with its Oyu Tolgoi mine in Mongolia.

In Mongolia Rio Tinto has to set up, and leave behind if it exits, an entire infrastructure consisting of airports, railways, housing, and water and sewage treatment -- not to mention the mine itself. Mongolia is using its Rio Tinto copper play to enhance the quality of life and standard of living in its country and thus stabilize the politics. More stable politics mean secure extraction and transport of product to borders, happier workers, less social unrest, and even less government corruption.

Steady demand and politics notwithstanding, the price of copper is another thing. Physical supply and demand are not the only factors that matter. What is beginning to matter more are the value of the largest copper demander's currency, the Chinese renminbi, and the growing influence of financial players in the global copper markets.

Corporate defaults in China, a major importer of copper, and dampening of demand are beginning to reflect the declining value of the renminbi versus the dollar, yen, and rouble. This means that imports will cost more to Chinese firms, even as their exports will become more valuable.

Copper mining companies may actually make up declining copper prices with dollar appreciation against the renminbi. Even if Chinese imports of copper are more renminbi expensive, the government has pledged to expand the electricity grid significantly by 13% -- meaning more copper is required. Demand might not be dampening after all.

What's happening now?
Suppose I am trying to make payroll at my factory in China. I'm tapped out of loans and have to make some big scheduled debt payments. What do I do? I go to a Chinese trust and trading company. There I can get a letter of credit, import copper, use the copper as collateral, and borrow renminbi to pay my workers. In the meantime the copper arrives, I take possession, and sell it to the highest bidder.

Now copper prices are falling. My bank doesn't return my phone calls. No wait, I do get a call from my bank -- they are calling in my loans. As banks call in my copper collateralized loans, I have to sell my copper at any price. Everyone I know is doing this! We have all created a glut in copper, even as demand for copper is also dropping like a rock, for the moment. Not only that but loan rates are climbing now as defaults loom. This is one result of the financialization of copper globally.

What's a Fool to do?
As usual I look at the long run. I look for long-term bargains as Glencore, Rio Tinto, BHP, and Freeport-McMoRan prices dip in tune with Chinese defaults, temporary supply bursts, and demand slumps. As the Chinese default drama continues to unfold, the U.S. dollar will become more valuable against the renminbi. Companies that supply U.S. metal demand know this and are preparing with greater mining and refining efficiency.

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