Has Copper’s Down-Cycle Ended?

Copper prices have made a strong recovery amid an improved economic environment and a drop in inventory levels.

Jul 9, 2014 at 3:57PM

Copper prices, which lost about a third of their value due to a supply glut, have made a strong comeback recently. Although prices are still down about 5% year to date, copper has still staged a strong recovery given the fact it lost 10% in the first quarter of the year. Earlier this month, copper prices vaulted to a 16-week high on the London Metal Exchange (LME) after some encouraging economic data from China. The jump comes after the metal climbed 5.9% in the second quarter. While the gains are being driven by an improving economic environment, a fall in inventory levels at the LME to a six-year low has also boosted prices. So has copper's down-cycle ended?

Dreadful start to the year
At the beginning of the year, it looked very likely that copper prices would once again feel the heat. Indeed, back in April, I had been bearish on copper, expecting a further fall.

Copper prices, which fell 7.4% in 2013 due to the fundamental imbalance and tepid demand, plunged 10% in the first quarter of the year as both the U.S. and Chinese economy showed signs of a slowdown. Adding to the woes were concerns over China's financing deals backed by copper. Copper prices in March fell to a multi-year low after a Chinese solar panel maker defaulted on its bond. As discussed in an earlier article, trade financing deals in China allow companies that find it difficult to secure loans from banks to keep industrial metals as collateral in lieu of loans. So when a Chinese solar company defaulted there were concerns that more companies could default, triggering large-scale liquidations of copper.

Copper rebounds
Last month, I had noted in an article that copper was staging a mild recovery. The recovery has continued as the demand for the industrial metal picked-up, thanks to the accelerating pace of economic activity in the U.S. Meanwhile in China, in order to allay global concerns following the debt default, Beijing announced its 'mini-stimulus' measures to shore up the economy. Copper prices have also risen as inventory levels at the LME fell to a six-year low.

Fall in LME inventories
The fall in LME inventories is due to a series of worldwide production disruptions this year. According to the International Copper Study Group, copper mines witnessed the lowest number of production disruptions in nearly a decade in 2013. This was the main reason why total mined production jumped 8% to 18 million tons in 2013. However, this is not the case this year.

One of the key factors helping copper to stage a recovery was Indonesia's decision to put an export ban on mineral ores earlier this year. Indonesia's decision to place a ban on copper concentrate exports has hit Freeport-McMoRan's (NYSE:FCX) production facility in the country badly. The plant has been operating at a mere 45% of its production capacity while the production of copper concentrate has fallen to 3,150 tons per day. Last week, Newmont Mining Corporation (NYSE:NEM) said that it will seek international arbitration over this issue; however, Freeport-McMoRan is trying to sort out the matter through talks with the Indonesian government.

Earlier this year, production at Anglo America's Los Bronces mine near Santiago had to be suspended for a day due to discontent contract workers. Likewise, production at Glencore Xstrata's Tintaya-Antapaccay mine in Peru was suspended for two days due to a strike.

In March, China's leading copper miner, Jinchuan Group had to cut down its annual output of copper by 100,000 tons due to an equipment failure in a furnace at the Gansu smelter.

As a result of these production disruptions, inventory levels at the London Metal Exchange have fallen sharply. LME's stock chart shows that the inventories have fallen from about 350,000 tons to just under 160,000 tons by the first week of July.

Production to get squeezed in the longer term
Additionally, in the longer term, global production of copper is expected to get further squeezed. According to Ernst and Young, the copper market is expected to fall into a deficit from 2016 due to tighter supply.

The lack of discoveries of major copper pits that are economical to mine, falling copper ore grades, rising costs of energy, water scarcity, and deepening mines are some of the factors that are likely to limit the copper production, the consulting firm believes.

Codelco, the world's leading copper miner, produced about 1.62 million tons in 2013, a 1.5% drop from the preceding year due to these reasons.

As a result, prices are expected to move upwards due to scarcity, unlike the early 2000s when a China-led commodity boom boosted the price.

That's the reason why speculators are making bullish bets on copper. According to The Wall Street Journal, money managers as of June 24 were holding 14,325 more bullish contracts than bearish contracts, while a week ago they had more bets on prices going down.

Earlier this year, I was bearish on miners such as Freeport-McMoRan and Southern Copper because they were increasing production despite tepid demand. As I noted in an article last month, Freeport-McMoRan is planning to increase its total copper production by 7% in 2014, while Southern Copper is aiming to increase its copper production capacity from 630,000 tons to 1,175,000 tons by 2017.

While increasing production was seen as bearish for copper prices and miners, that scenario has changed as copper prices have staged a comeback. The miners that are already committed to increasing copper production would benefit from the anticipated copper shortage in the long term.

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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.

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