Economic Data Points to Southern Copper Margin Compression

Copper is the lifeblood of the industrial world. On the surface the copper market appears quite happy. Global copper consumption increased 14% year over year in the first quarter of 2014. Meanwhile, the underlying fundamentals are remarkably sanguine, pointing to future margin compression for Southern Copper (NYSE: SCCO  ) . 

Copper LME Settlement Price Chart

Copper LME Settlement Price data by YCharts

The demand side 
The copper usage increase in the first quarter of 2014 might not be as strong as it looks. For a couple of years, copper prices have been falling along with world GDP growth. China is the second-largest economy in the world, and Chinese-specific issues are worth a second look. 

Specific Chinese industrial indexes are the best way to get around very optimistic official GDP figures. Year over year China's Q1 2014 railway-freight index turned negative, and its electricity production's growth rate is heading south. Also, in the same time frame, residential real estate sales and new constructions were negative.

Ex-China world copper usage only increased 4% year over year in Q1 2014, while world refined production increased 5%. After considering less-than-optimistic industrial figures, China appears to be cooling, and the world's copper production is already close to demand.

The supply side
Rising costs and falling grades are worrying. From 2007 to 2012, copper site mining costs in Chile and Peru rose at a rate far above the world average. It just so happens that Southern Copper's operating mines are in Mexico and Peru, and its exploration projects are in Mexico, Peru, and Chile. Mexico is seeing cost pressure through new taxes designed to counteract falling oil production.

With all these macro challenges, it is not surprising that Southern Copper's year-over-year Q1 2014 earnings before interest, taxes, depreciation, and amortization fell 22.7%, while its revenue only fell by 16.5%. After accounting for rising royalty taxes, Southern Copper's net income fell by an even steeper 34.7%. 

Community activism, rising wage inflation, and energy inflation are pushing up costs in Latin America.  Falling ore grades only add more difficulties.

Southern Copper can do little to fight off these macro trends, but its fat margins give it room to endure margin compression. Its operating cash cost per pound in Q1 2014 net of byproduct credits was a very low $1.02 per pound.

Southern Copper's rivals are not helping
Many of Southern Copper's competitors are large, diversified miners. With copper around $3.15 per pound, it is estimated that 95% of miners are in the money. Ninety-five percent is a great figure compared to the seaborne met-coal markets, where 60% of quality adjusted global production is estimated to be underwater. Even higher cost marginal iron ore producers are underwater.

Copper looks especially attractive compared to many other materials. Vale's (NYSE: VALE  ) Salobo II project is expected to come online any time now, increasing the project's capacity to 200,000 annual tons of copper concentrate. Copper is still an attractive market for Vale to diversify into. It only represented 3.2% of Vale's Q1 2014 adjusted EBITDA.

Freeport-McMoRan Copper & Gold (NYSE: FCX  ) is putting significant capital expenditures into its energy operations, but mining and copper continue to be a major focus. In 2014 it expects that mining will consume 57.8% of its capex. Together its Cerro Verde Mill expansion and Morenci Mill expansion are expected to add 825 million pounds of additional copper capacity per year. Relative to its 2013 production, Freeport-McMoRan is on track to boost copper production by 1 billion pounds annually by 2016.

Teck Resources (NYSE: TCK  ) is another diversified miner with copper assets. Its smaller size, met coal mines, and lack of low-cost assets have severely constricted its profits. Recently Teck laid off 5% of its workforce to spend on its energy investments. The important take for the copper industry is that Teck expects base metals to produce around 66% of its 2014 cash operating profit, and copper is the largest contributor to its base-metal business.

Thanks to favorable copper economics, Southern Copper can expected further competition from fellow miners.

Bottom line
Weak Chinese real estate construction does not help copper demand, and attractive copper margins make the industry attractive for big miners. Investors can expect Southern Copper to face margin compression as it deals with multiple headwinds. Margin compression does not make Southern Copper a bad investment, but the company needs to keep an eye on increased competition from Freeport-McMoRan and Vale.  

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