In an article last month, I had noted (citing a report from Thomson Reuters GFMS) that copper prices could fall further this year as miners such as Freeport-McMoRan Copper & Gold (NYSE:FCX), BHP Billiton (NYSE:BHP), and Southern Copper (NYSE:SCCO) continue to increase their production despite a slowdown in China. Despite the bearish outlook, copper prices have held up well in the past month. In fact, copper prices touched an 11-week high on Tuesday. So what is driving the recovery in copper prices?
Slight recovery after weak start
The supply glut and weakness in global copper demand drowned copper prices by 10% in the first quarter of the year. Additionally, most miners' decisions to ramp up production in 2014 also threatened to create further imbalance in the demand-supply fundamental. Freeport has plans to increase its total copper production by 7% in 2014. Last month, the company said that at its biggest U.S. mine, Morenci, it was expanding mining and milling capacity to process additional sulfide ores identified through exploratory drilling. The company expects Morenci's copper production to reach 1 billion pounds in 2015, compared with 564 million pounds in 2013.
Southern Copper reported last month that its first-quarter copper mine production rose 9.2%. The company said that it is continuing with the development of its important capital expansion program, which aims to increase copper production capacity from 630,000 tons to 1,175,000 tons by 2017.
Given the demand/supply imbalance, it was not surprising that Thomson Reuters GFMS warned of another 10% plunge in copper prices. The consultancy firm feared that copper prices could sink under $6,000 per ton level during the second half of the year. However, copper prices have surprisingly held up well.
Copper prices have pared some of their losses from earlier in the year and started to hover around $7,000 per ton as the demand outlook began looking far more promising.
Two factors have played a significant role behind copper's resilient comeback in a very short span of time.
First is the improving macroeconomic environment, driven by a recovery in the U.S. and some encouraging economic data from China. The second factor is falling inventory levels at the London Metal Exchange.
Improving U.S. economic outlook & mild recovery in China
The U.S. economy is showing signs of steady economic recovery after a sluggish first quarter, which was affected by harsh weather conditions. Recent housing data and auto sales manufacturing data underpin the fact that the U.S. economy is gaining momentum in the second quarter. Retail sales were surprisingly flat in April, but the sales for the previous month (March) were upwardly revised to 1.5%; that was the biggest jump since March 2010. This bodes well for copper as it has applications in wide-ranging industries from construction to electronic appliances and the automobile sector.
In China, after a series of disappointing economic indicators, manufacturing activity finally showed some improvement in May although the pace of recovery still signals contraction. The most recent HSBC preliminary manufacturing PMI data showed that manufacturing activities in China expanded at its fastest pace in last four months in May.
Falling inventories level at the LME
As I discussed in few of my earlier articles on copper, the major reason why prices have been under pressure since the financial crisis of 2008/2009 is overproduction of the red metal. When prices peaked in 2011 due to a China-led commodity boom, global miners started ramping up production. However, the demand for industrial metals started to slow down as the global economic momentum decelerated after 2011. As a result, copper prices started to weaken even as global inventory level started to pile up.
However, the situation has now changed. As Indonesia has announced ban on raw-material exports in order to make domestic firms focus more on vertical integration, China, the Southeast Asian country's biggest unprocessed mineral importer, is witnessing scarcity.
Ever since Indonesia announced a ban on exports of unprocessed minerals starting on Jan. 12, 2014, Freeport Indonesia is operating at only 45% of its production capacity even as production of copper concentrate plunged to 3,150 tons a day.
Amid a drop in imports from Indonesia and improving domestic demand, China's State Reserve Bureau has been reported to have purchased 200,000 tons of copper in recent times, according to TD Securities.
Moreover, the inventory levels at the LME facilities have dropped below 200,000 tons. LME currently has an inventory of level of around 175,850 tons, the lowest level recorded since October 2008.
According to TD Securities, on-warrant copper inventory, which is the stock actually accessible to buyers, has fallen to around 100,000 tons. This is the lowest level recorded since May 2008.
These recent developments will come as a huge relief for copper miners. As most miners have been committed to ramping up their productions, lower prices would have hurt their cash flows. While the outlook for copper prices has not improved dramatically, the recent developments have at least provided some support to prices.
Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.
Varun Chandan Arora 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.